One of the most powerful remedies available to a judgment creditor or a bankruptcy trustee is the power to avoid and recover fraudulent transfers.  Very generally, fraudulent transfers are transfers made by a debtor (1) with the actual intent to prevent creditors from seizing an asset to satisfy a judgment, or (2) while insolvent and the debtor receives less than reasonably equivalent value. The purpose of the fraudulent transfer remedy is to ensure that the asset pot available to satisfy creditor claims is not dissipated by transfers pending judgment enforcement.

The recovery of fraudulent transfers is governed by applicable state law and, if the debtor files for bankruptcy, an overlapping scheme under the Bankruptcy Code.  While the statutory schemes are comprehensive, certain issues are not specifically addressed.  And one of the most important issues not specifically addressed is whether the amount recovered can exceed the amount of creditor claims.

Assume a debtor while insolvent transfers property worth $100 for $25, so the debtor received less than reasonably equivalent value.  Generally, the property can be recovered, but the transferee is granted a lien on the property in the amount of $25, so the avoidance of the transfer recovers $75.  When added to the $25 previously paid by the transferee, the asset pot of $100 is reestablished.

Now further assume that the creditor suing to avoid the transfer has a claim of $50.  If the creditor’s claim is $50, is the transferee of the property required to return the entire $75 fraudulently transferred, or does the transferee only have to return $50, the amount of the creditor’s claim?  If the entire $75 is recovered and $50 paid to the creditor, the debtor will be the beneficiary of $25, which is a windfall that is hard to justify.

Outside of bankruptcy, this conundrum is rarely an issue, because the judgment creditor prosecuting the fraudulent transfer action presumably is only concerned with satisfaction of that creditor’s claim.  But inside of bankruptcy, the issue is very real, because the bankruptcy trustee prosecutes fraudulent transfer claims not on behalf of a specific creditor, but the bankruptcy estate as a whole.

The issue was very recently addressed by the Delaware Bankruptcy Court in PAH Litig. Tr. v. Water St. Healthcare Partners, L.P. (Physiotherapy Holdings, Inc.), 2017 Bankr. LEXIS 3774 (Bankr. D. Del. Nov. 1, 2017).  While the issue has been addressed by several other courts, which have uniformly held that the recovery is not capped, this was the first reported decision from the Delaware Bankruptcy Court, which is the venue for a substantial portion of the largest bankruptcy cases filed in the United States.

The debtor filed bankruptcy following an unsuccessful leveraged buyout.  The debtor confirmed a plan in which claims totaling $210 million were exchanged for common stock and 50% of any recoveries from a liquidating trust.  The liquidating trust then asserted fraudulent transfer claims to recover $246 million. Subsequent to the filing of the lawsuit, the debtor’s assets were sold and the creditors holding common stock received $282 million.

As a result of the sale, the defendant moved to dismiss the lawsuit, arguing that the creditors had already recovered more than the amount of their claims, so any recovery in the lawsuit would be a windfall.  In other words, the defendant argued that fraudulent transfer recoveries should be capped by the amount of creditor claims.

Following the decisions from other circuits, the Court concluded that recoveries are not capped by creditor claims.  The Court started with the Supreme Court decision in Moore v. Bay, 284 U.S. 4 (1931).  One of the elements of a fraudulent transfer action in a bankruptcy case is that there must be in existence an unsecured creditor that was an unsecured creditor when the transfer was made.  The issue in Moore v. Bay was what happens if the unsecured creditor’s claim is less than the amount of the fraudulent transfer?  Can the trustee avoid the entire transfer for the benefit of all creditors, or only an amount up to the required creditor’s claim?  The Supreme Court held the entire amount can be avoided, which result is codified in section 550 of the Bankruptcy Code, which provides that the trustee can avoid a transfer “for the benefit of the estate.”

The Court then analyzed the phrase “for the benefit of the estate.”  Contrary to the argument of the defendant, “for the benefit of the estate” does not mean for the benefit of creditors.  The “estate” is more than the interest of creditors and includes all potentially interested parties.  While not specifically mentioned by the Court, this analysis is consistent with Delaware corporate case law that holds the duties of a fiduciary of an insolvent company run to the enterprise as a whole and not simply to the creditors.  Production Resources Group, LLC v. NCT Group, Inc., 863 A.2d 772 (Del. Ch. 2004).

The decision will provide considerable negotiating leverage to debtors and trustees in future Delaware cases.  Where the amount of challenged transfers significantly exceeds the amount of creditor claims, the transferee will assume considerable risk if it refuses a settlement offer that permits the repayment of creditor claims.