Quadrant v. Vertin: Determining Rights of Creditors

In Quadrant Structured Products Company, Ltd. v. Vertin (Oct. 20, 2015), the Delaware Court of Chancery, in a post-trial decision, rejected Quadrant’s challenges to transactions by Athilon Capital Corp., with Athilon’s sole stockholder (private equity firm Merced), after Athilon had returned to solvency following a long period of insolvency. Merced held all of Athilon’s equity and all of its junior notes; and both Quadrant and Merced held the company’s publicly traded senior notes. Quadrant challenged Athilon’s (i) repurchases of senior notes held by Merced (the “Note Repurchases”) and (ii) purchases of certain relatively illiquid securities owned by Merced (the “Securities Purchases”). A majority of the Athilon board that approved the challenged transactions was viewed by the court as non-independent (with two directors affiliated with Merced; the Athilon CEO; and two independent directors). Vice Chancellor Laster, applying New York law, rejected (i) Quadrant’s claims that the Note Repurchases (a) were prohibited by the indenture and (b) were fraudulent conveyances; and (ii) Quadrant’s derivative claim that the Note Repurchases and the Securities Purchases constituted a breach of the directors’ fiduciary duties.

Background

After Athilon had become insolvent, the board had adopted a plan to maximize the value of the company’s equity—even though, if the company had then dissolved and liquidated, there would have been sufficient funds to pay off the senior notes in full and to provide a “meaningful recovery” on the company’s junior notes. In a prior decision in this litigation, the court had rejected Quadrant’s view that the equity value maximization plan should be evaluated under the entire fairness standard because, Quadrant had argued, the plan disproportionately benefitted the controller while the risk of failure of the plan was disproportionately on the creditors. The court instead applied business judgment deference (reasoning that, notwithstanding the disproportionate effects, the plan potentially benefitted the company and all of its constituencies). The court upheld the board’s adoption of the plan. When, during the course of discovery in the litigation on that claim, Quadrant learned about the Note Repurchases and the Securities Purchases, Quadrant filed an amended complaint challenging those transactions.

Key Points

• The court will look first to the contract terms, and then to fraudulent conveyance statutes, to determine creditors’ rights. The court emphasized that creditors’ contractual rights (i.e., the express terms of the debt instrument and, under limited circumstances, implicit terms that may be read into the contract under the implied covenant of good faith and fair dealing) are “the principal source” of protection for creditors. The court stated that creditors next should look to fraudulent conveyance statutes, which, depending on the facts and circumstances of any given case, may provide creditors with protections.
• Creditors’ derivative claims based on breach of fiduciary duties will succeed under only very unusual circumstances. The court characterized derivative claims based on directors’ breaches of fiduciary duties, which are available to creditors of insolvent companies, as only a “final resort” for creditors. The Vice Chancellor stated that, when the contractual terms do not provide the protection sought by creditors, creditors’ fiduciary duty claims will be evaluated by the court “against that backdrop” and “with an extra grain of salt.” The opinion, together with the prior decision in which the court upheld Athilon’s equity value maximization plan, suggests that fiduciary duty claims by creditors will succeed only under very unusual circumstances.
• The court will not stretch to bail out a creditor from an improvident investment when the debtor company has not violated the terms of the indenture governing the debt. The decision indicates that the courts will be hesitant to “bail out” a sophisticated investor from a risky investment (where the debtor company has not violated the terms of the indenture)—and even more so when, as in Vertin, the investor is aware of the specific risks involved and makes a calculated bet to proceed. Quadrant’s investment decision was made based on Quadrant’s interpretation of provisions in Athilon’s charter that restricted Athilon’s business following an insolvency. Quadrant knew that its view that those restrictions would compel Athilon to dissolve, liquidate, and pay off its debt might be wrong. Quadrant knew that its view was contrary to Merced’s and Athilon’s interpretation of the restrictions, and knew that Athilon intended to continue to operate the company by entering into new businesses.
• The court will be hesitant to interfere with a company’s plan to return to solvency, even if the plan has a disproportionate effect on the creditors based on their not being paid out in a liquidation. In the prior opinion issued in the case, the court upheld the equity value maximization plan that had been advocated by Merced following Athilon’s insolvency—even though the plan could disproportionately benefit Merced as the sole equity holder and sole holder of the junior notes (because the company had sufficient funds to pay the senior notes in full, but not to pay the junior notes in full), while the holders of the senior notes bore almost all of the risk of failure of the plan. In this latest opinion, the court characterized the plan as an effort by Merced to continue Athilon’s ability to operate in order to return it to solvency, and then to “generate returns for itself [(Merced)] over time in its capacity as the [sole equity holder],” while taking advantage of the borrower-friendly terms of the outstanding long-term debt. Indeed, Vice Chancellor Laster wrote: “Generating returns for equity holders is the opposite of a fiduciary wrong; it is the purpose of a for-profit entity.”

