The Delaware Court of Chancery recently held that, for a creditor to have standing to bring a derivative breach of fiduciary duty action, the creditor need only establish that the corporation was insolvent at the time the creditor’s action was filed—not that the corporation continued to be insolvent until the date of judgment. Further, the creditor need only establish that the corporation was “balance sheet insolvent,” rather than meeting the more rigorous “irretrievably insolvent” standard. Finally, the decision provides a useful summary of the current state of Delaware law regarding creditor breach of fiduciary duty claims.
In Quadrant Structured Products Co., Ltd. v. Vertin, Quadrant Structured Products Co., Ltd., a creditor of Athilon Capital Corp., sued Athilon’s directors, its controlling shareholder EBF & Associates, and EBF’s affiliate Athilon Structured Investment Advisors, LLC (ASIA) for alleged breaches of fiduciary duty and preferential transfers. Athilon had been created to sell credit protection to large financial institutions, writing credit default swaps on senior tranches of collateralized debt obligations. Following the 2008 financial crisis, Athilon paid hundreds of millions of dollars to unwind two swaps involving mortgage-backed securities. In the wake of the crisis, financial institutions were unwilling to enter into credit swaps with entities such as Athilon that lacked substantial capital. Athilon could no longer engage in the only business that it was permitted to pursue under its charter and operating guidelines, which had been narrowly limited to meet requirements imposed by the credit rating agencies.
EBF acquired Athilon’s junior subordinated notes and the rest of its equity, gaining control of the company and its board. The board then sought permission from the rating agencies to amend Athilon’s operating guidelines to loosen its investment restrictions and allow it to invest in riskier securities. The board also continued to pay interest to EBF on the junior notes, even though it could have deferred these payments, and paid allegedly excessive service and license fees to ASIA.
Earlier decisions in this saga dismissed some of Quadrant’s claims as we discussed previously here. Quadrant’s surviving claims addressed by the court were:
(i) that the directors breached their fiduciary duties by transferring value preferentially to EBF and ASIA, and
(ii) that those transactions constituted fraudulent transfers under the Delaware Uniform Fraudulent Transfer Act in part because they were made when Athilon was insolvent.
In North American Catholic Programming Foundation, Inc. v. Ghewalla, the Delaware Supreme Court held that
the creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duty.
But here, Athilon asserted that it had returned to a state of solvency during the pendency of the derivative action. Accordingly, because the Company was no longer insolvent, it moved for summary judgment arguing that Quadrant no longer had standing to pursue the derivative claims. The Company also argued that the proper test for insolvency for purposes of giving creditors standing to bring derivative claims was that the company had no reasonable prospect of returning to solvency (i.e., that it was “irretrievably insolvent”).
"If the creditor no longer holds a debt claim against the corporation, regardless of whether the divestiture was voluntary or involuntary, then the creditor loses standing to sue." This standard, reasoned the court, provides a bright-line test. By contrast, the question of whether a corporation is solvent is often determined after litigation and with the benefit of hindsight—i.e., hardly a bright-line standard upon which the question of standing can be answered.
Thus, the court held that “to maintain standing to sue derivatively, a creditor must establish that the corporation was insolvent at the time the creditor filed suit. The creditor need not demonstrate that the corporation continued to be insolvent until the date of judgment.”
Irretrievable Insolvency or Balance Sheet Insolvency
In addition to the standing argument, Athilon, citing the Gheewalla trial decision by the Court of Chancery, asserted that Quadrant must prove Athilon was “irretrievably insolvent,” rather than just “balance sheet insolvent.” The “balance sheet insolvency” standard provides that a corporation is insolvent “when it ‘has liabilities in excess of a reasonable market value of assets held.'” The "irretrievable insolvency" standard is more rigorous because it requires a showing that the corporation not only has "a deficiency of assets below liabilities," but that there is "no reasonable prospect that the business can be successfully continued in the face thereof."
The court noted that the “irretrievable insolvency” standard had historically been limited to cases in which the appointment of a receiver was sought. This heightened standard applied in such circumstances due to the “drastic” nature of such relief (displacing a corporation’s board of directors). The court chose not to follow the Court of Chancery's prior adoption of the "irretrievable insolvency" test in Gheewalla because it was drawn from an earlier decision, Production Resources, that was considering appointment of a receiver. Instead, the court followed the “traditional balance sheet test” used by courts in the Trenwick, Blackmore Partners, Timberlands and Geyer cases. Therefore, the court held that Quadrant had satisfied its burden by demonstrating that Athilon was insolvent under the “balance sheet test.”
The Quadrant decision clarifies the standard a creditor of an insolvent corporation must meet in order to sue derivatively for breach of fiduciary duty. The decision also provides a useful summary of the current state of Delaware law for creditor breach of fiduciary duty claims, which will be the subject of a future blog post.