Quadrant Structured Products v. Vertin: Implied Covenant of Good Faith and Fair Dealing Does Not Protect Noteholders from Actions Not Expressly Prohibited Under Indenture | Practical Law

Quadrant Structured Products v. Vertin: Implied Covenant of Good Faith and Fair Dealing Does Not Protect Noteholders from Actions Not Expressly Prohibited Under Indenture | Practical Law

The Court of Chancery of the State of Delaware held that the implied covenant of good faith and fair dealing in an indenture does not protect creditors from actions that are not expressly prohibited under the indenture.

Quadrant Structured Products v. Vertin: Implied Covenant of Good Faith and Fair Dealing Does Not Protect Noteholders from Actions Not Expressly Prohibited Under Indenture

by Practical Law Finance
Published on 17 Dec 2015 • USA (National/Federal)
The Court of Chancery of the State of Delaware held that the implied covenant of good faith and fair dealing in an indenture does not protect creditors from actions that are not expressly prohibited under the indenture.
On October 20, 2015, the Court of Chancery of the State of Delaware held, in Quadrant Structured Products Company LTD v. Vertin, that the implied covenant of good faith and fair dealing in an indenture does not protect creditors from actions that are not otherwise prohibited under the indenture ( (Del. Ch. Oct. 20, 2015)).

Background

Defendant Athilon Capital Corporation (Athilon) was an issuer of credit default swaps (CDS) and had sold more than $45 billion in notional amount of CDS. The company was capitalized by a $100 million investment and $600 million of long-term covenant-lite debt (see Practice Note, Covenant-lite Loans: Overview) with borrower-friendly interest rates. Its debt capital structure included:
  • Senior Subordinated Deferrable Interest Notes (Senior Notes) in an aggregate principal amount of $350 million.
  • Subordinated Deferrable Interest Notes (Mezz Notes) in an aggregate principal amount of $200 million.
  • Junior Subordinated Deferrable Interest Notes (Junior Notes) in an aggregate principal amount of $50 million (the Junior Notes, Mezz Notes and Senior Notes, together, the Athilon Notes).
The indenture under which the Senior Notes were issued (Senior Indenture) included a right-of-optional-redemption clause, which stated that the issuer could unilaterally redeem all or part of the securities at certain intervals. The indenture also included an exclusion from the redemption (the redemption and exclusion provisions together, the Redemption Provisions), which stated:
Securities shall be excluded from eligibility for selection for redemption if they are identified by registration and certificate number in a written statement signed by an Officer of the Issuer and delivered to the Trustee at least 20 days prior to the Redemption Date, as being owned of record and beneficially by, and not pledged or hypothecated by, either (a) the Issuer or (b) an Affiliate of the Issuer.
In order to engage in its business of writing (or selling, as credit protection seller) uncollateralized CDS, Athilon was required to maintain a triple-A credit rating with Moody's and Standard & Poor's. To do that, it was required to adhere to its operating guidelines, which required it to invest in only the highest quality securities. The Athilon operating guidelines required credit rating agency approval to diverge from that investment strategy.
Additionally, the Athilon operating guidelines defined certain "suspension events" which would require the company to cease writing CDS until the events were cured, or if the events remained uncured, "run off" its existing swaps (continue payments under the swaps until their maturity date but and cease writing new CDS). One such suspension event was an Athilon insolvency.
In 2008, Athilon became insolvent.
Between 2008 and 2011, defendant Merced Capital, L.P., a private investment manager and private equity sponsor, purchased all of Athilon's equity and all of the Junior Notes, and a portion of both the Senior Notes and the Mezz Notes, all at deep discounts (collectively, the Merced Notes). During the same period, plaintiff Quadrant Structured Products Company, Ltd., another a private investment manager, also purchased a portion of the Senior Notes and the Mezz Notes (together, the Quadrant Notes), also at deep discounts.
Both Merced and Quadrant viewed Athilon's insolvency as an opportunity to profit, but with conflicting investment strategies:
  • Plaintiff Quadrant believed that Athilon was required to liquidate after it had run off its remaining CDS (as many other issuers of CDS were required to do under their indentures) and that the liquidation and immediate payout on the Athilon Notes was the only plausible means to recover for any of the debt holders. However, this strategy posed some risk, of which plaintiff was aware.
  • Merced took the opposite view and believed that Athilon was not required to liquidate once it had run off all of its remaining CDS. Merced believed that the credit rating agencies would allow Athilon to alter its investment strategy to a more risky and potentially more profitable one without lowering its credit rating (due to the insolvency, Athilon's rating had already dropped below investment grade, which could allow a shift in strategy without further lowering its rating). As borrower under a large portfolio of covenant-lite loans, with borrower friendly terms, Merced believed that it could return Athilon to profitability and reap profits from both its debt and equity holdings of Athilon.
The credit rating agencies gave the approval required under Athilon's governing documents to modify its investment strategy, and Merced refused to liquidate Athilon. Over the next four years, Merced returned Athilon to solvency through a variety of measures, including directing Athilon to:
  • Hold the CDS that it was running off to maturity, which converted a large mark-to-market loss into a small mark-to-market gain.
  • Invest in marginally more risky securities at discounts, some of which were purchased from Merced. The securities purchased from Merced by Athilon were purchased at market prices.
  • Redeem the Junior Notes (owned by Merced) at two different intervals (the Junior Redemptions). The Junior Redemptions were structured to avoid taxes and ultimately did not require any consideration from Athilon because the transactions compensated Merced with preferred stock in Athilon's holding company, which was subordinate to the obligations under the Quadrant Notes.
  • Permanently writing off a potential tax liability after a no-change letter from the IRS.
Once Athilon had returned to solvency, it repurchased the balance of the Merced Notes (the 2015 Repurchase) for $194.6 million, at 92% of par.
Quadrant originally filed suit in 2012, and filed an amended complaint in April 2015, which alleged that:
  • Athilon's directors had breached their fiduciary duty by refusing to liquidate and offer immediate payout to the debt holders (a derivative claim Quadrant argued it was entitled to bring by virtue of Athilon's insolvency).
  • Certain payments to Merced, including management fees and interest payments made on the Junior Notes (which Athilon could have deferred), were fraudulent transfers.
  • Athilon breached both the text and the implied covenant of good faith and fair dealing in the indentures under which the Senior Notes were issued by executing the 2015 Repurchase.

