Norman D. Farnam
Douglas C. Scriver
In a recent bankruptcy action, the Court of Appeals for the Seventh Circuit (which covers Illinois, Indiana and Wisconsin) stripped a bank’s senior secured creditor status, reducing it to an unsecured creditor. The Court held that the bank was on “inquiry notice” of its borrower’s misrepresentations when the bank originated its loan. Therefore, the bank had a duty to investigate and discover the debtor’s wrongdoing. The bank’s failure to do so deprived it of its security interest.
Sentinel Management Group, Inc. (“Sentinel”) was a cash management firm which, in addition to trading on its own behalf, invested its customers’ funds. Sentinel used a line of credit from the Bank of New York Mellon Corp. and Bank of New York (“BNYM”) to fund its own investments and to redeem customer investments. It secured repayment of the line of credit by pledging securities it purchased on its customers’ behalf. The pledge violated Sentinel’s agreements with its customers and federal law requiring account segregation.
At the time BNYM extended credit to Sentinel, BNYM’s Managing Director of Financial Institutions Credit questioned the pledge in an internal email: “How can they [i.e., Sentinel] have so much collateral? With less than $20MM 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?” He received an evasive response from other bank employees and the inquiry was dropped.
Sentinel suffered trading losses and could not both maintain its collateral with BNYM and redeem securities to its customers that Sentinel had bought with their assets. For a time, Sentinel used its BNYM line of credit to meet its customers’ demands, but Sentinel eventually ran out of money. It halted redemptions to its customers and declared bankruptcy, owing BNYM $312 million. In bankruptcy, the trustee refused to classify the bank as a senior secured creditor. The trustee considered the transfers of customer assets to accounts that Sentinel used to collateralize its BNYM loan to be fraudulent.
The Court of Appeals agreed with the trustee’s treatment of the bank’s claim. The Court determined that BNYM had “inquiry notice” of Sentinel’s wrongdoing – i.e., the bank had an “awareness of suspicious facts that would have led a reasonable firm, acting diligently, to investigate further and by doing so discover wrongdoing.” In addition to the internal email questioning the validity of the pledge, the Court noted that BNYM possessed documents that showed, “on even a casual perusal,” that Sentinel lacked authority to pledge the assets it did. Because there was sufficient evidence to put a reasonable lender on notice that something might be wrong with the pledge, the Court took away BNYM’s security for its $312 million loan.
The significance of In re Sentinel Management Group, Inc. is that the bank did not have actual knowledge of any borrower fraud or wrongdoing. The Court of Appeals emphasized that whether the bank knew of any wrongdoing was irrelevant. Instead, BNYM failed to investigate when presented with facts a reasonable lender would have regarded as suspicious. The bank’s decision to originate the loan and to turn a blind eye to the borrower’s dubious pledge resulted in punishment in bankruptcy through the loss of its secured status.
The upshot is that banks must follow up when they suspect borrower impropriety. The bank cannot be so eager to make loans that it chooses to ignore evidence of borrower fraud or wrongdoing. Lack of knowledge will not be a defense when the truth easily could have been discovered.
If you have any questions about how the information in this article may affect you or your business, please contact Norm Farnam at email@example.com or Doug Scriver at firstname.lastname@example.org or (608) 257-2281 or your Stroud attorney.
DISCLAIMER: The information in this article is provided for general informational purposes only, is not necessarily updated to account for changes in the law, and should not be considered tax or legal advice. This article is not intended to create, nor does the receipt of it constitute, an attorney-client relationship. You should consult with your own legal and/or financial advisors for legal and tax advice tailored to your specific circumstances.