The Logical Structure of Fraudulent Transfers and Equitable Subordination

INTRODUCTION 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 The usual interpretation of fraudulent transfer law is that X's claim is simply disallowed or rescinded.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. …