The Delaware Court of Chancery recently issued an opinion in Quadrant Structured Products Company1that addresses creditors’ rights to bring derivative lawsuits against directors and officers of a corporation. The Court held that Delaware law does not impose a continuous insolvency requirement and that the “traditional balance sheet test” is the appropriate test for determining solvency. The opinion also provides a roadmap on the current landscape under Delaware law for analyzing breach of fiduciary duty claims.
In Quadrant, members of the board of directors of Athilon Capital Corporation sought summary judgment in response to derivative claims asserted against them by Quadrant for breach of fiduciary duty. Quadrant owns debt securities issued by Athilon and brought a lawsuit alleging the board breached its fiduciary duties by, inter alia, engaging in certain alleged preferential and fraudulent transfers. The directors moved for summary judgment. They contended Athilon was solvent, and that for a creditor to have standing to maintain a derivative suit, the corporation on whose behalf the creditor brings the lawsuit must be both insolvent at the time of the lawsuit and remain continuously insolvent thereafter.
The Court started its analysis by discussing a series of older Delaware cases,2 and the Court’s view of the “landscape for evaluating a creditor’s breach-of-fiduciary-duty claim” after Gheewalla, a 2007 decision of the Supreme Court of Delaware.3 The Court concluded that certain fundamental principles have changed following Gheewalla. The Quadrant opinion provides a thorough analysis of the current state of the law and sets forth the following principles:
- There is no legally recognized “zone of insolvency” with implications for fiduciary duty claims. The only transition point that affects fiduciary duty analysis is insolvency itself.
- Regardless of whether a corporation is solvent or insolvent, creditors cannot bring direct claims for breach of fiduciary duty. After a corporation becomes insolvent, creditors gain standing to assert claims derivatively for breach of fiduciary duty.
- The directors of an insolvent firm do not owe any particular duties to creditors. They continue to owe fiduciary duties to the corporation for the benefit of all of its residual claimants, a category which now includes creditors. They do not have a duty to shut down the insolvent firm and marshal its assets for distribution to creditors, although they may make a business judgment that this is indeed the best route to maximize the firm’s value.
- Directors can, as a matter of business judgment, favor certain non-insider creditors over others of similar priority without breaching their fiduciary duties.
- Delaware does not recognize the theory of “deepening insolvency.” Directors cannot be held liable for continuing to operate an insolvent entity in the good faith belief that they may achieve profitability, even if their decisions ultimately lead to greater losses for creditors.
- When directors of an insolvent corporation make decisions that increase or decrease the value of the firm as a whole and affect providers of capital differently only due to their relative priority in the capital stack, directors do not face a conflict of interest simply because they own common stock or owe duties to large common stockholders. Just as in a solvent corporation, common stock ownership standing alone does not give rise to a conflict of interest. The business judgment rule protects decisions that affect participants in the capital structure in accordance with the priority of their claims.4
With these principles set out, the Court addressed and rejected the defendants’ argument that continuous insolvency is required for a creditor to have standing in a derivative suit, holding instead that a creditor must establish only that the corporation was insolvent at the time the lawsuit was filed. The Court, however, acknowledged that its holding — that there is no requirement to show continuous insolvency — is a matter of first impression and the Delaware Supreme Court has yet to address the issue.
The defendants also contended in their summary judgment motion that Quadrant must “do more than establish insolvency under the traditional balance sheet test,” arguing that Quadrant must show that the corporation is irretrievably insolvent. The Court disagreed, holding that irretrievable insolvency is not necessary to give a creditor standing to sue derivatively. The Court distinguished “irretrievable insolvency” cases relied upon by the defendants because the Court viewed the “irretrievable insolvency test” as applying only in receivership proceedings. Instead, the Court in Quadrant held that, for creditor-derivative claims, insolvency under the traditional balance sheet test is sufficient to confer standing. The Court further held for purposes of the summary judgment motion that Quadrant had shown sufficient evidence to create a genuine issue of fact as to solvency. It remains to be seen whether the Delaware Supreme Court will agree with the Quadrant Court’s analysis that a showing of irretrievable insolvency is not required to confer standing in the context of creditor-derivative fiduciary duty claims.
The Quadrant decision, if followed by other courts, removes a potential defense to creditor fiduciary duty claims against officers and directors by holding that a lawsuit can proceed even if during the course of the lawsuit the corporation returns to solvency. More generally, the decision provides a useful analysis of the current state of Delaware law governing breach of fiduciary duty claims.