In the

United States Court of Appeals

For the Seventh Circuit

Nos. 10‐3787, 10‐3990 & 11‐1123

IN RE:

SENTINEL MANAGEMENT GROUP, INC.,

Debtor.

APPEAL OF:

FREDERICK J. GREDE, not individually

but as Liquidation Trustee of the

Sentinel Liquidation Trust.

Appeals from the United States District Court for the

Northern District of Illinois, Eastern Division.

No. 1:08‐cv‐02582 — James B. Zagel, Judge.

ARGUED SEPTEMBER 8, 2011 — DECIDED AUGUST 26, 2013

Before MANION, ROVNER, and TINDER, Circuit Judges.

TINDER, Circuit Judge. The collapse of investment manager

Sentinel Management Group, Inc., in the summer of 2007 left

its customers ina lurch.Insteadof maintaining customer assets
2 Nos. 10‐3787, 10‐3990 & 11‐1123

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 subordina‐

tion, 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 thedistrict court’s painstaking

efforts, we cannot agree with its conclusion that Sentinel’s

failure to keep client funds properly segregated was insuffi‐

cient 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 judg‐

ment of the district court with respect to Grede’s fraudulent

transfer and equitable subordination claims.

I. Factual Background

Eventhough we findsome inconsistencies inthe thirty‐nine‐

page opinion of the district court, its comprehensive review of

the evidence still provides a useful starting point for our

discussion. See Grede v. Bank of N. Y. Mellon, 441 B.R. 864 (N.D.

Ill. 2010). The district court’s findings of fact, of course, “are

entitled to great deference and shall not be set aside unless

they are clearly erroneous.” Gaffney v. Riverboat Servs. of Ind.,

Inc., 451 F.3d 424, 447 (7th Cir. 2006). Nonetheless, we review

the district court’s findings of law—including the district
Nos. 10‐3787, 10‐3990 & 11‐1123 3

court’s determination of actual intent to hinder, delay, or

defraud—de novo. Johnson v. West, 218 F.3d 725, 729 (7th Cir.

2000).

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 broker‐dealers. In Sentinel’s hands, FCMs’ client

money could, in compliance with industry regulations govern‐

ing 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 invest‐

ing,” 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. Sentinelreceived a no‐action” letterfrom the

Commodity Futures Trading Commission (CFTC) exempting

it from certain requirements applicable to FCMs. But Sentinel

represented that it would maintain customer funds in segre‐

gated accounts as required under the Commodity Exchange

Act, 7 U.S.C. § 1 et seq. Maintaining segregation meant that at

all times a customer’s accounts held assets equal to the amount

Sentinel owedthe customer, andthat Sentineltreatedanddealt

with the assets ?as belonging to such customer.” 7 U.S.C. §

6d(a)(2) (?Such money, securities, and property shall be

separately accounted for and shall not be commingled with the

funds of such commission merchant or be used to margin or
4 Nos. 10‐3787, 10‐3990 & 11‐1123

guarantee the trades or contracts, or to secure or extend the

credit, of any customer or person other than the one for whom

the same are held ...”).

Maintaining segregation serves as commodity customers’

primary legal protection against wrongdoing orinsolvency 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 otherinvestors such as hedge funds and commod‐

ity pools, and as early as 2005, began maintaining a house

account forits 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‐

regulated 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, 441 B.R. at 874. When customers

wanted their capital back, Sentinel could sell securities or

borrow the money. Sentinel’s borrowing practices, and in

particular an overnight loan it maintained with the Bank of

New York, is this appeal’s focal point. This arrangement

allowed Sentinel to borrow large amounts of cash while

pledging customers’ securities as collateral.
Nos. 10‐3787, 10‐3990 & 11‐1123 5

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 account, 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 arrange‐

ment that?THIS ACCOUNT IS AN ACCIDENT WAITING TO

HAPPEN ... .I AM NOTIFYING YOU THATI NO LONGER

FEEL COMFORTABLE CLEARING THESE TRANSAC‐

TIONS 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 sufficient

assets in lienable accounts to serve as collateral. A senior bank

executive had to approve requests that put the line of credit

above a predetermined ?guidance line.” Third, Sentinel

maintained segregated accounts that held assets that could not
6 Nos. 10‐3787, 10‐3990 & 11‐1123

