Delaware Bankruptcy Court Allows Trustee to Pursue Recovery of Fraudulent Transfers for the Sole Benefit of Subordinated Claimholders

The Bankruptcy Code provides a bankruptcy trustee or chapter 11 debtor-in-possession ("DIP") with the power to avoid and recover certain fraudulent transfers that a creditor could have avoided outside of bankruptcy under applicable non-bankruptcy law. In In re ONH AFC CS Investors, LLC, 2025 WL 1353850 (Bankr. D. Del. May 8, 2025), the U.S. Bankruptcy Court for the District of Delaware was presented with the question of whether a bankruptcy trustee may exercise this power for the benefit of defrauded investors whose claims were statutorily subordinated to the level of equity by operation of section 510(b) of the Bankruptcy Code. 

Persuaded by the reasoning of another Delaware bankruptcy court, the bankruptcy court in ONH concluded that, generally, a bankruptcy trustee cannot seek to avoid fraudulent transfers for the benefit of equity holders. With respect to the specific situation presented, however, the court ruled that the Bankruptcy Code's subordination of certain claims of investors did not preclude the trustee from bringing fraudulent transfer actions for their benefit.  

Avoidance of Transfers in Bankruptcy 

The Bankruptcy Code provides a trustee or DIP with the power to avoid certain pre-bankruptcy transfers or obligations. For example, section 547 authorizes a trustee or DIP to avoid a transfer that is preferential because the transfer was made to a creditor by an insolvent debtor on account of an antecedent debt within 90 days prior to a bankruptcy filing (or one year if the recipient is an insider) that permits the creditor to receive more than it would have recovered without the transfer in a hypothetical chapter 7 liquidation. Section 548 of the Bankruptcy Code authorizes the avoidance of pre-bankruptcy transfers or obligations that either are made with the intent to hinder, delay, or defraud creditors or are constructively fraudulent because the debtor was insolvent at the time of the transfer (or rendered insolvent by it) and received inadequate consideration in exchange. 

Section 544(b) allows a trustee or DIP to assert avoidance claims that could have been asserted by an actual unsecured "triggering" creditor under applicable non-bankruptcy (generally state) law, such as the Uniform Voidable Transactions Act or its predecessor, the Uniform Fraudulent Transfer Act, which have been enacted in nearly every state. See generally Collier on Bankruptcy ("Collier") ¶ 544.06 (16th ed. 2025). Section 544(b) is an important tool, principally because the reach-back period for avoidance of fraudulent transfers under state fraudulent transfer laws (or even non-bankruptcy federal laws, such as the Internal Revenue Code) is typically longer than the two-year period for avoidance of fraudulent transfers provided under section 548. Id.  

Subordination of Investor Claims in Bankruptcy 

The concept of claim, debt, or lien subordination is well recognized under federal bankruptcy law. A bankruptcy court's ability to reorder the relative priority of claims or debts under appropriate circumstances is part and parcel of its broad powers as a court of equity. The statutory vehicle for applying these powers in bankruptcy is section 510 of the Bankruptcy Code. 

Section 510(a) provides that an enforceable pre-bankruptcy subordination agreement will be enforced in a bankruptcy case. Section 510(b) generally subordinates claims arising from the purchase or sale of a security of the debtor to all claims that are senior or equal to the claim or interest represented by the security. Under section 510(c), a bankruptcy court can equitably subordinate the claim of a creditor or a shareholder to the claims of other creditors or interest holders in cases of misconduct or unfair advantage. 

Section 510(b) provides as follows: 

For the purpose of distribution under this title, a claim arising from rescission of a purchase or sale of a security of the debtor or of an affiliate of the debtor, for damages arising from the purchase or sale of such a security, or for reimbursement or contribution allowed under section 502 on account of such a claim, shall be subordinated to all claims or interests that are senior to or equal the claim or interest represented by such security, except that if such security is common stock, such claim has the same priority as common stock. 

11 U.S.C. § 510(b). 

The purpose of section 510(b), consistent with the Bankruptcy Code's "absolute priority rule" (generally providing that, absent consent, creditor claims must be paid in full before equity holders can receive any value) is to prevent the bootstrapping of equity interests into claims that are on a par with other creditor claims. See generally Collier at ¶ 510.04[1]. 

