Fraudulent Conveyance & § 510(b) Subordination (Phillips v. Josmic)

By: Donald L Swanson

Here’s a new issue—at least for me: a combination of fraudulent conveyance law & § 510(b) subordination addressed in:

• Phillips v. Josmic 2 LLC (ONH AFC CS Investors, LLC), Adv. Proc. No. 24-50085, Delaware Bankruptcy Court (decided May 8, 2025).

The Issue

At common law, fraudulent conveyance is a remedy available to creditors.

The Bankruptcy Code gives the trustee the same power to avoid and recover fraudulent conveyances in bankruptcy that creditors had outside of bankruptcy. It does so through both:

• § 548, which creates a federal fraudulent conveyance cause of action; and
• § 544(b)(1), which gives the trustee the same right to avoid transfers that a creditor holding an allowable claim would have had before bankruptcy.

QUESTION: May a bankruptcy trustee exercise this power when the beneficiaries of a successful claim are not creditors, but will instead be the debtor’s equity holders?

ANSWER: No—that’s because, outside of bankruptcy, the fraudulent conveyance remedy is available only to creditors, and nothing in the Bankruptcy Code changes that rule.

HOWEVER: The dispute in this case is a variant on this Q & A.

Facts

Owner forms Debtor to invest in commercial real estate.

Debtor raises $44 million from investors to purchase the Atlanta Financial Center. The pitch to investors is that:

• all their money will be used to purchase, lease, reposition, and renovate the Atlanta Financial Center;
• all their money will be held in segregated accounts until the closing of the purchase; and
• if the purchase fails to close, the funds will be returned.

Funds are raised, but the purchase does not close.  And the raised funds are gone.

Bankruptcy & Adversary Proceeding

Debtor files Chapter 11 bankruptcy.  A plan is confirmed, which established a liquidating trust with authority to pursue claims held by the bankruptcy estate.

Liquidating Trustee files a Complaint for avoiding five transfers to Defendant as fraudulent.  The largest claim is for recovery of a $5 million payment to Defendant—one of Owner’s personal creditors. The other four claims, totaling $2 million, are against the same person.

Defendant moves to stay or dismiss the Liquidating Trustee’s Complaint, arguing that the fraudulent conveyance remedy is unavailable here because:

• sufficient funds are recovered from other sources to pay Debtor’s creditors in full;
• fraudulent transfer claims may only be asserted where the beneficiaries of such claims are creditors; and
• claims of defrauded investors are subordinated and “effectively treated as equity holders” (not as “creditors”) by § 510(b).[Fn. 1]

Ruling & Analysis

The Delaware Bankruptcy Court allows the Complaint to move forward.  What follows is a summary of the reasons why.

The operative rule is:

• if the beneficiary of a bankruptcy trustee’s fraudulent conveyance action would not have been able to assert the fraudulent conveyance claim immediately before the bankruptcy filing; then
• the bankruptcy trustee should not be able to assert a fraudulent conveyance claim for the benefit of that same party.

The problem for Defendant’s argument is that the defrauded investors in this case would have been able to assert fraudulent conveyance claims outside of bankruptcy. 

Here’s how the operative rule applies in this case:

• beneficiaries of the Trustee’s fraudulent conveyance action were defrauded into purchasing equity interests in the debtor; and
• it is true that such defrauded investor claims are subordinated for the purpose of distribution in this bankruptcy by § 510(b), and thus treated as equity interests in this bankruptcy; yet
• such defrauded investor claims are still proper beneficiaries here because:
  • outside of bankruptcy, such a defrauded investor is a creditor that may assert a state law fraudulent conveyance claim; and so,
  • nothing prevents a bankruptcy trustee from bringing a fraudulent conveyance claim for the benefit of that same defrauded investor.

Defendant’s argument is premised on the idea that fraudulent conveyance claims are limited to the amount necessary to satisfy claims of creditors in full—and do not include claims subordinated by § 510(b).  But the Court holds:

• “That premise is incorrect.”

Conclusion

The combination of fraudulent conveyance law and § 510(b) subordination in this case is a new one for me. 

And here’s a “Thank you” to the Delaware Bankruptcy Court for this item of “learn something new every day.”

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Footnote 1.  11 U.S.C. § 510(b) says: “For the purpose of distribution . . . , 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” (emphasis added).

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