Delaware Bankruptcy Court Rules on Fraudulent Transfer Actions for Subordinated Claimholders

Jones Day reports that the US Bankruptcy Court for the District of Delaware recently addressed whether a trustee may pursue fraudulent transfer actions when the ultimate beneficiaries are investors whose claims are subordinated under section 510(b) of the Bankruptcy Code.

In In re ONH AFC CS Investors, LLC, the court concluded that although fraudulent transfer actions are ordinarily a remedy reserved for creditors, subordination under section 510(b) does not bar trustees from seeking recovery for defrauded investors.

Fraudulent transfer provisions under the Bankruptcy Code allow trustees to avoid certain pre-petition transactions for the benefit of creditors.

Sections 544(b), 547, and 548 provide distinct avoidance powers, with Section 544(b) enabling trustees to borrow from state law remedies that have longer reach-back periods.

Separately, Section 510(b) ensures that claims tied to securities purchases or sales are subordinated below general creditor claims, consistent with the Code’s absolute priority rule and risk-allocation principles between creditors and shareholders.

Courts have differed in interpreting the scope of Section 510(b), particularly in distinguishing between creditor-like recovery and equity-like risk.

In ONH, a liquidating trustee sought to recover $7 million in transfers associated with failed real estate investments, in which investors alleged fraudulent misrepresentations. Defendants argued that because these investors’ claims were subordinated, only equity holders would benefit.

Judge Craig T. Goldblatt, relying in part on In re DSI Renal Holdings, LLC, reasoned that while fraudulent transfer claims are typically “a creditor’s remedy,” investors here could have asserted such claims under state law outside of bankruptcy. Therefore, subordination for distribution purposes did not eliminate the trustee’s power to act on their behalf.

The court allowed certain actual fraudulent transfer claims to proceed, while dismissing others for lack of sufficient allegations.

ONH reinforces that trustees may pursue avoidance claims even when subordinated claimholders are the primary beneficiaries, provided those claimholders could have acted outside bankruptcy.

Bankruptcy counsel will note that this case featured some unusual circumstances. Nevertheless, the nuanced ruling offers important guidance for future disputes where Section 510(b) subordination intersects with recovery efforts, particularly in cases where estates become solvent only through subordination.