The Duty to Maximize Value of an Insolvent Enterprise

The following post comes to us from Brad Eric Scheler, senior partner and chairman of the Bankruptcy and Restructuring Practice at Fried, Frank, Harris, Shriver & Jacobson LLP, and is based on a Fried Frank M&A Briefing authored by Mr. Scheler, Steven Epstein, Robert C. Schwenkel, and Gail Weinstein. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

In Quadrant Structured Products Company, Ltd. v. Vertin (October 1, 2014), Vice Chancellor Laster clarified the Delaware Chancery Court’s approach to breach of fiduciary duty derivative actions brought by creditors against the directors of an insolvent corporation. Importantly, the Vice Chancellor applied business judgment rule deference to the non-independent directors’ decision to try to increase the value of the insolvent corporation by adopting a highly risky investment strategy—even though the creditors bore the full risk of the strategy’s failing, while the corporation’s sole stockholder would benefit if the strategy succeeded. By contrast, the court viewed the directors’ decisions not to exercise their right to defer interest on the notes held by the controller and to pay above-market fees to an affiliate of the controller as having been “transfers of value” from the insolvent corporation to the controller, which were subject to entire fairness review.

Legal framework

The Delaware Supreme Court’s landmark 2007 Gheewalla decision established that while stockholders are the sole residual claimants of a solvent corporation’s value, upon insolvency, creditors also become residual claimants and thus gain standing to derivatively sue the directors for breaches of fiduciary duty. Gheewalla also established, however, that directors of an insolvent corporation owe no special duty to the creditors; rather, their duty after insolvency—as before insolvency—is to seek to maximize the value of the corporation for the benefit of all the then residual claimants. Before Gheewalla, application of the business judgment rule to actions by directors of insolvent corporations had been controversial, given the concern that directors might be inclined to engage in high-risk “bet the ranch”-type strategies in a frantic attempt to increase shareholder recoveries, while creditors would bear the full risk of failure of the strategy. The Quadrant decision highlights this concern.

Key points

  • Quadrant appears to stand for the proposition that, under all but the most egregious circumstances, the business judgment rule will apply to directors’ decisions that relate to efforts to maximize the value of an insolvent corporation.
  • Thus, even decisions (as in Quadrant) made by a non-independent board for a high-risk business plan that favors the sole equity holder over the creditors—because almost all the upside, and none of the downside, of the plan would accrue to the sole stockholder—will be subject to business judgment deference.
  • The court distinguished decisions involving direct transfers of value from the insolvent corporation to the controller (such as, in Quadrant, the decision not to enforce the corporation’s right to defer interest on the notes held by the controller and to pay excess fees to the controller’s affiliate), holding that these decisions would be subject to entire fairness review because the controller stood on both sides of such transactions.


Athilon Capital Corp. (the “Company”), a credit derivative product company, was in the business of selling credit protection to large financial institutions. The Company guaranteed the credit default swaps that its wholly-owned subsidiary wrote on senior tranches of collateralized debt obligations. To maintain the credit rating it needed to pursue its business model, the Company had to adopt and follow operating guidelines for its business that limited its business activities; imposed structural, portfolio, and leverage constraints on its operations; and provided that, after insolvency, the Company would be required to enter a “runoff” stage, in which it would have to limit its operations to paying off outstanding guarantees of swap transactions as they matured and then would have to liquidate.

Due to two credit swaps written on residential mortgage-backed securities, and then the effects of the 2008 financial crisis, the Company was forced into runoff mode. During this period, when the Company was widely viewed as being insolvent, EBF & Associates (the “Controller”) bought all of the Company’s Junior Subordinated Notes and all of its equity, gaining control over the Company. The Controller placed four directors on the board (to join the Company’s CEO, who was the fifth director), three of whom had strong ties to the Controller. Thereafter, Quadrant Structured Products Company, Ltd. and its affiliates (the “Plaintiffs”) acquired Senior Subordinated Notes and Subordinated Notes issued by the Company.

The Plaintiffs later challenged the directors’ decisions i) to not exercise their right to defer interest payments on the Notes held by the Controller, ii) to pay above-market service and licensing fees to an affiliate of the Controller, and iii) to adopt a new, riskier business strategy—as to which the corporation’s creditors bore the full downside of lack of success, while the Controller bore none of the risk but would share in any upside—rather than proceeding to an orderly dissolution which would have benefitted the creditors. The new business strategy involved the Company purchasing high-risk securities and making highly speculative investments.

