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Banking and Financial Matters Blog

The Problem of Lender "Inquiry Notice" Status

Authored by Randi L. Osberg
Posted on January 19, 2017
Filed under Banking and Financial Matters

If a lender is fully secured, can it just ignore suspicions of borrower misconduct?  The danger is that a lender could lose its collateral under these circumstances and be treated as an unsecured creditor.  This is exactly what happened to a lender that failed to inquire further about collateral pledged by a borrower that was engaged in fraud.  See In re Sentinel Management Group, Inc., 809 F.3d 958 (7th Cir. 2016).

In the Sentinel case, an employee of the lender raised the following question to a member of his department: How could the borrower have pledged $300 million in collateral when the borrower only had about $20 million in capital?  Had the lender followed up on this suspicion, the lender would have discovered the borrower had illegally pledged securities that were owned by the borrower’s customers but transferred to a borrower-owned clearing account. [Ag lenders: Think about stored grain for a potentially equivalent situation.]

When the borrower filed for bankruptcy, the Trustee sought to avoid the pledge of collateral to the lender as a fraudulent transfer.  The lender asserted a defense, namely, that the lender was a good-faith transferee of the collateral.  However, the Seventh Circuit held the lender had been put on notice to inquire further about the collateral.  Because the lender failed to follow up on the employee’s suspicion, the Seventh Circuit held that the lender was not a good-faith transferee and therefore, the pledge of collateral was avoided as a fraudulent transfer.  The end result was that the lender lost hundreds of millions of dollars of collateral.

In the Sentinel case, the Seventh Circuit held that lenders who are put on “inquiry notice” are not good-faith transferees.  So, what does “inquiry notice” mean?  The Seventh Circuit indicates that the “term signifies awareness of suspicious facts that would have led a reasonable firm, acting diligently, to investigate further, and by doing so discover wrongdoing.”

So, the takeaway here is to not ignore warning signs of a customer’s misconduct thinking “I’m okay.  I have sufficient collateral for my loan.  I don’t have to do anything.”  Further inquiry and action may be required.  For more information, please contact Randi Osberg, the author of this article.