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Grede v. Bank of New York

United States District Court, Seventh Circuit

November 26, 2013

FREDERICK J. GREDE, not individually but as Liquidation Trustee of the Sentinel Liquidation Trust, Plaintiff,
v.
THE BANK OF NEW YORK and THE BANK OF NEW YORK MELLON CORP., Defendants.

TRUSTEE'S MOTION FOR ENTRY OF JUDGMENT

JAMES B. ZAGEL, District Judge.

Frederick J. Grede, not individually but as Liquidation Trustee of the Sentinel Liquidation Trust (the "Trustee"), respectfully requests that the Court enter a judgment order against defendant The Bank of New York Mellon ("BONY"). In support, the Trustee states as follows:

INTRODUCTION

On August 26, 2013, the Seventh Circuit reversed this Court's November 3, 2010 decision entering judgment against the Trustee on his fraudulent transfer and equitable subordination claims. In re Sentinel Mgmt. Group, Inc., 728 F.3d 660, 672 (7th Cir. Aug. 26, 2013). On October 8, 2013, the Seventh Circuit issued its mandate. (Dist.Dkt. 488.)

The Seventh Circuit's judgment order and mandate ask this Court to do two things. First, with respect to the Trustee's fraudulent transfer claim, the Seventh Circuit concluded that the Trustee had established his prima facie case under 11 U.S.C. § 548(a)(1)(A) to avoid BONY's liens on the securities Sentinel pledged as collateral. Id. at 668. It remanded the fraudulent transfer claim to this Court for the limited purpose of deciding BONY's affirmative defenses to the claim, noting with respect to BONY's only potentially applicable affirmative defense-its Section 548(c) defense-that based on the record before the Seventh Circuit, it was unlikely that BONY could prevail on this defense. Id. at 668 n.2.

Second, with respect to the Trustee's equitable subordination claim, the Seventh Circuit directed this Court to answer two questions:

1. What exactly did BNYM know before Sentinel's collapse? Did BNYM know that Sentinel was engaged in misconduct of any kind (including abuse of the loan proceeds)?
2. Was BNYM's failure to investigate Sentinel before its collapse merely negligent? Or was it reckless? Or was it deliberately indifferent?

Id. at 672. The Seventh Circuit further directed that once this Court answers these two questions, it "can then revisit the ultimate issue of whether the Bank's claim merits equitable subordination." Id.

To assist the Court in performing these post-remand tasks, the Trustee provides the following analysis of the controlling legal standards and proposed additional factual findings. As explained herein, BONY failed to prove its one affirmative defense to the Trustee's fraudulent transfer claim and therefore, as directed by the Seventh Circuit, this Court should avoid all of BONY's liens in Sentinel's property. The record also establishes that BONY was deliberately indifferent to the fact that Sentinel was pledging property to secure BONY's loan to Sentinel when Sentinel should have been holding that property in segregated accounts for the benefit of Sentinel's customers. BONY knew that Sentinel could not legally pledge customer property to secure BONY's loans to Sentinel. BONY also acknowledged and agreed that it could not, and would not, take a lien on the property Sentinel was required to hold for its customers and BONY was legally obligated to treat that property as belonging to the customers. Yet, BONY deliberately ignored what Sentinel was doing and accepted property that should have been held in segregated accounts as its collateral anyway. BONY's conduct in doing so justifies equitable subordination of BONY's liens and claims to the claims of all other creditors. 11 U.S.C. § 510(c). Accordingly, the Trustee requests that the Court make the additional proposed findings attached hereto and enter judgment on both claims in the Trustee's favor.

ARGUMENT

I. This Court Should Enter Judgment In Favor Of The Trustee Under Section 548(a)(1)(A).

The Seventh Circuit found that the Trustee proved the elements of his fraudulent transfer claim and that he "should be able to avoid the Bank of New York's lien." Sentinel, 728 F.3d at 668. The Court stated that all that remained for this Court to do on remand was "to revisit" BONY's defenses. Id. at 668 n.2. Although BONY pled every affirmative defense listed in Rule 8 (and some multiple times) ( see Dkt. 140 at 73-79), the only affirmative defense potentially applicable to the Trustee's fraudulent transfer claim is its section 548(c) defense, which it pled as its Twelfth Affirmative Defense. (Dkt. 140 at 75.)[1] But, as the Seventh Circuit noted, "based on the record currently before us, we suspect that the Bank will have a very difficult time proving that it was not on inquiry notice of Sentinel's possible insolvency." 728 F.3d at 668 n.2. As set forth herein and in the Trustee's Proposed Additional Findings, BONY failed to sustain its burden of proof on this defense. See, e.g., Jobin v. McKay ( In re M&L Bus. Mach. Co.), 84 F.3d 1330, 1338 (10th Cir. 1996) (defendant bears burden of proof under §548(c).)

Although it did not plead section 550 of the Bankruptcy Code, 11 U.S.C. § 550, as an affirmative defense in its Answer ( see generally Dkt. 140 at 73-79), BONY also argued before trial that the Trustee may not recover a money judgment under section 550. Section 550, however, is inapplicable here because the Trustee's fraudulent transfer claims seek to avoid a lien, not to affirmatively "recover" property. See, e.g., Rodriquez v. Drive Fin. Serv., L.P. (In re Trout), 609 F.3d 1106, 1109-10 (10th Cir. 2010); see also Peoples Bank & Trust Co. v. Burns, 95 Fed.App'x 801, 804 (6th Cir. 2004). Section 551 of the Code automatically preserves avoided liens for the benefit of the estate and its creditors without the need to resort to section 550. 11 U.S.C. § 551. Accordingly, BONY's section 550 defense is irrelevant and should be rejected.

A. BONY Cannot Establish A "Good Faith" Defense Under Section 548(c).

1. The Legal Standard.

To establish a good faith defense under section 548(c), BONY was required to prove at trial that: (1) BONY gave Sentinel "value" for the liens securing BONY's claim; and (2) BONY took the liens in "good faith." 11 U.S.C. § 548(c); M&L Bus. Mach., 84 F.3d at 1335-38. Only BONY's good faith is in dispute.

BONY's "good faith" is measured under an objective standard. As the Seventh Circuit noted in its decision: "this defense is generally unavailable to any creditor who has sufficient knowledge to place him on inquiry notice of the debtor's possible insolvency.'" Id. at 7 n.2 (quoting M&L Bus. Mach., 84 F.3d at 1336, in turn quoting Brown v. Third Nat'l Bank ( In re Sherman), 67 F.3d 1348, 1355 (8th Cir. 1995) (emphasis added)). The two Circuit Court decisions that the Seventh Circuit cites with approval, Sherman and M&L Business Machines, both hold that the standard for measuring good faith under section 548(c) is an objective one: "courts look to what the transferee objectively knew or should have known'" about the transferor's intent, "instead of examining the transferee's actual knowledge from a subjective standpoint." Sherman, 67 F.3d at 1355; accord M&L Bus. Mach., 84 F.3d at 1338; In re Agric. Research & Tech. Grp., 916 F.2d 528, 536 (9th Cir. 1990). In Scholes v. Lehman, 56 F.3d 750, 757, 759 (7th Cir. 1995), the Seventh Circuit also held that the comparable inquiry under Illinois fraudulent transfer law was an objective inquiry-whether the transferee "knew or should have known of the [transferor's] fraudulent intent."

As the Court explained in M&L Business Machines, under this objective analysis, "the presence of any circumstance placing the transferee on inquiry as to the financial condition of the transferor" will defeat a good faith defense unless an actual investigation by the transferee disclosed the transferor to be in good financial health. 84 F.3d at 1336-37. Moreover, a transferee also lacks good faith when it "ignore[s] facts which would put a reasonable person on inquiry of the [d]ebtor's purpose and would excite the suspicions' of a prudent person or lead a person of ordinary perception to infer fraud.'" Helms v. Roti (In re Roti), 271 B.R. 281, 298 (Bankr. N.D.Ill. 2002). Put another way, a transferee cannot remain "willfully ignorant of facts which would cause it to be on notice of a debtor's fraudulent purpose, " or "put on blinders" when entering into transactions with the debtor. Cuthill v. Greenmark, LLC ( In re World Vision Entm't, Inc.), 275 B.R. 641, 659 (Bankr. M.D. Fla. 2002).

