Court of Chancery Clarifies Creditors' Rights

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Delaware Business Court Insider - May 13, 2015

A just-issued Court of Chancery decision clarifies, and possibly expands, creditors' rights. In 2007, the Delaware Supreme Court ruled that a corporation's creditors may sue its board of directors for violating its fiduciary duties, but only after the corporation became insolvent, in North American Catholic Educational Programming Foundation v. Gheewalla, 930 A.2d 92 (Del. 2007). While creditors continued to be unable to sue directly, Gheewalla did permit them to file derivative suits in those circumstances. For insolvent entities, D&O insurance may provide a previously unavailable source of funds to pay creditors. Hence, Gheewalla was an important decision.

Yet, Gheewalla left some important questions unanswered. Now, Quadrant Structured Products v. Vertin, C.A. 6990-VCL (Del.Ch. May 4, 2015), has answered those questions. Drawing on Gheewalla and a series of Court of Chancery decisions in closely related areas, Quadrant carefully summarizes this area of creditor rights and explains how directors may fulfill their duties to avoid creditor liability claims for breach of fiduciary duty.

First, do creditors need to show that the corporation continued to be insolvent during the course of the litigation? After all, a plaintiff stockholder in a typical derivative suit will lose standing to continue the litigation if she sells her company stock. As the company insolvency is what gives creditors standing to sue, there were questions about whether that insolvency had to continue for creditor standing to continue throughout the litigation. Quadrant held that creditors only need to show company insolvency at the time the complaint is filed.

But still this question remained: Did that insolvency have to be irretrievable? The Court of Chancery had previously declined to appoint receivers for insolvent companies when there was some chance the company would become solvent in the future. Thus, only if the insolvency was said to be "irretrievable" was a receiver appointed. After a lengthy analysis, Quadrant held that creditors do not have to prove irretrievable insolvency.

These holdings were critical in Quadrant because the company had a colorable argument that it either had become solvent during the course of the litigation or that it was going to become solvent soon. If Quadrant had required proof of post-filing insolvency or irretrievable insolvency, the Quadrant plaintiff's claims probably would have been dismissed. Creditor breach-of-fiduciary-duty claims against directors already suffer a significant economic disincentive. Because those claims must be filed as derivative claims under Gheewalla, any recovery goes to the corporate entity and not directly to the creditor plaintiff. In that sense, a successful plaintiff has to share her recovery with all the other creditors of the insolvent corporation. That is a disincentive to sue. But Quadrant does keep those suits alive by its holdings.

Quadrant also used a balance sheet test to determine insolvency. That is easier to apply than the alternative test involving the ability to pay debts as they become due. Hence, in that way as well, Quadrant strengthens creditor rights to recover for breach of fiduciary duty claims.

Finally, Quadrant is not all good news for creditors. Prior to 2007, creditors were able to argue that the directors of an insolvent corporation owed a duty to creditors to protect their interests as creditors and to not protect stockholder interests as well. That theory was based on the notion that stockholders were out of the money upon insolvency and thus did not deserve protection of their worthless stake in the company.

Gheewalla rejected that argument that favored creditor interests. Instead, it held that the directors had a duty to the corporate entity as a whole and were entitled to use their business judgment about what business plan to follow. Hence, directors could decide to take business risks, even if the creditors would have preferred a safer course to protect their "trust fund." Quadrantfully and faithfully follows Gheewalla in that respect.

That has profound implications for creditors considering suit for a breach of fiduciary duty by directors. Overcoming the protection of the business judgment rule or the usual director exculpation provisions in corporate charters is very difficult. One key to doing so is found in the Quadrant decision.

Self-dealing by directors is not protected by the business judgment rule or director exculpation provisions. Quadrant involved just such a claim that the directors had run Quadrant's business to favor its controlling stockholder, such as by issuing it debt at inflated prices. So-called "vulture investors" buy interests in insolvent companies and have an incentive to maximize their returns by manipulating company assets to benefit themselves. In such a case, a Quadrant claim may make sense, both legally and in terms of a sufficient recovery that benefits the creditor plaintiff.

Quadrant explains all these points very well. It is the decision to read if you want to understand creditor rights to sue for breach of fiduciary duty.

Delaware Business Court Insider  |  May 13, 2015

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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