Quadrant v. Vertin: Delaware Court of Chancery Clarifies Balance Sheet Test for Creditor Standing

Practical Law Legal Update 3-612-3847 (Approx. 7 pages)

Quadrant v. Vertin: Delaware Court of Chancery Clarifies Balance Sheet Test for Creditor Standing

by Practical Law Bankruptcy and Practical Law Finance

Background

Athilon Capital Corp. was a credit derivative product company that became insolvent during the 2008 financial crisis. Athilon guaranteed the credit default swaps on senior tranches of collateralized debt obligations (CDOs) written by its wholly owned subsidiary.

In 2010, due to the unwinding of two residential mortgage-backed securities and the effects of the financial crisis, Athilon was forced into runoff mode, during which it would wind down its operations and then liquidate. At that time, EBF & Associates purchased all of Athilon's Junior Subordinated Notes (Junior Notes) and all of its equity. EBF thereby gained control over Athilon and its board of directors and appointed four of the five directors to the board, joining Athilon's CEO, who was the fifth director. The plaintiff, Quadrant Structured Products Company, Ltd., acquired Senior Subordinated Notes and Subordinated Notes issued by Athilon after the EBF takeover.

For further background described in a Legal Update on the Court of Chancery's 2014 decision in this litigation, see Legal Update, Quadrant v. Vertin: Delaware Chancery Court Clarifies Fiduciary Duties of an Insolvent Company's Board of Directors.

Quadrant sued Athilon in October 2011, arguing that Athilon was insolvent and that, by adopting an investment strategy that involved greater risk, albeit with the potential for greater return, the board acted for the benefit of EBF contrary to the interests of Athilon's more senior creditors. Quadrant asserted derivative claims for breach of fiduciary duty against the individual defendants, who are members of Athilon's board. Quadrant claimed that:

The board breached its fiduciary duties by transferring value preferentially to Athilon's controller, EBF, and to Athilon Structured Investment Advisors, LLC (ASIA), an EBF affiliate, and by changing Athilon's business model to make speculative investments for the benefit of EBF.
The transactions constituted fraudulent transfers under the Delaware Uniform Fraudulent Transfer Act.

In the 2014 decision mentioned above, the Court of Chancery held that Quadrant's complaint stated a derivative claim for breach of fiduciary duty as to the defendants' decision not to defer interest payments on the Junior Notes and the payments of fees to ASIA, but that the complaint failed to state a claim as to the board's adoption of a riskier business strategy (Quadrant Structured Prods. Co. v. Vertin, 102 A.3d 155 (Del. Ch. 2014)).

In February 2015, the defendants moved for summary judgment on the grounds that Athilon had returned to solvency. They argued that for a creditor to maintain standing when bringing a derivative action, the corporation on whose behalf the creditor sues must be insolvent both at the time of suit and continuously thereafter. According to the defendants, there was no dispute of material fact about Athilon's current solvency, as Athilon had improved its balance sheet to the point that the value of its total assets exceeded the value of its total liabilities by over $152 million.

The defendants also contended that for Quadrant, as a creditor, to establish standing, it must show not only that Athilon is insolvent, but that it has no reasonable prospect of returning to solvency. The defendants argued that this test, which the Delaware courts already use when determining whether to appoint a receiver, should also govern whether the creditor has standing to bring a derivative claim.

Outcome

The Court held, as a matter of first impression, that Delaware law does not impose a continuous insolvency requirement for creditor standing. Rather, a creditor need only establish that the corporation was insolvent at the time the suit was filed. The Court also refused to apply the test of irretrievable insolvency to determine a creditor's standing. Consequently, the Court denied the defendants' motion to dismiss.

To reach its decision, the Court outlined the following principles from Gheewalla and its companion cases regarding the ability of creditors to sue for breach of fiduciary duty:

There is no legally recognized "zone of insolvency" with implications for fiduciary duty claims. Rather, the only transition point that affects fiduciary duty analysis is insolvency itself.
Regardless of whether a corporation is solvent or insolvent, creditors cannot bring direct claims for breach of fiduciary duty. After a corporation becomes insolvent, creditors gain standing to assert claims derivatively for breach of fiduciary duty.
The directors of an insolvent corporation do not owe any particular duty to creditors. Instead, they owe fiduciary duties to the corporation for the benefit of all of its residual claimants, which at the point of insolvency includes creditors. This further means that the directors have no obligation to liquidate the corporation and marshal its assets for distribution to the creditors (though the directors can decide that they should in fact do just that).
Directors can, in exercising business judgment, favor certain non-insider creditors over others of similar priority without breaching their fiduciary duties.
Delaware does not recognize the theory of "deepening insolvency" as an actionable claim against the directors. Directors cannot be held liable for continuing to operate an insolvent entity in the good faith belief that they may achieve profitability, even if their decisions ultimately lead to greater losses for the creditors.
As with solvent corporations, a conflict of interest is not implied simply because the directors own shares of common stock of the insolvent corporation.