Good faith is determined on a case-by-case basis. Sherman, 67 F.3d at 1355. But in general, a transferee does not take a transfer in good faith if it has received information about the debtor's financial condition indicating the debtor is in financial difficulty. In Sherman, for example, the Eighth Circuit upheld the finding that a bank lacked good faith when it knew of the debtor's significant liabilities and the bank's own plan to foreclose on some of the debtor's assets. Id. at 1357 (analyzing comparable good faith element of § 550(b)(1)). Other indicia that a transferee has not received a transfer in good faith include evidence that the transferee was aware of restrictions on the transferor's ability to transfer the property and failed to investigate whether the transfer violated those restrictions. See Dev. Specialists Inc. v. Hamilton Bank, N.A. (In re Model Imperial, Inc.), 250 B.R. 776, 799 (Bankr. S.D. Fla. 2000). Failure to comply with industry standards is another factor that leads courts to conclude that a transferee did not receive a transfer in good faith. Id. ; World Vision, 275 B.R. at 654-55. A transferee also lacks good faith if it is on inquiry notice that a debtor is using investor funds to trade for its own benefit. See Armstrong v. Collins, 2010 WL 1141158, at *27 (S.D.N.Y. Mar. 24, 2010). In Armstrong, the court denied an investor summary judgment on a good faith defense because of evidence that the investor knew of facts suggesting that the transferor was investing investor money for his own account. Id.

2. The Evidence Already Presented To The Court Conclusively Demonstrates That BONY Has Not Proved Its Section 548(c) Defense.

The factual findings that this Court has already made conclusively demonstrate that BONY lacked good faith and was not only on inquiry notice, but also had actual knowledge of Sentinel's insolvency and that Sentinel was transferring collateral to BONY that it should have been holding in segregation for its customers. To assist the Court in addressing BONY's section 548(c) defense, the Trustee has prepared proposed supplemental findings of fact, attached hereto as Exhibit A, which set forth the findings this Court has already made and the additional evidence in the record that demonstrate that BONY has not proved its section 548(c) affirmative defense.

In summary, the Court's findings and the evidence establish that:

• BONY knew that Sentinel was required to hold customer funds in segregation and BONY had entered into an agreement with Sentinel that the property held in segregated accounts would not be available to pay BONY's loan to Sentinel ( see Proposed Supplemental Findings ¶¶ 1-7);
• BONY maintains a substantial business providing custodial services to its customers and knew or should have known that under section 4d(b) of the CEA it was unlawful for BONY "to hold, dispose of, or use any such money, securities, or property" that Sentinel was required to segregate "as belonging to" Sentinel (7 U.S.C. § 6d(b));[2]
• Despite BONY's industry experience and its knowledge that Sentinel was required to hold property in segregation, it switched Sentinel from the custodial branch of the bank and established an account structure that was atypical for these types of accounts and which allowed BONY to lien property that should have been in segregated accounts (Proposed Supplemental Findings ¶¶ 8-14);
• BONY knew from the inception of the parties' relationship that Sentinel was thinly capitalized ( id. ¶¶ 15-17);
• BONY knew that the amount and nature of Sentinel's loan had changed, and that beginning in 2001 and increasing after 2004, Sentinel was borrowing large sums of money to finance its own leveraged trading ( id. ¶¶ 18-25); Sentinel, 728 F.3d at 670;
• BONY knew or should have known based upon financial documents it received from Sentinel on a regular basis that Sentinel did not have sufficient property to secure BONY's loan (Proposed Supplemental Findings ¶¶ 18-21, 24-29);
• BONY knew that the financial statements it received contained inaccurate information and that Sentinel's 1-FRs sent to its regulators failed to disclose the existence of the BONY loan or Sentinel's proprietary trading in repos ( id. ¶¶ 20-21);
• BONY knew by sometime in 2004 or 2005, that Sentinel was borrowing hundreds of millions of dollars and pledging hundreds of millions of dollars in securities to collateralize the BONY loan, but that Sentinel itself did not have the capital to provide that collateral ( id. ¶ 24);
• By the spring and summer of 2007, BONY knew that Sentinel's repo counter-parties were demanding payment from Sentinel and that Sentinel was using its loan from BONY to repay these repo counterparties and securing its ever increasing BONY loan with securities taken out of the customer segregated accounts ( id. ¶¶ 36-39);
• BONY knew or suspected that Sentinel was pledging property to secure the BONY loan that Sentinel was required to hold in segregation for the benefit of Sentinel's customers ( id. ¶¶ 30-31, 34); and
• BONY suspected that Sentinel might file for bankruptcy ( id. ¶¶ 40-42). Despite its knowledge of these facts, BONY did nothing to investigate further and instead demanded more and better collateral from Sentinel and considered demanding changes to its agreements to improve its position in the event of a Sentinel bankruptcy. ( Id. ¶¶ 32-33, 35, 39-42.) Under these circumstances, both the Trustee's banking expert and BONY's bank expert testified that when BONY failed to investigate whether Sentinel had rights in the collateral it was taking as security for Sentinel's loan it acted contrary to accepted industry standards. ( Id. ¶¶ 43-45.) When presented with a hypothetical set of facts which conservatively represented what BONY knew in this case, BONY's banking expert, W. Barefoot Bankhead explained that BONY should have reported Sentinel to regulators or law enforcement. ( Id. ¶ 44.) Similarly, the Trustee's industry expert, former Head of BMO Harris's Financial Institutions Group, Chuck Hohman, testified that BONY should have stopped lending to Sentinel and returned the customer securities to segregated accounts. ( Id. ¶ 45.)

Based upon these facts, this Court has already found that under an "objective standard" BONY "should have known that Sentinel was violating segregation requirements." Grede v. Bank of New York, 441 B.R. 864, 892 (N.D. Ill. 2010). In addition, this Court has found that:

a simple review of the monthly 1-FRs indicated that the difference between the amount of assets listed as funds segregated or in separate accounts pursuant to the CEAct and Regulations' and Sentinel's total assets was never more than approximately $15 million. Therefore, in order for Sentinel to pledge collateral in excess of that difference, it would have to use assets that had been held in segregation and then removed from segregation to allow them to be pledged.

Id. at 889. Finally, this Court found that "[t]he evidence at trial revealed the Bank's knowledge that Sentinel insiders were using at least some of the loan proceeds for their own purposes." Id. at 883. These three findings alone lead to the conclusion that BONY did not act in good faith when it took liens on customer property because it knew or should have known that the collateral Sentinel pledged to it was actually property that Sentinel was required to hold in its customer segregated accounts and that Sentinel was improperly using that property to secure loans made to it.

The conclusion that BONY did not take the collateral in good faith is made inescapable by this Court's findings about an email that BONY's head of Financial Institutions Credit, Mark Rogers, sent on June 13, 2007. In that email, "Rogers asked the Sentinel team at BNYM how Sentinel was able to put up as much collateral as it had, with only $2 million in capital. Rogers wrote... I have to assume most of the collateral is for somebody else's benefit. Do we really have rights on the whole $300MM?'" Id. at 889. Instead of asking Sentinel whether it was pledging property that it should have been holding in customer segregation or otherwise investigating the facts before accepting this collateral, Terence Law, a BONY officer responsible for the Sentinel relationship, testified that he consulted with a number of colleagues prior to responding: "Hello. We have a clearing agreement which gives us a full lien on the box position outlined below." Id. According to Law, "this was a well-advised and carefully worded statement" and as the Court also found, Rogers was unable to recall why "he would have been satisfied with the response from Law when it did not directly answer his question and consisted of information he already knew." Id. at 889-90, 893. This Court found that "Rogers' inquiry is certainly evidence that he had a suspicion that the securities were not Sentinel's to pledge and he shared this suspicion with Law. " Id. at 890 (emphasis added); see also Sentinel, 728 F.3d at 665.

