A case against a hedge fund, and one of its partners and in-house counsel, related to actions at a portfolio company and alleging breach of fiduciary duties survived a motion to dismiss.  The portfolio company, alleged to be insolvent, was a credit derivative product company that had a subsidiary that wrote credit default swaps. A creditor of the portfolio company brought an action alleging breach of fiduciary duty.  A partner of the hedge fund and its in-house counsel were members of the board of directors of the portfolio company and were named as defendants in the action, together with the hedge fund.

The hedge fund held all of the junior notes of the portfolio company.   The complaint alleged that the board of the portfolio company had the ability to defer interest payments on junior notes, that the junior notes would not receive anything in an orderly liquidation, that the hedge fund owned all of the junior notes, and that the board decided not to defer paying interest on the junior notes to benefit the hedge fund.   The court stated a conscious decision not to take action is just as much of a decision as a decision to act.

By virtue of the decision not to defer interest, funds flowed from the portfolio company to the hedge fund. As the owner of 100% of the portfolio company‘s equity, the hedge fund controlled the company and stood on both sides of the transaction. Delaware law imposes fiduciary duties on those who effectively control a corporation.  In the past, Delaware courts have held that challenges to similar transfers from an insolvent subsidiary to its controller state a derivative claim for breach of fiduciary duty.  Based on a review of precedent,  the court found the complaint stated a derivative claim for breach of fiduciary duty to the extent they challenged the failure to defer interest on the junior notes. The  court added the defendants will have the burden of proving that the failure to defer interest on the junior notes was entirely fair.

Using a similar analysis to that employed for the junior notes, the court refused to grant a motion to dismiss related to allegedly excessive payments under a license agreement to an affiliate of the hedge fund.  As before, the court held the hedge fund “stands on both sides of the transaction, making entire fairness the governing standard of review with the burden of proof on the defendants.”

The complaint also alleged that the defendants  breached their fiduciary duties by amending operating guidelines of the portfolio company to permit it to invest in riskier securities and make speculative investments while the portfolio company was insolvent.   The court noted that current Delaware law does not require the board to shut down the portfolio company’s business and manage towards a near-term dissolution for the benefit of creditors. Notwithstanding a company‘s insolvency, the directors continue to have the task of attempting to maximize the economic value of the firm.  The court stated in such a scenario the directors are protected by the business judgment rule.  After a lengthy analysis examining arguments that the board was attempting to favor the sole stockholder, the court held the plaintiff cannot rebut the business judgment rule by alleging that the board of the portfolio company has decided to pursue a relatively more risky business strategy to benefit the hedge fund as its sole common stockholder. Although the portfolio company was insolvent, and although the directors were dual-fiduciaries, the board did not face a conflict between the interests of the primary residual claimants (the creditors) and the interests of secondary residual claimants (the stockholders).