As a general proposition, courts in the Third Circuit don’t permit a bankruptcy trustee to mount a fraudulent transfer suit for the benefit of shareholders. Bankruptcy Judge Craig T. Goldblatt of Delaware, however, explained when there’s an exception to the rule.

When the claims and interests of defrauded equity investors are subordinated under Section 510(b), a trustee may avoid a fraudulent transfer for the benefit of equity holders once the claims of creditors have been paid in full.

Judge Goldblatt based his May 8 opinion on the history of fraudulent transfers and Moore v. Bay, 284 U.S. 4 (1931), which he called “nearly inscrutable.” We recommend reading Judge Goldblatt’s opinion in full text for a better understanding of the two-paragraph opinion by Justice Oliver Wendell Holmes, Jr.

A Surplus for Defrauded Investors

The facts before Judge Goldblatt were simple, but the course he was required to follow was circuitous.

The debtor was a corporation that had defrauded its equity investors by raising $44 million from them, ostensibly to purchase a valuable asset. The debtor never bought the asset, but the debtor’s manager dissipated the $44 million.

Before bankruptcy, the manager caused the debtor to transfer $5 million of the debtor’s funds to a lender in repayment of a loan by the lender to the manager.

The chapter 11 case for the debtor culminated in the creation of a liquidating trust. The trustee of the trust filed a fraudulent transfer suit against the lender. By the time the dispute came to Judge Goldblatt, the trustee had paid creditors in full. Defrauded equity investors would be next in line for anything more that came into the estate.

The lender filed the equivalent of a motion to dismiss, contending that the trustee could not pursue the complaint when the beneficiaries would be equity holders, not creditors.

Section 550 Isn’t for Equity Holders

The motion to dismiss was seemingly well taken in view of In re DSI Renal Holdings, LLC, 14-50356, 2020 WL 550987 (Bankr. D. Del. Feb. 4, 2020), by Delaware’s Chief Bankruptcy Judge, Karen B. Owens. To read ABI’s report on DSI, click here.

In DSI, the chapter 7 trustee was pursuing a fraudulent transfer with the prospect of recovering $700 million, but there was only $170 million in creditors’ claims. Anything more than $170 million would benefit equity holders. Judge Owens capped the trustee’s recovery at $170 million.

Judge Goldblatt said he was “persuaded by the core reasoning” of DSI, which was based on three decisions from the Third Circuit. He described the DSI opinion as explaining “that while the transfers may be avoidable under §§ 544 or 548, the trustee’s recovery is governed by § 550, which permits recovery ‘for the benefit of the estate.’”

Judge Goldblatt said that the court in DSI read the circuit’s authority “to stand, collectively, for the proposition that this language should be understood to mean ‘for the benefit of creditors.’” Since equity holders are not creditors, Section 550 would mean that a trustee cannot pursue a recovery for noncreditors such as equity holders.

However, Judge Goldblatt went on to say that the circuit opinions “might be read more narrowly” to permit an exception for defrauded equity holders.

The ‘Old Soil’ of Fraudulent Transfers

To buttress the holding in DSI, Judge Goldblatt explored the history of fraudulent transfers and characterized them as protecting creditors, saying they “could be invoked only by creditors.” Were equity holders injured by the same activities, he said that shareholders might have a claim “for breach of fiduciary duty against the corporation or its directors.”

When fraudulent transfers were engrafted onto the Bankruptcy Code, Judge Goldblatt said that Congress had “no reason to believe that [fraudulent transfers were] intended … to operate for the benefit of equity holders for whom the remedy was unavailable outside of bankruptcy.”

Judge Goldblatt explained how the common law of fraudulent transfers became bankruptcy law via Section 550, which provides that “the trustee may recover [avoided property] for the benefit of the estate.” He said that “the ‘old soil’ of the creditor’s remedy of fraudulent conveyance would strongly suggest that, at the very least, when a trustee seeks to recover under § 550 on a claim for fraudulent conveyance, the term ‘for the benefit of the estate’ should be understood to mean for the benefit of creditors.”

Explicating Moore v. Bay

The language in Section 550 — “for the benefit of the estate” — was “drawn from” Moore v. Bay, Judge Goldblatt said. It means “that the proceeds of the recovery are to be shared with all creditors, not just those who could have brought the claim under non-bankruptcy law.”

Judge Goldblatt asked whether the language “goes further” by “also allowing the trustee to pursue fraudulent conveyance claims once all creditors are paid in full.” Although he identified cases that read the Holmes opinion more expansively, he was “persuaded by the analysis of [DSI] that nothing in Moore v. Bay itself requires that result.”

“But,” Judge Goldblatt said, “Moore v. Bay does not require such an expansive reading.” [Emphasis in original.] He explained,

Moore v. Bay did say that the lien was avoided in its entirety and that the unencumbered value was to be distributed to all creditors, not just those who could have themselves avoided the lien outside of bankruptcy. But critically, the beneficiaries of that action were creditors, not the holders of equity in the debtor.

Judge Goldblatt concluded that “a bankruptcy trustee’s recovery on a fraudulent conveyance claim cannot exceed the total value of the valid claims against the bankruptcy estate.” Allowing the remedy to “benefit equity holders would unmoor it from its historical foundations.”

The Advantage and Disadvantage of Section 510(b)

Having agreed with DSI as a matter of principle, Judge Goldblatt tasked himself with developing a rationale for allowing the trustee to proceed for the benefit of equity holders. Outside of bankruptcy, he said that a defrauded investor “would have been able . . . to bring an action against the recipient of a fraudulent conveyance, since outside of bankruptcy a defrauded investor is of course a creditor.”

In the case before him, the defrauded investors fell under Section 510(b), which subordinated their claims for “the purpose of distribution under this title.” The text of the subsection, he said, “makes clear that the subordination provided for under that section is only ‘[f]or the purposes of distribution under this title.’”

Judge Goldblatt decided that the statute “should not be applied for the very different purpose of reducing the liability of a fraudulent conveyance defendant.” If the trustee could not pursue the fraudulent transfers, he said that “§ 510(b) would leave the trustee in bankruptcy with lesser rights than the creditors enjoyed before the bankruptcy filing.”

Judge Goldblatt effectively denied the defendant’s motion to dismiss.

Observation

Invoking Section 510(b) and the progeny of Moore v. Bay, Judge Goldblatt interpreted bankruptcy law in a manner that would neither disadvantage defrauded investors nor create a safe-haven windfall for recipients of fraudulent transfers.