The US Court of Appeals for the Seventh Circuit in Grede v. Bank of New York Mellon Corp. (In re Sentinel Management Group, Inc.), held that suspicion of wrongdoing is sufficient to give a bank inquiry notice of that wrongdoing, barring the bank's defense of good faith in a fraudulent transfer claim. The Seventh Circuit also provided guidance on the standard required for equitable subordination of a non-insider creditor's claim.
Sentinel Management Group, Inc. (Sentinel) was an investment-management firm. Sentinel's strategy was to use cash loaned by individuals or firms and invest that cash in liquid, low-risk securities. Not only did Sentinel make investments on behalf of outside customers, it also had an in-house, Sentinel-owned account, which financed its investments using money borrowed from Bank of New York Mellon Corp and Bank of New York (together BNYM).
Sentinel represented to customers that it would, at all times, maintain customer funds in segregated accounts as required under the Commodity Exchange Act. This meant that, at all times, customer accounts should contain assets equal to the amount Sentinel owed the specific customer. However, beginning in 2007 Sentinel moved some of the assets from its customer accounts into the Sentinel owned accounts. These assets were used as collateral to secure the loan from BNYM to Sentinel.
At some point in 2007, after reviewing a Sentinel collateral report, a BNYM managing director sent an email to other BNMY employees inquiring whether Sentinel really had as much collateral as was listed on the report and suggested that perhaps the collateral was owned by a third party. The bank officer did not receive a direct response to his question, and did not follow up on the inquiry.
Sentinel filed for Chapter 11 in August 2007, and aChapter 11 trustee (Grede) was appointed to the Sentinel estate. BNYM filed a secured claim in the amount of $312 million as Sentinel's only secured creditor. In his investigation, Grede uncovered that Sentinel had fraudulently used assets owned by its customers to collateralize the BNYM loan, and in turn sued BNYM seeking to recover the securities that were pledged as a fraudulent transfer under section 548(c) of the Bankruptcy Code. The trustee alleged that BNYM knew about Sentinels fraudulent use of customer funds and, therefore, BNYM's lien on this collateral was invalid and BNYM's claim was unsecured. Grede also brought claims to equitably subordinate BNYM's claim under section 510(c) of the Bankruptcy Code. BNYM argued that they were protected from avoidance of their claim since the transaction was made in good faith.
The district court ruled that:
BNYM was protected from avoidance since the loan was made in good faith.
Sentinel had not engaged in sufficiently egregious conduct to merit subordination of BNYM's lien on equitable grounds.
Grede appealed, and the Seventh Circuit reversed and remanded the finding to the district court. On remand, the district court again ruled against Grede and issued a supplemental opinion to clarify its earlier findings. Grede appealed again.
The Seventh Circuit ruled that BNYM was precluded from using good faith to defend against the fraudulent transfer claim brought by Grede because BNYM was on inquiry notice of Sentinel's wrongful conduct. The Seventh Circuit also ruled BNYM's claim should not be subject to equitable subordination.
The Seventh Circuit rejected BNYM's defense that the transfer was made in good faith and criticized the district court for misunderstanding the concept of inquiry notice. It held that BNYM's inquiry notice stemmed from its awareness of "specific facts that would have led a reasonable firm, acting diligently, to investigate further and by doing so discover wrongdoing." The financial statements that BNYM had access to clearly raised a red flag, and should have resulted in a further investigation regarding the funds. Because of this inquiry notice, BNYM could not retain the liens on the collateral securing its loan, its claim was unsecured rather than secured, and its good faith defense to the fraudulent transfer claim could not stand.
The Court also ruled that BNYM's loan should not be equitably subordinated. Under section 510(c) of the Bankruptcy Code, the bankruptcy court has the authority to reduce the priority of a claim in bankruptcy in certain cases. Although there is no clear cut standard of what conduct is sufficient to merit equitable subordination, courts are generally in agreement that the conduct must be worse than merely "inequitable," and must rise to the level of harm to other creditors. The Court agreed with the district court and held that the trustee did not satisfy the high standard necessary to merit equitable subordination of its claim. In this case, BNYM acted negligently in not following up on its suspicions of Sentinel's wrongdoing. However, since there was no actual knowledge of wrongdoing, and no proof of fraud or purposeful avoidance of the truth, there was no basis for equitable subordination. Therefore, BNYM's claim should be treated as an unsecured claim on par with the debtor's other unsecured creditors.
This case underlines the importance of proper investigation into suspicious circumstances that may put a lender on inquiry notice. Without this step of investigation, a lender is unable to make a good faith defense to a fraudulent transfer avoidance action. Lenders should be critically aware of any suspicious facts regarding loan transactions and must protect themselves by investigating properly.
The case gives further guidance on the type of conduct necessary to cause equitable subordination. In ruling that mere negligence is not enough to warrant equitable subordination, plaintiffs who seek such treatment of a creditor's claim should be prepared to demonstrate a higher standard of misconduct.