The court’s analysis

  • Business judgment review will almost invariably apply to a board decision relating to maximizing the value of an insolvent corporation.
    • The fact that a board’s plan for maximizing value will benefit some residual claimants at the expense of others will not affect business judgment deference. In Quadrant, the Plaintiffs argued that the non-independent directors’ decision to adopt a risky investment strategy for the Company would favor the Controller if it were successful (and would not harm the Controller if unsuccessful), while the creditors would bear the full loss of the strategy being unsuccessful. They argued further that “faithful fiduciaries” would have pursued a conservative strategy and prepared for a near-term dissolution and liquidation that would have benefitted the creditors. The Vice Chancellor rejected these arguments. He wrote: “In the case of an insolvent corporation, board decisions that appear rationally designed to increase the value of the firm as a whole will be reviewed under the business judgment rule, without speculation as to whether those decisions might benefit some residual claimants more than others.”
    • The fact that the plan for maximizing value was made by a board that lacks independence will not affect business judgment deference. The decision specifically addresses the fact that four of the Company’s five directors (i.e., all other than the CEO of the Company) had been designated by the Controller and that at least two of them had “dual-fiduciary status” due to their current primary employment being with the Controller. Another of the directors was a former employee of the Controller; another was apparently independent; and another the CEO of the Company. Even the non-independent directors “are not deemed conflicted,” the Vice Chancellor wrote, “in the context of an effort to increase the value of the company as a whole.”
    • The fact that the plan for maximizing value has a disproportionate impact on the residual claimants will not affect business judgment deference. The Vice Chancellor reasoned that the corollary principle applicable to solvent corporations is that equal treatment of stockholders operates as a presumptive safe harbor for controllers and directors, even when they allegedly have divergent economic interests. He also referred to a number of court precedents that “treat decisions that benefit the firm as a whole similarly, thereby rejecting the proposition that a plaintiff can rebut the business judgment rule as to matters of ongoing business strategy by alleging that the directors own material amounts of common stock, or are dual-fiduciaries who owe competing duties to a large equity holder or even a sole or controlling stockholder.” Finally, he suggested that to hold otherwise would be contrary to the explanation the Supreme Court gave in Gheewalla for refusing to recognize the existence of fiduciary duties owed directly to creditors: i.e., that it would create uncertainty for directors who would then have a conflict between their “duty to maximize the value of the insolvent corporation for the benefit of all having an interest in it and the newly recognized fiduciary duty to individual creditors.”
  • Entire fairness review will apply to the actions of directors to transfer value from an insolvent corporation to the corporate controller. The Plaintiffs alleged that, after the Company had become insolvent, the board had transferred value to the Controller by a) not exercising its right to defer the payment of interest on the Notes of the Company that had been acquired by the Controller and b) causing the Company to pay excessive service and license fees to an affiliate of the Controller. The Vice Chancellor found that these claims would be evaluated under an entire fairness standard, as the Controller stood on both sides of the challenged transactions. He noted that when a controller owns all of the equity of a solvent corporation, the controller’s interests are fully aligned with the interests of the corporation and its fiduciaries, and “a transfer of value from a solvent subsidiary to the holder of 100% of the equity cannot give rise to a fiduciary wrong.” In that case, both before and after the transfer, the 100% stockholder owned the value, either directly or indirectly. By contrast, however, in the case of ownership of an insolvent corporation, directors continue to have an obligation to maximize the value of the company, but a transfer of value to the sole stockholder transfers value that before the transfer was owned by all of the residual claimants (i.e., including the creditors). Thus, the Vice Chancellor found that these allegations stated a derivative claim for a breach of the directors’ fiduciary duty.

Key issue

The decision emphasizes the court’s adherence to business judgment deference for directors’ decisions about how to operate a company. The key issue is whether, in the context of an insolvent company—where creditors join stockholders as residual claimants, but by definition have very different legal and economic interests and concerns as compared to stockholders—a maximization of value plan should always be evaluated under business judgment. Quadrant appears to say “yes”. The court accorded business judgment review even though the court viewed the board as not independent, there was a controller, the controller was the sole stockholder of the company, and the board had taken other actions that the court founded stated non-dismissible claims for direct transfers of value from the insolvent corporation to the controller. The court’s basic rationale appears to have been grounded in the concept that maximization of value has the potential to benefit all corporate constituencies, even if disproportionately.

A remaining issue, then, is whether there is any point at which a board’s plan to maximize value of an insolvent corporation would be so disproportionate in its effect on creditors and a controller that the court might find that the plan has crossed the line from being a value maximization plan to being a transfer of value to the controller.

The closer an insolvent company is to being able to cover the creditors’ claims, the less potential there is for the creditors to benefit, even theoretically, from a high-risk value maximization plan and the more potential there is for them to be disadvantaged by the plan—while the upside for the controller increases because more of whatever additional value may be captured will be for the controller’s account. The Quadrant opinion does not address to what extent the company had or lacked sufficient funds to cover the creditors’ claims. It remains to be seen whether the court might reach a different conclusion in a case like Quadrant if the company is very close to being able to cover the creditors’ claims—so that the creditors would stand to receive not just a disproportionate (that is, disproportionately low) benefit from a high-risk value maximization plan but no benefit at all.

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