Interest holders have resorted to a wide array of devices and legal arguments in an effort to overcome the effect of section 510(b), including contractual provisions purporting to entitle them to damages upon the issuer's breach of a stock purchase agreement and alternative theories of recovery, such as unjust enrichment and constructive trust. See Stucki v. Orwig, 2013 WL 1499377 (N.D. Tex. Apr. 12, 2013) (discussing case law). 

In deciding cases under section 510(b), some courts have highlighted the traditional allocation of risk between a company's shareholders and its creditors. Under this policy-based analysis, shareholders are deemed to undertake more risk in exchange for the potential to participate in the profits of the company, whereas creditors can expect only repayment of their fixed debts. Accordingly, shareholders, and not creditors, assume the risk of a wrongful or unlawful purchase or sale of securities.  

This risk allocation model is sometimes referred to as the "Slain/Kripke theory of risk allocation," as described in a 1973 law review article written by Professors John J. Slain and Homer Kripke titled "The Interface Between Securities Regulation and Bankruptcy—Allocating the Risk of Illegal Securities Issuance Between Securityholders and the Issuer's Creditors," 48 N.Y.U.L. Rev. 261 (1973). See, e.g., In re SeaQuest Diving LP, 579 F.3d 411, 420 (5th Cir. 2009); In re Betacom of Phoenix, Inc., 240 F.3d 823, 829 (9th Cir. 2001); In re Granite Partners, L.P., 208 B.R. 332, 336 (Bankr. S.D.N.Y. 1997). 

As a result of the parties' differing expectations for risk and return, it is perceived as unfair to allow a shareholder to recover from the limited assets of a debtor as a creditor by "converting" its equity stake into a claim through the prosecution of a successful securities lawsuit. The mechanism by which such a conversion is thwarted is subordination of the shareholder's claim under section 510(b). 

Notwithstanding general agreement regarding the policy underlying section 510(b), courts have applied differing formulations in interpreting its language. Compare In re American Housing Found., 785 F.3d 143, 156 (5th Cir. 2015) (holding that a claim should be subordinated if: (i) the claim is for "damages"; (ii) the claim involves "securities"; and (iii) the claim "arise[s] from" a "purchase or sale," and explaining that "[f]or a claim to 'arise from' the purchase or sale of a security, there must be some nexus or causal relationship between the claim and the sale"), with In re Lehman Brothers Holdings Inc., 855 F.3d 459, 472–78 (2d Cir. 2017) (examining whether: (i) the claimant owns a security; (ii) the claimant acquired the security by means of a purchase or sale; and (iii) the claimant's damages arose from the purchase or sale of the security or the rescission of such a purchase or sale).

Section 101(49) of the Bankruptcy Code defines the term "security" broadly to "include" notes, stock, treasury stock, bonds, debentures, and an extensive catalogue of other investments. In addition, the definition contains a broad residual clause providing that a security also includes "any other claim or interest commonly known as [a] 'security.'" 11 U.S.C. § 101(49). Although, the scope of the residual clause is broad, the statutory definition also expressly excludes a number of items, including, among other things, currency, checks, drafts, bills of exchange, bank letters of credit, commodity futures contracts, forward contracts, options, and warrants. Section 101(16) of the Bankruptcy Code defines an "equity security" to mean shares in a corporation or any "similar security," limited partnership interests, and certain warrants or rights.  

In Lehman Brothers, the U.S. Court of Appeals for the Second Circuit noted that "some interests will not perfectly match any of the specific examples in [the Bankruptcy Code's definition of security]," and that, should this be the case, it is of "most significance" that a claimant "ha[s] the same risk and benefit expectations as shareholders." Lehman Brothers, 855 F.3d at 473–74; accord In re Linn Energy, 936 F.3d 334, 344 (5th Cir. 2019) (even though the beneficiary of a stock trust did "not fit perfectly in the investor box," his claims should be subordinated under section 510(b) because his entitlement to "deemed dividends" originally arising from the trust "was certainly more like an investor's interest than a creditor's interest"); In re WorldCom, Inc., 2006 WL 3782712, at *6 (Bankr. S.D.N.Y. Dec. 21, 2006) ("The form in which the equity interest is held is ultimately irrelevant. So long as the claimant's interest enabled him to participate in the success of the enterprise and the distribution of profits, the claim will be subordinated pursuant to section 510(b)."). 

