Quadrant Structured Products Company, Ltd. v. Vertin, C.A. No. 6990-Vcl (Del. Ch. Ct. Oct. 20, 2015)
On October 20, 2015, Vice Chancellor J. Travis Laster of the Delaware Chancery Court rejected a minority noteholder’s claims challenging decisions made by directors of a distressed Delaware corporation. The defendant, Athilon Capital Corporation (“Athilon”), was in the business of writing credit default swaps. Following the financial crisis, by the end of 2009, Athilon became insolvent and had no operating business. Around that time, Merced Capital, L.P. (“Merced”) acquired a substantial amount of Athilon’s senior and junior notes at 24% and 10% discounts to par, respectively, and, subsequently, acquired all of Athilon’s equity. The plaintiff, Quadrant Structured Products Company, Ltd. (“Quadrant”), invested in Athilon’s senior notes believing that Merced would dissolve Athilon and liquidate its assets (which could have paid off the senior notes in full and provided a meaningful recovery on the junior notes). Instead, however, Merced chose to continue operating the company rather than liquidating its assets and attempted to generate returns for itself as Athilon’s sole equity holder. Athilon subsequently became solvent, and repurchased senior notes owned by Merced at a 92% discount to par in January 2015.
Quadrant initially commenced litigation against Athilon in 2011, asserting that the company was prohibited from engaging in business outside its failed credit default swap line of business and challenging the board’s decision to continue operating Athilon. In April 2015, Quadrant filed a supplemental complaint challenging the January 2015 repurchase as a breach of the board’s fiduciary duty, suing derivatively on behalf of Athilon, and asserting that the repurchase breached express covenants in the indenture governing the senior notes, violated the implied covenant of good faith and fair dealing, and fraudulently transferred value to Merced.
The court began with Quadrant’s indenture and fraudulent transfer claims, and summarily held that Quadrant failed to assert relief under any of them. The court held that the language of the senior indenture did not prevent the January 2015 transaction, and that the transaction did not breach the implied covenant of good faith and fair dealing. Lastly, the court dismissed Quadrant’s fraudulent transfer claim by finding no evidence of actual intent to defraud creditors and that Athilon was solvent at the time of the January 2015 transaction.
Quadrant’s final claim relied on its ability to assert derivative standing to sue the directors on behalf of Athilon. Delaware case law provides creditors of an insolvent corporation an opportunity to bring derivative claims against directors on behalf of the corporation for breaches of fiduciary duties. This allowance is based on the theory that during insolvency, “creditors replace the stockholders as the equitable owners of the firm’s assets and the initial [residual] beneficiaries of any increases in value.” At the summary judgment stage, the defendants asserted that Quadrant only enjoyed derivative standing so long as Athilon remained insolvent, and that Quadrant had lost standing when Athilon subsequently returned to solvency. The court rejected the notion that creditor standing is subject to a “continuous insolvency requirement” because “a troubled firm could move back and forth across the insolvency line such that a continuing insolvency requirement would cause creditor standing to arise, disappear, and reappear again.” Instead, the court held that a creditor maintains derivative standing even after a company becomes solvent so long as the company was insolvent “at the time the suit was filed.” Having already established under its fraudulent transfer analysis that Athilon was solvent at the time of the January 2015 transaction and when Quadrant filed its supplemental complaint, the court held that Quadrant’s claims did not relate back to the time when Athilon was insolvent.
Quadrant serves as a reminder of the challenges that noteholders face in bringing derivative suits on behalf of a distressed company and protecting their investment when the documents governing their debt provide little relief. Although the court did not commend Athilon’s and Merced’s conduct, noting that “they were neither open nor forthright about their preparations for the January 2015 Repurchase, and they resisted providing information about the transaction once Quadrant learned of it,” the court stressed that Quadrant and other noteholders had knowingly purchased debt that had minimal contract rights, which provided Quadrant with no remedy for its disappointing investment.