be subject to any bank lien. These included accounts (corre‐

sponding with the lienable clearing accounts) for government,

corporate, and foreign securities but no corresponding segre‐

gated account for physical securities. To receive FCM funds in

the segregated accounts, the Bank countersigned letters

acknowledging that the funds belonged to the customers and

that the accounts would ?not be subject to your lien or offset

for, and on account of, any indebtedness now or hereafter

owing us to you ... .” The agreement between Sentinel and the

Bank provided thatthe ?Bank will not have, and will not assert,

any claim or lien against Securities held in a Segregated

Account nor will Bank grant any third party ... any interest in

such Securities.”

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 collat‐

eral into the lienable accounts. Sentinel used cash from the

overnight loan for customer redemptions 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
Nos. 10‐3787, 10‐3990 & 11‐1123 7

securities to sell. This arrangement did not violate segregation

requirements. When a customer cashed out, the amount

needed in segregation dropped by the amountlent 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

withcounterparties such as FIMATUSAand 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 pointforthe amount loaned plus

interest. By 2007, Sentinel held more than $2 billion in securi‐

ties through repo arrangements. Meanwhile, Sentinel’s

guidance line forthe 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 point, 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 focus of the

market as counterparties stopped accepting securities previ‐
8 Nos. 10‐3787, 10‐3990 & 11‐1123

ously used as collateral. They wanted cash. But the crunch

prevented selling the securities. Cash was tough to obtain. As

Sentinel turned increasingly to its line of credit for cash, the

Bank’s thirst for the highest‐rated, most‐liquid securities to

secure the loan intensified.

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 segrega‐

tion 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 collateral is for

somebody else’s benefit. Do we really have rights on the whole

$300MM??”1 After speaking to several bank officers, a Bank of

New York client executive responded, ?We have a clearing

agreement which gives us a full lien on the box position

outlined below.” The client executive testified that this was a

well‐advised and carefully worded statement, but both the

managing director and the client executive knew Sentinel had

1

  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.
Nos. 10‐3787, 10‐3990 & 11‐1123 9

an agreement that gave the Bank a lien on any securities in

clearing accounts. Grede, 441 B.R. at 889‐90. Then on June 26, a

counterparty returned $166 million in physical securities. The

Bank loan balance accordingly grew to $497.5 million. For

collateral, Sentinel moved $66.6 million in government

securities out of segregated accounts and into the lienable

account. These securities, however, were not enough for the

Bank. In turn, Sentinel pledged $165 million in physical

securities, and the segregation deficiency grew to $667 million.

On June 27, Sentinel’s loan balanced peaked at $573 million.

Two days later, the Bank told Sentinel it would no longer

accept physical securities as collateral. That day, Sentinel

transferred $166 million in corporate securities from segre‐

gated accounts to the lienable account. Sentinel’s under‐

segregation problem grew to $813 million.

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 segrega‐

tion 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 segrega‐

tion deficit at $700 million.
10 Nos. 10‐3787, 10‐3990 & 11‐1123

Afterthese transactions, Sentinel couldnot hang onandtold

customers on August 13 that it was halting redemptions

because of problems in the credit markets. Once Sentinel told

the Bank about this decision the next day, the Bank cut Senti‐

nel’s remote access to its systems, sent its officials to Sentinel’s

offices, demanded full repayment of the loan, and threatened

to liquidate the collateral. Sentinel filed for bankruptcy on

August 17, owing the Bank $312,247,000.

