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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,


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:


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.


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 ...

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