Recent Seventh Circuit Ruling Clarifies "Inquiry Notice" Doctrine

Bank of New York Mellon lost priority status for its claim of $312 million in the liquidation of Sentinel Management Group when the 7th Circuit held that it should have suspected Sentinel was misusing customer assets and conducted an investigation into the source of the collateral Sentinel had posted.  The 7th Circuit clarified the doctrine of "inquiry notice" in a bankruptcy proceeding in its decision, and the holding requires firms to be reasonably diligent in investigating any suspicions they have relating to their customers or risk the loss of their security interest in pledged collateral.

Sentinel, a trading firm, had (in violation of federal law) pledged its customers' securities to Bank of New York Mellon and Bank of New York ("BNYM") as collateral for $312 million of loans to support Sentinel's proprietary trading.  Following the bankruptcy, BNYM asserted a senior secured claim against Sentinel based on these pre-petition loans. The bankruptcy trustee,