May 11, 2015
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, 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, the Court determined that the latter characterization was correct, and accordingly refused to impose a continuous insolvency requirement.
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.
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:
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."
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:
 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.
Gibson, Dunn & Crutcher’s lawyers are available to assist with any questions you may have regarding these issues. For further information, please contact the Gibson Dunn lawyer with whom you usually work, any member of the firm’s Business Restructuring and Reorganization, Private Equity or Securities Regulation and Corporate Governance practice groups, or the following authors:
Michael A. Rosenthal – New York (+1 212-351-3969, email@example.com)
Robert B. Little - Dallas (+1 214–698–3260, firstname.lastname@example.org)
Chris Babcock - Dallas (+1 214–698–3138, email@example.com)
Please also feel free to contact the following practice group leaders:
Business Restructuring and Reorganization Group:
Craig H. Millet – Orange County (+1 949-451-3986, firstname.lastname@example.org)
Michael A. Rosenthal – New York (+1 212-351-3969, email@example.com)
Jeffrey C. Krause – Los Angeles (+1 213-229-7995, firstname.lastname@example.org)
David M. Feldman – New York (+1 212-351-2366, email@example.com)
Private Equity Group:
Paul Harter – Dubai (+971 (0)4 318 4621, firstname.lastname@example.org)
Sean P. Griffiths – New York (+1 212-351-3872, email@example.com)
Charlie Geffen – London (+44 (0)20 7071 4225, firstname.lastname@example.org)
Steven R. Shoemate – New York (+1 212-351-3879, email@example.com)
Ari Lanin – Los Angeles (+1 310-552-8581, firstname.lastname@example.org)
Securities Regulation and Corporate Governance Group:
James J. Moloney - Orange County, CA (+1 949-451-4343, email@example.com)
Elizabeth Ising – Washington, D.C. (+1 202-955-8287, firstname.lastname@example.org)
© 2015 Gibson, Dunn & Crutcher LLP
Attorney Advertising: The enclosed materials have been prepared for general informational purposes only and are not intended as legal advice.