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)(1), 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 subordination 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, 2009

WL 188460, at *8 (N.D. Ill. Jan. 27, 2009), and the Bank moved

for summary judgment on the other claims. The courtreserved

ruling on the Bank’s motion and held a bench trial that lasted

seventeen days. After hearing from more than a dozen wit‐

nesses, listening to audio recordings between bank and
Nos. 10‐3787, 10‐3990 & 11‐1123 11

Sentinel officials, and reviewing hundreds of exhibits, the

district court ruled in the Bank’s favor on the remaining

counts. The court found that Grede had “failed to prove that

Sentinel made the Transfers with the actual intent to hinder,

delay or defraud its creditors.” Grede, 441 B.R. at 881. The court

also rejected the preference claim because the Bank was

over‐collateralizedonthe transferdates.Id. at 886.With respect

to equitable subordination, the court rejected Grede’s claim

because it did not believe that the Bank’s conduct was “egre‐

gious or conscience shocking.” Id. at 901. Moreover, the court

found that the Bank employees “had no legal obligation ... to

seek out or analyze the data” that would have revealed

Sentinel’s misuse of the segregated funds. Id. at 895.

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

11U.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
12 Nos. 10‐3787, 10‐3990 & 11‐1123

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 lienable 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. §§ 548(a)(1)(A) & 544(b), and should

thus be avoided.

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

relied on Grede’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 concludedthatthis behavior was not

enough to show that Sentinel had actual intent to hinder,

delay, or defraud its FCM clients. Rather, the opinion charac‐

terized Sentinel’s behavior as a desperate “attempt to stay in

business.”
Nos. 10‐3787, 10‐3990 & 11‐1123 13

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., 38 F.2d 10, 21 (7th Cir. 1930); see also Reno

v. Bossier Parish Sch. Bd., 520 U.S. 471, 487 (1997); Trzcinski v.

Am. Cas. Co., 953 F.2d 307, 313 (7th Cir. 1992).

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, 644 F.3d 364,

367 (7th Cir. 2011), Michael Segal appealed his conviction of,

among other crimes, mail and wire fraud under 18 U.S.C. §§

1341, 1343. Segal argued that his fraud convictions should be

overturned because he lacked “a specific intent to cause

injury.” Id. We rejected this argument, finding that a defendant
14 Nos. 10‐3787, 10‐3990 & 11‐1123

could have an actual intent to defraud without having an

actual intent to cause harm. Id.

Similarly, in United States v. Davuluri, 239 F.3d 902, 906 (7th

Cir. 2001), the defendant, Surya Davuluri, also appealed his

conviction of mail and wire fraud under 18 U.S.C. §§ 1341,

1343. Davuluri argued that the undisputed evidence demon‐

strated that “he always intended only to earn profits for [his

victim], rather than imposing any kind of loss on him,” and

that such intentions were inconsistent with an actual intent to

defraud.Id.We rejectedDavuluri’s argument.Even ifDavuluri

had possessed nothing but the best intentions for his victim,

we held that “a rational jury could find beyond a reasonable

doubt that [Davaluri had] imposed a large risk of loss on [his

victim]. Exposing the victim to a substantial risk of loss of

which the victim is unaware can satisfy the intent require‐

ment.” Id.; cf. United States v. Hamilton, 499 F.3d 734, 736 (7th

Cir. 2007) (Fraud is “not excused just because you had an

honest intention of replacing the money.”).

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 FCMclients as collateralfor Sentinel’s overnightloans 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

Davaluri that someone who has the best intentions can still

possess an actual intent to defraud. 239 F.3d at 906. Conse‐

quently, even if we assume that Sentinel had the best inten‐

tions forits FCM clients when it pledged the segregated funds,
Nos. 10‐3787, 10‐3990 & 11‐1123 15

the fact remains that Sentinel knowingly exposed its FCM

clients to a substantialrisk of loss of which they were unaware.

Sentinel’s pledge ofthe segregatedfunds as collateralforits

own loan becomes particularly egregious when viewedin light

ofthe legalrequirements imposedon Sentinel by the Commod‐

ity 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 “ensur[ing] the

financial integrity of all transactions” involving FCMs,

“avoid[ing] systemic risk,” and “protect[ing] all market

participants from ... misuses of customer assets.” 7 U.S.C.

§ 5(b). In orderto furtherthese 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. Forthis reason, we findthat Sentinel’s actions,

as determined by the factual findings of the district court,

demonstrate an actual intent to hinder, delay, or defraud. As
16 Nos. 10‐3787, 10‐3990 & 11‐1123

such, Grede should be able to avoid the Bank of New York’s

lien under 11 U.S.C. § 548(a)(1)(A).2

B. Equitable Subordination

Courts will subordinate a claim under 11 U.S.C. § 510(c)

whenthe claimant creditor engagedininequitable conductthat

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, 546 F.3d 863, 866 (7th Cir.

