More Clarity for Delaware Directors When Considering Restructuring Transactions
In Quadrant Structured Products Co., Ltd. v. Vertin (May 4, 2015) (“Quadrant”), the Delaware Court of Chancery confirms – again – that ordinary corporate fiduciary duties govern the conduct of directors of an insolvent corporation, rather than a special duty to creditors. The Court also clarifies the circumstances in which creditors may have derivative standing to enforce those fiduciary duties on behalf of an insolvent corporation.
FIDUCIARY DUTIES DURING A RESTRUCTURING
In many jurisdictions, the fiduciary duties of directors during a restructuring are difficult to determine with precision. Once a corporation enters a “zone of insolvency,” creditors can bring a variety of vaguely defined fiduciary claims, many based on contradictory case law. Generally, these causes of action arise from one of two underlying legal propositions. First, when a corporation nears insolvency, there is an inherent conflict of interest between owners and creditors that requires heightened judicial review of decisions by directors. Second, an insolvent entity at some point becomes a trust fund for its creditors and, if the directors allow it to operate and incur greater losses, the creditors should have a direct claim against directors for those losses.
Not in Delaware. In a clear opinion by Vice Chancellor Laster, the Court of Chancery in Quadrant summarizes the fiduciary duties of directors of an insolvent Delaware corporation.
- Directors have the same duties whether a corporation is solvent or insolvent: the duty of loyalty and the duty of good faith.
- The business judgment rule applies to insolvent corporations, as do the protections afforded by good corporate governance and reliance on experts.
- Directors of insolvent corporations owe duties only to the corporation. There is no direct duty to creditors.
- If a corporation is insolvent, creditors have standing to assert derivative claims for a breach of fiduciary duties to the corporation. The same general principles apply to creditor and shareholder derivative actions, including that any recoveries belong to the corporation.
- Ownership of common stock does not, by itself, create a conflict of interest. Directors who own common stock, or have duties to large stockholders, can authorize a corporation to take on risks when insolvent without Delaware courts applying heightened scrutiny.
- Insolvency itself is the transition point at which creditors can assert derivative claims. There is no broader “zone of insolvency” in Delaware.
The net result for directors of Delaware corporations is that they should be protected by the business judgment rule regardless of the financial condition of the corporation, absent conventional grounds to rebut the business judgment rule such as a personal interest in the transaction, lack of independence or bad faith.
CREDITOR STANDING TO BRING DERIVATIVE ACTIONS
That’s the good news for directors. However, after confirming the limited nature of director fiduciary duties in insolvency, the Court in Quadrant goes on to make two important holdings that will help creditors challenge director decisions in those rare cases where creditors have grounds to rebut the business judgment rule. Each holding facilitates the ability of creditors to show that a corporation is insolvent and, therefore, creditors should be granted standing to sue directors in the name of the corporation.
First, the Court held that the standard of “insolvency” for determining when creditors can bring a derivative action is simply balance sheet insolvency: liabilities in excess of the “reasonable market value” of a corporation’s assets. The defendant corporation had argued for a tougher standard — “irretrievably insolvent” — derived from cases concerning the appointment of a receiver. The Court reasoned that balance sheet insolvency was sufficient because it was the point at which creditors became the “equitable owners” of the corporation’s assets and, therefore, should be granted rights analogous to those of a solvent corporation’s shareholders. The Court also noted that using balance sheet insolvency for derivative standing discouraged true misconduct by directors, and was consistent with the solvency test used by courts when creditors seek to avoid a fraudulent transfer or challenge an illegal dividend under Delaware law.
Second, the Court held that creditors can be granted standing if they show the corporation was insolvent at the time of the filing of the lawsuit, even if the corporation subsequently recovers. The Court rejected a novel argument by the defendant corporation that a creditor should be required to show “continuous insolvency” at all times after the action was filed. Vice Chancellor Laster reasoned that “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.”
Taken together, the Court’s two holdings on how and when to measure insolvency will make it difficult for defendants to dismiss creditor derivative actions on standing grounds at summary judgment. Indeed, in denying the defendant corporation’s motion for summary judgment in Quadrant, Vice Chancellor Laster found “evidence sufficient to create a genuine issue of fact as to [the corporation’s] solvency” by listing facts that are ubiquitous in restructuring situations:
- Low credit ratings (ranging from B3 to CC);
- Negative GAAP shareholder equity (approximately $300 million); and
- Low trading prices for unsecured debt securities (roughly $0.20 on the dollar).
In addition, Quadrant may create a new tactic for hold-out creditors. Creditors who file an action while a corporation is insolvent will continue to have standing even after a corporation has successfully completed an out-of-court exchange offer or other financial restructuring. A hold-out creditor whose obligation is not yet due and payable may consider the ability to prosecute fiduciary litigation after an out- of-court restructuring to be a source of leverage, even if any monetary recoveries must be paid to the corporation, not the individual creditor. Absent further developments in Delaware case law, the only certain means of removing creditor standing on fiduciary claims in an out-of-court restructuring is now repayment.
Quadrant etches more deeply recent jurisprudence that protects Delaware directors when they make decisions in a restructuring context. However, Quadrant also warns that acts and omissions by directors in violation of their fiduciary duties are subject to challenge by creditors. Delaware law provides a viable derivative cause of action for creditors, as well as an insolvency test for standing that is fact-intensive and difficult to dismiss at summary judgment. Restructurings of Delaware corporations will remain as litigious as public M&A and other transactions where the stakes are high. The upshot for directors is that the same corporate governance best practices are as relevant in restructuring as they are anywhere else.