This Court also found that "a diligence process that excludes [verification that Sentinel had the right to pledge the collateral] seems to be ineffective and reckless in light of the facts of which the Sentinel team at the bank was aware, and a reasonably prudent person would have taken a closer look at, at least, the 1-FRs sitting in front of him or her." 441 B.R. at 892 (emphasis added). Because BONY "was in possession of information more than sufficient to affirmatively suggest to a reasonable person that the source of [Sentinel's collateral] was an improper use of [customer] funds. [BONY] could not, therefore, sit on [its] heels' and yet retain those funds as a good faith transferee...." See Ameriserv Fin. Bank v. Commercebank, N.A., 2009 WL 890583, at *6 (W. D. Pa. Mar. 26, 2009) (quoting In re Bressman, 327 F.3d 229, 236-37 (3rd Cir. 2003)). BONY's knowledge of Sentinel's financial condition and its failure to investigate in light of what it knew and what it suspected about the collateral it was receiving defeats BONY's good faith defense. See World Vision, 275 B.R. at 659; Roti, 271 B.R. at 298. Accordingly, the Trustee requests that the Court enter judgment on Counts I and II in the Trustee's favor, finding that BONY's liens are avoided as fraudulent transfers.

B. Section 550 Is Inapplicable Here And Thus, BONY's Section 550 Defense Is Irrelevant.

BONY also argued before trial (although this defense is not included in its Answer) that even if the Trustee prevails on his fraudulent transfer claim, he is not entitled to a recovery from BONY under 11 U.S.C. § 550. But BONY's argument reflects a fundamental misunderstanding about the interplay between the avoidance provisions of the Code at issue here (sections 544 and 548), and the remedies specified in sections 550 and 551.

Sections 548 and 544 are the statutory provisions at issue in this case that allow the Trustee to avoid BONY's liens as fraudulent transfers. Once this Court determines that BONY's liens are avoided as fraudulent transfers under sections 544 and 548, two additional Code sections then govern the potential remedies available to ensure that the avoidance action results in distributions to the estate's creditors-sections 550 and 551. Trout, 609 F.3d at 1109-10. Section 550 applies when title to the property that was fraudulently transferred is vested in a third party, such as when a trustee avoids a payment of cash. In those circumstances, the trustee requires a money judgment against the transferee for the estate to be made whole and section 550 supplies the statutory basis for the court to enter that judgment. But if the avoided transfer is the transfer of a security interest, "upon avoidance of a lien, under §551 the trustee steps into the shoes of the former lienholder, with the same rights in the collateralized property that the original lienholder enjoyed.'" Trout, 609 F.3d at 1110 (citation omitted). In other words, relief under section 551 is automatic. Id.

As the Seventh Circuit noted, in this case, the Trustee is seeking to avoid BONY's $312 million lien on Sentinel's property, see Sentinel, 728 F.3d at 668, not to avoid specific payments to BONY, so any arguments about section 550 are irrelevant. See Peoples State Bank, 95 Fed.App'x at 804 ("[b]ecause the trustee did not seek recovery" under § 550, "the § 550 defenses are not available.") The Trustee is not asking for a money judgment against BONY under section 550 because such a judgment is unnecessary. Upon avoidance of BONY's liens as fraudulent transfers, section 551 will automatically preserve those liens for the benefit of the estate without further action by the Trustee, and the Trustee will be able to distribute the property that had been subject to BONY's liens to creditors in accordance with the terms of the confirmed plan.[3]

Accordingly, inasmuch as BONY has not established any defenses to the Trustee's fraudulent transfer claim, judgment should be entered avoiding BONY's lien.

II. BONY's Claim Should Be Subordinated In Full.

The Seventh Circuit vacated this Court's ruling denying the Trustee's equitable subordination claim and directed the Court to answer two questions:

1. What exactly did BNYM know before Sentinel's collapse? Did BNYM know that Sentinel was engaged in misconduct of any kind (including abuse of the loan proceeds)?
2. Was BNYM's failure to investigate Sentinel before its collapse merely negligent? Or was it reckless? Or was it deliberately indifferent?

Sentinel, 728 F.3d at 672.

The answer to the Seventh Circuit's question about whether BONY knew that Sentinel was engaged in misconduct is a resounding "yes." As this Court has already found, "the evidence at trial revealed the Bank's knowledge that Sentinel insiders were using at least some of the loan proceeds for their own purposes." Grede, 441 B.R. at 883. This finding was supported by extensive and undisputed evidence. ( See, e.g., Tr. at 402-03 (Ciacciarelli); Tr. at 1079-82 (Brennan).) Moreover, there can be no doubt that knowledge that Sentinel was pledging customer assets to support its own proprietary trading amounts to knowledge of misconduct. BONY witnesses admitted as much (Tr. at 2723-24 (Rogers)), and the Seventh Circuit so found, concluding that this finding "indicates that the Bank of New York knew Sentinel was engaged in wrongful conduct before its collapse." Sentinel, 728 F.3d at 670. BONY thus had actual, subjective knowledge of wrongdoing. This, alone, is sufficient to answer the Seventh Circuit's first question in the affirmative, but as discussed below, there is in fact much more in the record.

The answer to the Seventh Circuit's second question follows from the answer to the first. Because BONY had actual knowledge that Sentinel was engaged in misconduct, its failure to investigate and BONY's alleged continued reliance on the representations and warranties that Sentinel made in a clearing agreement it had signed years earlier was at the very least deliberate indiffereness and by definition, cannot have been merely negligent. As the Seventh Circuit stated, "if the Bank knew that Sentinel insiders were misusing the loan proceeds, then how could the Bank rely on representations and warranties' made by Sentinel?" Sentinel, 728 F.3d at 671. "[K]knowledge that insiders were misusing corporate funds should have provided the Bank with more than enough reasons to distrust any representations and warranties made by Sentinel." Id. One "may not blindly [rely] upon a misrepresentation the falsity of which would be patent to him if he had utilized his opportunity to make a cursory examination or investigation.'" BPI Energy Hldgs., Inc. v. IEC (Montgomery), LLC, 664 F.3d 131, 139 (7th Cir. 2011) (quoting Field v. Mans, 516 U.S. 59, 71 (1995)); accord State Farm Mutual Auto Ins. Co. v. Abrams, 2000 WL 574466, at *17 (N.D. Ill. May 11, 2000) (same).

Moreover, BONY's own conduct here was particularly reckless and egregious. This is not just the case of a bank which learned that (but did not report or take action to stop) a bank customer that was misusing the assets of its clients, but to whom the bank owed no duties. Here, BONY was acting as custodian of Sentinel's client assets, and the CEA imposed upon BONY an obligation not to use Sentinel's customer assets as collateral for Sentinel's loan. See 7 U.S.C. § 6d(b); CFTC Interpretative Letter No. 79-01, Comm. Fut. L. Rep. (CCH) ¶20, 835 (May 29, 1979). Moreover, BONY had committed in the letter agreements it signed that it would respect Sentinel's segregation obligations and not look to segregated funds to satisfy its own claims against Sentinel. Grede, 441 B.R. at 871; (TTX 11-13; Proposed Supplemental Findings ¶¶ 1-7.) Because of those independent obligations, once BONY suspected misconduct at Sentinel, BONY did not have the luxury of attempting to work out of Sentinel's troubled loan by continuing to accept customer securities as collateral for loans it was making to Sentinel. But BONY did precisely that, and that is why its claim must be equitably subordinated to the claims of customers harmed by Sentinel and BONY's misconduct.

