Delaware Court of Chancery Rejects Contemporaneous Ownership Requirement For Creditors Asserting Derivative Claims
In Quadrant Structured Products Co. v. Vertin, C.A. No. 6990-VCL, 2014 Del. Ch. LEXIS 193 (Del. Ch. Oct. 1, 2014), the Delaware Court of Chancery held that when creditors of insolvent firms assert derivative claims, they need not meet the contemporaneous ownership requirement applied to stockholder-plaintiffs. Section 327 of the Delaware General Corporation Law requires that in any derivative suit brought by a stockholder of a corporation, the plaintiff must be a stockholder at the time that the fiduciary wrong allegedly occurred. The Court held that Section 327 refers only to stockholder-plaintiffs, thus the contemporaneous ownership requirement does not apply to creditor-plaintiffs bringing derivative suits. However, the Court stated that its reasoning did not necessarily excuse creditor-plaintiffs from complying with other substantive doctrines of shareholder derivative suits. In dicta, the Court declined to address whether creditors must satisfy the pre-lawsuit demand requirement, but the Court’s emphasis on the requirement’s importance leaves the door open for applying it to creditors in a future decision.
Defendant Athilon Capital Corp. (“Athilon”) is a credit derivative product company that wrote credit default swaps on senior tranches of collateralized debt obligations. The collapse of the credit derivative industry during the 2008 financial crisis caused Athilon’s securities to trade at steep discounts, allowing defendant EBF & Associates (“EBF”) to buy Athilon’s junior subordinated notes, and eventually all of Athilon’s equity. Shortly after the EBF takeover, plaintiff Quadrant Structured Products Company, Ltd. (“Quadrant”) purchased debt securities issued by Athilon and became a creditor stakeholder in the company.
Quadrant alleged that the company was insolvent prior to the EBF takeover and was unlikely to return to solvency. Quadrant argued that a well-intentioned board of directors would have tried to maximize the company’s value for its stakeholders by minimizing expenses during a runoff, liquidating the company’s remaining assets, and returning Athilon’s capital to its investors. Rather than taking that course, Quadrant alleges that the EBF-controlled board breached its fiduciary duty by using Athilon’s assets to benefit EBF. Defendants moved to dismiss the complaint for failure to state a claim.
The Court first held that Quadrant adequately pled standing to assert its derivative claim for breach of fiduciary duty because Athilon was insolvent. The Delaware Supreme Court held in North American Catholic Educ. Programming Found. v. Gheewalla, 930 A. 2d 92, 103 (Del. 2007), that when a corporation is insolvent, creditors of the corporation may sue derivatively, but have no right to assert direct claims for breach of fiduciary duty against corporate directors. Here, the Delaware Court of Chancery made it clear that creditors merely “gain derivative standing to enforce . . . duties that directors owe to the corporation to maximize its value for the benefit of all residual claimants.” Gheewalla, 930 A.2d at 101 (emphasis added). Based upon the financial information alleged in Quadrant’s complaint, the Court held that Athilon’s liabilities were greater than the reasonable market value of its assets, thus meeting the balance sheet test for insolvency. Therefore, Quadrant had standing to sue derivatively.
Next, the Court held that creditor-plaintiffs bringing derivative claims need not meet the contemporaneous ownership requirement. Section 327 of the Delaware General Corporation Law requires stockholder-plaintiffs to hold shares in the corporation when the breach of fiduciary duty allegedly occurred and throughout the pendency of the lawsuit. Because of policy concerns and that the statute solely refers to stockholder-plaintiffs, the Court held that the plain language of the statute did not apply to creditor-plaintiffs bringing derivative claims. Therefore, creditors need not acquire their creditor status before the fiduciary wrong allegedly occurred, and Quadrant was not required to plead contemporaneous ownership.
However, the Court expressly limited its holding to the contemporaneous ownership requirement. The defendants did not raise demand excusal or demand refusal as an objection to Quadrant’s derivative claim, but in dicta, the Court explained that it is possible that creditors could be required to meet the demand requirement. Demand excusal and demand refusal flow from the board’s managerial authority in Section 141(a) of the Delaware General Corporation Law, which does not distinguish between stockholders and other corporate constituencies. Therefore, the Court reasoned, the demand requirement might apply to creditor-plaintiff derivative suits. Additionally, the court emphasized the importance of the demand requirement in preventing derivative plaintiffs from usurping the board’s authority to decide how to proceed on a corporate claim.
Having concluded that Quadrant had standing to assert its derivative claims, the Court analyzed whether those claims survived Athilon’s motion to dismiss. The Court denied the motion to dismiss on the breach of fiduciary duty claims for specific transfers of value to EBF in the form of deferrable interest, and excessive service and software license fees. However, the Court granted the motion to dismiss the claims that Athilon breached its fiduciary duties by investing in riskier securities and speculative investments. The Court rejected Quadrant’s argument that EBF improperly benefited from this risker business strategy by holding all the potential for gain, while the residual claimants held all the risk for loss. The Court reasoned that Athilon’s riskier business strategy appeared rationally designed to increase the value of the entity as a whole. Thus, the decision was protected by the business judgment rule, which entitles the board to exercise its good faith business judgment to maximize the company’s value even when the company is insolvent.
In Quadrant, the Chancery Court’s rejection of the contemporaneous ownership requirement for creditor-plaintiffs in derivative actions means that creditors may challenge alleged fiduciary breaches occurring before the corporation becomes insolvent, as long as the creditor can plead that the corporation is currently insolvent. The decision could open up new avenues for creditors to assert derivative claims and expose corporations to additional litigation. Quadrant also gives needed guidance with respect to pleading requirements for creditors-plaintiffs in derivative actions. However, the Court left unanswered the question of whether the pre-lawsuit demand requirement applies to creditor-plaintiffs. Further, the court left the door open for future decisions applying the demand requirement by showing that there are no substantive or procedural barriers to imposing it on creditors and emphasizing the importance of the demand requirement in Delaware corporate law.