Grede v. Bank of N.Y. Mellon Corp. (In re Sentinel Mgmt. Grp., Inc.)

• Decision Date: 08 January 2016
• Docket Number: No. 15–1039.,15–1039.
• Citation: 809 F.3d 958
• Parties: In re SENTINEL MANAGEMENT GROUP, INC., Debtor. Frederick J. Grede, as Liquidation Trustee of the Sentinel Liquidation Trust, Plaintiff–Appellant, v. Bank of New York Mellon Corp. and Bank of New York, Defendants–Appellees.
• Court: U.S. Court of Appeals — Seventh Circuit

809 F.3d 958

In re SENTINEL MANAGEMENT GROUP, INC., Debtor.Frederick J. Grede, as Liquidation Trustee of the Sentinel Liquidation Trust, Plaintiff–Appellant,

v.Bank of New York Mellon Corp. and Bank of New York, Defendants–Appellees.

No. 15–1039.

United States Court of Appeals, Seventh Circuit.

Argued Nov. 10, 2015.

Decided Jan. 8, 2016.

POSNER, Circuit Judge.

The plaintiff in this case, now in its eighth year, is the trustee of a bankrupt firm named Sentinel Management Group, Inc. Sentinel was what is called a cash-management firm: it invested cash, which had been lent it by persons or firms, in liquid low-risk securities. It also traded on its own account, using money borrowed from Bank of New York Mellon Corp. and Bank of New York (affiliates usually referred to jointly as BNYM) to finance the trades. BNYM required that its loans be secured by its borrowers, of whom Sentinel was one. Not owning enough assets to provide the required security, however, Sentinel pledged securities that it had bought for its customers with their money even though its loans from BNYM were used for trading on its own account—improperly. Federal law (7 U.S.C. §§ 6d(a)(2), 6d(b) ), as well as the contracts between Sentinel and its customers, required the securities to be held in segregated accounts, that is, accounts separated from Sentinel's own assets. Sentinel was forbidden to pledge the assets in the segregated accounts to BNYM as security for BNYM's loans to it.

In August 2007, with the securities markets becoming shaky (the following year, the year of the financial crash, segments of these markets would be even shakier), Sentinel experienced trading losses that prevented it from both maintaining its collateral with BNYM and meeting the demands of its customers for redemption of the securities that Sentinel had bought with their assets. Sentinel used its line of credit with BNYM to meet those demands. By June 2007 its loan balance with BNYM was $573 million; two months later it halted redemptions to its customers and declared bankruptcy, owing BNYM $312 million. A BNYM executive notified Sentinel that because of its inability to repay the bank's loan the bank planned to liquidate the collateral that Sentinel had pledged to secure the loan. The bankruptcy trustee (Grede, the plaintiff in our case) believed that the liquidation would deny Sentinel's customers more than $500 million in redemptions. He refused to classify the bank as a senior secured creditor with respect to the $312 million that the bankrupt Sentinel owed it. He considered the transfers of customer assets to accounts that Sentinel could (and did) use to collateralize its loans from BNYM to be fraudulent transfers, unlawful under 11 U.S.C. § 548(a)(1)(A).

The bank would have been in the clear had it accepted the pledge of the assets "in good faith," 11 U.S.C. § 548(c), but it would not have been acting in good faith had it had what's called "inquiry notice." In re Sentinel Management Group, Inc., 728 F.3d 660, 668 n. 2 (7th Cir.2013). The term signifies awareness of suspicious facts that would have led a reasonable firm, acting diligently, to investigate further and by doing so discover wrongdoing. In re M & L Business Machine Co., 84 F.3d 1330, 1335–38 (10th Cir.1996) ; In re Sherman, 67 F.3d 1348, 1355 (8th Cir.1995) ; In re Agricultural Research & Technology Group, Inc., 916 F.2d 528, 535–36 (9th Cir.1990). The trustee believed that officials of BNYM had been aware of suspicious facts that should have led them to investigate, and that an investigation would have revealed that the bank could not in good faith accept assets of Sentinel's customers as security for the bank's loans to Sentinel.