B. BONY Knew That Sentinel Was Engaged In Extensive Misconduct.

The evidence establishing BONY's actual knowledge of Sentinel's misconduct is straightforward: (1) BONY knew the loan was collateralized almost exclusively with Sentinel's customer securities (Tr. at 482-83 (Ciacciarelli); Tr. at 1141-42, 1177 (Brennan); Tr. at 1065, 1353, 1436 (Law); Tr. at 2793-94 (Rogers)); (2) BONY "understood that Sentinel used the loan to finance purchase[s] of securities for its own benefit[]" (Tr. at 402-03 (Ciacciarelli); accord Tr. at 1082-83, 1115 (Brennan)); and (3) BONY understood "it would be improper for BONY to accept customer securities as collateral for the loan if BONY knew that Sentinel was using the loan proceeds for Sentinel's own proprietary trading" (Tr. at 2723-24 (Rogers)).

That knowledge constitutes actual knowledge of Sentinel's misconduct. Pledging customer securities to support Sentinel's proprietary trading is a flagrant violation of Section 4d(b) of the Commodity Exchange Act ("CEA"), which makes it "unlawful" to treat customers assets as "belonging to the depositing futures commission merchant" (here, Sentinel). 7 U.S.C. § 6d(b). The same is true even without the protections of the CEA. Using someone else's funds for one's own purposes is the very definition of misappropriation. Sentinel, 728 F.3d at 667-68; United States v. Hamilton, 499 F.3d 734, 736-37 (7th Cir. 2007).

BONY has never seriously contested that Sentinel's use of customer assets to support proprietary trading was wrongful and cannot plausibly deny its knowledge of that conduct given its own witnesses' testimony. Instead, during closing arguments, BONY's lawyers argued that BONY believed Sentinel's proprietary trading was de minimis and thus BONY's knowledge was insignificant. (Def.'s Post Trial Br., Ex. A at 7.) The problem for BONY is that there is not one shred of evidence supporting this contention. Not a single BONY witnesses testified that he believed Sentinel's proprietary trading was de minimis. Nor is the contention plausible in light of the evidence at trial.

The events of the summer of 2007 demonstrate that BONY knew Sentinel had massive proprietary positions which were being supported by customer securities. As merely one example, on June 29, the same day that BONY informed Sentinel it would no longer accept physical securities as collateral, Sentinel transferred $166 million (par) in corporate securities from segregated accounts to the Clearing/Collateral account. (TTX 371, 374, 376, 1006.) BONY knew the source of the collateral because it insisted that Sentinel make the transfers in the first place. (Tr. at 482-83 (Ciacciarelli); Tr. at 1177 (Brennan); Tr. at 1373-74 (Law).) BONY further knew that the purpose of the transfers was unrelated to any customer activity, but instead was merely to finance the return of the over $150 million in physical CDOs for Sentinel's own account. (Tr. at 491 (Ciacciarelli); Tr. at 1161 (Brennan); Tr. at 1373 (Law); Tr. at 2698 (Rogers).) The only reasonable conclusion to draw from the June 29 transfer and the other block transfers in the summer of 2007 is that Sentinel was pledging hundreds of millions of dollars in customer securities to support the re-purchase of hundreds of millions of dollars in Sentinel's proprietary positions in illiquid CDOs, and that BONY was well aware of those activities- conduct and knowledge that cannot be dismissed as de minimis.

BONY's knowledge does not end with the misuse of customer securities to support Sentinel's proprietary trading. BONY also knew the resulting segregation violations these activities caused. Again, the evidence of this knowledge is straightforward and is based on two unavoidable facts: (1) Sentinel was required to segregate customer assets; and (2) Sentinel did not segregate hundreds of millions of dollars in customer securities that were pledged as collateral for the loan.

As this Court found, "[t]he evidence made clear that [BONY] knew that Sentinel was subject to the CEA and that its customer assets had to be segregated." Grede, 441 B.R. at 887. BONY, however, knew that upwards of $700 million in securities were not segregated but instead were held in lienable, unsegregated accounts. (Tr. at 454-55, 482-85 (Ciacciarelli); Tr. at 1177 (Brennan); Tr. at 1353, 1375, 1436 (Law); Tr. at 2793-94 (Rogers).) BONY witnesses knew and admitted the collateral was comprised of customer securities from segregated accounts. Law admitted all but $2 million pledged in support of the loan were customer securities. (Tr. at 1436.) Ciacciarelli and Brennan admitted that they knew Sentinel lacked the assets to collateralize the loan other than by using customer securities from segregated accounts. (Tr. at 482-83 (Ciacciarelli); Tr. at 1177 (Brennan).) Mark Rogers testified it was his understanding that the only way for Sentinel to pledge collateral to BONY was to "tak[e] assets out of seg accounts and pledg[e] them" to the bank. (Tr. at 2793-94.)

BONY further knew that pledging hundreds of millions of dollars in customer assets left Sentinel undersegrated. BONY's own expert witness, Professor Bradford Cornell, testified that "if you have to segregate, you can't use leverage no matter what because you can't take your securities and pledge them as collateral." (Tr. at 2890.) This Court found that "the 1-FRs reviewed by Law and Ciacciarelli... contained significant improper reporting, demonstrating that Sentinel was violating its segregation requirement." Grede, 441 B.R. at 890. Sentinel's massive undersegration became even more obvious in the summer of 2007, when hundreds of millions of dollars were removed from segregation unrelated to customer activity without corresponding movements of assets back into segregation. As the Seventh Circuit stated, "[t]here was no way to maintain segregation levels via the returned physical securities because Sentinel did not keep segregated accounts for physical securities." Sentinel, 728 F.3d at 665. BONY's undisputed knowledge of Sentinel's segregation obligations plus its knowledge that Sentinel pledged hundreds of millions of dollars in customer securities as collateral for the loan necessarily amounts to knowledge that Sentinel was violating segregation obligations and thus was engaged in misconduct.[4]

Resolution of the question of whether BONY knew of Sentinel's misconduct does not depend on the applicable standard of knowledge being objective as opposed to subjective. As discussed above, BONY's knowledge of Sentinel's pledging of customer securities to support the loan that was used for its own proprietary trading was actually, subjectively known by the key BONY personnel that dealt with Sentinel. (Tr. at 402-03, 482-83 (Ciacciarelli); Tr. at 1082, 1141-42, 1177 (Brennan); see also Tr. at 1353, 1373, 1436 (Law).)

Moreover, there is no doubt that BONY had actual knowledge Sentinel was required to segregate customer assets and was not doing so with respect to the hundreds of millions of dollars in customer securities in lienable accounts. Its refusal to admit the only logical conclusion to be drawn from those facts-that Sentinel was violating the law and misusing customer assets that were supposed to be segregated-does not support a finding that it lacked the requisite knowledge. In the criminal context where knowledge is an element of the crime, courts routinely find knowledge of the ultimate issue based on circumstantial evidence and knowledge of underlying facts. See United States v. Griffin, 150 F.3d 778, 785 (7th Cir. 1998); United States v. Stribling, 94 F.3d 321, 324-25 (7th Cir. 1996). Indeed, in the criminal context even suspicion plus deliberate indifference to the truth is sufficient to establish knowledge. United States v. Ramsey, 785 F.2d 184, 189 (7th Cir. 1986).

In addition to its actual knowledge-which is more than sufficient to find it liable- BONY is charged with constructive knowledge of all facts which a reasonable investigation would have uncovered. Under Lerner v. Fleet Bank, N.A., 459 F.3d 273, 288 (2d Cir. 2006), "[f]acts sufficient to cause a reasonably prudent person to suspect that trust funds are being misappropriated will trigger [] a duty of inquiry on the part of a depository bank, and the bank's failure to conduct a reasonable inquiry when the obligation arises will result in the bank being charged with such knowledge as inquiry would have disclosed." Accord In re Knox, 64 N.Y.2d 434, 438 (1985); Diamore Realty Corp. v. Stern, 855 N.Y.S.2d 206, 207-08 (App. Div. 2008); Home Sav. Of Am., FSB v. Amoros, 661 N.Y.S.2d 635, 637-39 (App. Div. 1997). The evidence strongly supports such a duty here based on BONY's actual knowledge of at least some misconduct by Sentinel and this Court's express finding that BONY was in fact suspicious, Grede, 441 B.R. at 883, 890.

