Lack of Knowledge is No Defense: Seventh Circuit Strips Bank’s Lien on More than $300 Million in Assets

The Seventh Circuit (which covers Illinois, Indiana, and Wisconsin) appears to have added a new and potentially conflicting standard in analyzing  a third-party transferee’s “good faith” defense to a fraudulent transfer claim.  The good faith defense protects a third-party transferee from having to return the value it received from a debtor as a part of a fraudulent transaction so long as that third-party transferee entered into the transaction with the debtor in good faith. 

About a year ago, the Seventh Circuit first provided an expansive view of the “good faith” defense to defendants seeking to block the recovery of proceeds received in a fraudulent transfer.   In that case (which we posted about here), In re Equipment Acquisition Resources, Inc., the debtor’s former owners received funds from the debtor as part of a fraudulent scheme.  The former owners then proceeded to lose a substantial portion of those funds at a casino.  When the debtor’s estate attempted to recover those funds from the casino as proceeds from a fraudulent transfer, the casino argued that it did not need to turn over the funds because it had received them in good faith.  The Seventh Circuit agreed with the casino.  The court found that the casino was not required to investigate or chase down red flags or inquire as to the nature of the proceeds of the transaction in order for it to find good faith.   Rather, because the casino did not have actual knowledge of the fraudulent act perpetrated by the former owners, the casino received the proceeds in good faith.

Last month, however, the Seventh Circuit took a narrower view of the good faith defense with respect to liens.  In In re Sentinel Mgmt. Grp., Inc., a cash management firm, Sentinel Management Group, Inc., (Sentinel) invested cash for its clients into low‑risk securities.  Sentinel also made investments on its own account, borrowing from Bank of New York Mellon (BNY) for the necessary funds.  However, Sentinel did not have the necessary capital to collateralize against its loans with BNY so Sentinel pledged as collateral the securities purchased for its customers without authority to do so.

After Sentinel experienced trading losses that made it unable to satisfy demands from its customers and the loan demands from BNY, Sentinel filed for bankruptcy.  Soon after, BNY notified Sentinel of its intent to liquidate the collateral provided on its loan.  The bankruptcy trustee, however, refused to classify the more than $300 million owed to BNY as secured debt, believing that BNY did not accept the pledge of assets as collateral in good faith.  Believing that BNY had suspicions of the fraudulent origin of the collateral, the trustee argued that BNY had an obligation to investigate before accepting the pledge.   BNY disagreed, arguing that it accepted the pledge in good faith because it did not have actual knowledge of Sentinel’s fraudulent act.

Indeed, the evidence showed that at least one individual at BNY wondered how BNY could have the right to $300 million in collateral where Sentinel showed only $2-20 million in capital.  However, the district court agreed with BNY, finding that although records established that BNY had suspicions of the improper way in which the collateral was pledged, those suspicions did not rise to the level of actual knowledge.  As a result, the district court found that BNY entered into the transaction with Sentinel in good faith, thereby preserving the lien.

On appeal, the Seventh Circuit reversed. The court determined that BNY’s mere suspicion of fraud, not actual knowledge, put BNY on inquiry notice of the potential fraud and necessitated an investigation, which would have allowed BNY to discover that Sentinel was not authorized to pledge the collateral.  Without a reasonable investigation, the court found, BNY lacked good faith when entering into the transaction to acquire the lien.

Interestingly, the Seventh Circuit made no mention of Equipment Acquisition in an attempt to reconcile the competing standards for the good faith defense articulated by the court.  The oversight may have been intentional as a means to differentiate between intended forms of relief sought by the debtor’s estate.  The court clarifies in Sentinel that the good faith defense from the recovery of proceeds from fraudulent transfers  pursuant to section 550(b)(1) of the Bankruptcy Code (the type of relief sought in Equipment Acquisition) had no bearing on the case because the bankruptcy trustee did not attempt to recover any proceeds.  Rather, the transaction involved the acquisition of a lien and the bankruptcy trustee attempting to disqualify it, for which a separate good faith defense pursuant to section 548(c) applies.  Despite any lack of clarity from the court as to why it appears to have applied different standards for these analogous good faith defenses, the end result is clear.  Parties willing to provide secured credit should perform the necessary due diligence to protect their liens.  A mere suspicion of fraud or wrongdoing can put a lender’s secured position in jeopardy.  Lack of knowledge is no defense.

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