On May 4, 2015, Vice Chancellor Travis Laster of the Delaware Court of Chancery issued an opinion providing a thoughtful analysis of when the creditors of an insolvent corporation have the right to bring derivative claims, such as those alleging breach of director fiduciary duties. In Quadrant Structured Products Co., Ltd. v. Vertin,[1] the Court examined a question of first impression under Delaware law: whether that law imposes a continuous insolvency requirement for creditors to maintain standing to bring derivative claims against a corporation. The Court began its analysis with a discussion of the nature of a creditor’s claim. Was it “(i) an easily invoked theory that a creditor can assert directly as the firm approaches insolvency, (ii) a powerful cause of action that defendant directors will struggle to defeat because of an inherent conflict between their duties to creditors and their duties to stockholders, and (iii) a vehicle for obtaining a judicial remedy that would involve a forced liquidation of a firm that otherwise might continue to operate and return to solvency?” Or was a creditor’s claim instead “(i) something creditors only can file derivatively once the corporation actually has become insolvent, (ii) subject by default to the business judgment rule and not facilitated by any inherent conflict between duties to creditors and duties to stockholders, and (iii) only a vehicle for restoring to the firm self-dealing payments and other disloyal wealth transfers?” Applying the rule set forth in N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla,[2] the Court determined that the latter characterization was correct, and accordingly refused to impose a continuous insolvency requirement.
Background
Quadrant is the latest in a series of decisions arising out of Quadrant Structured Product Co., Ltd.’s (“Quadrant”) dispute with Athilon Capital Corp. (“Athilon”). Athilon was formed to sell credit protection to large financial institutions, and it suffered serious losses and was rendered insolvent as a result of the 2008 financial crisis. EBF & Associates, LP (“EBF”) acquired a significant amount of Athilon’s debt in 2010 and later, although initially determining that Athilon’s equity was valueless, acquired Athilon’s equity in order to gain control of the corporation.
Quadrant sued Athilon in 2011, alleging that Athilon was insolvent and that EBF had caused Athilon to transfer value to EBF by continuing to make payments on junior debt owned by EBF, despite provisions in the debt documents allowing Athilon to defer payment, and to engage in a risky investment strategy. A series of previous decisions dismissed Quadrant’s complaints as to Athilon’s business strategy, but held that Quadrant had stated a derivative claim for breach of fiduciary duty arising out of Athilon’s decision not to defer payments on debt held by EBF. In the interim, Athilon structured several transactions with EBF in an attempt to restore Athilon to balance sheet solvency. Believing that these transactions were successful, Athilon filed a motion to dismiss Quadrant’s derivative claims on the ground that it was now solvent.
The Gheewalla Standard
Noting that “[w]hether Delaware law imposes a continuous insolvency requirement presents a question of first impression,” the Court analyzed the current legal regime concerning the ability of creditors to sue for breach of fiduciary duties. Examining Gheewalla and decisions by Chief Justice Strine, he set forth the following principles:
- “The only transition point that affects fiduciary duty analysis is insolvency itself.” The Court read Gheewalla and its progeny as rejecting the notion of a “zone of insolvency”; only after actual insolvency do creditors gain standing to assert derivative claims for breach of fiduciary duty. The Court further rejected the concept of “irretrievable insolvency” as the appropriate standard of insolvency for derivative claims, instead determining that the “traditional balance sheet test is the proper standard for determining when a creditor has standing to bring a derivative claim.” Under this test, an entity is insolvent when it has “liabilities in excess of a reasonable market value of assets.”
- “The directors of an insolvent firm do not owe any particular duties to creditors.” Rather, directors “continue to owe fiduciary duties to the corporation for the benefit of all of its residual claimants, a category which now includes creditors.”[3] This means that there is no duty to shut down an insolvent entity and distribute its assets unless the directors make a business judgment that this is the best route to maximize an entity’s value. In addition, directors can “favor certain non-insider creditors over others of similar priority without breaching their fiduciary duties.”
- “Delaware does not recognize the theory of deepening insolvency.” Emphatically, it is not a breach of fiduciary duty for directors to continue to operate an insolvent entity “in the good faith belief that they may achieve profitability.” Further, just as with a solvent corporation, directors do not face a conflict of interest “simply because they own common stock or owe duties to large common stockholders.” Directors may rely on the protection of the business judgment rule even when the corporation is insolvent, and even if the decisions “affect providers of capital differently only due to their relative priority in the capital stack.”
- “[A]t the point of solvency [that is, the point at which a corporation becomes insolvent], standing to sue derivatively does not shift from stockholders to creditors.” Stockholders do not lose their ability to bring derivative claims once a corporation is insolvent; rather insolvency expands the number of potential derivative plaintiffs.
Applying these principles, and discussing the equitable reasons for granting derivative standing to sue directors for breaches of fiduciary duties, the Court held that continuous insolvency is not a requirement for a creditor to have standing to make derivative claims. Rather, to have standing, the creditor must make its claim while the corporation is insolvent and continuously hold a debt claim against the corporation. The Court gave two additional reasons for its rejection of a continuous insolvency requirement. First, “whether the corporation is solvent or insolvent is not a bright-line inquiry and often is determined definitively only after the fact, in litigation, with the benefit of hindsight.” Second, insolvency is not a “transformational point” when the creditors gain an interest in the financial condition of a corporation; rather, even solvent entities pose risks to the ability of a creditor to recover on its debt.
