The logical structure of fraudulent transfers and equitable subordination.

Author:Carlson, David Gray


In the 1980s, foreign issuers started to sell subordinated debentures in the United States market, pursuant to indentures invoking New York law. One notorious junk bond was the subject of intense litigation in Allstate Life Insurance Co. v. Linter Group Ltd. (1) In that case, the following crude fraud was alleged. An Australian debtor, whom I will call D, sought to issue a debenture in the United States. The underwriters, Drexel, BurnhAm & Lambert, advised D that the bonds could not be sold because there was too much bank debt on D's books. To disguise some of this debt, D requested a subset of its lenders, whom I shall collectively designate as X, to release its claims against D until the "junk" was peddled. The junk bonds were then issued to a class of creditors, whom I shall call [C.sub.1]. Soon after [C.sub.1] purchased the bonds, D gave X the old claims back. None of this was disclosed to [C.sub.1]. Later, new lenders, [C.sub.2], advanced funds to D. [C.sub.2] was fully knowledgeable about X's claim and [C.sub.1]'s claim but unaware of the fraud perpetrated by X on [C.sub.1]. D soon filed for bankruptcy protection in Australia. (2)

In the Australian proceeding, X anticipated a dividend worth well into the hundreds of millions of dollars. Under the law of New York, its misconduct arguably would generate two distinct claims for [C.sub.1]. First, X's claim against D was a fraudulent conveyance. According to the Uniform Fraudulent Conveyance Act (UFCA) to which New York adheres, the creation of an obligation deliberately intended to defraud creditors can be "set aside." (3)

Second, X's conduct might justify a claim of equitable subordination of X's claim to that of [C.sub.1]. Assuming equitable subordination is a good claim under New York law, and that X's claims should be equitably subordinated, how should the remedy be administered? [C.sub.2] did not deserve a remedy, because it knew all about X's claims. [C.sub.1] was the only party harmed.

The usual interpretation of fraudulent transfer law is that X's claim is simply disallowed or rescinded. Under this interpretation, [C.sub.2], whose claim dwarfed that [C.sub.1], would get the lion's share of X's enormous bankruptcy dividend (even though [C.sub.2] was not harmed by X's conduct.) Similarly, equitable subordination is usually interpreted to mean that X is demoted to a priority below all of the creditors of D. Under this interpretation, [C.sub.2] would once again capture most of the benefit, even though [C.sub.2] was not defrauded.

Should [C.sub.2] gain a huge windfall because X arguably defrauded [C.sub.1]? Certainly not. There is an alternate way of looking at the universe of fraudulent transfer law and equitable subordination that would avoid this unjustified result.

Under this alternative theory [C.sub.1] is the sole beneficiary of the remedy, [C.sub.2] is neither helped nor harmed by it, and X is more likely to obtain a surplus after [C.sub.1]'s claim is paid out. According to this alternative theory, fraudulent transfer law does not set aside X's claim. Nor does equitable subordination compel X to stand in line behind all the creditors. Rather, fraudulent transfer law and equitable subordination assign X's claim exclusively to [C.sub.1] as security for [C.sub.1]'s claim.

Linter Group, then, invites a deep inquiry into the nature of these remedies. (4) Consider first the fraudulent transfer claim. Suppose D transfers property to X or creates a fraudulent obligation. Suppose these transfers or debts are simply void. In Linter Group, this would mean that [C.sub.1] shares the remedy with [C.sub.2].

This picture, however familiar, is a metaphoric error. "Metaphors in law," Justice Cardozo once warned, "are to be narrowly watched, for starting as devices to liberate thought, they end often by enslaving it." (5) Strongly indeed does this observation manifest itself in fraudulent transfer law, which has enslaved itself to the language of avoidance, rescission, and annulment, when what is really going on is transfer. Avoidance is the wrong concept for fraudulent transfer. Rather, the thing is transferred to [C.sub.1]. From the beginning, X holds the thing in trust for [C.sub.1]--not for [C.sub.2].