The Bankruptcy Code does not define "damages." However, many courts have reasoned that "the concept of damages under Section 510(b) has the connotation of some recovery other than the simple recovery of an unpaid debt due on an instrument." American Housing, 785 F.3d at 153–54 (internal quotation marks omitted) (citing cases and ruling that claims seeking compensation for fraud or breach of fiduciary duty are claims for damages under section 510(b) as well as claims "predicated on post-issuance conduct," including breach of contract claims).

ONH

ONH AFC CS Investors, LLC ("AFC") was formed in 2022 to invest in commercial real estate. AFC's owner (the "principal") managed multiple commercial real estate investment companies, which were organized under two limited liability companies.

Beginning in 2022, AFC raised approximately $44 million to purchase the Atlanta Financial Center, an office complex located in Atlanta, Georgia. To do so, AFC and its affiliate ONH 1601 (collectively, the "debtors") used, among other things, the proceeds of equity interests sold to investors through securities offerings listed on an online brokerage platform. Investors were told that the proceeds from the securities offerings would be used to purchase and renovate the office complex. They were also informed that the funds would be held in segregated accounts to be returned if the deal failed to close.

Even though the debtors obtained the necessary funding, the Atlanta Financial Center sale failed to close. On July 14, 2023, the debtors filed for chapter 11 protection in the District of Delaware. The bankruptcy court later confirmed a joint liquidating chapter 11 plan for the debtors. The plan created a liquidating trust with the authority to pursue estate claims. It also subordinated under section 510(b) the investors' claims against the debtors for repayment of their investments, which they alleged were procured on the basis of fraudulent misrepresentations made by the debtors and the principal.  

In June 2024, the liquidating trustee filed a complaint seeking to avoid and recover under sections 544(b), 548, and 550 of the Bankruptcy Code $7 million in pre-bankruptcy transfers made by AFC—using funds raised from investors in the abandoned office complex sale transaction—to JOSMIC 2 LLC and JOSMIC HOLDINGS LLC (the "defendants"), in part to repay a $5 million personal loan made by the defendants to the principal in 2022. The complaint, which stated causes of action for both intentional and constructive fraudulent transfers, alleged that ONH AFC and its principal "'made untrue statements of fact and/or omitted statements of material[] facts to investors in connection with the AFC Offering' including with respect to [the principal's] 'intended use of the funds from the Offering.'" 

The defendants moved to dismiss the complaint or, in the alternative, to stay the litigation pending the outcome of the liquidating trustee's efforts to recover the transferred funds from the principal. Among other things, the defendants argued that a fraudulent transfer claim cannot be sustained if the beneficiaries of the litigation recovery would be equity holders, rather than creditors.

A report filed by the liquidating trustee with the bankruptcy court indicated that the trustee had already repaid millions of dollars to the class of equity holders that included the investors, and that the claims of all creditors would likely be paid in full (purportedly from funds already recovered by the trustee from the principal). 

According to the defendants, because the investors' remaining fraud claims against the debtors would be subordinated under section 510(b), and the bankruptcy estate had more than enough assets to pay creditors in full, holders of equity interests were the sole beneficiaries of the liquidating trustee's fraudulent transfer action. 

The Bankruptcy Court's Ruling

The bankruptcy court granted in part and denied in part the defendants' motion to dismiss, and denied the motion for a stay.

U.S. Bankruptcy Judge Craig T. Goldblatt was persuaded by the "core reasoning" of In re DSI Renal Holdings, LLC, 2020 WL 550987 (Bankr. D. Del. Feb. 4, 2020) (Owens, B.J.), where the court held that, although a transfer may be avoidable under section 544 or 548, a trustee's recovery is governed by section 550, which permits recovery "for the benefit of the estate." Based on Third Circuit precedent, the court in DSI Renal reasoned that this statutory language should be understood to mean "for the benefit of creditors." DSI Renal, 202 WL 550987, at **6–8 (citing In re Cybergenics Corp., 226 F.3d 237, 243–247 (3d Cir. 2000); In re Messina, 687 F.3d 74 (3d Cir. 2012); In re Majestic Star Casino, LLC, 716 F.3d 736 (3d Cir. 2013)).

