May 20, 2015

Delaware Court of Chancery Revisits Creditor Derivative Standing

Paul K. Rowe, William Savitt, Emil A. Kleinhaus, and Alexander B. Lees – May 20, 2015

The Delaware Bankruptcy Court recently determined that a shareholder’s right to move the Delaware Chancery Court to compel a shareholder meeting is not stayed by operation of the automatic stay, although the bankruptcy court retains the authority to enjoin the occurrence of the meeting (or any actions taken at such meeting) if the court concludes that there is “clear abuse,” as defined by the court to include delay and “real jeopardy” to the debtor’s ability to reorganized. In re SS Body Armor I, Inc., Case No. 10-11255 (Bankr. D. Del. Apr. 1, 2015) (CSS).

The movant filed for relief from the automatic stay to file and prosecute a proceeding before the Delaware Chancery Court to compel the debtor to hold an annual shareholder meeting.  Under Delaware’s General Corporations Law (DGCL 211(c)), the chancery court may summarily order a meeting to be held upon the application of any stockholder if the company fails to hold one within a period of 13 months. See Del. Code Ann. tit. 8, § 211(c) (West). The movant presented no evidence in support of its motion, instead relying on the (uncontested) fact that the debtor had not held a shareholder meeting in several years. The debtor acknowledged that it had not held a shareholder meeting but argued that the bankruptcy court should deny the motion because the movant wanted to frustrate the debtor’s reorganization plans and prospects.

The bankruptcy court principally relied on the Second Circuit’s Johns-Manville decision (Manville Corp. v. Equity Sec. Hldrs. Cmt. (In re Johns-Manville Corp.), 801 F.2d 60 (2d Cir. 1986)), the Delaware Chancery Court’s decision in U.S. Energy Systems (Fogel v. U.S. Energy Systems, Inc., 2008 WL 151857 (Del. Ch. Jan. 15, 2008)) and the Delaware District Court’s decision in In re Marvel Entm’t. (Official Bondholder Cmt. v. Chase Manhattan Bank (In re Marvel Entm’t Grp., Inc.), 209 B.R. 832 (D. Del. 1997)). According to the bankruptcy court, these authorities demonstrated that: (1) a shareholder’s right to move to compel a shareholder meeting continues after a bankruptcy filing; (2) the automatic stay provisions of the Bankruptcy Code generally are not implicated by a shareholder’s exercise of its governance rights; and (3) the bankruptcy court has the authority to enjoin the exercise or implementation of such rights if the court finds clear abuse, which includes delay or other threats to the debtor’s prospects for or ability to reorganize.

In light of these authorities, the court concluded that the automatic stay did not apply to stay the movant’s proposed action and granted the movant’s motion on that basis. While the court also noted that there appeared to be grounds on which the court could make a finding of clear abuse, it also determined that it could not issue an injunction because an injunction must be sought in an an adversary proceeding under Fed. R. Bankr. Proc. 7001(7).

In a significant decision, the Delaware Court of Chancery has rejected several proposed limitations on the ability of creditors to maintain derivative suits following a corporation’s insolvency. In doing so, however, the court reaffirmed the deference owed to a board’s decisions, regardless of the company’s financial condition and the high hurdles faced by creditors in seeking to prove a breach of fiduciary duty. Quadrant Structured Prods. Co. v. Vertin, C.A. No. 6990-VCL (May 4, 2015).

Quadrant, a creditor of Athilon Capital, brought a derivative action claiming that when Athilon was insolvent, its directors violated their fiduciary duties, including by authorizing repayments of debt owed to Athilon’s equity owner. The defendants moved for summary judgment on the basis that Quadrant lacked standing to sue under the Delaware Supreme Court’s decision in North American Catholic Educational Programming Foundation, Inc. v. Gheewalla (see WLRK memo of May 24, 2007), which permits creditors to sue directors for breach of fiduciary duty only on a derivative basis, and only once the corporation is insolvent.

First, the defendants argued that Quadrant lost its ability to sue because Athilon had been restored to solvency. The court disagreed, declining to require that a corporation be “continuously” insolvent from the date of the challenged transaction through the end of the creditor’s derivative litigation. Instead, the court required corporate insolvency only at the time of the transaction.

Second, the defendants argued that Quadrant had to show that Athilon was “irretrievably insolvent,” the standard used in receivership proceedings. Again, the court rejected the defendants’ position, holding that a creditor is required to show corporate insolvency only on a balance-sheet basis—i.e., liabilities in excess of the fair market value of assets.

In rejecting these “additional hurdles,” the court explained that, following Gheewalla and a series of Chancery Court decisions issued by now-Chief Justice Strine, a creditor’s derivative fiduciary duty claim is a “less potent” tool that: (1) can only be used after a corporation is actually insolvent (rather than in the “zone of insolvency”); (2) is generally subject to the business judgment rule and not “facilitated by any inherent conflict between duties to creditors and duties to stockholders”; and (3) serves only as “a vehicle for restoring to the firm self-dealing payments and other disloyal wealth transfers.”

Quadrant thus makes clear that a creditor’s claim for breach of fiduciary duty is not “an easily invoked theory” in need of further “impediments.” Rather, under Delaware law, directors of a corporation—whether solvent or insolvent—are protected by the business judgment rule in making good-faith decisions aimed at maximizing the value of the firm, even if those decisions benefit shareholders or favor certain non-insider creditors over others.

Paul K. Rowe, William Savitt, Emil A. Kleinhaus, and Alexander B. Lees – May 20, 2015