BONY has mischaracterized Lerner as espousing a negligence standard that is incompatible with equitable subordination, but that is simply wrong. Lerner involved a claim against the defendant bank for aiding and abetting breach of fiduciary duty, which requires "actual knowledge." 459 F.3d at 295. Thus, Lerner, as well as the other authorities cited above that BONY has never addressed, stand for the proposition that the standard of knowledge for banks like BONY holding trust funds subsumes facts the bank would have learned from a reasonable investigation once such a duty to investigate is triggered (as it plainly was here). This Court found that even a "relatively cursory review" by BONY would have revealed massive segregation violations and that BONY objectively knew of Sentinel's wrongdoing, Grede, 441 B.R. at 890, and thus when properly judged under Lerner's knowledge standard, BONY plainly had extensive knowledge of Sentinel's misconduct.

C. BONY Was Deliberately Indifferent To Sentinel's Misconduct.

The Seventh Circuit noted apparent inconsistencies between this Court's finding that BONY's conduct was "reckless in light of the facts of which the Sentinel team at the bank was aware" and its subsequent statement that negligence was insufficient to establish equitable subordination. Sentinel, 728 F.3d at 671. It then posed the question of whether BONY's admitted failure to investigate whether Sentinel was authorized to pledge hundreds of millions of dollars of customer securities was "merely negligent, " "reckless, " or "deliberately indifferent." Id. at 672. The Seventh Circuit suggested that the answer to this question depended on whether BONY knew Sentinel was engaged in misconduct: "If Bank employees knew that Sentinel insiders were misusing loan proceeds, then it certainly suggests that Bank employees (at the very least) turned a blind eye to the rest of Sentinel's misconduct." Id. at 671. Because BONY knew Sentinel wrongfully pledged customer securities to support its proprietary trading, its continued acceptance of hundreds of millions of dollars in additional customer securities as collateral and failure to do even a minimal investigation was-as the Seventh Circuit stated-"at the very least" rises to the level of deliberate indifferentness. Id.

Indeed, there actually is no dispute about what BONY should have done in light of the knowledge it had. BONY's own banking expert, Bankhead, testified that a "universal principle of lending [is] to make sure that the person pledging the collateral actually has the right to pledge the collateral." (Tr. at 2494-95.) When presented with a hypothetical set of facts which conservatively represented what BONY knew in this case, Mr. Bankhead explained that BONY should have reported Sentinel to regulators or law enforcement. (Tr. at 2601-10.) The Trustee's industry expert, former Head of BMO Harris's Financial Institutions Group, Chuck Hohman, testified that BONY should have stopped lending to Sentinel and returned the customer securities to segregated accounts. (Tr. at 1600-01, 1613-14, 1618.)

BONY's continued acceptance of customer securities as collateral and failure to perform any investigation in light of the facts it knew and suspicions it harbored are even more egregious in light of the duties imposed upon it as a custodian of trust funds. First, BONY had duties under § 4d(b) of the CEA as a depository of customer funds not to treat such funds as belonging to Sentinel-which is precisely what it did each and every night when it accepted hundreds of millions of dollars in customer securities as collateral for Sentinel's loan. Second, BONY contractually agreed not to lien on customer assets in the 1997 Seg letters, which this Court found "were in fact binding agreements." Grede, 441 B.R. at 900. Third, as a recipient of "special deposits, " BONY had a common law duty not to lien on customer funds or take any action to "frustrate the terms of an explicit special deposit" arrangement. Merrill Lynch Mortgage Capital, Inc. v. FDIC, 293 F.Supp.2d 98, 110 (D.D.C. 2003).

BONY violated each of those three duties. In the face of its actual knowledge of at least some misuse of customer funds by Sentinel and suspicions about whether it "really ha[d] rights on the whole $300 [million]" that Sentinel had pledged to it, BONY did nothing. Grede, 41 B.R. at 890; (TTX 287.) It failed to conduct any investigation and avoided following up on any of the knowledge or suspicions it had. Turning a blind eye to known risks is the very definition of deliberate indifferentness. BPI Energy, 664 F.3d at 139; Archie v. City of Racine, 847 F.2d 1211, 1219 (7th Cir. 1988); Ramsey, 785 F.2d at 189. The Court's findings regarding BONY's knowledge, suspicions, affirmative acts, and inaction are incompatible with a conclusion that it was merely negligent.

At the very least, BONY was reckless, which has repeatedly been found to be sufficient for equitable subordination. In Branch Banking & Trust Co. of Va. v. M/Y Beowulf, 883 F.Supp.2d 1199, 1210, 1218 (S.D. Fla. 2012), the court subordinated a bank's claim, holding that its recklessness in failing to confirm its borrower's ability to pledge the collateral at issue "allowed [the borrower] to bury the fraud which he had orchestrated." In Picard v. Katz, 462 B.R. 447, 456 (S.D.N.Y. 2011), the court held that a SIPA trustee "can potentially subordinate [claims] by proving that the defendants invested with Madoff Securities with knowledge, or in reckless disregard, of its fraud." See also In re Jemsek Clinic, P.A., 441 B.R. 756, 784-86, 788 (Bankr. W.D. N.C. 2010) (conduct egregious where defendant was "recklessly indifferent to its legal responsibilities"); In re Adler, Coleman Clearing Corp., 277 B.R. 520, 559 (Bankr. S.D.N.Y. 2002) (subordinating claim of defendant who recklessly "closed his eyes to" wrongdoing); In re Aluminum Mills Corp., 132 B.R. 869, 895-96 (Bankr. N.D.Ill. 1991) (conduct egregious where lender was "party to [debtor's] fraudulent act").

D. This Court Should Subordinate BONY's Claim In Its Entirety.

The Seventh Circuit noted that the contours of "inequitable conduct" necessary to subordinate a claim under the Bankruptcy Code were not well-defined in the case law, but suggested that this should not serve as a prohibition against subordinating claims in appropriate cases. Sentinel, 728 F.3d at 670, 672. This is such a case. By consciously accepting and indeed requiring hundreds of millions of dollars in customer securities to be pledged as collateral for Sentinel's loan, which BONY knew was being used for proprietary trading and which left Sentinel massively undersegregated, BONY actively participated in wrongdoing.

Although equitable subordination is a remedy that the Trustee is entitled to pursue for the general benefit of the estate, it is a somewhat unique remedy in that equitable subordination focuses on proof of some harm to creditors. See, e.g., In re Kreisler, 546 F.3d 863, 865 (7th Cir. 2008) ("[e]quitable subordination is generally appropriate only if a creditor is guilty of misconduct that causes injury to the interests of other creditors"); accord Schubert v. Lucent Tech. Inc. (In re Winstar Commc'ns, Inc.), 554 F.3d 382, 413-14 (3rd Cir. 2009). Moreover, a trustee does not need to provide an exact "quantification" of the injury; rather he need only present evidence sufficient to allow the court to provide a remedy that is proportionate to the harm caused to creditors. Winstar, 554 F.3d at 413. In Winstar, for example, the Third Circuit upheld a judgment subordinating the creditor's entire $900 million claim based on a finding that the creditor's misconduct caused approximately $710 million in injuries. Id. at 414.

Accordingly, this Court should subordinate all of BONY's claim to the claims of customers. The Court's prior ruling that subordinating the entire claim would not be equitable was inextricably tied to its conclusions regarding liability, and the damages that Sentinel (and not its customers) suffered as a result of BONY's conduct. The Seventh Circuit has now questioned those findings and the Trustee respectfully submits that the issue of harm to customers must be revisited.