Judge Goldblatt interpreted these decisions to mean that fraudulent transfer claims are exclusively "a creditor's remedy." ONH, 2025 WL 1353850, at *5. According to Judge Goldblatt, a shareholder could not assert a fraudulent transfer claim outside of bankruptcy under state law based upon the dissipation of a company's assets, and "it would make no sense to permit a bankruptcy trustee to assert a fraudulent conveyance claim for the benefit of that party." Id. The bankruptcy court found no reason to believe that Congress intended to expand the rights of equity holders by importing this remedy into the Bankruptcy Code. Id.

Even so, the bankruptcy court held that DSI Renal was distinguishable from the case before it due to the subordination of the investors' claims under section 510(b). Judge Goldblatt reasoned that equity holders may assert claims against a company as creditors outside of bankruptcy, and subordination under section 510(b) is a limitation imposed solely by operation of the Bankruptcy Code. Thus, he explained, strict application of DSI Renal would limit trustee recoveries on fraudulent transfer claims to only "the amount necessary to satisfy in full those claims that are 'allowed' in the bankruptcy case and are not subject to subordination under § 510(b)." Id. at *9. According to the bankruptcy court, section 510(b) makes clear that subordination is only "[f]or the purposes of distribution under this title" and not "for the very different purpose of reducing the liability of a fraudulent conveyance defendant. Id. at *10. 

"Properly understood," Judge Goldblatt wrote, "[the DSI Renal rule] does not turn on the allowance, classification, or treatment of the claims in bankruptcy" but instead, "it is focused on whether the beneficiaries of the fraudulent conveyance action would have had the right to assert fraudulent conveyance claims outside of bankruptcy." Id. at *6. Following this logic, the court concluded that, "there is no reason why a bankruptcy trustee should not be able to bring a fraudulent conveyance claim for the benefit of [investors]" because the investors could have asserted state law fraudulent conveyance claims outside of bankruptcy. Id.

In further elaboration of the general rule articulated in DSI Renal, the bankruptcy court also examined the U.S. Supreme Court's ruling in Moore v. Bay, 284 U.S. 4 (1931). In that case, which was brought under the former Bankruptcy Act, the Court ruled that a bankruptcy trustee could bring an action to avoid a lien for the benefit of all creditors, even those that would not have been able to bring the action outside of bankruptcy. Id. at 5.

Consistent with Moore, the bankruptcy court in ONH explained that recovery from a successful avoidance action brought pursuant to section 544(b) can extend beyond just the creditors who could bring the action. ONH at *8. According to Judge Goldblatt, "[t]he recovery is not for the exclusive benefit of those triggering creditors. Rather, it is 'for the benefit of the estate.'" Id. However, he noted, Moore does not "require[] the conclusion that the trustee in bankruptcy may affirmatively recover amounts that could not have been recovered by any creditor outside of bankruptcy." Id. Thus, settling on a narrow interpretation similar to DSI Renal, the bankruptcy court held that "a bankruptcy trustee's recovery on a fraudulent conveyance claim cannot exceed the total value of the valid claims against the bankruptcy estate." Id. at *9.

Although the evidence established that creditors would be paid in full under the debtors' liquidating chapter 11 plan after subordination of the investors' claims, there was no evidence that the trustee's recoveries would be sufficient "to pay the amounts the debtor owed to the defrauded investors immediately before the bankruptcy." Id. The bankruptcy court concluded that prohibiting the liquidating trustee from avoiding and recovering fraudulent transfers on account of the defrauded investors would effectively undermine the principles of DSI Renal. Id. It therefore declined to stay the adversary proceeding and found that DSI Renal "should not be applied for the very different purpose of reducing the liability of a fraudulent conveyance defendant." Id. 

The court denied the motion to dismiss the liquidating trustee's actual fraudulent transfer claims against the defendants with respect to the $5 million personal loan, but dismissed the intentional fraudulent transfer claims with respect to the remaining $2 million in payments because the complaint failed to allege intentional fraud in connection with those transfers. The court granted the defendants' motion to dismiss the trustee's constructive fraudulent transfer claims because the complaint did not allege that debtors were insolvent. 

Outlook

In allowing a liquidating trustee to continue pursuing fraudulent transfer actions solely for the benefit of creditors whose claims were subordinated by operation of section 510(b), the court in ONH adopted and clarified the rationale articulated in DSI Renal. While the circumstance presented to the bankruptcy court—a debtor's estate rendered solvent solely by virtue of the subordination of equity-related claims—is perhaps unusual, the bankruptcy court's opinion provides an interesting insight into the balancing of creditors' rights inside and outside of bankruptcy.