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In re Sentinel Management: Seventh Circuit Considers Equitable Subordination

Equitable subordination in bankruptcy can be a powerful tool, providing a court with considerable latitude to set things right insofar as the estates of the penniless and the rights of their creditors are concerned.

But it’s also a doctrine more frequently discussed than applied (even 11 U.S.C. § 510(c)(1), the statute authorizing the remedy’s use, offers no hint as to what justifies its use), which is what makes the Seventh Circuit’s recent decision in In re Sentinel Management Group, Inc., No. 15-1309 (7th Cir. Jan. 8, 2016), worth remembering. Judge Richard Posner wrote for the court.

The case concerned the fallout from the collapse of Sentinel Management, a cash-management firm that pledged the assets of its customers as collateral to finance loans that Sentinel used to trade on its own account. Not surprisingly, pledging other people’s assets to support your own borrowings violates federal law, to say nothing of the contracts Sentinel signed with its customers, which required that customer assets be held in segregated accounts.

Bank of New York Mellon had extended credit to Sentinel based on the clients’ collateral, and the first issue before the Seventh Circuit was whether the bank could retain its position as a senior secured creditor, or whether it had relinquished that favored status by having been on “inquiry notice” of the fraudulent transfers that Sentinel made by moving client funds to its own accounts for use as collateral. 11 U.S.C. § 548(c) would have allowed the bank’s lien to prevail, despite those fraudulent transfers, had it accepted the pledge of assets in “good faith”; but “inquiry notice” scotches “good faith.”

What concerned the court was one event in particular. A bank executive, when reviewing a list of Sentinel’s collateral prepared by another bank employee, responded to the list’s preparer by asking, “‘How can they 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?’” That insight got a nonresponsive answer, but the executive dropped the issue.

Inquiry notice, the court explained, requires only “information that would cause a reasonable person to be suspicious enough to investigate,” and the quoted exchange and other similar events were sufficient, in the court’s view, to put the bank on inquiry notice and to lose it its senior secured claim, demoting its claim to unsecured status.

But what of equitable subordination? After deciding that the bank was on inquiry notice, the Seventh Circuit took up the trustee’s argument that the bank’s conduct “was sufficiently egregious” to justify the use of equitable subordination—that is, to render the bank’s claim subordinate even to those of the other unsecured creditors.

What we do know about equitable subordination is that its standard is not the same as that for inquiry notice; it’s a higher hurdle to overcome. A bank executive’s negligence might have been sufficient to destroy the bank’s secured claim, but the Seventh Circuit explained that the use of a bankruptcy court’s equitable-subordination powers (under 11 U.S.C. § 510) required conduct “not only ‘inequitable’ but seriously so (‘egregious,’ ‘tantamount to fraud,’ and ‘willful’ are the most common terms employed) and [that conduct] must harm other creditors.”

Bank of New York Mellon’s conduct had harmed other creditors, but the court did not think that the bank had engaged in “‘purposeful avoidance of the truth’” by failing to follow up on its executive’s suspicions.

Its conduct amounted to nothing more than negligence, and that, the court held, still permitted the bank to stand in line with the other unsecured creditors—for whatever that might one day be worth.

© 2020 Foley & Lardner LLP


About this Author

Eric G Pearson, Business Litigation Attorney, Appellate, malpractice, Foley
Senior Counsel

Eric G. Pearson is a business litigation lawyer with Foley & Lardner LLP, where his practice involves counseling and litigating in a variety of areas, including appellate litigation, professional-malpractice cases, and financial- and accounting-related controversies. In addition, he has represented clients in internal investigations and enforcement-defense actions in the financial, health care, and sports industries. Mr. Pearson is a member of the firm’s Appellate, Business Litigation & Dispute Resolution, and Government Enforcement, Compliance & White Collar...