BONY asserts a secured claim of $312 million-the amount of its loan on August 17, 2007, which was collateralized entirely by what was supposed to be customer securities. The fact that BONY provided Sentinel with loan proceeds did not offset or reduce the harm to customers. The loan proceeds went to Sentinel, not the customers whose assets were misappropriated. The harm is particularly pronounced in the case of SEG 3 customers. On July 31, 2007, Sentinel transferred $289.9 million in corporate securities from the SEG 3 account to the Clearing/Collateral Account for purposes of collateralizing the BONY loan. (TTX 482, 489, 497, 1012; Tr. at 1855-61 (Feltman).); Grede v. FCStone, LLC, 485 B.R. 854, 866 (N.D. Ill. -); Grede, 441 B.R. at 878. As a result of the collateral swap in late July, the Seg 3 account was virtually emptied. That BONY in exchange released liens on other securities, some of which were then returned to Seg 1 customer segregated accounts, did nothing to mitigate the losses suffered by SEG 3 customers whose assets were misappropriated at the time BONY turned a blind eye to the improper pledging of customer assets. Proportionally, the subordination of BONY's entire claim is justified given the harm its inequitable conduct caused.

Moreover, subordinating the entire claim because specific customers suffered the losses comports better with the facts than the alternative liquidation shortfall analysis, which focuses only on Sentinel. BONY's loan to Sentinel was re-booked each day. (Tr. at 1309, 1339 (Law.) Thus, each and every day throughout the summer of 2007 (after BONY had acquired knowledge and suspected Sentinel of wrongdoing), BONY made two critical choices that give rise to equitable subordination of its claim: first, to continue each day to re-book and make a loan to Sentinel knowing that Sentinel was engaged in serious misconduct, and second, to accept as collateral for each loan customer securities it knew were required to be segregated, and which BONY had a legal obligation not to accept. Having made each of those two improper decisions every day for several months, BONY cannot now seek to revert to the situation that existed prior to the summer of 2007. That option was eliminated when BONY consciously chose to disregard the facts known to it and its suspicions regarding Sentinel's rights to pledge collateral, failed to blow the whistle and instead permitted customers' assets to continue to be misappropriated while attempting to work out its troubled loan to Sentinel. Having made its decisions, BONY should now be called to account for the full extent of customer losses caused by accepting as collateral customer securities to which it was not legally entitled.

CONCLUSION

For all of the foregoing reasons, the Trustee respectfully requests that this Court enter judgment in his favor on the fraudulent transfer claim avoiding BONY's liens, and subordinate BONY's claim in its entirety and transfer any liens securing its claim to the estate and grant such other relief as may be just.

TRUSTEE'S PROPOSED SUPPLEMENTAL Fl NDI NGS OF FACT

Frederick J. Grede, not individually but as Liquidation Trustee of the Sentinel Liquidation Trust (the "Trustee"), respectfully submits his Proposed Supplemental Findings of Fact on BONY's Section 548(c) defense.

A. BONY Knew That Sentinel Was Required To Hold Customer Funds In Segregation.

1. BONY had actual knowledge that Sentinel was required to hold its customer funds in segregation and could not pledge those funds to secure its loan with BONY. Ample evidence supports this fact. This Court found in its Finding Nos. 39-42 that:

On December 13, 1996, Debra Coscia (of BNYM) sent a letter to Barbara Sapienza (of Sentinel) regarding Sentinel's transition from First Chicago National Bank to BNYM and certain draft "CFTC compliance letters" that Sentinel had provided to BNYM. (BTX 390.)
Ms. Coscia told Sentinel that the draft "CFTC compliance letters" were sent to BNYM's legal department for review. (BTX 390.)
On March 13, 1997, Sentinel and BNYM executed the Global Custody Agreement, pursuant to which Sentinel became a customer of BNYM's Institutional Custody Division ("Custody Division"). (BTX 5; Tr. 373:19-374:10.)
On March 31, 1997, Joseph Ciacciarelli, who ran BNYM's relationship with Sentinel, signed TTX 11, 12, and 13, dated March 14, 1997.

Grede v. Bank of New York, 441 B.R. 864, 871 (N.D. III. 2010). TTX Nos. 11-13 are the final versions of the CFTC compliance letters (the "Seg Letters"). Eric Bloom at Sentinel sent these letters to Joseph Ciacciarelli, advising BONY that Sentinel was opening segregated accounts with BONY to hold commodity customer funds and to "meet the provisions of the Commodity Exchange Act." (TTX 11-13.) Sentinel also told BONY through those Seg Letters that the Commodity Exchange Act required that customer money be held in segregated accounts and "treated as belonging to our customers rather than as belonging to ourselves." ( Id. ) Sentinel asked BONY to "agree that the funds in said accounts will not be subject to your lien or offset for, and on account of, any indebtedness now or hereafter owing us to you and shall not be applied by you upon any such indebtedness nor will you apply the funds in said accounts to the indebtedness of either our so-called Seg II or Seg III accounts." (TTX 11; accord TTX 12-13.) Mr. Ciacciarelli, who was a BONY officer, signed each of those letters under the heading "Accepted this 31 day of March, 1997." (TTX 11-13.)

2. This Court has found that the Seg Letters were "in fact binding agreements." Grede , 441 B.R. at 900. Ciacciarelli testified that the Seg Letters created a contract with Sentinel. (Tr. at 367-68.) The Trustee's industry expert Charles Hohman, the former Head of BMO Harris's Financial Institutions Group with decades of FCM banking experience, testified that letters between a futures commission merchant and its custodial bank are common and are treated as contractual agreements in the commodities industry. (Tr. at 1545-46, 1565-68.)

3. This Court found in its Finding No. 69 that:

On March 31, 2006, Mark Rogers sent an email to Joseph Ciacciarelli, Terence Law, Stephen Brennan and Bernard Lambert raising certain questions regarding Sentinel and forwarded a copy of the January 21, 2004 letter from the Division. (TTX 188; Tr. 2664:8-2666:5.)

Grede, 441 B.R. at 873. The "questions" that Rogers raised in his March 31, 2006 email were: "Operationally: Have we set up the seg accounts and operate them as outlined in the letter? I assume the collateral we lend against is not in the seg accounts." (TTX 188.)

4. The January 21, 2004 "letter from the Division" that was part of the Rogers' email and referenced in his question was from the Division of Clearing and Intermediary Oversight of the Commodity Futures Trading Commission ("CFTC") confirming "its views concerning the application of the Commission's segregation and net capital regulations" to Sentinel's customer segregated accounts at BONY. (TTX 188.) The CFTC stated in this letter that "Sentinel has obtained from BONY a letter acknowledging that the funds maintained in the Seg I Account are held pursuant to section 4d(a)(2) of the CEAct and CFTC regulations for the benefit of Sentinel's commodity customers." ( Id. ) The letter also states that "[t]he custody accounts require BONY to segregate the funds in the Seg I and Seg III accounts from BONY's own assets and prohibits BONY from using the funds in the Seg I and Seg III accounts for BONY's own purposes" and that federal regulatory segregation requirements governed both the Seg I and Seg III accounts. ( Id. ) Finally, the only Sentinel loan that is referenced in the CFTC letter is a loan necessary to satisfy customer redemption requests. ( Id. )

5. Rogers, Brennan, Ciacciarelli, and Law each reviewed Rogers' email and the CFTC letter that was part of that email. (TTX 188; Tr. at 342-43 (Ciacciarelli); Tr. at 1124-25 (Brennan); Tr. at 1329 (Law); Tr. at 2780 (Rogers).) But neither Ciacciarelli, who was responsible for ensuring that BONY understood the regulatory requirements governing Sentinel's accounts (Tr. at 2789-90), nor any of his colleagues, responded to Rogers' email. (Tr. at 1129 (Brennan); Tr. at 2665-66 (Rogers).)

6. This Court found in its Finding Nos. 70 and 71 that:

On April 6, 2006, Terence Law scheduled a conference call with Eric Bloom. (BTX 323.)
On April 10, 2006, BNYM had a conference call with Sentinel. (BTX 324; BTX 325; Tr. 634:9-16.)

