The collapse of investment manager Sentinel Management Group, Inc., in the summer of 2007 left its customers in a lurch. Instead of maintaining customer assets in segregated accounts as required by law, Sentinel had pledged hundreds of millions of dollars in customer assets to secure an overnight loan at the Bank of New York, now Bank of New York Mellon. This left the Bank in a secured position on Sentinel’s $312 million loan but its customers out millions. Once Sentinel filed for bankruptcy, Sentinel’s Liquidation Trustee, Frederick J. Grede, brought a variety of claims against the Bank—including fraudulent transfer, equitable subordination, and illegal contract—to dislodge the Bank’s secured position. After extensive proceedings, including a seventeen-day bench trial, the district court rejected all of the Trustee’s claims. Although we appreciate the district court’s painstaking efforts, we cannot agree with its conclusion that Sentinel’s failure to keep client funds properly segregated was insufficient to show an actual intent to hinder, delay, or defraud. We also find significant inconsistencies in both the factual and legal findings of the district court with respect to the equitable subordination claim. For these reasons, we reverse the judgment of the district court with respect to Grede’s fraudulent transfer and equitable subordination claims.
I. Factual Background
Even though we find some inconsistencies in the thirty-nine-page opinion of the district court, its comprehensive review of the evidence still provides a usеful starting point for our discussion. See Grede v. Bank of N.Y. Mellon,
Before filing for bankruptcy in August 2007, Sentinel was an investment manager that 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’s customers were not typical investors; most of them were futures commission merchants (FCMs), which operate in the commodity industry akin to the securities industry’s brоker-dealers. In Sentinel’s hands, FCMs’ client money could, in compliance with industry regulations governing such funds, earn a decent return while maintaining the liquidity FCMs need. “Sentinel has constructed a fail-safe system that virtually eliminates risk from short term investing,” proclaimed Sentinel’s website in 2004.
To accept capital from its FCM customers, Sentinel had to register as a FCM, but it did not solicit or accept orders for futures contracts. Sentinel received a no-action” letter from the Commodity Futures Trading Commission (CFTC) exempting it from certain requirements applicable to FCMs. But Sen
Maintaining segregation serves as commodity customers’ primary legal protection against wrongdoing or insolvency by FCMs and their depositories, similar to depositors’ Federal Deposit Insurance Corporation protection, see 12 U.S.C. § 1811 et seq., or securities investors’ Securities Investor Protection Corporation protection, see 15 U.S.C. § 78aaa et seq. Sentinel also served other investors such as hedge funds and commodity pools, and as early as 2005, began maintaining a house account for its own trading activity to benefit Sentinel insiders. In 2006, Sentinel represented that non-FCM entities made up about one-third of its customer base. By 2007, Sentinel held about $1.5 billion in customer assets but maintained only $3 million or less in net capital.
Sentinel pooled customer assets in' various portfolios, depending on whether the customer assets were CFTC-regulateB- assets of FCMs or unregulated funds such as hedge funds or FCMs’ proprietary funds. But Sentinel handled “its and its customers’ assets as a single, undifferentiated pool of cash and securities.” Grede,
Sentinel’s relationship with the Bank began in 1997 in the Bank’s institutional-custody division but within months moved to the clearing division (technically dubbed broker-dealer services) because Sentinel actively traded securities and frequently financed transaction settlements. Under the old arrangement, for each segregated aсcount, Sentinel had a cash account for customer deposits and withdrawals. Assets could not leave segregation without a corresponding transfer from a cash account. But the risks of overdrafts prompted a switch to an environment where securities would be bought and sold from clearing accounts lienable by the Bank. In an email, one bank official said in reference to Sentinel’s original arrangement that “THIS ACCOUNT IS AN ACCIDENT WAITING TO HAPPEN.... I AM NOTIFYING YOU THAT I NO LONGER FEEL COMFORTABLE CLEARING THESE TRANSACTIONS AND REQUEST AN IMMEDIATE RESPONSE FROM YOU. THANK YOU.”