Under the Bankruptcy Code, it is especially clear that avoidance is the wrong concept. Avoidance of a fraudulent transfer does not mean that the transfer disappears. According to [section] 551:

Any transfer avoided under section 522, 544, 545, 547, 548, 549, or 724(a) of this title, or any lien void under section 506(d) of this title, is preserved for the benefit of the estate but only with respect to property of the estate. (6) This section virtually confesses that avoidance is a misnomer. According to the Bankruptcy Code, avoidance means preservation for the benefit of the estate. (7) Preservation, not avoidance, should be the theme of fraudulent transfer's tongue. (8)

Likewise, demotion is the wrong concept for equitable subordination. According to the Bankruptcy Code, bankruptcy courts are invited to subordinate the claims of wicked creditors to the claims of those creditors with finer deportment. (9) The usual view of the matter is that the evil creditor is demoted behind all other creditors. Yet [section] 510(c) specifically provides for subordination to specific creditors in appropriate cases. General demotion cannot serve when, as in the Linter Group case, only specific creditors are harmed.

This Article proposes that we jettison the metaphors of avoidance and demotion. Instead, this Article proposes that the concept that organizes these bodies of law is transfer. The fraudulently transferred thing is not returned to the debtor. The wicked creditor is not demoted. Rather, the property and claims of X are transferred to [C.sub.1]. Insofar as D is concerned, D has conveyed away her property forever, and D definitely must pay the subordinated claim.

Replacing the concept of avoidance, annulment and subordination with the notion of transfer brings commercial law discourse into closer identity with its actual logical structure, while steering clear of the injustice that sometimes results when courts enslave themselves to these metaphors. The transfer concept allows for a unified account of both fraudulent transfer law and the law of equitable subordination.

Both fraudulent transfer law and the law of equitable subordination entail the same remedy of expropriation and transfer. The moral intuition behind the two doctrines, nevertheless, has come to differ. Fraudulent transfer law focuses on the debtor's intent to cheat her creditors--though intent is presumed in the so-called "constructive" fraud cases. (10) Equitable subordination, on the other hand, focuses on creditor misconduct. (11) Whereas the debtor's intent is examined at the time of the fraudulent transfer, creditor action unrelated to the origin of the creditor's claim can justify equitable subordination. (12)

The concepts of rescission, avoidance, and demotion have led to a series of confusions. For example, fraudulent transfer law is subject to the notorious rule of Moore v. Bay, (13) but equitable subordination doctrine is not. According to Moore v. Bay, a bankruptcy trustee is subrogated to an individual creditor's fraudulent transfer rights, but these rights must be used for the benefit of all the creditors equally. (14) Moore v. Bay, then, turns on the rescission theory of fraudulent transfer. In contrast, equitable subordination expressly permits creditors to benefit individually from the subordination of a wicked creditor. If, however, equitable subordination and fraudulent transfer remedies are the same, the limitation of Moore v. Bay to fraudulent transfer cases cannot be justified. Indeed, Moore v.. Bay should itself be understood as driven by metaphorical confusion as to the nature of avoidance theory. (15)

By way of a second example, courts have erroneously supposed that state law cannot effectuate equitable subordinations. Rather, equitable subordination is considered to be a uniquely federal remedy. (16) If, however, equitable subordination is simply the fraudulent transfer remedy in the special context of a collective proceeding, this conclusion must be rejected--equitable subordination is indeed part of a state's general common law. (17) This principle would have served greatly in Linter Group, where [C.sub.1]'s indenture invoked New York law but not the American Bankruptcy Code. (18)

To establish the identity of these two seemingly diverse remedies, this Article proceeds as follows. Part I describes the fraudulent transfer remedy. The laws provide for two such remedies. First, transfers of property are avoided or set aside. Second, fraudulent obligations are annulled. Each of these italicized terms will be exposed as misnomers. In actuality, fraudulent transfer law assigns the property of third parties to the defrauded creditors as security for their claims. The assignment (not avoidance) fraudulently conveyed property is then compared to the annulment of an obligation created by a debtor. Just as "set aside" or "avoidance" presents a false picture of the fraudulent transfer remedy, so annulment of an obligation is equally misleading. Obligations are not annulled but are transferred--assigned for security--to the creditor with the fraudulent transfer right.

Armed with this insight, Part II examines the equitable subordination remedy and shows that it is precisely the same as annulment of an obligation under fraudulent conveyance law. That is to say, a creditor's claim is not subordinated but is assigned to those creditors harmed by the creditor's inequitable conduct. Part II also shows that the origin of equitable subordination doctrine is, historically speaking, drawn from the state law of fraudulent transfer. This further supports the point that, structurally, equitable subordination is simply the fraudulent transfer remedy in disguise and that both...

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