Grede, 441 B.R. at 873. During this conference call, Eric Bloom told BONY that the reason Sentinel had different seg accounts was that FCM customer money could not be commingled with other funds, and that Sentinel's clients were counting their investments with Sentinel towards their own seg requirements under CFTC regulations. (BTX 324-25; Tr. at 1354 (Law).) During that same conference call, in response to Mark Rogers' question about how margin for BONY's loan was generated, Bloom told BONY that Sentinel took assets out of segregation in order to collateral ize the loan. (BTX 324-25.)

7. Sentinel's public website also placed BONY on notice that Sentinel "marketed itself to its customers as providing a safe place to put their excess capital, assuring solid short-term returns, but also promising ready access to the capital.... Sentinel has constructed a fail-safe system that virtually eliminates risk from short term investing, ' proclaimed Sentinel's website." Sentinel, 728 F.3d at 662; ( see also TTX 925). Law testified that he looked at this website. (Tr. at 1250.)

B. BONY Changed Sentinel's Initial Segregated Account Structure Because BONY Was UnableTo Lien TheAccountsTo Secure Its Credit Risks.

8. At all relevant times, a significant part of BONY's banking operations were providing custodial banking services to financial firms required to hold customer property in segregation. (Tr. at 372-73 (Ciacciarelli).)

9. Within a year after Sentinel moved its custodial banking arrangements to BONY, BONY changed Sentinel's initial account structure from one which complied with the industry standard for maintaining segregation. BONY made this move because it was concerned that this account structure created credit risk for BONY. Sentinel's segregated or "Seg" accounts initially consisted of a segregated securities account in which securities would settle, linked with a segregated cash account for customer deposits and withdrawals; a security would not leave segregation without a corresponding transfer of cash into the linked cash account. (Tr. at 375-77, 383 (Ciacciarelli); Tr. at 1559-63, 1571 (Hohman); Tr. at 2100-01 (Clark); TTX 14.) Expert witness Hohman testified that Sentinel's original BONY account structure was the industry standard for maintaining segregation. (Tr. at 1558-63.)

10. BONY changed Sentinel's account structure due to its concern that BONY could be exposed to a credit loss if there were overdrafts on the cash account. Sentinel, 728 F.3d at 663. This Court found in its Finding Nos. 43-44 that:

On May 20, 1997, Joseph Ciacciarelli sent an email to Jeffrey Tessler, Mike Burns, Charles McGraw, Martin Geffon, and A. Lucia Ferrara, copying John Bhonslay. (TTX 18; Tr. 602:6-607:7.)
In the May 20, 1997 email, Mr. Ciacciarelli recommended that Sentinel be transitioned to Broker Dealer Services ("BDS"). (TTX 18.)
Mr. Bhonslay responded to Mr. Ciacciarelli's May 20, 1997 email and explained that he agreed. ( Id. )

Grede, 441 B.R. at 871.

11. Specifically, what Mr. Bhonsl ay told Mr. Ciacciarelli and Mr. Tessler, when he explained that he agreed the Sentinel account structure should be changed, is:

THIS ACCOUNT IS AN ACCIDENT WAITING TO HAPPEN.... YES, THE ACCOUNT IS OVERDRAWN ON THE "STREET" (I.E. LIENABLE) BUT I HAVE NO WAY OF KNOWING IF THERE ARE SECURITIES IN THE CORRESPONDING CUSTODY ACCOUNT BECAUSE NO ONE IN SIBD IS AUTHORIZED TO ACCESS CUSTODY ACCOUNTS.... I AM NOTIFYING YOU THAT I NO LONGER FEEL COMFORTABLE CLEARING THESE TRANSACTIONS AND REQUEST AN IMMEDIATE RESPONSE FROM YOU. THANK YOU.

(TTX 18 (emphasis in original)); see also Sentinel, 728 F.3d at 663.

12. This Court found in its Finding No. 47 that:

On October 21, 1997, Sentinel signed the Securities Clearing Agreement and related Security Agreement. (TTX 21; BTX 14; Tr. 387:6-10.)

Grede, 441 B.R. at 871. Under the new structure, all securities Sentinel bought and sold, whether purchased for customers or Sentinel's proprietary account, settled in a clearing account lienable by BONY. (Tr. at 393, 399 (Ciacciarelli).) When Sentinel bought a security on behalf of a customer, the purchased security was delivered into the clearing account and was subject to BONY's lien. There was no automatic transfer of the purchased security into a segregated account. (Tr. at 393-94, 397-99 (Ciacciarelli); Tr. at 1749-50 (Feltman).) Unless Sentinel requested that BONY move the security, the security would (and often did) stay in the lienable account indefinitely. (Tr. at 397-99 (Ciacciarelli); Tr. at 1750 (Feltman).) To sell a customer security, Sentinel needed to transfer it from the segregated accounts to the clearing account, where the cash proceeds from the sale remained. (Tr. at 1751 (Feltman).)

13. Hohman testified the new structure made it difficult to comply with segregation obligations and did not comport with industry practice. (Tr. at 1572-74.) He testified Sentinel's and BONY's operation of the accounts consistently violated segregation requirements. (I d.)

14. As stated above, during an April 10, 2006 conference call between Eric Bloom of Sentinel, and Rogers, and others at BONY, Bloom told BONY that Sentinel took assets out of segregation in order to collateralize the loan in response to Roger's question about how margin for BONY's loan was generated. (BTX 324-25.)

C. BONY Knew That At All Times Sentinel Was Thinly Capitalized.

15. BONY knew at all times that Sentinel was very thinly capitalized. As set forth above, this Court found that on May 20, 1997, Ciacciarelli sent an email to others at BONY. See Grede, 441 B.R. at 871. In that email, Cicacciarelli states that Sentinel is "a thinly capitalized firm, approximately $1mm in equity." (TTX 18.00002.)

16. This Court found in its Finding Nos. 56, 57, and 58 that:

Beginning in November 2005, BNYM received copies of Sentinel's monthly Form 1-FRs that Sentinel filed with the CFTC. (TTX 140; TTX 155; TTX 164; TTX 175; TTX 182; TTX 189; TTX 197; TTX 199; TTX 202; TTX 203; TTX 211; TTX 214; TTX 218; TTX 220; TTX 224; TTX 235; TTX 247; TTX 392.)
Joseph Ciacciarelli, Terence Law, and Stephen Brenan reviewed Sentinel's Form 1-FRs. (Tr. 449:9-450:12; Tr. 1236:2-11; Tr. 1243:25-1244:2; Tr. 1287:18:1288:14: Tr. 1290:13-22.)
From October 2004 through June 2007, Sentinel's 1-FRs and BNYM's credit reviews of Sentinel reflected that Sentinel had approximately $3 million in net capital or less. (TTX115, 140; TTX 155; TTX 164; TTX 171; TTX 172; TTX 175; TTX 182; TTX 185; TTX 189; TTX 197; TTX 199; TTX 202; TTX 203; TTX 211; TTX 214; TTX 218; TTX 220; TTX 224; TTx 235; TTX 247; TTX 392.)

Grede, 441 B.R. at 873.

17. This Court found that "Sentinel's total assets was never more than approximately $15 million." Grede , 441 B.R. at 889.

D. BONY Had Access To Sentinel's Financial Statements And Knew That Sentinel's Financial Statements And 1-F Rs Contained False Information.

18. This Court found in its Finding No. 59 that:

On November 22, 2005, Terence Law circulated a call report regarding his November 9, 2005 visit to Sentinel. (TTX 150).

Grede, 441 B.R. at 873. In TTX 150, Law reports that he had asked Sentinel for monthly financial statements going forward.

19. Sentinel provided BONY with its 2005 and 2006 financial statements. (TTX225; TTX930.)

20. Note 2 on the audited financial statements stated a logical imposcibility: that hundreds of millions of dollars in "Customers Cash and Securities Segregated and Held in Trust" were simultaneously pledged to BONY. (TTX225.00008; Tr. at 463 (Ciacciarelli); Tr. at 1314-16 (Law); Tr. at 2533-34 (Bankhead).) This Court found that:

the 2005 financial statements showed customer securities segregated and held in trust' to be approximately $1.14 billion, but that approximately $156 million of this total was pledged as collateral for a short $280 million short-term bank loan.
Law and Ciacciarelli, both of whom reviewed these monthly statements, admitted that securities pledged as collateral could not simultaneously beheld in segregation.