Under the new arrangement, Sentinel maintained three types of accounts at the Bank. First, clearing accounts allowed Sentinel to buy or sell securities, including government, corporate, and foreign securities and securities traded with physical certificates. The Bank maintained the right to place a lien on the assets in clearing accounts. Second, Sentinel maintained an overnight loan account in conjunction with its secured line of credit. To borrow on the line of credit, Sentinel would call bank officials to confirm whether it had
Sentinel could independently transfer assets between accounts by issuing electronic desegregation instructions without significant bank knowledge or involvement. This system allowed for hundreds of thousands of trades worth trillions of dollars every day at the Bank. Sentinel maintained responsibility for keeping assets at appropriate levels of segregation. The Bank’s main concern was ensuring Sentinel had sufficient collateral in the lienable accounts to keep its overnight loan secured. In fact, at no point does it appear that the Bank was under-secured. If Sentinel sought to extend the line of credit beyond the value of the assets held in the lienable accounts, the Bank made sure Sentinel moved enough collateral into the lienable accounts. Sentinel used cash from the overnight loan for customer re-demptions or failed trades and provided collateral in the form of the customers’ redeemed securities. When customers redeemed investments, Sentinel could provide cash, via the loan, without waiting for the securities to sell. This arrangement did not violate segregation requirements. When a customer cashed out, the amount needed in segregation dropped by the amount lent by the Bank via the line of credit. The line of credit was in turn secured by assets moved out of customers’ segregated accounts and into clearing accounts.
But in 2001, and increasingly in 2004, Sentinel started using the loan to fund its own proprietary repurchase arrangements with counterparties such as FIMAT USA and Cantor Fitzgerald & Co. Sentinel would finance most of a security’s purchase price by transferring ownership of the security to a counterparty, who would lend Sentinel an amount of cash equal to a percent of the asset’s market value. Sentinel used the overnight loan to cover the difference (known as a “haircut”) between the security’s cost and the repo loan. Sentinel had to buy the security back at some point for the amount loaned plus interest. By 2007, Sentinel held more than $2 billion in securities through repo arrangements. Meanwhile, Sentinel’s guidance line for the Bank loan grew from $30 million pre-May 2004, to $55 million in May 2004, to $95 million in December 2004, to $175 million in June 2005, to $300 million in September 2006. The average loan balance from June 1, 2007, to August 13, 2007; was $369 million. The line topped out at $573 million at one рoint, while all along customer assets served as collateral. In 2004, Sentinel faced a segregation shortfall of about $150 million, and by July 2007, that figure reached nearly $1 billion.
During the summer of 2007, the cloud of a liquidity and credit crunch settled in. Repurchase lenders became nervous. The type of securities Sentinel held became a
On June 1, a counterparty returned $100 million in physical securities, and as a result, the Bank loan jumped from $259.7 million to $353 million over the course of a day. To meet the Bank’s demands for collateral, Sentinel moved about $88 million in government securities from segregated accounts to the lienable account. There was no way to maintain segregation levels via the returned physical securities because Sentinel did not keep segregated accounts for physical securities. Sentinel’s segregation deficit grew to $644 million. On June 13, the Bank became suspicious, and a managing director emailed various bank officials involved with the Sentinel account, asking how Sentinel had “so much collateral? With less than $20MM in capital I have to assume most of this collatеral is for somebody else’s benefit. Do we really have rights on the whole $300MM? ?”
A similar transaction occurred on July 17, with a counterparty returning about $150 million in corporate securities. Sentinel transferred $84 million in corporate securities from a segregated account to a lienable account. The Bank loan settled at $496.9 million and Sentinel’s segregation shortfall grew to $935 million. At the month’s end, Sentinel briefly sent capital in the other direction. On July 30, Sentinel moved $248 million in corporate securities back into segregation from a lienable account and on July 31, $263 million in government securities back into segregation from a lienable account. Yet that same day, Sentinel moved $289 million in corporate securities from a segregated account to a lienable account. Sentinel’s loan settled at $356 million and its segregation deficit at $700 million.
