The Court of Chancery issues a liberal ruling on creditor derivative standing and more obsequies for the “zone of insolvency.”
On May 4, Delaware Vice Chancellor J. Travis Laster denied defendants’ motion for summary judgment in Quadrant Structured Products v. Vertin, writing, “There is no legally-recognized zone of insolvency with implications for fiduciary duty claims.” Quadrant involves a claim that a board of directors breached fiduciary duties to an insolvent special-purpose company, Athilon, by launching in 2010 a controlled liquidation in order to prefer insider debts.
In the ruling, Vice Chancellor Laster issued further guidance about how creditors of Delaware corporations gain standing to sue for breaches of fiduciary duty and what sorts of conduct may constitute such breaches.
Eight years ago, Gheewalla set a bright-line rule that Delaware director duties are constant, both in scope and object, and do not change in any “zone of insolvency,” noting in dicta that when a company is insolvent, creditors have standing to assert, derivatively on the corporation’s behalf, breaches of the board’s fiduciary duty.
Since 2011, Morgan Lewis lawyers have been testing Gheewalla’s ruling in the Quadrant case. With a trial scheduled for June 2015, Quadrant has now generated its third significant pretrial ruling. In 2014, the New York State Court of Appeals, resolving a certified question, held that a no-action clause in the operative indenture did not bar claims for breach of fiduciary duty. In late 2014, the vice chancellor issued a second ruling that dismissed much of the plaintiff’s case as sought relief for the board’s pursuit of a riskier alternative to liquidation, unless the plaintiff could show a favoring of insider interests sufficient to invoke an “entire fairness” review.
The case forged further into uncharted territory this week with a ruling that the plaintiff need allege corporate insolvency only as of the filing date of suit to obtain derivative standing. Insiders had exchanged insider debt holdings (of long maturity) for preferred shares that might receive early payment styled as “dividends.” The defendants alleged that, because of the exchange, Athilon had regained solvency, and so, three years into the case, the plaintiff had lost standing.
The court held that a “creditor plaintiff must plead and later prove that the corporation was insolvent at the time the suit was filed.” In doing so, the court accepted the argument that creditor derivative standing is one branch of derivative standing doctrine and itself a creature of equity developed by courts to prevent the “complete failure of justice.” A failure of justice would result if conflicted fiduciaries could, through control of the corporation, prevent review of valid corporate claims.The court declined to apply either a “continuous insolvency” or an “irreparable insolvency” test, noting that the latter concept had arisen from and should be limited to receivership actions.
The court went beyond the narrow question presented to note that the rules governing board duties in insolvency are now fairly well distilled—among them, there is no pertinent “zone of insolvency”; in actual insolvency, both shareholders and creditors can assert cognizable claims against a board; a board continues to enjoy the protection of the business judgment rule; and the chief function of the creditor derivative suit is to protect a corporation from “self-dealing payments and other disloyal wealth transfers.”