Section 548(c) of the Bankruptcy Code entitles the recipient of a fraudulent transfer in certain circumstances to retain a lien on the property received through the debtor’s fraud if the transferee took the property in good faith and for value. The Seventh Circuit recently, In addressing a case where the bankruptcy trustee asserted the recipient of a fraudulent lien did not take in good faith and its claim should be equitably subordinated to unsecured claims, held suspicion, negligence and ineptitude on the part of the claimant to be sufficient to defeat the recipient’s claim that it acted in good faith but insufficient to equitably subordinate the claim. Grede v. Bank of New York Mellon Corp. (In re Sentinel Management Group, Inc.), 809 F.3d 958 (7th Cir. 2016).
In Sentinel, the debtor was a cash management firm which borrowed money from BNYM to funds its operations. Sentinel received money from its customers, which it used to purchase securities for its customers and which it was required by law to maintain in segregated accounts separate from the accts which Sentinel used for its own trading. Sentinel had a capitalization of less than $3 million, but also had securities it had purchased for its customers’ accounts which exceeded $300 million. When securities markets became shaky in the summer of 2007, Sentinel found itself unable to meet both its collateral levels with the bank and its customers’ requests to redeem their securities. Sentinel embarked on a scheme under which it borrowed on its line of credit with the bank to meet its customers’ redemption demands, and transferred its customers’ securities from their segregated accounts into Sentinel’s personal accounts on which the bank held a lien. By transferring customer securities to accounts on which the bank held a lien, Sentinel violated federal law. When Sentinel filed bankruptcy, a dispute arose between the bank and the trustee over whether the bank received its lien in good faith or whether the trustee could avoid the lien under § 548. The district court ruled in favor of the bank, finding the bank’s actual belief that Sentinel had not pledged the securities in question without its customers’ consent, was sufficient to establish it acted in good faith. The Seventh Circuit reversed.
The Seventh Circuit stated the district court’s conclusion was wrong. The court held that inquiry notice, which it defined as “awareness of suspicious facts that would have led a reasonable firm, acting diligently, to investigate further and by doing so discover wrongdoing,” prevents the recipient of a fraudulent transfer from the protections afforded a good faith transferee. The court further stated “inquiry notice is not knowledge of fraud or other wrongdoing but merely knowledge that would lead a reasonable, law-abiding person to inquire further—would make him in other words suspicious enough to conduct a diligent search for possible dirt.” As a result, an actual belief that the transfer is not fraudulent is insufficient if the recipient has knowledge of facts which place him on notice that further investigation is warranted. In this instance, the fact that the debtor’s capital was less than $3 million yet it had the ability to post $300 million of collateral to secure its debt to the bank, were sufficient to place the bank on notice that the debtor was using someone else’s property to collateralize the loan. A memo from a bank employee who worked on the Sentinel account to the bank evidencing “puzzlement” at the source of the collateral and a suspicion that the collateral was owned by parties other than the debtor, was sufficient to require additional investigation on the bank’s part. As a result, the court held the bank did not qualify as a good faith transferee with respect to its lien on securities owned by the debtor’s customers.
The next question before the court was whether the bank’s conduct was sufficient to warrant equitable subordination of its unsecured claim to claims of general unsecured creditors. The trustee argued that the same conduct which prevented the bank from being considered a good faith transferee was sufficient to warrant equitable subordination of its claim. The court disagreed, stating that, while mere negligence or ineptitude may be sufficient to place a transferee on inquiry notice for purposes of a good faith defense, they are insufficient to warrant equitable subordination under § 510(c)(1). In order to warrant equitable subordination, the court held the transferee’s conduct must not only be inequitable but “seriously so,” using the words “egregious,” “tantamount to fraud” and “willful” as the type of conduct required. The bank should have suspected something was amiss, and that was sufficient to eliminate its good faith defense, but because the trustee did not establish the bank knew Sentinel had pledged its customers’ securities without their consent, the court found there was insufficient evidence to equitably subordinate the bank’s unsecured claim.