After these transactions, Sentinel could not hang on and told customers on August 13 that it was halting redemptions because of problems in the credit markets. Once Sentinel told the Bank about this decision
Plaintiff Frederick J. Grede was appointed Chapter 11 Trustee for Sentinel’s estate and, subsequent- to the Chapter 11 plan’s confirmation, the Trustee of the Sentinel Liquidation Trust. The Bank filed a $312 million claim as the only secured creditor. Grede filed an adversary proceeding against the Bank alleging that Sentinel fraudulently used customer assets to' finance the loan to cover its house trading activity. Grede further alleged that the Bank knew about it and, as a result, acted inequitably and unlawfully. Grede brought claims of fraudulent transfer under the Bankruptcy Code and state law, 11 U.S.C. §§ 544(b)(1), 548(a)(1)(A); 740 ILES 160/5(a)(l), and preferential transfer, 11 U.S.C. § 547(b), all to avoid the Bank’s lien, see 11 U.S.C. § 550(a). Grede also brought claims of equitable subordinar tion of the Bank’s claim, 11 U.S.C. § 510(c), and invalidation of the Bank’s lien, 11 U.S.C. § 506(d), among others. The district court dismissed the lien invalidation count on the pleadings, Grede v. Bank of New York, No. 08 C 2582,
II. Analysis
In the district court, Grede advanced three arguments why the Bank of New York should be dislodged from its secured position. First, Grede argued that Sentinel acted with actual intent to hinder, delay, or defraud when it borrowed money from the Bank, and thus, the Bank’s lien should be avoided. Second, Grede argued that the Bank engaged in inequitable conduct when it allowed Sentinel to borrow money, and as a result, the Bank’s lien should be subordinated to the claims of unsecured creditors. Third, Grede argued that Sentinel’s contracts with the Bank violated the law on their face, so the Bank’s lien should be invalidated. We address each of Grede’s arguments in turn.
A. Fraudulent Transfer
11 U.S.C. § 548(a)(1)(A) allows the avoidance of any transfer of an interest in the debtor’s property if the debtor made the transfer “with actual intent to hinder, delay, or defraud” another creditor. Grede claims that the transfers of customer assets out of segregation and into the liena-ble accounts (which Sentinel used as collateral for its overnight loan with the Bank of New York) in June and July 2007 constituted fraudulent transfers under 11 U.S.C.
At the conclusion of the bench trial, the district court acknowledged that Sentinel “[was already insolvent at the time of the transfers” and had “missed] creditor assets.” But the district court did not believe such behavior was enough to prove that Sentinel possessed the actual intent to hinder, delay, or defraud other creditors besides the Bank (including its FCM clients), as required to avoid a lien under 11 U.S.C. § 548(a)(1)(A). In reaching this conclusion, the district court reliеd on Gre-de’s expert witness, James Feldman, who had testified that “three of the transfers in question ‘had to do with the closing out of repo positions[,]’ and the remaining two were related to what Feldman called ‘structuring of collateral, the movement of securities between accounts.’ ” Based on this testimony, the district judge appeared to believe that Sentinel had robbed Peter (Sentinel’s FCM clients) to pay Paul (the Bank of New York) in the months before it filed for Chapter 11 bankruptcy. While the district court’s opinion certainly did not condone such behavior, it concluded that this behavior was not enough to show that Sentinel had actual intent to hinder, delay, or defraud its FCM clients. Rather, the opinion characterized Sеntinel’s behavior as a desperate “attempt to stay in business.”
This finding that Sentinel’s pledge of segregated funds as collateral for loans with the Bank of New York was driven by a desire to stay in business correctly identified the motive. Nonetheless, we disagree with the district court’s legal conclusion that such motivation was insufficient to constitute actual intent to hinder, delay, or defraud Sentinel’s FCM clients. Such a result too narrowly construes the concept of actual intent to hinder, delay, or defraud. When Sentinel pledged the funds that were supposed to remain segregated for its FCM clients, Sentinel’s primary purpose may not have been to render the funds permanently unavailable to these clients (although Sentinel falsely reported to both its FCM clients and the CFTC that the funds remained in segregation). But Sentinel certainly should have seen this result as a natural consequence of its actions. In our legal system, “every person is presumed to intend the natural consequences of his acts.” In re Danville Hotel Co.,
Consequently, we conclude that Sentinel’s transfers of segregated funds into its clearing accounts demonstrate an “actual intent to hinder, delay, or defraud” under 11 U.S.C. § 548(a)(1)(A). To treat these transfers as fraudulent is consistent with our construction of actual intent to defraud in other contexts. For example, in United States v. Segal,
Similarly, in United States v. Davuluri,
Like Davuluri, Sentinel exposed its FCM clients to a substantial risk of loss of which they were unaware when it pledged funds that were supposed to remain segregated for the FCM clients as collateral for Sentinel’s overnight loans with the Bank of New York. Even though the district court found that Sentinel’s pledge was not an attempt “to drain its assets and make them unavailable to other creditors,” we held in Davuluri that someone who has the best intentions can still possess an actual intent to defraud.
