In a three-line order, the Delaware Supreme Court recently affirmed the Court of Chancery’s dismissal of a suit by a creditor against Athilon Capital Corp. and its sole shareholder, Merced Capital Partners, arising from claims of self-interested transactions by Merced. Quadrant Structured Products Company, Ltd. v. Vertin serves as a reminder of the limited recourse of creditors against controlling shareholders of a debtor that is solvent, even in the cases of egregious conduct.
Athilon Capital Corp. was formed to sell credit default swaps.1 As a result of the 2008 financial crisis, Athilon became deeply insolvent and its debt attained junk rating status. Two investors, Merced and Quadrant, began purchasing Athilon’s deeply discounted debt as an investment opportunity.
Merced also saw value in Athilon’s equity, and Merced later acquired all of Athilon’s equity from its private equity backers to become Athilon’s sole owner. Merced and Quadrant had different investment theses: Quadrant’s thesis was that Athilon would liquidate itself after its existing swaps portfolio ran off,2 while Merced viewed Athilon’s long-term debt as a cheap way to fund investments in higher-yielding securities. Merced’s and Quadrant’s investment theses were inherently at odds, and after Merced began pursuing its strategy of enhancing the value of Athilon’s equity, Quadrant was left holding Athilon’s “covenant-light” debt with far-dated maturities. An aggrieved Quadrant filed suit, alleging that Athilon and Merced had engaged in egregious conduct that ultimately benefited insiders rather than creditors at a time when Quadrant was insolvent. The transactions between Athilon and Merced included:
- The payment of cash interest on Athilon’s junior notes, all of which were held by Merced, even though Athilon had the ability to pay interest in kind.
- The payment of excessive management fees to Merced.
- The resignation of Athilon’s auditor, Ernst & Young, over insistence that Athilon remove a contingent tax liability from its balance sheet.
- The sale of complex, illiquid reinsurance securities to Athilon, at prices Quadrant alleged were inflated, after Merced discovered that it could not sell them in the open market at the prices it desired.
- The amendment of Athilon’s operating agreement to permit it to purchase these complex, illiquid securities from Merced.
- The repurchase of Athilon’s notes held by Merced.
Quadrant’s complaint challenged the transactions under three theories: (1) the repurchases and sales of the reinsurance securities breached the board’s fiduciary duty, (2) the repurchases constituted a fraudulent transfer, and (3) the repurchase violated the indenture governing the notes.
At the outset, the court objected to the fact that Quadrant had primarily focused its time and effort on the claims for breach of fiduciary duty and fraudulent transfer. Critical of this approach, the court stated that because creditors have strong contractual and statutory protections, the likelihood of a creditor bringing a successful claim for a breach of fiduciary duty is small. As the court noted, “creditors should only look to fiduciary duty claims as a last resort.” As a result, the court first analyzed Quadrant’s claims for violation of the indenture.
Quadrant alleged that the repurchase of the notes violated the express terms of the indenture that limited the ability of Athilon to redeem notes held by its affiliates, to wit, Merced. The court easily rejected this argument based on the express terms of the indenture; a repurchase, even of notes held by a controlling affiliate, does not equate to the exercise of a contractual right of redemption.
Quadrant also argued that in order to protect unaffiliated noteholders, the indenture should include an implied term that would have required Athilon to treat all noteholders equally. Athilon, it was argued, should have redeemed all the notes, not just those held by its affiliates, after Athilon could no longer carry on its business as a result of its low credit rating. The court again looked to the express terms of the indenture to conclude that such an implied term would conflict with the express terms of the indenture that permitted redemption only at the option of the noteholders in the event of default.
Next, the court analyzed whether the note repurchase constituted a fraudulent transfer under Delaware’s version of the Uniform Fraudulent Transfer Act. However, after a detailed factual analysis, the court concluded that two threshold requirements for a fraudulent transfer claim – insolvency and actual or constructive intent to defraud – were absent. The court observed that, even putting aside the issues of solvency, Athilon had a long-term plan to operate its business, which was to take advantage of its covenant-light debt. Although the note repurchase reduced the amount of cash that Athilon held, which increased the risk of default faced by Athilon’s creditors, the repurchases were not made with an actual intent to hinder, delay or defraud any creditor.3 Quadrant had purchased debt with minimum contractual rights, which were of consequence only insofar as Athilon was motivated to preserve its triple-A rating. Once it had lost its rating, the contractual rights were of little effect, and Athilon could take full advantage of the lenient terms under its indenture.
Finally, Quadrant claimed that the note repurchases and the purchases of the reinsurance securities amounted to breaches of fiduciary duties. The court held, however, that Quadrant failed to satisfy the threshold requirement for a creditor when suing on behalf of the corporation; the creditor-plaintiff must establish that the corporation was insolvent at the time the suit was filed. By the time Quadrant amended its complaint to include the fiduciary duty claims, Athilon was already solvent.
Quadrant serves as a reminder that creditors of a solvent debtor are generally out of luck in cases where an indenture or other contractual provision does not expressly protect their interests, even when their interests are harmed by seemingly egregious conduct. Courts will not fashion an equitable remedy where a creditor could have otherwise protected itself through the negotiation of sound contractual rights and remedies.