Decision

First, the Court rejected the argument that both the express terms of, and the implied covenant of good faith and fair dealing in, the Redemption Provisions prevented the 2015 Repurchase of Athilon debt from Merced under New York law, which governed the Senior Indenture and therefore those provisions.
Plaintiff Quadrant argued that certain of the Redemption Provisions prohibited selective repurchases benefiting insiders. However, the Court found that
since the Redemption Provisions were only applicable to unilateral redemptions, those provisions did not apply to redemptions executed by mutual consent, as occurred here.
Quadrant also argued that the implied covenant of good faith and fair dealing in the Senior Indenture implied a term that should be understood to state "with no business left to pursue, [Athilon] will return capital to its stakeholders, and will not return capital only to its insiders."
The Court rejected this argument and refused to imply a term that was inconsistent with the explicit language of the Senior Indenture. Since the amount borrowed under the Senior Indenture did not become due for another 20 years and no event of default existed, Athilon was entitled to use the debt financing however it saw fit (as long as it did not breach the explicit terms of the indentures).
Moreover, the Court examined Quadrant’s own CDS subsidiary and found that the indentures that governed its debt had explicit terms that created mandatory redemption when the CDS business had concluded. Those provision were conspicuously absent in the Senior Indenture.
Next, the Court rejected the argument that the 2015 Repurchase was a fraudulent transfer. A fraudulent transfer may either be constructive, which requires the transferor be insolvent at the time of the transfer, or intentional, in which case the transferor's solvency is a factor.
However, by 2014, Athilon had returned to solvency, precluding a finding of a constructively fraudulent transfer for the 2015 Repurchase. Moreover, Athilon did not have the "actual intent to hinder, delay or defraud any creditor of the debtor,” as required for a fraudulent transfer claim under 6 Del. C. § 1304(a)(1), because it remained solvent and planned to continue making its debt payments as they became due.
Lastly, Quadrant argued that Athilon's purchase of certain securities from Merced and the 2015 Repurchase breached the Athilon board's fiduciary duty. This was a derivative claim that Quadrant argued that it was entitled to bring by virtue of Athilon's insolvency. (Normally, only shareholders are entitled to bring derivative claims unless the entity has become insolvent, in which case a board’s duty may shift to debt holders. For details, see Practice Note, Fiduciary Duties of Directors of Financially Troubled Corporations.)
However, for a debt holder to bring a derivative claim, the corporation must be insolvent at both the time of the alleged fraudulent transfer and when the complaint is filed. Because Athilon was solvent at the time of the amended complaint, Quadrant argued that the amended complaint should relate back to the 2012 complaint. To relate back, the subsequent complaint must concern the same conduct, occurrence or transaction as the original. Here, since the original complaint did not allege violations based on the purchase of securities from Merced or the 2015 Redemption, the claim could not relate back and was dismissed.

Practical Implications

The Court made it clear that protections for debt holders should come first from their negotiated instruments, then from statutory provisions, and only as a last resort from claims for breaches of implied duties, such as a board's fiduciary duty and the duty of good faith and fair dealing.
Implied duties will not aid a debt holder in forcing business decisions upon a debtor if the debt holder failed to negotiate for the rights it wishes to exercise. Disagreement over investment strategy does not constitute a breach of duty if the parties’ actions are not prohibited by law or contract.