Sentinel’s pledge of the segregated funds as collateral for its own loan becomes particularly egregious when viewed in light of the legal requirements imposed on Sentinel by the Commodity Exchange Act (CEA). Again, even if we assume that Sentinel eventually intended to replace the segregated funds and earn greater returns for their FCM clients, Sentinel knew that its pledge of the segregated funds violated the CEA. The CEA exists explicitly for the purpose of “ensuring] the financial integrity of all transactions” involving FCMs, “avoid[ing] systemic risk,” and “protecting] all market participants from ... misuses of customer assets.” 7 U.S.C. § 5(b). In order to further thеse aims, the CEA requires that the “money, securities, and property [belonging to clients] shall be separately accounted for and shall not be commingled with the funds of such commission merchant.” 7 U.S.C. § 6d(a)(2). Moreover, 7 U.S.C. § 6d(b) makes it “unlawful” for an FCM “to hold, dispose of, or use any such money, securities, or property as belonging to the depositing futures commission merchant.”
The language of the CEA makes clear that Sentinel did more than just expose its FCM clients to a substantial risk of loss of which they were unaware; Sentinel, in an unlawful manner, exposed its FCM clients to a substantial risk of loss of which they were unaware. Thus, even if Sentinel did not intend to harm its FCM clients, Sentinel’s intentions were hardly innocent. For this reason, we find that Sentinel’s actions, as determined by the factual findings of the district court, demonstrate an actual intent to hinder, delay, or defraud. As such, Grede should be able to avoid the Bank of New York’s lien under 11 U.S.C. § 548(a)(1)(A).
Courts will subordinate a claim under 11 U.S.C. § 510(c) when the claimant creditor engaged in inequitable conduct that injured other creditors or conferred an unfair advantage on the claimant, but not when subordination is inconsistent with the Bankruptcy Code. See In re Kreisler,
“Equitable subordination means that a court has chosen to disregard an otherwise legally valid transaction.” Lifschultz,
Besides these two concerns, the difficulty of proving that a creditor has engaged in inequitable behavior has further increased our hesitance to apply the doctrine of equitable subordination. For example, the question of “ ‘whether a party has acted opportunistically,’ ” is quite subjective. Id. at 349 (quoting David A. Skeel, Jr., Markets, Courts, and the Brave New World of Bankruptcy Theory, 1993 Wis. L.Rev. 465, 506). There are simply no clear rules for determining whether underhanded behavior occurred. Id. (“Equitable subordination relies on courts’ peering behind the veil of formally' unimpeachable legal arrangements to detect the economic reality beneath.”). Underhanded behavior is typically clearest, however, when “corporate insiders [have attempted] to convert their equity interests into secured debt in anticipation of bankruptcy.” Kham & Nate’s Shoes No. 2, Inc. v. First Bank of Whiting,
Proving that an outside creditor behaved inequitably in anticipation of the debtor’s
In the past, our court has not directly addressed the degree of wrongful conduct sufficient to invoke the doctrine of equitable subordination against an outside creditor, so the district court here looked to decisions outside our circuit. Relying primarily on Granite Partners,
But in reaching the conclusion that the Bank’s behavior was neither egregious nor conscience-shocking, the district court relied upon factual findings that were internally inconsistent. Although we normally give great deference to the district court’s factual findings after a full bench trial, we cannot extend the same deference to internally inconsistent factual findings, which are, by definition, clearly erroneous. See United States v. Sablotny,
In particular, the district court appears to contradict itself regarding the extent of the Bank’s knowledge before Sentinel’s cbllapse. Approximately halfway through its opinion, the district court states, “[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.” Grede,
The fact that the Bank knew Sentinel insiders were misusing the loan proceeds before Sentinel’s collapse renders other statеments in the district court’s opinion equally puzzling. For instance, at one
If BNYM should have been more diligent with regard to verifying the source of collateral, such a lack of care does not rise to the level of the egregious misconduct necessary for equitable subordination. The fact remains that BNYM had little reason to conduct such a verification and could rely on representations and warranties. Notwithstanding the evidence that demonstrates that at least one BNYM employee was suspicious, several of the facts that Trustee maintains support a finding of knowledge do not necessarily suggest that Sentinel was misusing customer assets.
Id. at 891 (emphasis added). Again, if the Bank knew that Sentinel insiders were misusing the loаn proceeds, then how could the Bank “rely on representations and warranties” made by Sentinel? True, the Bank had experienced a previously “unremarkable ten-year relationship with Sentinel.” Id. But 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.
