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Quadrant Structured Products Co., Ltd. v. Vertin: Court of Chancery Declines to Extend Contemporaneous Ownership Requirement to Derivative Claims of Creditors and Dismisses Claims Against Board of Directors Related to "Risk-On" Business Strategy

February 17, 2015

In Quadrant Structured Products Company, Ltd. v. Vertin, 102 A.3d 155 (Del. Ch. Oct. 1, 2014), the Delaware Court of Chancery held that the contemporaneous ownership requirement of Section 327 of the General Corporation Law of the State of Delaware (the "DGCL") does not apply to corporate creditors for purposes of determining whether a creditor has standing to bring derivative claims against the board of directors of an insolvent corporation. The Court also declined to dismiss the creditor's fiduciary duty and fraudulent transfer claims related to certain transactions between the corporation and its controlling stockholder, but granted the motion to dismiss with respect to fiduciary duty claims related to the decision of the board of directors to pursue a "risk-on" business strategy that allegedly favored junior creditors over more senior creditors.

The individual defendants were members of the board of directors (the "Board") of Athilon Capital Corp. ("Athilon") that were allegedly controlled by EBF & Associates ("EBF"), Athilon's sole stockholder and the holder of junior notes issued by Athilon (the "Junior Notes"). The plaintiff, Quadrant Structured Products Company, Ltd. ("Quadrant"), owned debt securities issued by Athilon that were senior to the Junior Notes held by EBF. Quadrant alleged that the EBF-controlled Board took a number of actions while Athilon was insolvent to benefit EBF at the expense of its other stakeholders, including (i) paying interest on the Junior Notes instead of deferring the payments to future periods as permitted by the terms of the Junior Notes, (ii) entering into certain agreements with EBF's affiliates at above-market rates, and (iii) amending the limited purpose provisions in Athilon's certificate of incorporation to allow Athilon to pursue a riskier business model that allegedly preferred the interests of EBF over more senior creditors.

As a preliminary matter, the Court held that Quadrant, as a creditor of Athilon, had stranding to pursue its claims derivatively. The Court clarified that the fact of insolvency does not give rise to any special duty that is owed by a board of directors directly to the corporation's creditors, but rather gives the corporation's creditors derivative standing to enforce the general fiduciary duty that the board of directors owes to the corporation to maximize the firm's value for all residual claimants. In addition, the Court declined to extend the contemporaneous ownership requirement of Section 327 of the DGCL to creditors, thereby holding that creditors are not prevented from bringing derivative claims in respect of transactions that pre-date the corporation's insolvency or their acquisition of an insolvent corporation's debt. Although the argument was not raised by the defendants, the Court noted that it is possible that creditors could be required to comply with other substantive principles of derivative actions, such as demand excusal and demand refusal, in order to pursue derivative claims.

With respect to Quadrant's substantive claims, the Court found that Quadrant's allegations adequately stated a claim for breach of fiduciary duty and fraudulent transfer with respect to the payment of interest on the Junior Notes and the agreements with EBF's affiliates. Furthermore, because EBF was a controlling stockholder that allegedly stood on both sides of the transactions, the Court held that the transactions would be subject to scrutiny under the entire fairness standard of review. The Court dismissed Quadrant's claims with respect to the Board's decision to pursue a riskier business strategy, finding that the directors had made decisions that appeared rationally designed to increase the value of the firm as a whole rather than impermissibly preferring the interests of EBF, as a junior creditor and stockholder, to the interests of other residual claimants. Finally, the Court concluded that none of the directors could invoke the protections of the exculpatory provision in Athilon's certificate of incorporation because three of the directors were officers of either Athilon or EBF and it was not possible at the motion to dismiss stage of the proceeding to determine whether any breach of fiduciary duty on the part of the other two directors resulted solely from a breach of the duty of care.

In a decision issued less than one month later, the Court of Chancery, in Quadrant Structured Products Company, Ltd. v. Vertin, 2014 WL 5465535 (Del. Ch. Oct. 28, 2014), denied Quadrant's motion for reconsideration of the dismissal of claims related to the Board's risk-on strategy. Quadrant contended that the Court had overlooked the importance of the fact that Athilon was a limited purpose corporation and that pursuing the riskier business strategy was outside the scope of its original purpose, as set forth in its certificate of incorporation. Quadrant also argued that the Court had failed to consider whether its allegations were sufficient to support an inference of bad faith and rebut the business judgment rule with regard to the Board's decision to amend the corporation's certificate of incorporation in order to pursue the riskier strategy. The Court noted that Quadrant's first argument did not present grounds for reconsideration because Quadrant's own complaint established that Athilon's governing documents authorized the Board's risk-on strategy. Specifically, the complaint recognized that the Board had the authority to amend Athilon's certificate of incorporation and, thus, could expand Athilon's limited purpose to make investments involving greater risk. With respect to Quadrant's second argument, the Court noted that the motion to dismiss opinion considered and rejected Quadrant's bad faith claims when it held that the Board had made a rational business decision to pursue a riskier investment strategy.