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Secured lender loses security interest because it was on "inquiry notice" of its customer's fraudulent conveyance

February 2, 2016
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On January 8, 2016, the Seventh Circuit ruled that the Bank of New York Mellon Corporation (the Bank) forfeited its first position secured creditor status as to the assets of Sentinel Management Group (Sentinel), a now-defunct investment management firm, because the bank was on “inquiry notice” of Sentinel’s fraudulent pledge of collateral. In re Sentinel Management Group, Inc., No. 15-1039, 2016 WL 98601 (7th Cir. Jan. 8, 2016). In this decision, the Seventh Circuit reversed the district court’s ruling in favor of the Bank and held that the Bank should be treated as an unsecured creditor with respect to Sentinel’s $312 million debt. The Bank was on “inquiry notice” of Sentinel’s fraudulent conduct based on an email sent by a senior bank employee questioning how Sentinel could be in a position to pledge the amount of collateral it presented and other evidence that the Bank should have looked further into whether Sentinel had the right to pledge securities as collateral for its loan. Because the Bank failed to follow up on that “inquiry notice,” the Court ruled that it could not assert a “good faith” defense to Sentinel’s fraudulent transfers. This ruling, authored by Judge Posner, has potentially broad-reaching implications for all lenders.

The Sentinel decision
Sentinel was a cash-management firm—it invested cash, which had been lent to it by persons or firms, for investment in liquid, low-risk securities. The firm also traded on its own account, using money borrowed from the Bank to finance its trading. Sentinel improperly pledged securities that it had bought for its customers with their money as security for its loans.

In August 2007 as the economy began to falter, Sentinel experienced trading losses that left it unable to simultaneously maintain its collateral with the bank and meet the demands of its customers for redemption of their securities. Sentinel filed Chapter 11 and the Bank sought to liquidate the collateral pledged as security for Sentinel’s loan, which included accounts that held Sentinel’s customers’ assets. The bankruptcy trustee refused to recognize the Bank as a senior secured creditor and deemed Sentinel’s transfer of customer assets to accounts that Sentinel used to collateralize its loans to be “fraudulent transfers” in violation of 11 U.S.C. § 548(a)(1)(A).

The bankruptcy statute on fraudulent transfers, 11 U.S.C. § 548(a)(1)(A), allows a bankruptcy trustee to avoid any transfer of an interest in the debtor’s property if the debtor transferred the property “with actual intent to hinder, delay, or defraud” another creditor (granting a security interest constitutes a “transfer”). However, the recipient of the transfer (the Bank) may prevent avoidance if it can establish that it acted in good faith as to the debtor’s transfer. As discussed by the Seventh Circuit, when a recipient is on “inquiry notice”—i.e. notice that a transfer is potentially fraudulent—and fails to act on that notice, it cannot establish the good faith defense.

The Bank argued that it remained entitled to its senior secured creditor status because it accepted Sentinel’s pledge of assets “in good faith.” The Seventh Circuit disagreed, holding that, because the bank was on “inquiry notice” that Sentinel was improperly using its customers’ assets as security, the bank could not establish that it acted with the requisite “good faith.” “Inquiry notice” refers to an awareness of suspicious facts that would lead a reasonable firm, acting diligently, to investigate further to discover wrongful conduct.

The Seventh Circuit held 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—would make him in other words suspicious enough to conduct a diligent search for possible dirt.” 

Critical to the Court’s finding that the Bank was on inquiry notice was a single email from a bank’s Managing Director of Financial Institutions Credit to other bank employees servicing Sentinel’s account, in which the Managing Director questioned how Sentinel could have so much collateral and stated the he assumed most of the collateral is for “somebody else’s” benefit. The Seventh Circuit found that the “somebody else” was an “obvious reference to Sentinel’s customers whose money was being used to secure the Bank’s loans. Accordingly, the Court found the Bank was on inquiry notice, triggering an obligation to investigate what assets Sentinel used to secure its $312 million debt.

The Seventh Circuit found it suspicious that Sentinel’s loans surpassed $300 million while the company only had capital equal to 1/150th of that amount. The Court also held that the Bank knew or should have known that the security for Sentinel’s loans came from the customer accounts and that the failure to follow up on the “obvious lead” created by the Managing Director’s email was a failure to act on inquiry notice. Because the Bank had failed to act on inquiry notice, the Court eliminated its security interest. The Court further held that even if the bank’s “obtuseness” failed to actually trigger suspicion, the “obvious lead” still created “inquiry notice” because it would cause a “reasonable” person to be suspicious enough to investigate.

How does Sentinel impact lenders?
The Sentinel decision highlights the need for lenders to actively supervise the conduct of their customers. While this case arose in the bankruptcy context, its ruling has significance for all claims under the Uniform Fraudulent Transfer Act. Because this ruling could potentially be used to justify removal of a bank’s secured position in a variety of scenarios, lenders should carefully review their policies and practices regarding the administration of customer accounts. When suspicion arises as to a customer’s potentially fraudulent conduct, a lender must conduct due diligence and thoroughly investigate—or risk losing its secured position.

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