In Quadrant Structured Products Co., Ltd. v. Vertin, C.A. No. 6990-VCL, 2015 WL 2062115 (Del. Ch. May 4, 2015), the Delaware Court of Chancery held that a creditor plaintiff needs only establish that a corporation was insolvent at the time the suit was filed in order to establish standing to sue derivatively on behalf of the corporation. Creditors do not need to show that the corporation was continuously insolvent throughout the litigation to maintain standing, nor do they need to show that the corporation was “irretrievably insolvent.” The decision clarifies a murky area of Delaware law regarding creditor-led derivative suits and may further broaden the situations in which creditors can assert derivative breach of fiduciary duty claims.

The creditor plaintiff in the case, Quadrant Structured Products Company, Ltd. (“Quadrant”), owned debt securities issued by defendant Athilon Capital Corp. (“Athilon”). Athilon was a credit derivative product company that guaranteed credit default swaps on senior tranches of collateralized debt obligations written by its wholly owned subsidiary, Athilon Asset Acceptance Corp. 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.

Quadrant sued in 2011, arguing that the EBF-controlled board of Athilon breached its fiduciary duties by using Athilon’s assets to benefit EBF and by pursuing an unnecessarily risky business strategy. In a previous decision [see blog article here], the Chancery Court dismissed Quadrant’s claims, to the extent that they were based on Athilon’s business strategies, but allowed the other claims to proceed. In that decision, the Court also rejected Athilon’s argument that creditors must meet the contemporaneous ownership requirement for shareholders in order to maintain standing.

Following the resolution of its motion to dismiss, Athilon moved for summary judgment on the theory that Quadrant lacked standing because, even if Athilon was insolvent at the time the suit was initiated, Athilon had since returned to solvency. The Chancery Court disagreed. Under Delaware law, a creditor may only sue derivatively if the corporation is insolvent. The Chancery Court clarified that insolvency need only exist at the time the lawsuit is filed, and need not exist continuously throughout the litigation. The Court rejected an analogy to the contemporaneous ownership requirement for stockholders and concluded that a bright-line rule requiring insolvency only at the initiation of a lawsuit was beneficial because it promoted predictability and reduced the risk of misconduct evading review. Without a bright line rule, the Court noted, “[d]uring the course of a litigation, a troubled firm could move back and for the across the insolvency line such that a continuing insolvency requirement would cause creditor standing to arise, disappear, and reappear again.”

The Court was not dissuaded by the risk that such a rule would lead to dual standing by stockholders and plaintiffs, creating situations where a corporation would have to defend multiple suits by corporate stakeholders with significant different interests. The Chancery Court reasoned that courts have “ample tools available to manage” such situations, and the two-group dynamic may even help courts come to fairer decisions.

The Chancery Court also rejected Athilon’s argument that creditor plaintiffs in derivative suits must satisfy the higher standard of showing that the corporation was “irretrievably insolvent” or had “no reasonable prospect” of returning to solvency. That standard, the Court held, belongs exclusively to cases where plaintiffs seek receiverships. Creditor plaintiffs not seeking receiverships need only show that the corporation was insolvent under the balance sheet test or the cash flow test.

Applying these principles, the Chancery Court concluded that Quadrant had presented sufficient evidence to create a dispute of fact as to Athilon’s insolvency at the time Quadrant brought suit. At that time, Athilon’s balance sheet showed $300 million in negative stockholders equity. Athilon also had poor credit ratings and sold its debt to EBF in 2010 at significant discounts, suggesting it had low value. Thus, the Court found sufficient evidence to deny summary judgment on the issue of Quadrant’s standing for a derivative suit.

The Chancery Court’s decision permits creditors to sue derivatively anytime the corporation could be considered insolvent under either the balance sheet or cash flow tests, even if the corporation later returns to solvency. As the Court acknowledged, this could open the door to dual derivative suits by creditors and stockholders who may both have standing at the same time. The Court’s dismissal of policy and manageability concerns with such a situation suggests we may see even more complicated litigation in this area for corporations at or nearing insolvency.