ONCE INSOLVENT, ALWAYS INSOLVENT? CLARIFYING THE CURIOUS CASE OF DERIVATIVE CREDITORS

Quadrant Structured Prods. Co., LTD. v. Vertin, 115 A.3d 525 (Del. Ch. 2015)

Did you know as an officer or director of a Delaware corporation you may owe fiduciary duties to creditors and not just shareholders? If your company is insolvent, you do. But directly or derivatively? What duties? And what if your company later becomes solvent? The Court of Chancery decision Quadrant Structured Products Company, LTD. v. Vertin from earlier this year went a long way to clarifying this area of the law.

The answer: A creditor has standing to sue officers and directors derivatively for breaches of the duties of loyalty and care to a company insolvent at the time the creditor filed suit, without having to show the company was irretrievably insolvent and regardless of whether a company later returns to solvency. It is thus possible for both creditors and shareholders to simultaneously pursue derivative claims against officers and directors of an insolvent company that later regains solvency.

Quadrant involved yet another company that suffered significant losses during the 2008 financial crisis. Athilon Capital Corporation, a Delaware entity, issued $600 million in long-term notes to fund its operations. In 2010 after the market crashed, Defendant EBF & Associates, LP bought significant portions of Athilon’s debt at deep discounts, but Plaintiff Quadrant Structured Products Company remained a significant senior creditor. EBF then realized that if it bought Athilon’s equity as well it could take control of Athilon’s board and thereafter control the making of Athilon’s payments, and that’s exactly what it did. Quadrant then brought suit alleging that after EBF took control of Athilon’s board, the board made several decisions benefiting EBF at the expense of the company and senior creditors.

After suit was filed, however, Athilon’s board engaged in a series of questionable transactions that flipped its balance sheet and allowed it to claim solvency. Athilon then claimed Quadrant no longer had standing as a creditor, and alternatively argued that Quadrant had to show not only insolvency at the time of filing suit, but irretrievable insolvency. The court rejected both arguments.

The court began with a thorough recounting of Delaware law on derivative creditors. Creditors cannot assert direct claims, but they can assert derivative claims. Directors and officers owe duties to the company, and those same duties—loyalty and care—exist regardless of whether a creditor or shareholder brings suit on the company’s behalf. Creditors gain standing when a company is insolvent because they have a greater interest in the reasonable operations of the company than do the shareholders, whose stock has no value. Shareholders would prefer for the company to engage in high risk transactions that have some, however slight, hope of returning the company to solvency because they have nothing to lose. This conduct would likely lead to further losses and impairment of the company’s ability to pay its debts, however, which would injure the creditors.

Addressing Athilon’s arguments, the court rejected Athilon’s analogy of continuous insolvency to the requirement that a shareholder remain a continuous owner. The court held that the proper analogy is being a continuous creditor—not continuous insolvency. To hold otherwise would be especially troublesome here where the alleged self-dealing wrongdoers own 100% of the equity. The creditors are the only group with an interest in pursuing derivative claims. The court also noted that that if a company later becomes solvent, that means both creditors and shareholders could pursue derivative claims. The court was not worried about the potential conflict, however, citing the business judgment as a protection for directors and officers.

As to Athilon’s second argument that Quadrant had to show irretrievable insolvency at the time the suit was filed, the court found Athilon’s authority dealt only with the appointment of a receiver and not a creditor’s standing to sue derivatively. The court found instead that the traditional balance sheet test for insolvency was the appropriate metric for determining a creditor’s standing.

In sum, creditors of a Delaware corporation can sue derivatively. To do so, they must prove that the corporation was insolvent at the time suit was filed;  if so, a creditor can pursue derivative claims against directors and officers for breaches of their duties of loyalty and care regardless of whether a company later becomes solvent.