LASTER, Vice Chancellor.
Plaintiff Quadrant Structured Products Company, Ltd. ("Quadrant") owns debt securities issued by defendant Athilon Capital Corp. ("Athilon" or the "Company"), a Delaware corporation. Quadrant alleges that Athilon is insolvent and that the individual defendants, who are members of Athilon's board of directors (the "Board"), should wind up the Company's business and dissolve the entity. Quadrant contends that instead, the Board has found ways to transfer value preferentially to Athilon's controller, defendant EBF & Associates ("EBF"). In this action, Quadrant has asserted breach of fiduciary duty claims derivatively against the Board and EBF. Quadrant has also asserted fraudulent transfer claims directly against EBF and its affiliate, Athilon Structured Investment Advisors, LLC ("ASIA"). The defendants have moved to dismiss the complaint. Their motion is denied to the extent that Quadrant has challenged specific transfers of value to EBF or ASIA. To the extent that Quadrant has challenged the Board's business decision to take on greater risk, the motion to dismiss is granted.
The facts are drawn from Quadrant's verified amended complaint (the "Complaint" or "Compl.") and the documents it incorporates by reference. At this procedural stage, the Complaint's allegations are assumed to be true, and Quadrant receives the benefit of all reasonable inferences.
Athilon is a credit derivative product company created to sell credit protection to large financial institutions. The Company's wholly owned subsidiary, Athilon Asset Acceptance Corp. ("Asset Acceptance"), wrote credit default swaps on senior tranches of collateralized debt obligations. The Company guaranteed the credit swaps that Asset Acceptance wrote. In a typical transaction, Asset Acceptance sold protection to a bank in the form of a credit swap that referred to a designated pool of investment grade debt securities, known as "Reference Obligations." If the pool of Reference Obligations suffered net losses that exceeded a contractually defined figure, then Asset Acceptance was liable up to a fixed limit. The Company was liable as the guarantor of Asset Acceptance's performance.
To obtain and maintain a AAA/Aaa credit rating, which was essential to the Company's business model, the ratings agencies required the Company to have a limited business purpose and to adopt and follow operating guidelines for its business (the "Operating Guidelines"). The Amended and Restated Certificate of Incorporation for the Company (the "Athilon Charter") limits its business to "guaranteeing or providing other forms of credit support for the obligations of its subsidiaries" and activities related to that business. The Amended and Restated Certificate of Incorporation for Asset Acceptance (the "Asset Acceptance Charter") limits its business to "transactions judged by [Asset
Both the Athilon Charter and the Asset Acceptance Charter require that their businesses be "conducted in compliance with the Operating Guidelines." The Operating Guidelines:
• limit the business activities of the Company and Asset Acceptance;
• impose structural, portfolio, and leverage constraints on their operations;
• establish ratings categories for the collateralized debt obligations covered by the credit swaps written by Asset Acceptance and guaranteed by the Company;
• cap the aggregate notional amount of any single credit swap;
• limit the permissible maturity of credit swaps;
• limit the nature of credit events that could give rise to payment obligations under the credit swaps;
• restrict the Company to investing in short-term, low-risk securities, such as U.S. government and agency securities, certain Euro-dollar deposits, bankers' acceptances, commercial paper, repurchase transactions, money market funds, and money market notes with high short-term ratings;
• require that its portfolio contain sufficient assets to cover all liabilities; and
• define certain Suspension Events relating to capital shortfalls, leverage ratios, downgrades in counterparty credit ratings, and the insolvency, bankruptcy, or reorganization of the Company or Asset Acceptance.
The Operating Guidelines provide that if a Suspension Event is not timely cured, then the Company enters runoff. Once in runoff, the Company can no longer pay dividends or write new guarantees for credit swaps. While in runoff, its operations are limited to paying off outstanding swap transactions as they mature. After the runoff process is complete, the Operating Guidelines obligate the Company to liquidate.
To fund its business, the Company secured approximately $100 million in equity capital and $600 million in long-term debt. The debt was issued in multiple tranches comprising $350 million in Senior Subordinated Notes, $200 million in Subordinated Notes, and $50 million of the Junior Subordinated Notes. Depending on the series, the Notes will mature in 2035, 2045, 2046, or 2047. Interest payments on all of the Notes are deferrable at the Company's option for up to five years. Each class of Notes is subordinate to the Company's credit default swap obligations. On the strength of its $700 million in committed capital, the Company guaranteed more than $50 billion in credit default swaps written by Asset Acceptance.
