A recent opinion from the Seventh Circuit Court of Appeals that the Bank of New York Mellon Corp. should be treated as an unsecured creditor for a $312 million loan it made to bankrupt Sentinel Management Group serves as a cautionary tale to lenders to investigate red flags.
The case — In re Sentinel Management Group, Inc. — concerns cash management firm Sentinel, which invested money lent to it by its customers in liquid, low-risk securities. Sentinel also borrowed funds from Bank of New York and Bank of New York Mellon Corp. to trade on its own account. As collateral, Sentinel pledged the securities it had purchased for its customers. This violated federal law as well as Sentinel’s own customer agreements.
Sentinel filed Chapter 11 bankruptcy in 2007, and BNY Mellon asserted a secured claim for $312 million. When BNY Mellon notified the bankruptcy trustee that it planned to liquidate the collateral pledged for the loan, the trustee instituted an adversary proceeding alleging that the transfer of the customers’ securities as collateral for the loan was a fraudulent transfer intended to defraud current or future creditors. A district court found for Sentinel without additional findings of fact, ruling that the company did not intend to defraud its creditors.
On appeal, the Seventh Circuit partially reversed the district court ruling, saying that the lower court should have ascertained if the bank had knowledge that would lead a reasonable person “suspicious enough to conduct a diligent search for possible dirt.” In reviewing the record, the appeals court found evidence that the bank should have put Sentinel on inquiry notice. Nevertheless, the court affirmed the district court’s refusal to subordinate the bank’s unsecured claim because the bank’s “negligence” was not “an adequate basis for imposing equitable subordination.”
The case has been returned to the lower court for further proceedings.
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