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May 2015

  

Delaware Courts Continue to Clarify Creditor Standing With Respect to Insolvent Companies

  

  

 
 

  

     

  

 
 

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Christopher A. Ward

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Samira Torshizi

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On May 4, 2015, Vice Chancellor J. Travis Laster of the Delaware Court of Chancery issued an opinion in Quadrant Structured Products Company, Ltd. v. Vertin clarifying when a creditor gains standing to pursue derivative claims and why permanent insolvency is not necessary to maintain standing. In Quadrant, the Vice Chancellor held that a creditor must establish a corporation's insolvency at the time the creditor filed suit and need not demonstrate that the corporation remained insolvent through judgment. The court also held that the traditional balance sheet test is sufficient to establish insolvency and a creditor is not required to show that the corporation had no reasonable prospect of returning to solvency. The court's ruling allows creditors of an insolvent corporation to more easily pursue claims for breaches of fiduciary duty against the corporation's directors and officers. Plaintiff Quadrant Structured Products Company, Ltd. ("Quadrant") asserted derivative claims for breaches of fiduciary duty against the directors of Athilon Capital Corporation (the "Company") and EBF & Associates ("EBF"), which held equity and certain junior debts of the Company. The Company returned to solvency while Quadrant's suit was still pending. Defendants moved for summary judgment, advocating for a continuous insolvency requirement, under which a creditor can only maintain a derivative claim during the time a corporation is insolvent. Defendants argued that summary judgment was appropriate because Quadrant was no longer a creditor "of an insolvent corporation" and lacked standing to pursue its claims.

The Court, however, held that Delaware law does not impose a continuous insolvency requirement for creditor standing. Rather, a creditor must only establish that the corporation was insolvent at the time suit was filed. The court was "driven by the rationale that once a firm is insolvent, the creditors replace the stockholders as the equitable owners of the firm's assets and the initial beneficiaries of any interest in value." Also, a corporation's future is always uncertain and possibly volatile, so "a troubled firm could move back and forth across the insolvency line such that a continuing insolvency requirement would cause creditor standing to arise, disappear, and reappear again. If the corporation's financial condition fluctuated sufficiently, misconduct would evade review." Finally, if both stockholders and creditors have standing to sue a distressed corporate board, "the court supervising the derivative litigation has ample tools available to manage it".

Defendants also argued that Quadrant must do more than establish insolvency under the traditional balance sheet test—under which "an entity is insolvent when it has liabilities in excess of a reasonable market value of assets held." Rather, Defendants claimed Quadrant must also show "that the corporation is irretrievably insolvent," such that the insolvent corporation had no reasonable prospect of returning to solvency. The court rejected this argument and held "the irretrievable insolvency test only applies in receivership proceedings" and is not an element to consider when discussing creditor-derivative standing. Therefore, "[t]o bring a derivative action, the creditor-plaintiff must plead and later prove insolvency under the traditional balance sheet or cash flow tests."

Takeaways

Quadrant eliminated two potential hurdles creditors face when bringing derivative claims for breaches of fiduciary duty. It clarified that (i) a creditor need only show insolvency when initiating the suit to establish standing and (ii) a return to solvency will not revoke the requisite standing to maintain derivative claims for breaches of fiduciary duty. While this case seemingly expanded a creditor's right to pursue derivative claims against insolvent companies, Quadrant reaffirmed long-standing restrictions that protect the directors and officers of distressed corporations. Specifically, (i) creditors still cannot bring direct claims for breaches of fiduciary duty, (ii) Delaware continues to reject the theories of "deepening insolvency" and "zone of insolvency," and (iii) protections of the business judgment rule still afford directors of insolvent corporations considerable latitude to take actions to maximize a corporation's value.

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