Recent Seventh Circuit Ruling Clarifies “Inquiry Notice” Doctrine

January 22, 2016 - Bank of New York Mellon lost priority status for its claim of $312 million in the liquidation of Sentinel Management Group when the 7th Circuit held that it should have suspected Sentinel was misusing customer assets and conducted an investigation into the source of the collateral Sentinel had posted.  The 7th Circuit clarified the doctrine of “inquiry notice” in a bankruptcy proceeding in its decision, and the holding requires firms to be reasonably diligent in investigating any suspicions they have relating to their customers or risk the loss of their security interest in pledged collateral.

Sentinel, a trading firm, had (in violation of federal law) pledged its customers’ securities to Bank of New York Mellon and Bank of New York (“BNYM”) as collateral for $312 million of loans to support Sentinel’s proprietary trading.  Following the bankruptcy, BNYM asserted a senior secured claim against Sentinel based on these pre-petition loans. The bankruptcy trustee, Fredrick J. Grede asserted that the transfer of customer securities to the firm’s clearing account constituted a fraudulent transfer, and that BNYM had not accepted the securities “in good faith” because it was on ‘inquiry notice’ – it was aware of suspicious facts that should have prompted an investigation that would have uncovered Sentinel’s use of its customer’s assets.  The District Court originally ruled that no fraudulent transfer had occurred, and the 7th Circuit reversed that decision on appeal and ruled that Sentinel had made fraudulent transfers, and remanded for determination of if BNYM had been on inquiry notice. After the District Court held that BNYM had not been on inquiry notice, Sentinel’s trustee appealed again to the 7th Circuit.

At stake in a finding that BNYM had not received the securities “in good faith” was the priority of BNYM’s $312 million claim.  If BNYM had received the securities in good faith it was entitled to senior secured status and a full recovery, while if it had not received the securities in good faith it was entitled only to an unsecured claim.

The 7th Circuit held that a company or person is on inquiry notice if they have “knowledge that would lead a reasonable, law-abiding person to inquire further” or would make a reasonable person “suspicious enough to conduct a diligent search for possible dirt.”  It is not necessary that such search actually be done, and that the company did not know of fraud or other wrongdoing is not sufficient to avoid being on inquiry notice.

The 7th Circuit identified a specific email from a BNYM employee, asking how Sentinel was able to provide $300 million in collateral with less than $20 million in capital (and, as the 7th Circuit noted, the actual figure was closer to $2-3 million) as sufficient information for a reasonable person to have begun an investigation.  Furthermore, had BNYM conducted an investigation into how Sentinel was able to provide its collateral, it would have discovered Sentinel was pledging its customers assets based on documents already in the bank’s possession.  BNYM had never conducted such an investigation and had relied on Sentinel’s assurances, but the 7th Circuit held that given the apparent disconnect between Sentinel’s capital and Sentinel’s ability to supply collateral, a reasonable person would have investigated and discovered Sentinel was misrepresenting its rights in the collateral.

The Sentinel decision is a significant victory for the Sentinel trustee and offers significant support to future trustees of failed financial firms seeking to recover misused customer funds, and ultimately the customers whose funds or securities were misused.  To avoid similar results, companies must be diligent in investigating any suspicions with regard to collateral they have received.  Relying on assurances from the firm that all regulations have been followed will not be sufficient to protect a company if a court determines that more investigation was needed.