Suspicious Minds: Lender's Failure to Investigate and Search For "Possible Dirt" Leads to Fraudulent Transfer Liability, but Not Equitable Subordination

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[1]In a decision that deserves the close attention of secured lenders, the U.S. Court of Appeals for the Seventh Circuit held that a bank’s awareness of suspicious facts about the collateral pledged to secure its loan required bank officials to perform a diligent investigation of possible fraud or other wrongdoing by its borrower. The failure to conduct such an investigation scuttled the bank’s good-faith defense under § 548(c) of the Bankruptcy Code and ultimately left the bank’s claim unsecured after the borrower’s transfer of funds, from segregated to lienable accounts, was avoided as an intentional fraudulent transfer. The court went on to hold, however, that the bank’s conduct did not rise to the level of culpability necessary for the equitable subordination of its now-unsecured claim.[2]

Sentinel Management Group, Inc. was an investment management firm that invested in liquid, low-risk securities. Its customers consisted primarily of futures commission merchants, hedge funds and commodity pools. Sentinel also traded securities for its own account. Sentinel financed its trades with funds borrowed from the bank under a line of credit secured by assets held in lienable clearing accounts that Sentinel used to buy and sell securities.[3] Sentinel was required by law and contract to hold its customers’ securities in segregated accounts; the assets in those segregated customer accounts could not be pledged as collateral for the bank’s loan.[4] Faced with trading losses and liquidity issues at the outset of the financial crisis in 2007, Sentinel transferred funds from segregated customer accounts to the lienable clearing accounts, which thereby became collateral subject to the bank’s lien.[5] At the time of Sentinel’s bankruptcy filing, the bank was owed $312 million, and Sentinel’s customers were owed more than $500 million in redemption claims.[6]

The liquidation trustee brought various claims against the bank, including claims to avoid the transfers of the customer assets from the segregated accounts to the clearing accounts as transfers made with actual intent to hinder, delay or defraud creditors,[7] to equitably subordinate the bank’s claim.[8] Having previously held in a 2003 decision that transfers of funds from segregated accounts to clearing accounts were fraudulent transfers,[9] the Seventh Circuit here focused on whether the bank was on “inquiry notice” of Sentinel’s fraudulent activity and therefore precluded from relying on the “good faith” under § 548(c) of the Bankruptcy Code.[10]

Judge Posner, writing for the court, explained that the concept of “inquiry notice” turns on the “awareness of suspicious facts that would have led a reasonable firm, acting diligently, to investigate further and by doing so discover wrongdoing.”[11]Knowledge of fraud or wrongdoing is not required; rather, all that is necessary is “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.”[12] The court certainly believed that at the very least, the bank’s officers should have been suspicious enough to undertake a dirt-digging expedition here. The most damning evidence was an email from a managing director at the bank, who, in response to a report listing the bank’s collateral, stated, “I have to assume most of this collateral is for somebody else’s benefit. Do we really have rights on the whole $300MM?”[13] The officer received a nonresponsive answer, and made no further inquiry. To the court, the officer’s “puzzlement” was sufficient to put the bank on inquiry notice and require it to investigate the source of the collateral Sentinel was using to secure its $300 million of debt, especially when the bank was aware that Sentinel only had capital of $3 million or less.[14] The failure to investigate, despite the officer’s suspicions that something was amiss with the bank’s collateral position, doomed the bank’s good-faith defense under § 548(c).

In contrast, the court held that although the bank’s “secured claim goes down the drain because it was on inquiry notice of Sentinel’s fraud,”[15] the bank’s conduct was not so egregious as to warrant the equitable subordination of its now-general unsecured claim. Characterizing the remedy of equitable subordination as “Draconian,”[16] the court explained that before deciding to equitably subordinate a creditor’s claim, most courts require serious misconduct — actions that are “egregious,” “willful” or “tantamount to fraud” — that also results in harm to other creditors.[17] In order to satisfy this high standard in this case, the court concluded, it would be necessary to prove that the bank’s acceptance of the segregated customer assets as collateral was “tantamount to fraud.”[18] Under the facts of this case, the evidence would have to show that “the bank believed there was a high probability of fraud and acted deliberately to avoid confirming its suspicion.”[19] The bank officer’s failure to follow through on his suspicions about the collateral, while sufficient in the eyes of the court to establish “inquiry notice” for purposes of § 548(c) of the Bankruptcy Code, was not the type of willful or deliberate act necessary to justify equitable subordination of the bank’s claim.[20]

The bank’s success in defeating the equitable subordination claim most assuredly does not compensate for the loss of its secured lender status by virtue of the trustee’s fraudulent transfer action. Sentinel thus serves as an important reminder that lenders must remain both diligent and vigilant when it comes to protecting their secured position. When suspicions are raised that a borrower may be up to no good, the sooner a lender can discover and clean up any “dirt” it might find, the better.


[1] The views expressed herein are those of the author and not necessarily those of Blank Rome LLP or any of its clients.

[2] Grede v. Bank of New York Mellon Corp. (In re Sentinel Management Group Inc.), 809 F.3d 958 (7th Cir. 2016) (“Sentinel II”).

[3] In re Sentinel Management Group Inc., 728 F.3d 660, 662-63 (7th Cir. 2013) (“Sentinel I”).

[4] Sentinel II, 809 F.3d at 960.

[5] Id. at 960-61.

[6] Id. at 960.

[7] 11 U.S.C. § 548(a)(1)(A).

[8] 11 U.S.C. § 510(c).

[9] After a 17-day bench trial, the U.S. District Court for the Northern District of Illinois held in favor of the bank, but in a 2003 decision the Seventh Circuit reversed, holding that Sentinel’s transfers of segregated funds to the clearing accounts were fraudulent. The court remanded the case for further proceedings, including a determination of whether the bank gave value in good faith in exchange for the challenged transfers. Sentinel I, 728 F.3d at 668-69 n.2. In Sentinel II, the Seventh Circuit reviewed on appeal the district court’s supplemental opinion addressing the issues of inquiry notice under § 548(c) and equitable subordination under § 510(c) of the Bankruptcy Code. Sentinel II, 809 F.3d at 961-62.

[10] See 11 U.S.C. § 548(c) (“A transferee ... that takes for value and in good faith has a lien on or may retain any interest transferred ... to the extent that such transferee ... gave value to the debtor in exchange for such transfer....”).

[11] Sentinel II, 809 F.3d at 961.

[12] Id. at 962.

[13] Id.

[14] Id.

[15] Id. at 964.

[16] Id. at 965.

[17] Id.

[18] Id.

[19] Id.

[20] Id.

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“Suspicious Minds: Lender's Failure to Investigate and Search for ‘Possible Dirt’ Leads to Fraudulent Transfer Liability, but Not Equitable Subordination,” by Jeffrey Rhodes was published in the May 2016 edition of Commercial Fraud, an ABI Committee Newsletter. Reprinted with permission.

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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