The district judge conducted a seventeen-day bench trial that convinced him that Sentinel was in the clear—that it had not been shown to have intended to defraud its customers, in violation of 11 U.S.C. § 548(a)(1)(A), when it transferred their segregated funds into clearing accounts, where they became collateral for the bank's loans to Sentinel. He therefore dismissed the trustee's claim against the bank. A panel of this court reversed, however, holding that Sentinel had made fraudulent transfers and instructing the district judge to decide on remand whether BNYM had been on inquiry notice in its dealings with Sentinel. In re Sentinel Management Group, Inc., supra, 728 F.3d at 666–68.

But on remand the judge neither conducted an evidentiary hearing nor made additional findings. Instead he issued what he called a "supplemental opinion" intended merely to "clarify" his "prior opinion and findings of fact." He "incorporate[d] by reference [his] earlier opinion on the merits and the Seventh Circuit's opinion" that had reversed the earlier decision, without explaining how he could incorporate both an opinion that had been reversed and the opinion reversing it.

The supplemental opinion reveals a misunderstanding of the concept of inquiry notice. The opinion suggests that the bank, as long as it did not believe that Sentinel had pledged customers' assets to secure its loans without the customers' permission, was entitled to accept that security for its loans without any investigation. That's incorrect, because 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. See In re Sentinel Management Group, Inc., supra, 728 F.3d at 668 n. 2 ; In re M & L Business Machine Co., Inc., supra, 84 F.3d at 1338.

That the bank had information that should have created the requisite suspicion is illustrated by a note of Mark Rogers, the bank's Managing Director of Financial Institutions Credit, to other employees of the bank who like him worked on the Sentinel account. Rogers was responding to a message, from one of those other employees, that had listed Sentinel's collateral. The list puzzled Rogers. He responded: "How can they [i.e., Sentinel] have so much collateral? With less than $20MM [i.e., 20 million dollars] in capital I have to assume most of this collateral is for somebody else's benefit. Do we really have rights on the whole $300MM?" (Actually the "$20MM in capital" to which Rogers referred was incorrect; the correct figure was between $2 and $3 million.) The "somebody else" is an obvious reference to Sentinel's customers, owners of the accounts held by Sentinel; it was their money that was being used—improperly—to secure the bank's loans to Sentinel. Rogers' 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 secure a $300 million debt when it had capital of no more than $3 million.

He received a nonresponsive answer to the question in his note: "We have a clearing agreement [with Sentinel] which gives us a full lien on the box position outlined below." There was no further inquiry.

The district judge said that "Rogers did not claim he knew or believed that all the collateral was for somebody else's benefit." True, but he was suspicious, and that was enough to place him on notice of a possible fraud and so require that he or others at the bank investigate. In fact it was more than enough. Notice that because of the recipient's obtuseness fails to trigger suspicion is nevertheless sufficient to create inquiry notice because all that is required to trigger it is information that would cause a reasonable person to be suspicious enough to investigate.

The district judge acknowledged that the bank had in its possession documents that would show, on even a casual perusal, that Sentinel lacked authority to pledge all the assets that it pledged to the bank to secure the bank's loans to it. But he said that the bank wasn't required to conduct an investigation because there were no "grounds to believe that [the] bank should have known of the misconduct of its borrower." BNYM had Sentinel's assurances that it "was allowed to use client[s'] segregated funds as collateral," and on the basis of those assurances the judge concluded that "any inquiry BNYM might have made would likely have been fruitless, as BNYM believed, even to its own detriment, the lies" told by Sentinel's CEO. But Rogers had a reason to disbelieve Sentinel's assurances, and an investigation would have discovered their falsity.

The district judge noted that Rogers "came closer to an affirmative statement when he ‘assumed’ that most of the collateral was for somebody else's benefit, but this too was not an assertion of belief or knowledge." But the assumption was at least a suspicion, based on evidence, and it should have prompted an investigation.

The judge went on to say that "assuming arguendo that Rogers knew, rather than guessed, that some portion of the collateral was posted for the benefit of insiders, he did not assume that all of it came from the accounts of Sentinel's clients." But if some of it did, and Rogers knew it, he knew there was fraud. Again the judge missed the point when he said that the bank "neither knew nor turned a blind eye to the improper actions of Sentinel." Knowing 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 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.

He said there was no evidence that anyone agreed with Rogers that there was something fishy about the security for the bank's loan to Sentinel. We don't believe it. The bank had lent approximately $300 million to a company that had capital equal to roughly 1/150th of that amount. Yet the company had been able to secure the entire loan. Where could that security have come from? The obvious place was the...