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By Randy Klein

In a previous Alert, we suggested restoration of the good faith doctrine to enable courts to disallow reverse engineering of credit agreements if done in bad faith. Recently, the Boardriders Court denied the motion to dismiss the good faith claim (following similar results in NYDJ and Serta). Fundamentally, the "good faith" doctrine implies a duty to refrain from destroying the essence of the ratable contract among lenders. But, there is another under-utilized tool that curtails documentation mischief: voidable transaction statutes a/k/a fraudulent transfer statutes.

When most people think about fraudulent transfers, they think about a debtor hiding assets, Ponzi schemes or paying shareholder dividends when the company is insolvent. The law avoids these transactions for the benefit of creditors generally. Fraudulent transfer statutes avoid two types of transactions: one based on the debtor's wrongful intent (Ponzi) and the other based on inadequate property being exchanged (dividends). Liability management transactions can be both (especially if the preferred creditor is bootstrapping its old debt to a higher place in the waterfall along with its new loans). This Alert focuses on those transactions made with the actual intent to "hinder, delay or defraud"— more specifically, to "hinder." The classic case of "hindering" creditors is taking actions to put assets out of reach of certain creditors or knowingly depriving creditors payment on their claims.

"[I]f creditors get too good at ruthlessly exploiting each other, eventually courts might step in and say 'oh come on it can't have meant that.'"
~ Matt Levine, Bloomberg Columnist

In NYDJ, we asserted voidable transaction claims to defeat a non-ratable uptiering transaction, done intentionally to give a subset of lenders a leg up in the collateral waterfall. That voidable transaction was rooted in amendments designed to eviscerate the value of the minority lenders' interest in collateral. A "lien" is a specific interest in property that secures repayment of specific debts.[1] A secured interest has two interlocking parts, the lien itself and the debt secured by that lien. "A lien is parasitic on a claim. If the claim disappears—poof! the lien is gone."[2] If Creditor A, before the "liability management transaction," had to share collateral proceeds with Creditor B but did not have to share after the transaction, did that transaction create "an interest in property" that Creditor A did not have previously? It seems so. 

Defendants will claim there is no "transfer" because the lien was initially granted to the collateral agent, there is no new "grant" of a lien and, therefore, no new transfer. If there is no transfer, so their defense goes, there can be no fraudulent transfer even if the borrower actually intended to deprive a subset of creditors of their right to payment from collateral. Basically, their argument is a metaphysical one: if we are all eating at the same table, and the food does not move, then there is no transfer even though we changed the seats so only some can reach the plates.

This debate about whether changing the waterfall is a "transfer" is neither here nor there. Ultimately, it's about the actual payment for only some of the old pro rata debt that drains the collateral pool with prejudice to the other debt left behind. No one would dispute that making the payment would be a transfer, nor can anyone seriously dispute that incurring the obligation to make the payment is also the subject of the uniform fraudulent transfer statutes that avoid both the transfer and the related obligations incurred. To merely obligate yourself to make the non-pro rata payment - to "wanna" do it to paraphrase George Carlin - is the sin that unwinds the entire transaction. 

Asserting a NY fraudulent transfer claim served double duty in NYDJ because the majority (by amendment) purported to take away the minority lenders' rights to attorneys' fees for breach. That amendment could be avoided for bad faith. Separately, the NY statute gives the plaintiff the right to seek attorneys' fees against the debtor and any transferee. NYDJ settled; the fraudulent transfer claims that resurfaced in Tri-Mark were dismissed on procedural grounds, and the recent Incora minority lender complaint has asserted fraudulent transfer claims.

Of course, most secured lending transactions avoid scrutiny as fraudulent transactions. The difference is when other creditors are being harmed by design. Voidable deals are the ones where owners and included lenders conspire to take value away from others for themselves. They purportedly cloak themselves with documents that either do not expressly prohibit the transaction or with amendments that purport to expressly permit the transaction. 

The point remains: it's not all about the four corners of the contract. According to Matt Levine, the brilliant Bloomberg writer: "[i]f creditors get too good at ruthlessly exploiting each other, eventually courts might step in and say 'oh come on it can't have meant that.' If a rule like 'creditors are only entitled to what their contract explicitly says' always leads to absurd results, it might stop being the rule."[3] Indeed, it is not the rule.[4] Transactions, if done with wrongful intent to hinder creditors, can be attacked as a classic fraudulent transaction. And if attorneys' fees can be recovered, you can be sure that these counts will be added to various complaints.

[1] See 11 U.S.C. 101(37) ("the term 'lien' means charge against or interest in property to secure payment of a debt or performance of an obligation").

[2] Unisys Fin. Corp. v. Resolution Trust Corp., 979 F.2d 609, 611 (7th Cir. 1992).

[3] Matt Levine, Matt Levine's Money Stuff: Mergers Aren't Always Fair, Bloomberg Law (Nov. 2, 2022).

[4] See Marblegate Asset Mgmt., LLC v. Educ. Mgmt. Fin. Corp., 846 F.3d 1, 16 (2nd Cir. 2017) (noting that minority debt holders are protected by fraudulent transaction laws even if a challenged transaction does not violate the underlying documents or the Trust Indenture Act).

©Randall Klein, principal and co-chair of the Creditors' Rights and Bankruptcy Group at Goldberg Kohn Ltd.