Yesterday’s post discussed the recent appellate ruling in Sentinel’s bankruptcy, Grede v. Bank of New York Mellon Corp. (In re Sentinel Management Group, Inc.), and, specifically, the Seventh Circuit’s finding that Bank of New York Mellon (“BNY”) was on inquiry notice that the assets Sentinel had used to secure the bank’s loans had been fraudulently conveyed to the bank and that a reasonably diligent inquiry would have uncovered the fraud.  Thus, the court ruled that BNY could not avail itself of a good faith transferee defense to the liquidating trustee’s fraudulent transfer claim.  As a result of this ruling, BNY is an unsecured creditor of Sentinel’s estate.  The second question that the court resolved was whether the court should lower the priority of BNY’s unsecured claim through application of the doctrine of equitable subordination.  This second question is the focus of today’s post. 
To briefly recap, the liquidating trustee for Sentinel’s estate alleged that BNY was aware that Sentinel had misused customer assets, which were supposed to have been held in segregated accounts not subject to the bank’s lien, as collateral for Sentinel’s overnight loans with the bank.  The trustee brought an adversary proceeding against BNY, which filed the only secured claim in the case, seeking to avoid BNY’s lien on the customer assets that Sentinel pledged to the bank and to equitably subordinate BNY’s claims under section 510(c) of the Bankruptcy Code.
In an earlier decision, issued in August 2013 after rehearing en banc, the Seventh Circuit held that the district court’s conclusion after a bench trial that BNY’s actions were “neither egregious nor conscience-shocking” was based on factual findings that “were internally inconsistent.”  The appellate court remanded the equitable subordination claim to the district court to revisit whether the bank knew that Sentinel was “engaged in misconduct of any kind (including abuse of the loan proceeds).”  On remand, the district court adhered to its original decision.
What conduct warrants equitable subordination?
Section 510(c) of the Bankruptcy Code allows the bankruptcy court to subordinate all or part of an allowed claim to all or part of other allowed claims under principles of equitable subordination.
In the most recent decision, Judge Richard Posner, writing for the Seventh Circuit panel, observed that the statute does not indicate what conduct is necessary to impose equitable subordination as a remedy and that the first panel (which reviewed the district court’s decision after the bench trial) had wrestled with the level of misconduct necessary for equitably subordinating a claim.  The latest opinion holds that “the defendant’s conduct must be not only ‘inequitable’ but seriously so (‘egregious,’ ‘tantamount to fraud,’ and ‘willful’ are the most common terms employed) and must harm other creditors” in order to impose the “Draconian remedy” of equitable subordination.
The court acknowledged that Sentinel’s customers had been harmed by the bank’s acceptance of the accounts of the customers as security for the bank’s loan.  However, while the court found that a BNY executive had suspicions about the collateral and that he should have followed up on those suspicions, the trustee had not shown that BNY knew that Sentinel was securing the bank’s loans with customers’ money without their consent:

To suspect potential wrongdoing yet not bother to seek confirmation of one’s suspicion is negligent, and negligence has not been thought an adequate basis for imposing equitable subordination.

To order equitable subordination would “require that [BNY] believed there was a high probability of fraud and acted deliberately to avoid confirming its suspicion.”
The court provided clarity on the standard for equitable subordination of non-insider creditors, confirming that plaintiffs seeking such remedy must satisfy a high standard.  Without knowledge of the fraud, BNY’s acceptance of the collateral was not tantamount to fraud.  The result is that BNY’s claim will be treated as an unsecured claim, but will not be subordinated to other unsecured creditors.