In its October 1, 2014 decision in Quadrant Structured Prods. Co. v. Vertin, et al., C.A. No. 6990, the Delaware Court of Chancery applied the protections afforded under the business judgment rule to investment strategies adopted by directors of insolvent corporations. The court held that the business judgment rule barred derivative claims asserted against directors by a creditor who had alleged that the company’s high-risk investment strategy was implemented for the purpose of benefitting the corporation’s controller at the creditors’ expense.
However, the court determined that the entire fairness standard would be appropriate for claims regarding transfers of value from the insolvent corporation to the controlling shareholder and its affiliates.
The application of the business judgment rule to the business decisions of directors of insolvent corporations protects those decisions from judicial scrutiny. Significantly, the court applied these protections to a majority-interested board and to a decision clearly benefitting the controller. The court held that such decisions should be protected by the business judgment rule so long as the directors could justify the decisions as actions intended to maximize the value of the corporation as a whole.
Background Athilon Capital Corp. was a credit derivative product company that became insolvent during the 2008 financial crisis. EBF & Associates purchased all of Athilon’s Junior Subordinated Notes and all of Athilon’s equity, thereby assuming control of Athilon. EBF appointed four directors to the five-person board, which also included Athilon’s CEO.
After the EBF takeover, Quadrant Structured Products Company, Ltd. acquired senior subordinated notes, thereby becoming an Athilon creditor. Quadrant later brought this action alleging, among other things, that the EBF-controlled board breached its fiduciary duties by (1) adopting a risky investment strategy where any losses would be borne solely by the creditors, while any upside would benefit EBF as controller; (2) continuing to pay interest on EBF’s junior subordinated notes after Athilon became insolvent; and (3) paying fees to an EBF subsidiary at above-market rates.
Standing: Direct Claims versus Derivative Claims As a preliminary matter, the court held that creditors of an insolvent corporation cannot assert breach of fiduciary duty claims directly against directors, but can assert them derivatively, on behalf of the company. In so holding, the court undertook a thorough review of Delaware caselaw on this subject, and ultimately relied on the Delaware Supreme Court’s decision in North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.D.2d 92 (Del. 2007), which established that directors owe no fiduciary duty directly to creditors.
The court also held that creditors can assert claims that predate their ownership of the debt. Accordingly, the “contemporaneous ownership requirement,” which in Delaware is a statutory prerequisite to derivative claims brought by shareholders, does not apply to claims by creditors. However, the court emphasized that this ruling should not affect other prerequisites to bringing derivative claims, such as demand excusal.
The Business Judgment Rule Applies to Claims Related to Investment Strategy Turning to the substance of Quadrant’s claims, the court distinguished between decisions that would be evaluated under the business judgment rule and decisions that would be evaluated under the entire fairness standard. The court classified the investment strategy decisions as decisions intended to maximize the enterprise value of the corporation and therefore subject to the business judgment rule; however, the claims regarding payments to EBF and its subsidiary were viewed as transfers of value that would be subject to the entire fairness standard.
Quadrant argued that well-intended fiduciaries would have invested conservatively in order to preserve the value of the corporation for its creditors and prepare for liquidation. The board’s decision to instead pursue a riskier strategy, Quadrant claimed, constituted a breach of its fiduciary duties. According to Quadrant, this strategy was implemented:
[F]or the benefit of EBF and contrary to the interests of [Athilon’s] creditors. Because EBF owns [Athilon’s] equity and Junior Notes, which are currently underwater, EBF does not bear any of the risk if the investment strategy fails. Only Quadrant and the other more senior creditors bear the downside risk. If the riskier investment strategy succeeds, however, then EBF will capture the benefit.
(Opinion at 9.) Quadrant argued that where the corporation’s controller was the sole beneficiary of a board decision, and a conflict of interest was present, the entire fairness standard, rather than the business judgment rule, should apply.
The Delaware Chancery Court disagreed. Invoking Gheewalla, the court held that directors owe no duty directly to creditors, and thus do not owe conflicting duties to the corporation and to individual creditors. Instead, a director’s sole duty remains to maximize the value of a corporation for the residual claimants, which includes shareholders and, upon a corporation’s insolvency, creditors. The court thus held that “the fact that the residual claimants of the firm at that time are creditors does not mean that the directors cannot choose to continue the firm’s operations in the hope that they can expand the inadequate pie such that the firm’s creditors get a greater recovery” (Opinion at 38) (citing Trenwick Am. Litig. Trust v. Ernst & Young LLP, 906 A.2d 168, 174 (Del. Ch. 2006)).
Despite holding that the five-director board contained at least three interested directors, the court held that the directors faced no actual conflicts of interests, and therefore applied the business judgment rule to the board’s decisions regarding investment strategy. The court held that those decisions impacted the value of the corporation as a whole, and as a result, the court would not assess whether they were intended to benefit some residual claimants more than others.
The Entire Fairness Standard Applies to Claims Related to Actual Transfers of Value However, the court also held that decisions regarding the transfer of value to the controller will be subject to the entire fairness standard, which places the burden on the directors to prove that the terms of the transaction and the price were entirely fair.
With respect to the payment of interest on EBF’s junior subordinated notes, the court noted that EBF stood on both sides of the transaction as holder of the junior subordinated notes (and recipient of the interest payments), and as the sole equity shareholder of Athilon. The court also noted that these payments were discretionary, since under the terms of the notes, the board could have deferred payment. Thus, this transaction benefitted the controller at the expense of the senior creditors, who upon insolvency become the company’s “residual beneficiaries” (Opinion at 36) (quoting Gheewalla, 930 A.2d at 101). Because of the potential for self-dealing, the court determined that the entire fairness standard was appropriate.
The court similarly determined that the entire fairness standard would govern Quadrant’s claim related to the payment of fees to an EBF subsidiary at allegedly above-market rates. Because entire fairness governed these claims, the burden of proof fell on the directors, and the motion to dismiss was therefore denied.
With respect to the potential liability of the independent directors, the court held, “entire fairness governs interested transactions between a corporation and its controller, even if a special committee of independent directors or a majority-of-the-minority vote is used, because of the risk that when push comes to shove, directors who appear to be independent and disinterested will favor or defer to the interests and desires of the majority stockholder” (Opinion at 54) (emphasis in original).
Other Claims In addition to its claims for breach of fiduciary duty, Quadrant brought claims for waste, fraudulent transfer, constructive dividends, and injunctive relief. With the exception of the claim for constructive dividends, which the court held is not a cause of action recognized under Delaware law, the court held that the remainder of these claims survived the motion to dismiss.
Conclusion Quadrant demonstrates Delaware’s strict approach toward insolvent companies that transfer value to favored shareholders – but equally signifies Delaware’s hesitation to engage in an evaluative review of strategic decisions regarding the maximization of a corporation’s value as a whole. However, it remains unresolved whether all claims can be so conveniently classified as a maximization decision or as a transfer of value. For instance, it may be possible that an investment strategy may be so skewed to benefitting the controller that it may essentially be considered a transfer of value.