By Jonathan Stempel
(Reuters) - A federal appeals court on Friday set back Bank of New York Mellon (N:BK) Corp's effort to recoup $312 million it lent to Sentinel Management Group Inc, a money manager that collapsed in 2007 and whose former chief is now in prison for fraud.
The 7th U.S. Circuit Court of Appeals in Chicago said a lower court judge reviewing bankruptcy trustee Frederick Grede's lawsuit erred in clearing the bank of wrongdoing in its dealings with Sentinel and its chief executive officer, Eric Bloom.
Writing for the appeals court, Circuit Judge Richard Posner said the bank should be treated as an unsecured Sentinel creditor, not a secured creditor, because it was aware of suspicious facts that should have led it to investigate whether Northbrook, Illinois-based Sentinel was up to no good.
Posner also rejected Grede's argument that the bank's claim should be pushed further behind other claims, saying the trustee did not show that the bank acted deliberately to avoid confirming its belief there was a high probability of fraud.
The trustee objected to the bank's acceptance of Bloom's assurances that he had permission from customers to use their money as collateral for his loan.
Federal prosecutors said Bloom used the loan to help finance a "house" trading portfolio filled with risky and illiquid securities, and then concealed Sentinel's looming insolvency.
The firm went bankrupt in August 2007, and prosecutors later charged Bloom for running what they called a $666 million fraud.
Bloom was convicted in March 2014 on 19 fraud counts, and is serving a 14-year prison term. He is appealing the conviction.
Friday's decision partially reversed rulings in 2014 from U.S. District Judge James Zagel in Chicago, and returned the case to the lower court for further proceedings.
"The trustee is extremely pleased," Grede's lawyer Catherine Steege, who co-chairs Jenner & Block's bankruptcy litigation practice, said in an email. "The ruling paves the way for the trustee to make a very substantial distribution to Sentinel's customers harmed by Sentinel's fraud, which the Court of Appeals determined the Bank of New York should have investigated."
A spokesman for the bank had no immediate comment.
The case is Grede v. Bank of New York Mellon Corp et al, 7th U.S. Circuit Court of Appeals, No. 15-1039.