In a recent decision, the Delaware Court of Chancery dismissed a claim that the board of directors of an insolvent Delaware corporation breached its fiduciary duties by pursuing a risky business strategy to benefit the corporation’s sole stockholder at the expense of the corporation’s senior creditors. Quadrant Structured Products Co. Ltd. v. Vertin, C.A. No. 6990-VCL (Del. Ch. Oct. 1, 2014). Although the sole stockholder designated all but one member of the corporation’s board of directors and the corporation’s CEO held the remaining board seat, the court found that the stockholder’s board designees were not conflicted in the decision to change the company’s investment strategy from a risk-off to a risk-on strategy, a change which required the company to amend its operating guidelines and obtain approval from its rating agencies. According to the court, directors of insolvent corporations possess wide latitude to pursue value-maximizing strategies which may benefit all of the corporation’s residual claimants, including its creditors, even if the strategy might ultimately benefit one class of residual claimants more than others. The court also recognized that the corporation’s senior creditors bore the full risk of the risk-on strategy’s failure.
However, the court declined to dismiss claims that the board breached its fiduciary duties to the corporation by authorizing direct and specific payments to the sole stockholder which allegedly transferred corporate assets to the stockholder at the expense of the corporation’s senior creditors. The court further held that these claims would be reviewed under the entire fairness standard of review. Subsequently, on October 28, 2014, the court rejected the creditor’s motion to reconsider its dismissal of the fiduciary claim relating to the board’s adoption of a risk-on investment strategy.
Quadrant is the first decision of a Delaware state court to address a creditor’s claims that the directors of a financially troubled corporation breached fiduciary obligations owed to creditors since the 2007 Delaware Supreme Court decision in North American Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007). Gheewalla rejected much of the Chancery Court precedent which had evolved since the landmark decision in Credit Lyonnais Bank Nederland N.V. v. Pathe Communications Corp. C.A. No. 12150, Allen-C. (Del. Ch. Dec. 30, 1991) unsettled corporate boardrooms with its suggestion that directors of distressed corporations must consider creditors’ interests in their decision-making process.
From Credit Lyonnais to Gheewalla
Since the Delaware Court of Chancery’s decision in Credit Lyonnais and earlier decisions applying the trust fund doctrine, Delaware law has recognized that the fiduciary obligations of directors change when the corporation faces insolvency. According to Credit Lyonnais, the fiduciary duties of directors of troubled corporations run primarily to the corporate enterprise as a whole. The directors of distressed corporations are therefore not required to prefer the interests of stockholders to the exclusion of non-stockholder interests, as the law generally requires of directors of solvent corporations. Rather, the board must maximize the value of the entity for the benefit of all of the corporation’s residual claimants, including its creditors. According to Credit Lyonnais, the change in the nature of the directors’ fiduciary obligations occurred prior to actual insolvency at a point in time called the “vicinity” of insolvency. Other cases referred to the relevant transitional moment as the “zone” of insolvency. However, neither Credit Lyonnais nor subsequent decisions articulated a clear test for determining when a corporation was operating in the “vicinity” or “zone” of insolvency. The courts determined actual insolvency by using one of two tests: (1) a traditional balance sheet insolvency test and (2) an equitable insolvency test, the latter of which looked at the corporation’s ability to pay debts as they became due in the ordinary course. Based on Credit Lyonnais, the Delaware courts allowed creditors to pursue direct claims for breach of fiduciary duty against directors of insolvent and nearly insolvent corporations.
In the 2004 decision in Production Resources Group, LLC v. NCT Group. Inc., 863 A.2d 772 (Del. Ch. 2004), the Court of Chancery adopted a much narrower view of the Credit Lyonnais decision than any decision to date – finding that Credit Lyonnais did not support the creation of broad rights for creditors to assert direct claims for breach of fiduciary duties against the directors of distressed corporations. In this vein, the court held that creditors of insolvent corporations generally must pursue allegations that the corporation’s board breached its fiduciary duties by depleting corporate assets as derivative, not direct claims. The court left open the possibility that a creditor could bring a direct claim for breach of fiduciary duty if self-interested director action harmed a particular creditor or class of creditors to the benefit of other residual claimants.
Subsequently, in Gheewalla, the Delaware Supreme Court held that creditors may not bring direct claims against directors for breach of fiduciary duty under any circumstances. The court expressly rejected the contrary dictum in Production Resources Group, LLC and held that directors of insolvent corporations do not owe direct fiduciary obligations to creditors. In the court’s view, Delaware’s common law does not need to afford creditors fiduciary protection because creditors may protect their investments with contractual agreements and are afforded protection under fraudulent conveyance, bankruptcy, and general commercial laws. However, the court held that creditors of insolvent (but not nearly insolvent) corporations may pursue derivative actions to enforce the fiduciary duties that the directors owe to the corporation itself as the primary constituency injured by fiduciary breaches that diminish the corporation’s value.