Grede, 441 B.R. at 889.

21. This Court found that "[t]he 1-FRs also failed to reflect the [BONY] loan or the repos, which should have raised questions in the mind of BNYM employees who knew of the loan and the repos." Grede , 441 B.R. at 889.

E. BONY Knew That Sentinel Used The BONY Loan To Finance Its Proprietary Trading.

22. This Court found in its Finding Nos. 75-81, that Sentinel's guidance line at the bank grew from $30 million before May 1, 2004, $175 million in June, 2005, to $300 million in September 2006. Grede, 441 B.R. at 874. This Court found that Sentinel's average daily loan balance from November 4, 2005 through August 13, 2007 was $292, 632, 224 and its average daily loan balance from June 1, 2007 through August 13, 2007 was $369, 084, 986. Id. ; TTX 88; TTX 1000.)

23. BONY knew that Sentinel's loan had changed from a liquidity loan used to make customer redemptions to a loan used to leverage Sentinel's proprietary trading. (Tr. at 402-03; 409-12 (Ciacciarelli); Tr. at 1312 (Law); Tr. at 2640-41 (Rogers).)

24. Brennan testified that at some point in 2004 or early 2005, he knew that Sentinel was borrowing hundreds of millions of dollars and pledging hundreds of millions of dollars in securities to collateralize the BONY loan, but that Sentinel itself did not have the capital to provide that collateral. (Tr. at 1065-66.)

25. BONY knew that Sentinel had $2 billion in repos. (Tr. at 1302-03 (Law).)

F. BONY Knew Or Should Have Known That Sentinel Was Violating Segregation Requirements And Pledging Property It Should Have Held In Segregation To Secure The BONY Loan.

26. This Court found that "the 1-FRs reviewed by [BONY employees] Law and Ciacciarelli in and of themselves contained significant improper reporting, demonstrating that Sentinel was violating its segregation requirement" and that under an objective standard "the 1-FRs certainly put BNYM on notice that Sentinel was violating its segregation obligations." Grede , 441 B.R. at 890, 892.

27. This Court also found:

a simple review of the monthly 1-FRs indicated that the difference between the amount of assets listed as funds segregated or in separate accounts pursuant to the CEAct and Regulations' and Sentinel's total assets was never more than approximately $15 million. Therefore, in order for Sentinel to pledge collateral in excess of that difference, it would have to use assets that had been held in segregation and then removed from segregation to allow them to be pledged.

Grede, 441 B.R. at 889.

28. This Court also found that if BONY's employees, Law, Ciacciarelli, and Brennan conducted a "relatively cursory review" of those 1-FRs, Sentinel's violations of its segregation requirements would have been revealed. Grede , 441 B.R. at 890.

29. This Court found that "Law and Ciacciarelli, both of whom reviewed [the 1-FRs], admitted that securities pledged as collateral could not simultaneously be held in segregation." Grede , 441 B.R. at 889 (emphasis added).

30. This Court found that: "It is clear to me that by June 13, 200[7], certain BNYM employees had suspicions that Sentinel may not have had rights to the collateral." Grede, 441 B.R. at 890.

31. This Court found in its Finding No. 113 that:

On June 13, 2007 Mark Rogers sent an email to Terence Law, Stephen Brennan, Joseph Ciacciarelli, and others regarding Sentinel. (TTX 287.)

Grede, 441 B.R. at 876. Mr. Rogers email stated: "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 $300M M?" (TTX 287.)

32. This Court found in its Finding No. 114 that:

On June 13, 2007, Terence Law replied to Mark Rogers' June 13, 2007 email. (Tr. 1371:3-14; Tr. 1372:7-9; Tr. 1444:2-13.)

Grede, 441 B.R. at 876. Law's response was: "Hello. We have a clearing agreement which gives us a full lien on the box position outlined below. Thanks" (TTX 287.)

33. This Court found that "According to Law, this was a well-advised and carefully worded statement." Grede, 441 B.R. at 889-90.

34. This Court found that "Rogers' inquiry is certainly evidence that he had a suspicion that the securities were not Sentinel's to pledge and he shared this suspicion with Law." Grede, 441 B.R. at 890.

35. This Court found that "a diligence process that excludes [verification that Sentinel had the right to pledge the collateral] seems to be ineffective and reckless in light of the facts of which the Sentinel team at the bank was aware, and a reasonably prudent person would have taken a closer look at, at least the 1-FRs sitting in front of him or her." Grede, 441 B.R. at 892.

36. Rogers knew "Sentinel was pledging customer assets as security for the Bank of New York loan." (Tr. at 2793-94.)

37. Brennan "knew that Sentinel was pledging customer assets." (Tr. at 1141-42.)

38. Law knew "the securities pledged were actually beneficially owned by others." (Tr. at 1446.)

39. Despite BONY's suspicions and information that its officers knew or should have known, BONY presented no evidence that it conducted any investigation of Sentinel's rights to pledge the securities Sentinel had pledged to BONY. For example, Brennan testified that he knew in the summer of 2007 that Sentinel's repo counterparties were returning securities to Sentinel and that Sentinel was borrowing money from the bank to pay the repo counterparties. (Tr. at 1174-77.) He also testified that he knew that Sentinel did not have capital to post the additional collateral that BONY required to loan Sentinel additional funds to pay the repo counterparties and that the "if they needed collateral, I am not sure where it came from. It could've come from seg. I would imagine it would come from seg." (Tr. at 1177.) When asked "that's the only place it could have come from, isn't it?" Brennan answered "I think you're right, yeah." (Tr. at 1177). Brennan then testified:

Q. And did anyone at the Bank of New York in connection with the return of securities and the posting of additional collateral in the summer of 2007, did anyone at the Bank of New York take any steps to determine whether when collateral came out of seg accounts it was being used in connection with the transaction that was benefitting the seg account from which the collateral came?
A. No, not that I know of.

(Tr. at 1177-78.) Brennan also testified that even though it "would have mattered" if Sentinel was pledging customer property to secure the BONY loan, he never "inquire[d] with any of Sentinel's customers as to whether they authorized Sentinel to pledge their securities for the loan to Sentinel." (Tr. at 1068.)

40. By August 2007, BONY officers monitoring Sentinel "all were concerned that Sentinel could go bankrupt." (Tr. at 1194 (Brennan); see also Tr. at 1196-98 (Brennan).)

41. This Court found in its Finding No. 156:

On August 1, 2007, Mark Rogers sent Stephen Brennan an email regarding Sentinel. (TTX 503.)

Grede, 441 B.R. at 879. In his email, Mark Rogers wrote: "The more i hear george and julie talk about stays, expenses judges ect the more i think its stupid do have some of our exposure booked as loans. Move sentinel to a repo now. Lets consider others for the same in earnest." (TTX 503.)

42. BONY considered converting Sentinel's loan to a repo transaction so that BONY could further improve its position relative to other creditors. (Tr. at 1197-98 (Brennan).)

G. Industry Experts Testified That BONY Acted Contrary To Banking Industry Practices When It Failed To Investigate The Source The Collateral Sentinel Pledged To Secure The BONY Loan.

43. BONY's own banking expert, W. Barefoot Bankhead, testified that a "universal principle of lending [is] to make sure that the person pledging the collateral actually has the right to pledge the collateral." (Tr. at 2494-95.)

44. When presented with a hypothetical set of facts which conservatively represented what BONY knew in this case, Mr. Bankhead explained that BONY should have reported Sentinel to regulators or law enforcement. (Tr. at 2601-10.)

45. Similarly, the Trustee's industry expert, former Head of BMO Harris's Financial Institutions Group, Chuck Hohman, testified that BONY should have stopped lending to Sentinel and returned the customer securities to segregated accounts. (Tr. at 1600-01, 1613-14, 1618.)


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