Lender Beware: Ignore Suspicious Activity at Your Own Peril

Both federal law and Sentinel's contracts with its customers required that the securities purchased with customer funds be held in segregated accounts. Further, Sentinel was forbidden from pledging the customer assets as collateral for BNYM's loans. As the securities market became shaky in 2007, Sentinel's trading losses mounted and it was unable to maintain its collateral with the bank and meet its customers' demands for redemption of their securities. Halting redemptions and owing BNYM $312 million, Sentinel commenced a Chapter 11 bankruptcy case.

The Bankruptcy Case

In the bankruptcy case, BNYM attempted to assert a secured claim for $312 million so that it could liquidate the collateral that Sentinel had pledged to secure the loan. A Chapter 11 trustee was appointed by the court to take over control of Sentinel. The trustee rejected the bank's secured claim and asserted that transfers of the customer's assets to accounts that Sentinel used to collateralize BNYM's loans constituted fraudulent transfers that could be avoided pursuant to Bankruptcy Code section 548(A)(1)(a).

Under Bankruptcy Code section 548(c), BNYM would have a defense to the fraudulent transfer action if it had received the pledge of Sentinel's customer's assets “in good faith.” Good faith is lacking, however, if the bank had “inquiry notice.” The Seventh Circuit explained that “[t]he term signifies awareness of suspicious facts that would have led a reasonable firm, acting diligently, to investigate further and by doing so discover wrongdoing.” The court found that BNYM had information that should have resulted in the requisite suspicion.

The smoking gun was a note from a managing director at BNYM to other employees of the bank who worked with him on the Sentinel account. In the note, he questioned how the bank could have rights on $300 million of collateral when the entire capital of Sentinel was dramatically less. The note indicated that he assumed that most of the collateral was actually owned by somebody other than Sentinel. The managing director did not receive an answer to his question and there was no further inquiry.

The Seventh Circuit found that the managing director's “puzzlement was enough, given his position in the bank, to place the bank on inquiry notice and thus require it to conduct an investigation of what Sentinel was using to secured a $300 million debt when it had capital of not more than $3 million.” All that is required for inquiry notice is information that would lead a reasonable person to be suspicious enough to investigate. Expounding on this standard, the court 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 due diligence search for possible dirt.”

The Seventh Circuit rejected and reversed the district court's application of the good-faith defense in favor of BNYM, holding that the district court: 1) incorrectly found that the bank wasn't required to conduct an investigation because there were no grounds to believe the bank should have known of Sentinel's misconduct; and 2) erroneously concluded the bank could rely on Sentinel's false assurances that it was allowed to use client's assets as collateral. The Seventh Circuit found that the bank had reason to disbelieve Sentinel's assurances and that an investigation would have shown they were false.

Further, explaining where the lower court got it wrong, the court stated, “[k]nowing or turning a blind eye (refusing to look because of what you fear to see) would have made the bank guilty of fraud, but was not required to establish inquiry notice. And while the [district] judge may have been correct when he said that 'mere negligence ' or ineptitude ' is insufficient to establish inequitable conduct,' it would suffice for inquiry notice.”

Here, there was clearly something suspicious about the security for the bank's loan to Sentinel. How could the collateral be dramatically greater than the total capitalization of the company? Where did it come from?

As the Seventh Circuit stated, “[t]he obvious place was from the company's customer accounts. The bank's failure to follow this obvious lead was a failure to act on inquiry notice.” As a result, BNYM's secured claim goes down the drain because it had inquiry notice of Sentinel's fraud. This is extremely significant since a secured creditor gets paid first from its collateral and that is no longer a possibility for the bank. Nonetheless, the bank still has an unsecured claim for the $312 million it loaned to Sentinel that has not been paid back.

The Seventh Circuit then turned to the question of BNYM's unsecured claim and whether it should apply the doctrine of equitable subordination to the claim. Pursuant to Bankruptcy Code ' 510(c)(1), the priority of a claim can be reduced so that is it subordinated to other claims that would otherwise be of equal or lesser priority. The court stated that this draconian remedy is applied sparingly, since “the defendant's conduct must be not only 'inequitable' but seriously so ('egregious,' 'tantamount to fraud,' and 'willful” are the most common terms employed) and must harm other creditors.”

The court declined to find that BNYM's acceptance of accounts of Sentinel's customers as collateral was tantamount to fraud. To justify the remedy of equitable subordination, the court found that it would be necessary that “the bank believed there was a high probability of fraud and acted deliberately to avoid confirming its suspicion.” The court found that this high standard was not present here. Rather, the court found that the bank had been negligent.

Conclusion

In summary, BNYM's negligence constituted inquiry notice, which resulted in the bank losing its collateral and being rendered an unsecured creditor of Sentinel. Negligence, however, was not adequate to cause the bank's claim to be equitably subordinated.

David Kupetz is a shareholder in SulmeyerKupetz PC. This article also appeared in The Recorder, an ALM sibling publication of this newsletter.