Two of the credit swaps that Asset Acceptance wrote referenced residential mortgage-backed securities, rather than corporate debt obligations. In late 2008, the Company paid $48 million to unwind the first swap. In 2010, the Company paid $320 million to unwind the second swap. The termination payments wiped out over half of the Company's committed capital, including all of its equity capital and 65% of its long-term debt.
The effects of the 2008 financial crisis inflicted broader and more permanent damage on the Company. After Lehman Brothers filed for bankruptcy in September 2008, financial institutions no longer entered into credit swaps with entities that lacked substantial capital and could not post adequate collateral. As a result of the financial crisis, the Company and Asset Acceptance no longer could engage in the
At the end of 2008, the Company and Asset Acceptance lost their AAA/Aaa ratings. By August 2010, the Company and Asset Acceptance no longer had any investment grade debt or counterparty credit ratings. Under the Operating Guidelines, the loss of its AAA/Aaa ratings and significant capital deficiencies forced the Company into runoff.
The collapse of the credit derivative industry caused the Company's securities to trade at deep discounts, reflecting the widely held view that the Company was insolvent. EBF purchased all of the Company's Junior Subordinated Notes, then bought all of the Company's equity in 2010. By doing so, EBF gained control over the Company and its Board.
After acquiring control over the Company, EBF placed Vincent Vertin on the Board. Vertin is a partner at EBF who concentrates on EBF's investments in credit derivative product companies, and the Complaint alleges that Vertin's compensation is tied to the performance of EBF's in credit derivative product companies.
EBF also placed Michael Sullivan on the Board. Sullivan is an in-house attorney for EBF. Like Vertin, Sullivan concentrates on EBF's investments in credit derivative product companies.
EBF placed two other individuals on the Board whom EBF designated as independent directors. One is Brandon Jundt, a former employee of EBF. The other is J. Eric Wagoner.
The fifth and final Athilon director is Patick B. Gonzalez, the CEO of the Company.
Quadrant purchased debt securities issued by the Company after the EBF takeover. Quadrant acquired Senior Subordinated Notes in May 2011 and Subordinated Notes in July 2011.
The Complaint alleges that the Company had been insolvent for some time before the EBF takeover. The Complaint alleges that the Company continues to be insolvent and cannot return to solvency because the credit default industry has collapsed, and the Athilon Charter, the Asset Acceptance Charter, and the Operating Guidelines prohibit the Company from engaging in other lines of business. At this point, the Company consists of a legacy portfolio of guarantees on credit default swap contracts written by Asset Acceptance that will continue to earn premiums until the last contracts expire in 2014 or shortly thereafter.
According to the Company's Consolidated Statement of Financial Condition as of September 30, 2011 (the "September 2011 Financials") the Company carries $600 million in debt, excluding its outstanding credit swaps, against assets with a saleable value of only $426 million. The Company's GAAP shareholder's equity was stated at negative $660 million as of that same date. At the time of the filing of the Complaint, the Company was rated BB by Standard & Poor's and Bal by Moody's.
The Complaint alleges that a well-motivated board of directors faced with these circumstances would maximize the Company's economic value for the benefit of its stakeholders by minimizing expense during runoff, then liquidating the Company and returning its capital to its investors.
The Complaint alleges that the Board has transferred value from Athilon to EBF by continuing unnecessarily to make interest payments on the Junior Notes, which EBF owns. The Board has the authority to defer interest payments on the Junior Notes without penalty for a period of time that would exceed the term of the remaining credit swaps. Once the last credit swap expires, the Operating Guidelines require that the Company liquidate. The Junior Notes are currently out of the money and would not recover anything in an orderly liquidation. The Company therefore has no reason to pay interest on the Junior Notes, because by the time the interest would be due, the Company will have dissolved and liquidated with the Junior Notes taking nothing. The Complaint alleges that an independent Board presented with this situation would defer payments of interest on the Junior Notes to conserve assets for the Company's more senior creditors. But because EBF holds the Junior Notes, the EBF-controlled Board has continued paying interest.