2008) (quoting United States v. Noland, 517 U.S. 535, 538‐39

(1996)). “Equitable subordination allows the bankruptcy court

to reprioritize a claim ifit determines that the claimantis guilty

of misconduct that injures other creditors or confers an unfair

advantage on the claimant.” Id. (citing In re Lifschultz Fast

Freight, 132 F.3d 339, 344 (7th Cir. 1997)). Typically, the

misconductthat courts havedeemedsufficiently inequitable to

2

   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., 84 F.3d 1330, 1336 (10th Cir. 1996) (quoting In re Sherman, 67 F.3d 1348,

1355 (8th Cir. 1995)). As our discussion in the next section will demonstrate,

the district court needs to clarify on remand what exactly the Bank knew

before Sentinel’s collapse. But 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.
Nos. 10‐3787, 10‐3990 & 11‐1123 17

merit this remedy has fallen within one of three areas: A(1)

fraud, illegality, breach of fiduciary duties; (2)

undercapitalization; [or] (3) claimant’s use of the debtor as a

mere instrumentality or alter ego.” Lifschultz, 132 F.3d at 345

(quoting In re Missionary Baptist Found. of Am., 712 F.2d 206, 212

(5th Cir. 1983)). Keeping this general guidance in mind, we

must decide here whether the Bank of New York’s conduct

was sufficiently inequitable to merit the subordination of its

lien.

?Equitable subordination means that a court has chosen to

disregard an otherwise legally valid transaction.” Lifschultz,

132 F.3d at 347. In the past, our court—like other courts—has

treadedvery carefully beforedisregarding an otherwise legally

valid transaction. See, e.g., Lifschultz, 132 F.3d at 347 (citing In

re Mobile Steel Co., 563 F.2d 692, 701‐02 (5th Cir. 1977)). Two

fundamental concerns have motivated our hesitance to invoke

the doctrine of equitable subordination: (1) the upsetting of a

claimant’s legitimate expectations, and (2) the spawning of

legal uncertainty that courts will refuse to honor otherwise

binding agreements “on amorphous grounds of equity,”

increasing everyone’s credit costs. Id.

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 under‐

handedbehavior occurred.Id.(?Equitable subordination relies
18 Nos. 10‐3787, 10‐3990 & 11‐1123

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, 908 F.2d

1351, 1356 (7th Cir. 1990). Consequently, courts have most

frequently invoked this doctrine against corporate insiders,

requiring them “to return to their position at the end of the

line.” Id.

Proving that an outside creditor behaved inequitably in

anticipation of the debtor’s bankruptcy is much more difficult;

the interests of an outside creditor are not necessarily aligned

with the interests of the debtor (or with the interests of the

debtor’s shareholders). As a result, courts have been particu‐

larly hesitant to invoke the doctrine of equitable subordination

outside of cases involving insiders of closely heldcorporations.

Lifschultz, 132 F.3d at 343. Some bankruptcy courts have even

required wrongful conduct that rises to the level of “gross and

egregious,” “tantamount to fraud, misrepresentation, over‐

reaching or spoliation,” or “involving moral turpitude” before

equitably subordinating an outside creditor’s claim. In re

Granite Partners, L.P., 210 B.R. 508, 515 (Bankr. S.D.N.Y. 1997)

(quotations and citation omitted). Consequently, it is not

surprising that “[c]ases subordinating the claims of creditors

that dealt at arm’s length with the debtor,” such as the case at

hand, “are few and far between.” Kham, 908 F.2d at 1356.

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
Nos. 10‐3787, 10‐3990 & 11‐1123 19

district court here looked to decisions outside our circuit.

Relying primarily on Granite Partners, 210 B.R. at 515, the

district court determined that equitable subordination would

be inappropriate in this case unless the Bank’s behavior had

been “egregious and conscience shocking.” Grede, 441 B.R. at

886, 901. The district court did not believe that the Bank’s

behavior had sunk to this level, and thus, refused to subordi‐

nate the Bank’s claim.