Post-Gheewalla: Quadrant Structured Products Co. Ltd. v. Vertin
In Quadrant, the Delaware Court of Chancery applied Gheewalla to direct and derivative claims brought by a creditor of an insolvent Delaware corporation against the corporation’s directors and its sole equity holder for breach of fiduciary duty. The defendant in this action was Athilon Capital Corp., a credit derivative product company. Prior to the 2008 financial crisis, Athilon guaranteed credit default swaps on senior tranches of collateralized debt obligations written by a wholly owned subsidiary. Under the company’s operating guidelines, Athilon only could invest in highly-rated, short-term debt securities. Athilon’s business initially was funded through $100 million in equity and $600 million in long-term debt, consisting of $350 million in senior subordinated notes, $200 million in subordinated notes, and $50 million in junior subordinated notes. During the financial crisis, Athilon lost an AAA/Aaa credit rating, its securities traded at deep discounts and Athilon largely lost the ability to operate its business. In 2010, defendant EBF & Associates, L.P., acquired all of Athilon’s equity, some of its junior notes and the right to designate four directors, two of whom also were EBF directors, to Athilon’s five member board. In 2010, an EBF affiliate began providing services to Athilon for $23 million a year, a price which far exceeded the market rate of $5–7 million. In May 2011, Athilon received approval from its rating agencies to amend its operating guidelines to permit the company to invest in high-risk, long-term securities. In May and July 2011, Quadrant acquired Athilon senior subordinated notes and subordinated notes.
In October 2011, Quadrant filed the complaint in the present action and sought relief for breach of fiduciary duty as a creditor of Athilon. Quadrant alleged that the Athilon directors: (1) adopted a business strategy of making speculative investments to benefit EBF at the expense of Athilon’s senior creditors who would bear the entire risk of the strategy’s failure; (2) continued to pay interest on EBF’s junior subordinated notes, which were underwater, despite having the ability to defer payments without repercussions; and (3) paid excessive licensing and servicing fees to an EBF subsidiary at above-market rates. According to Quadrant, the directors breached their fiduciary obligations to Athilon’s creditors by authorizing the foregoing actions to EBF’s benefit. Defendants moved to dismiss Quadrant’s complaint for, inter alia, failure to state a claim.
In reviewing Quadrant’s claims, the court reiterated that post-Gheewalla, directors of an insolvent corporation do not owe direct fiduciary obligations to the corporation’s creditors. Rather, as the principal constituency injured by fiduciary breaches that diminish the firm’s value, creditors of an insolvent corporation may pursue derivative claims for fiduciary breaches that deplete the value of the corporation’s assets. Thus, the court rejected Quadrant’s allegations as direct claims for breach of fiduciary duty. However, given Athilon was insolvent on a balance sheet basis, the court found that Quadrant possessed standing to assert derivative claims on Athilon’s behalf. In so finding, the court rejected defendants’ argument that Quadrant lacked derivative standing because some of the challenged transactions pre-dated Quadrant’s acquisition of Athilon’s debt – holding that the contemporaneous ownership requirement in Section 327 of the Delaware General Corporation Law did not apply to creditors.
Quadrant argued that its claims must be reviewed by the court under the entire fairness standard and could not be resolved on a motion to dismiss. Specifically, Quadrant argued that a majority of Athilon’s directors were conflicted in the decision to embark on a risk-on strategy. The court disagreed. According to the court, business decisions which affect the value of the entity as a whole, without conferring specific benefits on the directors themselves or, in the case of dual fiduciaries, on the competing beneficiaries of fiduciary duty, are reviewed under the deferential business judgment standard of review. The court explained that when directors make decisions that appear rationally designed to increase the value of the firm as a whole, “Delaware courts do not speculate as to whether those decisions might benefit some residual claimants more than others.” The court concluded that “directors are not deemed conflicted on the theory that a riskier business strategy will benefit EBF and harm Athilon’s creditors.”
In contrast, the court found that plaintiff had stated a claim that Athilon’s board breached its fiduciary duties by failing to defer the payment of interest on the junior notes held by EBF and by paying excessive service and licensing fees to an EBF subsidiary. With respect to the interest payments, the complaint alleged that: (1) the Athilon board had the ability to defer payment of interest on the junior notes, (2) EBF owned all of the junior notes, and (3) as the holder of the junior notes, EBF would not have received anything in an orderly liquidation. The court held that this claim would be reviewed under the entire fairness standard of review because the payment effectively transferred value owed by all residual claimants of Athilon’s assets to the party in control of Athilon, EBF. With respect to the alleged payment of excessive licensing and service fees to an EBF affiliate, the court stated: “EBF stands on both sides of the transaction, making entire fairness the governing standard of review with the burden of proof on defendants.” Accordingly, the court declined to dismiss plaintiff’s claims relating to the alleged payment of excessive licensing and service fees to an affiliate of EBF and the failure to defer interest payments on the junior notes.
Quadrant reaffirms that directors of insolvent corporations have considerable latitude to pursue value-maximizing strategies which are designed to benefit the corporate enterprise as a whole absent evidence that some compelling personal interest tainted the decision-making process. According to the court, its decision was analogous to prior precedent upholding, under the business judgment standard of review, decisions of directors of solvent, but controlled corporations which affected all stockholders equally, such as the declaration of a pro rata dividend. However, it should be noted that board decisions which have facially treated the minority and a controller equally, but which have served some extraneous interest of the controller, such as a desire for liquidity, have been reviewed under the entire fairness standard of review. It seems questionable whether the risk-on strategy equally affected EBF and Quadrant and whether the decision fits under the “equal treatment” rubric. The decision seems more a product of the decisions in the Revlon context which have protected directors in their good faith, but imperfect attempt to carry out their Revlon duties of value maximization.
The court’s application of the business judgment rule to the issue of value maximization despite the presence of a controller, a controlled board, and a finding that plaintiff’s other fiduciary claims survived a motion to dismiss underscores the deference accorded by Delaware law to directors of insolvent corporations. In late October, Quadrant moved to reargue the dismissal of its fiduciary claim regarding the board’s adoption of a risk-on investment strategy. The Court of Chancery swiftly denied the motion, reaffirming its prior decision.