The Seventh Circuit is no safe haven for banks holding information that should lead them to suspect that their customers are up to no good.
Circuit Judge Richard A. Posner reversed a Chicago district judge a second time in the chapter 11 liquidation of Sentinel Management Group Inc., a money-manager that improperly used customers’ supposedly segregated funds for its own trading. When the case returned to the Seventh Circuit in August 2013 on a motion for rehearing en banc, a different three-judge panel reversed, saying the trustee “should be able” to void the bank’s lien and recover $312 million paid on a loan.
On remand, District Judge James B. Zagel did not take the hint. In an opinion in December 2014, he once again upheld the security interest, despite evidence that the bank suspected fraud was afoot. Reversing again in an opinion on Jan. 8, Judge Posner said that “the first panel’s opinion may have been unduly deferential in remanding this issue rather than reversing outright.”
The case is about “inquiry notice” and the consequences of ignoring red flags. In the Seventh Circuit, mere negligence in failing to inquire into possible fraud can result in the loss of a bank’s security interest.
Sentinel provided cash-management services and promised customers that their funds would be segregated. Using a secured line of credit with a bank, Sentinel traded for its own account. Following market reverses in 2007, Sentinel began improperly taking customer funds to use as collateral for its own bank loan. After Sentinel filed under chapter 11 in August 2007, the bank had a secured claim for $312 million, collateralized by money that should have been segregated for customers. Sentinel sought a trustee four days after the chapter 11 filing.
Pursuant to Sentinel’s chapter 11 plan, the trustee sued the bank in district court to void the security interest and subordinate the bank’s debt. The trustee contended that transferring customer funds to the bank was a fraudulent transfer with “actual intent” under Section 548(a)(1)(A). The bank could retain the collateral if it was in “good faith” as required by Section 548(c), Judge Posner said.
After a lengthy trial, District Judge Zagel exonerated the bank, saying that an attempt to “stay in business” by stealing from one creditor to pay another represented a motive not constituting intent to defraud. Writing for the appeals court on the first appeal, Circuit Judge John D. Tinder said that “someone who has the best intentions can still possess actual intent to defraud.”
Sending the case back to the district court on remand, Judge Tinder said the bank could raise defenses, such as having made the loan to Sentinel in good faith. He also said the so-called good-faith defense is unavailable to someone with “sufficient knowledge to place him on inquiry notice of the debtor's possible insolvency.”
Judge Tinder went on to add that the bank “will have a very difficult time proving that it was not on inquiry notice of Sentinel's possible insolvency.”
On remand, District Judge Zagel stuck by his guns and let the bank off the hook a second time. When the case came up again, Circuit Judge Posner said that Judge Zagel misunderstood “the concept of inquiry notice.” Establishing an objective standard, he said that inquiry notice “is not knowledge of fraud or other wrongdoing but merely knowledge that would lead a reasonable, law-abiding person to inquire further.”
The damning evidence was a banker’s message to a subordinate asking whether the bank had rights to the collateral and how Sentinel could post $300 million when it only had $20 million in capital. The banker got an evasive answer from the underling, and the inquiry went no further.
That “puzzlement,” according to Judge Posner, was enough to put the bank on inquiry notice. He went on to say that “knowing or turning a blind eye” to misconduct would make the bank guilty of fraud “but was not required to establish inquiry notice.”
Although the bank lost on the fraudulent transfer question, thus voiding its security interest, the second question on appeal dealt with equitable subordination, which the bank won. On that issue, Judge Posner upheld the district court, allowing the bank to retain an unsecured claim for $312 million.
Judge Posner said that reason to suspect wrongdoing is negligent, but negligence is not enough for equitable subordination, which requires conduct that is egregious or tantamount to fraud.
The opinion rejected two other defenses proffered by the bank. Judge Posner said that Section 550(b)(1) does not apply because voiding a lien is not the same as recovering an asset. He also barred the use of Section 550(d) because there was no double recovery by the trustee.
The Sentinel appeals hint at intrigue behind the scenes in the Seventh Circuit. The first time the case came up on appeal, the original three-judge panel upheld Judge Zagel in August 2012. After the trustee filed a motion for rehearing en banc, the three judges withdrew their first opinion, reversed, and remanded in August 2013, as described above. One wonders whether other judges on the circuit suggested to the original panel that they should reconsider to avoid a reversal en banc.
The Jan. 8 opinion is noteworthy because Circuit Judge Frank Easterbrook was on the panel. Judges Posner and Easterbrook often author the Seventh Circuit’s most important bankruptcy opinions. Only Circuit Judge Ilana D. Rovner was on both panels.