Butin reaching the conclusion thatthe 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, bydefinition, clearly erroneous. See United

States v. Sablotny, 21 F.3d 747, 751 (7th Cir. 1994) (“The district

court’s factual findings ... are not internally inconsistent, and

are thus not in clear error.”); see also Anderson v. City of Besse‐

mer, N.C., 470 U.S. 564, 575 (1985) (“[W]hen a trial judge’s

finding is based on his decision to credit the testimony of one

of two or more witnesses ... that finding, if not internally

inconsistent, can virtually never be clear error.”).

In particular, the district court appears to contradict itself

regarding the extent of the Bank’s knowledge before Sentinel’s

collapse. Approximately halfway through its opinion, the

district court states, “[T]he evidence attrialrevealed the Bankʹs

knowledge that Sentinel insiders were using at least some of

the loan proceeds for their own purposes.” Grede, 441 B.R. at

883. This statement indicates that the Bank of New York knew

Sentinel was engaging in wrongful conduct before its collapse.
20 Nos. 10‐3787, 10‐3990 & 11‐1123

In contrast, the district court later states, “I do find credible, if

not at all admirable, the testimony of the Bank employees that

they neither knew nor turned a blind eye to the improper

actions of Sentinel.” Id. at 894. If the Bank knew that Sentinel

insiders were misusing the loan proceeds, then how could it be

the case that bank employees “neither knew norturned a blind

eye to the improper actions of Sentinel”? The two factual

findings, though in different parts of the opinion, make no

sense when juxtaposed.

The fact that the Bank knew Sentinel insiders were misus‐

ing the loan proceeds before Sentinel’s collapse renders other

statements in the district court’s opinion equally puzzling. For

instance, at one point in the opinion, the district court con‐

cludes:

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. Notwith‐

standing the evidence that demonstrates that at

least one BNYM employee was suspicious,

several of the facts that Trustee maintains sup‐

port 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 loan proceeds, then how
Nos. 10‐3787, 10‐3990 & 11‐1123 21

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 thatinsiders weremisusing 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 regard‐

ing 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 sug‐

gests that Bank employees (at the very least) 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 deliber‐

ately 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’ knowl‐

edge), 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 our point well. Toward the end of its discus‐

sion 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
22 Nos. 10‐3787, 10‐3990 & 11‐1123

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 seemsto beineffective 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 Senti‐

nel’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 bank‐

ers 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 ofthese inconsistencies throughoutthe opinion, we

are understandably dubious of the district court’s ultimate

conclusion that the Bank’s conduct did “not rise to the level of

egregious andconscience‐shocking, andits claimshouldnot be

subordinated.” Id. at 898. Thus, before the district court can

reach any conclusion regarding the nature of the Bank’s

conduct, we believe that the district court must clarify two

critical issues:

1. What exactly did BNYM know before Sentinel’s col‐

lapse? Did BNYM know that Sentinel was engaged in
Nos. 10‐3787, 10‐3990 & 11‐1123 23

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 itreckless? 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, 526 F.3d 1074, 1081 (7th Cir. 2008).

Thedistrict court correctlydismissedthis claim because the

agreements were notthe cause of Sentinel’sunder‐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 allthird‐party claims when funds weredesegregated

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 ofits actual interest”); 17 C.F.R.

§ 1.29 (an FCM may receive and retain “as its own any incre‐

ment or interest resulting” from investments). Furthermore,

Grede fails to point to any evidence suggesting that the
24 Nos. 10‐3787, 10‐3990 & 11‐1123

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., 799 F.2d 265, 273 (7th Cir. 1986)

(citations omitted). Consequently, we agree with the district

court that the defense of illegality is inapplicable to the

contracts between Sentinel and the Bank of New York.

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

respecttoGrede’s fraudulenttransfer andequitable subordina‐

tion claims, and we REMAND the case back to the district court

forfurther proceedings on these two claims that are consistent

with this opinion. Circuit Rule 36 shall not apply on remand.