(N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007)).

No Requirement for Continuous Insolvency

Against this backdrop, the Court reviewed the rationale for stockholders of solvent corporations to bring derivative claims alleging breach of fiduciary duties by the directors. The Court explained that the animating principles are that:

The derivative action exists to prevent injustice that would result if conflicted or disloyal fiduciaries could prevent a corporation from pursuing valid claims, including claims against its own directors and officers.
Stockholders have standing to assert derivative claims because they can be regarded as the ultimate beneficial owners of the corporate assets, including the corporation's litigation assets, and therefore have an interest in pursuing the claim.

In the context of an insolvent corporation, the creditors assume the role of the stockholders outlined in these principles. The creditors have an interest in pursuing claims that the corporation itself might not, because they benefit initially from any recovery that the corporation obtains.

If creditors of insolvent corporations are to be analogized to the stockholders of solvent corporations, then creditors ought to satisfy similar requirements for standing that stockholders must satisfy. Under Delaware law, stockholders must maintain continuous ownership (of even a nominal sum) of stock to maintain standing to bring derivative claims. The defendants therefore argued that creditors should have to demonstrate the continuous insolvency of the corporation.

The Court held that this was the wrong analogy. Rather than imposing a continuous insolvency requirement, the creditors must only continuously hold a debt claim. This "continuous creditor" requirement mandates that if the creditor no longer holds a debt claim against the corporation, the creditor loses standing to sue.

The Court noted that the continuous creditor requirement offers a bright-line test for determining standing, much like the stockholder-plaintiff's continuous ownership of stock. By contrast, the determination of whether or not the corporation is insolvent is not always clear and often is determined definitively only after the fact, in litigation, with the benefit of hindsight. The rejection of the continuous insolvency requirement also recognizes that insolvency does not mark a transformational point when creditors suddenly gain and stockholders concomitantly lose an interest in the financial condition of the firm. Rather, creditors always have some interest in improving the financial condition of the firm.

The Court acknowledged that rejecting the continuous insolvency test creates the possibility that during the course of a derivative action, both stockholders and creditors could gain standing to sue. For example, a situation could arise where creditors suing derivatively allege that the directors should pay damages for failing to preserve the firm's assets, while at the same time stockholders suing derivatively allege that the same directors should pay damages for failing to pursue an aggressive business plan that would generate a return for the equity. However, the Court was satisfied that the business judgment rule, combined with exculpation under DGCL Section 102(b)(7) for breaches of the duty of care, will protect the board. Although there can nevertheless still be conflicts between the interests of creditors and stockholders, the Court expressed confidence that courts supervising the derivative litigation will have "ample tools available to manage it."

No Requirement for Irretrievable Insolvency

The defendants separately contended that for Quadrant to establish the corporation's insolvency under the balance sheet test, it must show that the corporation was "irretrievably insolvent." (Although a creditor can also establish insolvency under the cash flow test, Quadrant had only relied on the balance sheet test to establish Athilon's insolvency.) The defendants based their argument on language in a Court of Chancery decision in the Gheewalla litigation, which articulated the balance sheet test as "a deficiency of assets below liabilities with no reasonable prospect that the business can be successfully continued in the face thereof" (N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, , at *10 (Del. Ch. Sept. 1, 2006)) (emphasis added).

The Court here declined to follow that test. The Court explained that the earlier Gheewalla decision had relied on a test that had been used at common law in receivership proceedings for reasons unique to that remedy. The standard of irretrievable insolvency, however, had never governed creditor-derivative claims, and the weight of Delaware authority has used the traditional balance sheet test. (The Court also explained at length that the earlier Gheewalla decision had taken the test from the 2004 Production Resources decision in which both receivership and breach claims were at issue (Production Res. Grp., L.L.C. v. NCT Grp., Inc., 863 A.2d 772 (Del. Ch. 2004)). The Production Resources Court did not have to separately analyze the balance sheet test for standing because the plaintiff had been able to meet the more stringent test for receivership.)

Practical Implications

The decision in Quadrant establishes that, under Delaware law, creditors bringing a derivative claim:

Establish standing when they satisfy the traditional balance sheet test.
Maintain that standing as long as they continue to hold a debt claim.

The holding rejects both the standard of irretrievable insolvency that had been cited in pre-Gheewalla (2007) Court of Chancery decisions and the test of continuous insolvency.

The decision consequently makes it easier for creditors of insolvent companies to sue derivatively for breach of fiduciary duty. At a more general level, the decision helpfully lays out the current state of Delaware law governing fiduciary duties and standing for insolvent corporations in a manner that provides clear guidance for practitioners.

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