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“Inquiry Notice” of Borrower’s Fraud Voids Bank’s Security for $312 Million Loan

The Seventh Circuit Court of Appeals recently voided Bank of New York Mellon’s (“BNYM”) security for its $312 million dollar loan to Sentinel Management Group because the bank was aware of suspicious facts that should have led it to investigate whether Sentinel had authority to pledge securities to the bank. The case is Grede v. Bank of New York Mellon Corp. and Bank of New York (In re Sentinel Management Group, Inc.), Case No. 15-1039 (7th Cir. January 8, 2016). Sentinel was a cash management firm, investing cash which had been lent to it in liquid, low-risk securities. Sentinel also traded on its own account using money borrowed from BNYM to finance the trades. To secure its loan from BNYM, Sentinel pledged securities that it had bought for its customers with their money even though Sentinel’s loans from BNYM were used to trade on Sentinel’s own account. Sentinel was forbidden to pledge these securities to BNYM as security for BNYM’s loans to it. Sentinel experienced trading losses that prevented it from maintaining its collateral with BNYM and meeting the demands of Sentinel’s customers for redemption of the securities that Sentinel had bought with their assets. Sentinel used its line of credit with BNYM to meet redemption demands. When Sentinel declared bankruptcy, it owed BNYM $312 million. BNYM notified Sentinel that, because of Sentinel’s inability to repay BNYM’s loan, the bank planned to liquidate the collateral that Sentinel had pledged to secure the loan. Sentinel’s trustee refused to classify BNYM as a secured creditor with respect to the $312 million Sentinel owed it, asserting that Sentinel’s transfers of customer accounts to BNYM to collateralize Sentinel’s loans were fraudulent transfers under 11 U.S.C. 548(a)(1)(A). The Seventh Circuit noted that the bank would have been in the clear had it accepted the pledge of assets “in good faith” under 11 U.S.C. 548(c), but BNYM would not have been acting in good faith had it had “inquiry notice.” Inquiry notice is “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.” The Court held that BNYM was on inquiry notice to further investigate whether Sentinel could pledge the securities because the evidence showed that the bank, before it accepted the collateral, questioned whether Sentinel could pledge the securities. Therefore, BNYM was an unsecured creditor with respect to the $312 million Sentinel owed it.

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