Whether a Fraudulent Transfer Claim Is ‘Direct’ or ‘Derivative’ Depends on Point of View

Fraudulent transfer claims are typically seen as “derivative claims” from the point of view of creditors in a bankruptcy case. From the point of view of a debtor, fraudulent transfer claims are typically “direct claims.”

A December 15 opinion by the Delaware Supreme Court shows how point of view determines whether fraudulent transfer claims are “direct” or “derivative.” The opinion has the effect of protecting insurance companies from paying the costs of defense, judgments and settlements when an insured is sued for a fraudulent transfer and the insured seeks coverage under a policy providing coverage for violations of securities laws.

The opinion by the Delaware high court is highly complex, and we won’t pretend to fathom the intricacies of insurance law. When counsel are involved in a coverage suit resulting from costs or liability incurred in a fraudulent transfer suit brought under the Bankruptcy Code, we recommend reading the opinion in full text.

The Claims Arising from a Spinoff

One of the country’s largest telecommunications companies spun off a subsidiary that promptly went bankrupt. In part, the spinoff had entailed the issuance of securities. The bankrupt subsidiary’s chapter 11 plan created a litigation trust to bring suits on behalf of creditors.

The trust brought a fraudulent transfer suit against the former parent. Eventually, the former parent settled with the litigation trust by paying $95 million, after having spent $24 million in defense costs.

To recover costs of the settlement and defense, the former parent sued its insurer in a Delaware Superior Court under a directors’ and officers’ liability policy. The policy covered losses “arising from a Securities Claim made against [the insured] for any Wrongful Act of such Organization.”

Pertinent to the case on appeal, “Securities Claim” was defined as a claim made against an insured alleging violation of any federal or state “statute governing securities” which is “brought derivatively on the behalf of an [insured] by a security holder of such [insured].”

In his opinion for the Delaware Supreme Court, Chief Justice Collins J. Seitz, Jr., said that the “Superior Court held that a post-bankruptcy litigation trust’s state law fraudulent transfer claims were derivative claims and therefore qualified as a Securities Claim under the policies.”

Indeed, the Superior Court might be correct if one were looking only at fraudulent transfer claims in a bankruptcy case. Typically, a creditor cannot sue a recipient of a debtor’s fraudulent transfer unless the creditor has a direct claim, meaning a claim that is particular to that creditor. If it’s the same claim that belongs to the debtor, then an individual creditor’s claim is derivative and isn’t a direct claim that the creditor can assert in its own right.

In the liquidation of the Bernard Madoff Ponzi scheme, for example, the trustee has collected billions of dollars in fraudulent transfers. The Second Circuit has consistently ruled that defrauded creditors’ claims against recipients of fraudulent transfer are derivative claims that creditors cannot assert on their own behalf.

However, the Madoff litigation did not involve insurance policies. There’s a world of difference when an insured seeks coverage under an insurance policy with definitions like those set out above. Who’s the plaintiff and who’s the defendant matters in deciding what’s derivative and what’s direct.

Chief Justice Seitz described the Superior Court as having theorized that fraudulent transfer claims are “not necessarily” direct claims when brought outside of bankruptcy because creditors can be given derivative standing when the debtor is insolvent. He went on to say, however, that a “business entity’s insolvency does not convert direct claims like fraudulent transfer claims into derivative claims.”

“Applying bankruptcy law,” the Chief Justice said that “the Superior Court held that the direct state law fraudulent transfer claims became derivative within the bankruptcy proceeding.”

To decide whether the claims were direct or derivative, the Chief Justice looked at the litigation trust’s complaint. He noted that the litigation trust did not comply with the Federal Rules regarding derivative claims. He concluded that the trust brought the suit “directly, not derivatively.”

According to Chief Justice Seitz, the “Superior Court found that state law fraudulent transfer and other common law claims were Securities Claims under the Policies and therefore defense costs were covered losses.”

In fact, securities had been issued in connection with the spinoff that included fraudulent transfers. Nonetheless, the Chief Justice quoted a decision by his court in a related, prior appeal, where the Delaware Supreme Court said that fraudulent transfer provisions in the Bankruptcy Code “‘give rise to causes of action with or without the presence of securities. Thus, these claims are not specific to securities regulation, and do not fall within the definition of a Securities Claim under the policy.’” In re Verizon Insurance Coverage Appeals, 222 A.3d 566, 574 (Del. 2019).

Chief Justice Seitz held that the “Policies defined a Securities Claim in the context of securities and corporate law, not bankruptcy law. If a bankruptcy occurred, the Policies provided that existing contractual rights would be protected but did not expand or create new coverage.” He reversed the Superior Court and its ruling in favor of the insured because the “Litigation Trust’s state law fraudulent transfer claims were direct, not derivative claims, and therefore were not covered [by the definition of a] Securities Claim.”