In Brief: Delaware Chancery Court Rules That Creditor Does Not Forfeit Standing to Bring Derivative Suit if Corporation Becomes Solvent

In Brief: Delaware Chancery Court Rules That Creditor Does Not Forfeit Standing to Bring Derivative Suit if Corporation Becomes Solvent

In a matter of first impression, the Delaware Court of Chancery held in Quadrant Structured Products Co. Ltd. v. Vertin, No. 6990-VCL, 2015 BL 128889 (Del. Ch. May 4, 2015), that a creditor suing derivatively on behalf of an insolvent corporation does not lose standing to prosecute the derivative claims if the corporation becomes solvent while the lawsuit is pending. In so ruling, the court expressly rejected a “continuous insolvency” or an “irretrievable insolvency” requirement for standing purposes.

Quadrant Structured Products Co. Ltd. (“Quadrant”), a creditor of Athilon Capital Corp. (“Athilon”), commenced a derivative suit in 2011 against Athilon’s directors for alleged breaches of fiduciary duties. Although Athilon was insolvent on a balance sheet basis at the time Quadrant filed its complaint, Athilon achieved balance sheet solvency during the pendency of the lawsuit. The defendants moved for summary judgment, arguing that Athilon’s return to solvency eliminated Quadrant’s standing to maintain the derivative action. Alternatively, the defendants contended that they were entitled to summary judgment because Quadrant could not prove that Athilon was “irretrievably insolvent,” with no reasonable prospect of returning to solvency.

The court rejected both arguments as a matter of law. It ruled that, to bring a derivative action, a creditor-plaintiff must plead and later prove insolvency under the traditional balance sheet test and that insolvency is measured at the time the suit is commenced.

The court’s opinion is a primer on the evolution of creditor derivative suits asserting breach of fiduciary duty claims against directors of Delaware corporations. The court explained that, prior to the Delaware Supreme Court’s decision in North American Catholic Educational Programming Foundation Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007), some courts and commentators had expressed the view that: (i) the directors of a Delaware corporation owed fiduciary duties to creditors once the corporation entered the “vicinity” or “zone” of insolvency; and (ii) the creditors could assert direct or derivative claims on behalf of the corporation, because the directors were obligated to “manage the corporation conservatively as a trust fund for the creditors’ benefit.”

Before Gheewalla, concerns were also raised that directors’ decisions could be subjected to scrutiny under the more exacting “entire fairness” standard (as distinguished from the deferential “business judgment” standard) due to the inherent conflict of interest resulting from owing fiduciary duties to both creditors and stockholders. Directors also risked incurring liability to creditors for continuing to operate an insolvent corporation under a theory of “deepening insolvency.”

Gheewalla, the Delaware Chancery Court explained in Vertin, rejected the concept of a “vicinity” or “zone” of insolvency and clarified that Delaware law imposes upon directors fiduciary duties to creditors only after the corporation is actually insolvent. In addition, creditors may commence only derivative (as distinguished from direct) actions for breach of fiduciary duty. Moreover, Gheewalla established that directors do not owe any particular duties to creditors. Instead, the fiduciary obligations of directors run “to the corporation for the benefit of all of its residual claimants,” including creditors. Finally, in the aftermath of Gheewalla, it is clear that the directors of an insolvent corporation are entitled to the protection of the  business judgment rule, even if the company’s financial condition deteriorates (or deteriorates further) as a consequence of their decisions, provided that the directors were disinterested, were reasonably prudent, and acted in good faith.

Having established the groundwork, the Chancery Court in Vertin ruled that a creditor need establish insolvency only at the time it files a derivative action and that it is not stripped of standing to sue if the corporation becomes solvent during the pendency of the litigation. Continuous insolvency is not required, nor must the corporation be irretrievably insolvent in this context. The court acknowledged that its view on this issue might not be shared by the Delaware Supreme Court. It also noted that this approach might create the possibility of dual standing in some cases (i.e., both creditors and shareholders having standing to bring claims derivatively on behalf of a corporation which achieves solvency after derivative litigation has been commenced by a creditor against directors).