The Court admitted that this approach creates the possibility that “during the course of a derivative action, both stockholders and creditors could gain standing to sue.” However, the Court noted the business judgment rule and the exculpation provisions that most companies adopted pursuant to Section 102(b)(7) of the Delaware General Corporation Law would dramatically restrict the types of suits that could be brought. In light of these protections, a derivative plaintiff effectively can only “sue over acts of self-dealing and other examples of self-interested or bad faith conduct.” Although conflict between stockholders and creditors is possible even in this limited world of claims, the Court confirmed that “the court supervising the derivative litigation has ample tools available to manage it.”
Key Takeaways
This case, although described as merely “the opinion of one trial judge,” provides a clear summary of the current Delaware law governing when a creditor has standing to bring derivative claims against a corporation. It provides useful guidance to directors of distressed companies and others as to how to approach their fiduciary duties if insolvent. In particular, key takeaways of this case are:
- Creditors will gain standing to make derivative claims when a corporation is balance sheet insolvent, but must show that a corporation is “irretrievably insolvent” in order to appoint a receiver. Because derivative claims will generally be limited to self-dealing transactions or those entered into in bad faith, a creditor will only need to establish that a corporation’s liabilities exceed the reasonable market value of its assets to bring such a suit. However, Quadrant noted that a showing of irretrievable insolvency—that is, a showing that “that there is no reasonable prospect that [a corporation], if let alone, will soon be placed, by the efforts of its managers, in a condition of solvency”[4]—is still necessary to seek the remedy of receivership. Accordingly, while a creditor may have standing to challenge a transaction and seek damages if a corporation is only balance sheet insolvent, it will still be required to show that the corporation is not likely to become solvent if it seeks to force the corporation to cease operations and distribute its assets.
- GAAP is not dispositive of balance sheet insolvency. Despite the Court’s adoption of an insolvency threshold for creditor derivative standing, a determination of balance sheet insolvency can involve a fact specific inquiry. The Court considered the following facts in determining that Quadrant had met its burden in showing that Athilon was insolvent at the time of Quadran’t suit: (a) Athilon’s balance sheet showed negative stockholder equity in an amount of over $300 million; (b) a credit rating of Athilon’s junior debt indicating that default on such debt was a virtual certainty; (c) Athilon’s debt discount—the difference between the face value and fair market value of its debt—exceeded the fair market value of Athilon’s equity; and (d) EBF’s internal communications indicating that the value of Athilon’s equity was “[p]robably zero.” Although the Court read Gheewalla as overturning previous Delaware jurisprudence creating a “zone of insolvency,” a distressed corporation, in determining whether it might be subject to creditor derivative claims, should carefully monitor all aspects of its financial performance.
- A creditor will retain standing for a derivative claim made while the corporation is insolvent, even if the corporation is ultimately able to repay its debt. Quadrant acknowledges that creditors have an interest in the credit worthiness of a corporation. Accordingly, a creditor will have the standing to bring a derivative suit against a corporation’s board, even if the corporation returns to solvency and expects that it will be able to pay the creditor in full. It is worth noting, however, that the Court, which denied defendants’ motion to dismiss for lack of standing, did not discuss how a court would calculate a creditor’s damages in that scenario.
- Director fiduciary duties to an insolvent corporation are the same as those to a solvent corporation. In particular, Quadrant establishes that the board of an insolvent corporation has no special duties to adopt a more conservative business plan or to take specific actions to protect its creditors; rather the board remains charged with maximizing the value of the corporation. The same good governance safeguards adopted by boards of solvent companies—decisions by disinterested, independent directors, clear records establishing deliberation, advice from independent advisors—will generally protect boards of insolvent companies.[5] Although the potential plaintiffs increase once a corporation is insolvent, and in particular privately held corporations may need to examine their governance in an insolvency situation, the board’s fundamental role in maximizing the value of the corporation does not change.
ENDNOTES
[1] Case No. 6990-VCL (Del. Ch. May 4, 2015). All quotations not otherwise attributed come from this case.
[2] 930 A.2d 92 (Del. 2007).
[3] Emphasis added.
[4] Quoting Atl. Trust Co. v. Consol. Elec. Storage Co., 23 A. 934, 936 (N.J. Ch. 1892).
[5] However, although not addressed in the opinion, stockholder ratification of corporate action may not be available to an insolvent corporation. Delaware law has established that vote of “a majority of informed, uncoerced, and disinterested stockholders” in favor of “a specific decision of the board of directors” will usually be sufficient to cause such decision to be evaluated under the business judgment rule. Calma v. Templeton, Case No. 9579-CB (Del. Ch. Apr. 30, 2015). However, the logic behind this law is that because the stockholders are the ultimate beneficiary of corporate action, their approval of a decision will cleanse an otherwise conflicted decision of a board of directors. This logic does not necessarily hold in a situation where the creditors also have a legally recognized interest in the growth of a corporation. As a result, boards of insolvent corporations may not be able to rely on stockholder ratification to bring a decision within the protection of the business judgment rule.
The preceding post comes to us from Gibson Dunn. It is based on a memorandum prepared by Gibson Dunn on May 11, 2015, which is available here.