The Seventh Circuit Revisits Line Between Inquiry Notice and Equitable Subordination

In a Jan. 8, 2016, opinion, the U.S. Court of Appeals for the Seventh Circuit reminded secured lenders of their due diligence obligations when choosing to extend credit. In Grede v. Bank of New York Mellon Corp. and Bank of New York (Grede), a panel of the Seventh Circuit held that Bank of New York and its successor, Bank of New York Mellon Corporation, (collectively, the bank) were on inquiry notice of their obligation to investigate the provenance of the collateral used by Sentinel Management Group, Inc. to secure several hundred million dollars in loans made to Sentinel.[1] The bank’s failure to act on that inquiry notice, the court held, was sufficient to deny the bank its secured status.[2] That failure, though, was insufficient in itself to justify any equitable subordination of the bank’s claim.[3]

The Secured Claim

A detailed background of the arrangement between the bank and Sentinel is set out in a prior opinion from the Seventh Circuit.[4] Sentinel acted as an investment advisor to regulated and unregulated institutional investors, but also traded on its own account.[5] In order to maintain high liquidity in its customers’ accounts, Sentinel maintained an overnight lending facility with the bank that was secured by a series of clearing accounts.[6] The arrangement allowed Sentinel to cover its customers’ redemptions immediately without waiting for the securities in those accounts to actually sell.[7] Sentinel was responsible for maintaining appropriate segregation of its customers’ accounts from any other accounts it held, including the clearing accounts and the accounts it used to trade for its own benefit.[8] As Sentinel’s own trading activities increased, it began using its overnight loan facility to cover haircuts it would have otherwise taken on certain transactions.[9]

The bank called for increasing amounts of collateral to be deposited into the clearing accounts in which it was secured, leading Sentinel to commingle its customers’ segregated assets into the clearing accounts.[10] The deficit between what Sentinel was required to keep in segregation and what was actually segregated ballooned to $935 million.[11] The segregation deficit eventually settled at $700 million when Sentinel halted operations.[12] In order to forestall the bank’s liquidation of the collateral in the clearing accounts, Sentinel filed for bankruptcy.[13] After Sentinel’s liquidating plan was confirmed, the bank filed a $312 million claim, alleging its secured status.[14]

The Fraudulent Transfer Claim and the Inquiry Notice Defense

The trustee of Sentinel’s liquidating trust, Frederick Grede (the trustee), pursued a number of avenues of recovery, two of which targeted the bank. [15] The trustee sought to avoid the bank’s security interest in the clearing accounts, asserting fraudulent transfer claims under § 548(a)(1)(A) of the Bankruptcy Code and Illinois state law, as well as a preference claim under § 547(c).[16]

When it last addressed these issues in the trustee’s adversary proceeding in 2013, the Seventh Circuit found that Sentinel’s use of customer assets to secure the overnight loans constituted fraudulent transfers, and remanded to the district court for a determination of whether the bank could maintain a good-faith defense of its secured position under § 548(c), or whether the bank had “sufficient knowledge to place [it] on inquiry notice of the debtor’s possible insolvency.”[17]

Signaling its displeasure with the district court’s decision not to hold any further hearings or make any further findings of fact after the 2013 remand, the Seventh Circuit held in Grede that the trustee had presented ample evidence in the original 17-day trial to establish that the bank had sufficient information to put it on inquiry notice of Sentinel’s potential fraudulent conduct.[18] The court highlighted an internal note from one of the bank’s managing directors, which asked how the bank could have any rights in $300 million in collateral when Sentinel was reporting only a fraction of that amount in its own capital.[19] Combined with its 2013 fraudulent transfer ruling, the court’s holding that the bank was on inquiry notice of such fraudulent conduct deprived the bank of its secured status.

In summary fashion, the court quickly dismissed the bank’s additional defenses to losing its secured status under §§ 550(b)(1) and 550(d). Rejecting the bank’s good-faith defense under § 550(b)(1), Judge Posner noted that the avoidable fraudulent transfer was the security interest granted to the bank in Sentinel’s customers’ securities, not the transfer of the securities themselves, making § 550(b)(1) inapplicable.[20] The court was equally dismissive of the bank’s claim that avoiding the bank’s security interest would result in a windfall to the trustee, noting that the bank still had its claim arising out of the loans.[21]

The Equitable Subordination Claim

In his adversary proceeding against the bank, the trustee also argued that the bank’s failure to inquire into the nature of the collateral pledged by Sentinel justified equitable subordination of the bank’s claim under § 510(c).[22] Rejecting that argument, the court drew a clear line between the bank’s negligence in failing to act on inquiry notice, which supported avoidance of the bank’s secured status, and the higher standard of conduct sufficiently “egregious, tantamount to fraud, and willful” to warrant the “Draconian remedy” of equitable subordination.[23] Despite the trustee’s argument to the contrary, the Seventh Circuit held that the facts giving rise to inquiry notice were not necessarily sufficient to support a finding of fraud.[24]

The Takeaway

The net effect of the Seventh Circuit’s ruling was to place the bank on equal footing with the investors it would have otherwise deprived of a recovery had it successfully liquidated its collateral pre-petition. Although the dispute arose out of Sentinel’s long-running bankruptcy case, the court’s reasoning is equally applicable to secured lenders outside the bankruptcy context. Grede serves as a reminder that secured lenders cannot simply rest on the representations and warranties made by their borrowers when posting collateral. Rather, they have a duty to investigate the potential fraudulent conduct of their borrowers when they have sufficient information to cause a reasonable person to dig deeper.