Court’s Holdings

• The Note Repurchases were not a violation of the indenture. The Vice Chancellor found that no provision of the indenture under which the senior notes had been issued prohibited the challenged Note Repurchases. The court held that the express terms of the indenture permitted voluntary redemptions at the discretion of the company and did not restrict repurchases of senior notes from a company affiliate. Quadrant had argued that, based on the implied covenant of good faith and fair dealing, the court should read into the indenture a protection for creditors to the effect that, once the company’s charter had prevented it from continuing its existing business, the company should have had to dissolve and liquidate, and the company should not have been able to redeem notes held by an affiliate without redeeming other holders’ notes on a pro rata basis. The court refused to do so, noting that that protection would conflict with the express term permitting voluntary redemptions. The court also noted that peer companies’ indentures often included this type of protection in their express terms. The implied covenant “is not a license for judges to invent market terms that should act as a default rule simply because the plaintiffs or the judge think they would be a good thing,” the Vice Chancellor wrote.
• The Note Repurchases were not a fraudulent conveyance. Whether a creditor will succeed in challenging a transaction as a fraudulent conveyance will depend on the facts and circumstances of the case and the provisions of the applicable fraudulent conveyance statute. There was not a constructive fraudulent conveyance by Athilon, according to the court, because the prerequisite of insolvency of the company when the Note Repurchases were made was not present. There was not an intentional fraudulent conveyance, the court stated, because Athilon’s intention was not to “hinder, delay or defraud” any creditor—even though, the court acknowledged, the Note Repurchases reduced the amount of cash available to the company, making a future default on the debt potentially more likely. According to the court, Athilon’s intent was to continue operating, to increase the value of the equity, and to “comply with its obligations to its creditors, which were minimal.”
• Quadrant had no standing to bring a breach of fiduciary duty claim. For a creditor of an insolvent company to maintain a derivative claim, the creditor must plead and later prove that the corporation was insolvent at the time the suit was filed. The court held that Quadrant did not have standing to bring a derivative claim based on a breach of fiduciary duty—because Athilon was no longer insolvent at the time Quadrant amended its complaint to add the challenge to the Note Repurchases and Securities Purchases. The court rejected Quadrant’s argument that—because the challenge to the Note Repurchases and the Securities Purchases was based on the same principle as the challenge in the original complaint (i.e., that Merced should not be able to “extract value from Athilon without other holders of Notes receiving their pro rata share”)—its Supplemental Complaint should relate back to the original complaint. The court articulated the appropriate test as whether the original complaint had put the defendants on notice that the new challenges might be asserted. The original complaint could not have done so, the court concluded, as the Note Repurchases and Securities Purchases had not even occurred until after the original complaint had been filed. Moreover, according to the court, the original complaint (which had challenged servicing fees paid to a Merced affiliate and interest payments that Merced had received on the junior notes) had “involved different facts and different wrongs” and had not arisen “out of the same conduct, transaction, or occurrence as the claims that Quadrant originally asserted.”

Is there a factual context under which a creditor’s breach of fiduciary duty claim might succeed?

As discussed, the two Vertin decisions underscore that a creditor seeking protection based on a fiduciary duty derivative claim may succeed under only highly unusual circumstances. In this latest opinion, Vice Chancellor Laster quoted Delaware Chief Justice Strine (when he was a Vice Chancellor) as follows:

Creditors are often protected by strong covenants, liens on assets, and other negotiated contractual protections. The implied covenant of good faith and fair dealing also protects creditors. So does the law of fraudulent conveyance. With these protections, when creditors are unable to prove that a corporation or its directors breached any of the specific legal duties owed to them, one would think that the conceptual room for concluding that the creditors were somehow, nevertheless, injured by inequitable conduct would be extremely small, if extant…

[F]inancial creditors…know how to craft contractual protections that restrict their debtors’ use of assets. In a situation when creditors cannot state a claim that such contractual protections have been breached and cannot prove a fraudulent conveyance claim, the creditors’ frustration does not mean that there is a gap in the remedial fabric of the business law that equity should fill. Rather, it means that we remain a society that recognizes that reward and risk go together, and that there will be situations when business failure results in both equity and debt-holders losing some money.

In Vertin, the court states that not every creditor’s fiduciary duty claim will necessarily fail. What set of facts and circumstances would be viewed by the court as sufficient to support a creditor’s breach of fiduciary duty claim challenging a board’s post-insolvency decision (i) to adopt a high-risk equity value maximization plan in lieu of a dissolution, liquidation, and distribution of proceeds to creditors or (ii) to engage in a series of transactions that benefited an affiliate—when there was no breach of the indenture terms by the debtor company?

In our post on the court’s prior decision in Vertin, we raised the question whether the court would view as valid a creditor’s breach of fiduciary duty claim with respect to the adoption of an equity value maximization plan if the plan potentially benefitted only the equity, with no benefit to and all of the risk on the creditors. While those were not the facts in Vertin, the language and tone of the prior decision, together with this latest decision, indicate that the answer to that question is likely to be no. Based on the language of those decisions, it could be argued that a creditor’s fiduciary duty claim with respect to the adoption of an equity value maximization plan could succeed only if the directors were so uncareful or so disloyal in formulating the plan, or the plan was so patently flawed, that the plan would not even pass muster under business judgment deference.

There is perhaps more of a question left open as to the potential for a challenge to affiliated transactions to support a creditor’s breach of fiduciary duty claim. The latest Vertin opinion indicated that Athilon’s affiliated transactions with Merced did not support Quadrant’s breach of fiduciary duty claim—but the court did not discuss the issue at length because it found that Quadrant did not have standing to bring the claim, as the company was not insolvent at the time Quadrant filed its amended and supplemental complaint about the Note Repurchases and Securities Purchase. The court did note that the affiliated transactions were effected at or below market prices—suggesting the possibility of a different result in a case where the creditor has standing and the transactions were effected at above-market prices.

Conclusion

Creditors’ rights will flow out of the contractually agreed terms of the debt. Absent unusual circumstances, the court will look to the express terms of the indenture or other debt agreement to determine the extent of creditors’ rights. Depending on the facts and circumstances, creditors may also be able to successfully invoke protections under fraudulent conveyance statutes or the implied covenant of good faith. Based on the two Vertin opinions, it will be a rare case in which creditors will be successful under derivative claims for breach of fiduciary duty.