These inconsistencies in the district court’s opinion regarding the extent of the Bank’s knowledge before Sentinel’s collapse lead to further inconsistencies regarding the mental state of Bank employees. If Bank employees knew that Sentinel insiders were misusing loan proceeds, then it certainly suggests that Bank employees (at the very lеast) turned a blind eye to the rest of Sentinel’s misconduct. And yet the district court concludes that Grede “failed to prove that BNYM was deliberately indifferent to Sentinel’s alleged fraud.” Id. at 887. Even if we were to accept the district court’s conclusion that Bank employees were not deliberately indifferent to Sentinel’s misconduct (which,, of course, requires- overlooking the inconsistencies regarding the extent of the employees’ knowledge), we run into further inconsistencies regarding the employees’ mental states. The district court’s opinion appears to waffle back and forth between characterizing their mental states as negligent and as reckless. Two excerpts from the opinion illustrate оur point well. Toward the end of its discussion of equitable subordination, the district court remarks:
BNYM claims it did ongoing diligence, focused on Sentinel’s creditworthiness in an effort to ensure repayment and noticed nothing. But the question of whether Sentinel had the right to pledge the collateral certainly goes to the heart of whether BNYM was adequately secured. Even if the Bank was solely concerned with protecting its own interests, a diligence process that excludes such a verification seems to be ineffective and reckless in light of the facts of which the Sentinel team at the bank was aware.
Id. at 892 (emphasis added). This statement indicates that the Bank employees were reckless in their failure to detect Sentinel’s misconduct. But only a few pages later, the district court suggests that the Bank employees’ failure to detect Sentinel’s misconduct did not rise to the level of recklessness:
The fact that they would have been better bankers if they had made a more rigorous inspection of Sentinel’s operations or its reporting is not enough to hold BNYM liable. If some degree of negligence were enough to establish inequitable conduct, the result might be different.
Id. at 894.
Because of these inconsistencies throughout the opinion, we are under
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?
Once the district court clarifies these two points on remand, it can then revisit the ultimate issue of whether the Bank’s claim merits equitable subordination.
C. Voiding the Contracts
The district court dismissed under Rule 12(b)(6) the claim that Sentinel’s contracts with the Bank were inherently illegal. See 11 U.S.C. § 506(d) (voiding liens securing disallowed claims). We review this dismissal de novo. Tamayo v. Blagojevich,
The district court correctly dismissed this claim because the agreements were not the cause of Sentinel’s under-segregation. The contracts did not require either Sentinel or the Bank to do anything illegal, nor did they encourage either party to engage in illegal activity. The contracts’ provisions requiring Sentinel to release all third-party claims when funds were desegregated were not inherently unlawful because segregated funds could be deposited elsewhere Ain the normal course of business” to settle trades. 7 U.S.C. § 6d(a)(2); see also 17 C.F.R. § 1.23 (stating that § 6d(a)(2) does not prohibit an entity from withdrawing segregated funds “to the extent of its actual interest”); 17 C.F.R. § 1.29 (an FCM may receive and retain “as its own any increment or interest resulting” from investments). Furthermore, Grede fails to point to any evidence suggesting that the contract between Sentinel and the Bank was connected with an illegal scheme or plan.
Just because the parties to a contract have engaged in illegal behavior does not mean the contract itself is intrinsically illegal. Nor does “the defense of illegality ... come into play just because a party to a lawful contract ... commits unlawful acts to carry out his part of the bargain.” N. Ind. Pub. Serv. Co. v. Carbon Cnty. Coal Co.,
III. Conclusion
For the foregoing reasons, we Affirm the judgment of the district court with respect to Grede’s illegal contract claim. However, we Reverse the decision of the district court with respect to Grede’s fraudulent transfer and equitable subordination claims, and we Remand the case back to the district court for further proceedings on these two claims that are consistent with this opinion. Circuit Rule 36 shall not apply on remand.
Notes
. The official was actually referencing Sentinel’s $2 million in capital, even though he seemed to think Sentinel had ten times that amount. He was closer in referring to the Bank's $300 million in collateral, which at that point apparently reached $302 million.
. On remand, more than a little work remains to be done. The Bank of New York has the opportunity to revisit a number of its other defenses about the inapplicability of § 548(a) to these transfers because they have yet to be addressed. We will comment on just one, the contention that the Bank gave value in good faith in return for the transfers. In this defense, the Bank claimed it could maintain its senior secured creditor status under 11 U.S.C. § 548(c) because it gave value in good faith. But this defense is generally unavailable to any creditor who " 'has sufficient knowledge to place him on inquiry notice of the debtor’s possible insolvency.’ ” In re M & L Bus. Mach. Co.,