The Complaint also alleges that the Board has transferred value from Athilon to EBF by causing the Company to pay excessive fees to ASIA, which EBF indirectly owns and controls. In 2004, Athilon and Asset Acceptance entered into a services agreement with ASIA. In 2009, before the EBF takeover, the Company paid approximately $14 million in fees under the services agreement. After the Company entered runoff, the scope of ASIA's services substantially diminished and its fees should have decreased. Instead, after the EBF takeover, the fees paid to ASIA climbed dramatically and far exceeded market rates. In 2010, the Company paid $23.5 million in fees to ASIA, including a $2.5 million service fee to EBF. The market rate for ASIA's services would be $5-7 million per year. In 2011, Quadrant offered to provide comparable services for a flat fee of $5 million plus an estimated $2 million in costs for third party professionals. The Board rejected Quadrant's offer without taking any action to investigate it and has not reduced the fees it pays to ASIA.
The Complaint similarly alleges that the Board has transferred value from Athilon to EBF through a software license agreement. In 2004, the Company entered into a software license agreement with ASIA. In 2009, the license agreement fee was $1.25 million. In 2010, after the EBF takeover, it increased to $1.5 million. The Complaint alleges that the software license fee is well above market and exceeds what it would cost for the Company to build the licensed capital models from scratch.
Finally, the Complaint alleges that the Board is changing the Company's business model to make speculative investments for the benefit of EBF. Under the Athilon Charter, the Asset Acceptance Charter, and the Operating Guidelines, the Company only can invest in highly-rated, short-term debt securities. In May 2011, the Board sought permission from the rating agencies to amend the Operating Guidelines to loosen the Company's investment restrictions and expand its permitted investments. The rating agencies confirmed that the amendments would not cause a downgrade in Athilon's already low credit rating. The Complaint alleges that the Board subsequently took steps to amend the Operating Guidelines to permit Athilon to invest in longer-dated and riskier investments.
As an example of the shift in investment strategy, Athilon repositioned a portion of its auction rate securities portfolio in the first quarter of 2011. In doing so, Athilon
The Complaint alleges that by adopting an investment strategy that involves greater risk, albeit with the potential for greater return, the Board is acting for the benefit of EBF and contrary to the interests of other stakeholders, such as the Company's more senior creditors. Because EBF owns the Company's equity and Junior Notes, which are currently underwater, EBF does not bear any of the risk if the investment strategy fails. Only Quadrant and the other more senior creditors bear the downside risk. If the riskier investment strategy succeeds, however, then EBF will capture the benefit.
Despite having yet to move beyond the pleadings stage, this case has amassed an extended procedural history. Quadrant commenced this action on October 28, 2011, and filed the currently operative Complaint on January 6, 2012. The defendants moved to dismiss the Complaint, arguing among other things that Quadrant failed to comply with no-action clauses in the indentures that governed Quadrant's notes. The arguments that Quadrant made before this court about the no-action clauses had been addressed and rejected in two well-known Court of Chancery opinions, Feldbaum v. McCrory Corp., 1992 WL 119095 (Del.Ch. June 2, 1992) (Allen, C.), and Lange v. Citibank N.A., 2002 WL 2005728 (Del.Ch. Aug. 13, 2002) (Strine, V.C.). Finding those opinions to be directly on point, this court granted the motion to dismiss by order dated June 5, 2012.
Quadrant appealed. Before the Delaware Supreme Court, Quadrant advanced new arguments about how specific language of the no-action clauses in the Athilon notes differed from the no-action clauses at issue in Feldbaum and Lange. This court had not had the chance to address those arguments, which were raised for the first time on appeal. Finding the record "insufficient for appellate review," the Delaware Supreme Court remanded and directed this court to write a report addressing the newly raised arguments. Quadrant Structured Prods. Co. v. Vertin, No. 388, 2012 ¶ 1, 2013 WL 8858605 (Del. Feb. 12, 2013). In light of the new arguments, this court's report concluded that the no-action clauses in the Athilon notes did not apply to Counts I through VI and IX of the Complaint, or to Count X to the extent that it sought to impose liability on secondary actors for violations of the other counts. The report concluded that the no-action clauses continued to bar Counts VII and VIII of the Complaint, as well as Count X to the extent it sought to impose liability on secondary actors for violations of the indentures. Dkt. 95.
After receiving the report, the Delaware Supreme Court certified the two questions at the heart of its analysis, which were governed by New York law, to the New York Court of Appeals. Quadrant Structured Prods. Co. v. Vertin, 2013 WL 5962813, at *5 (Del. Nov. 7, 2013). In an opinion issued earlier this year, the New York Court of Appeals agreed with the analysis set forth in the report. Quadrant Structured Prods., Co. v. Vertin, 23 N.Y.3d 549, 992 N.Y.S.2d 687, 23 N.Y.3d 549 (2014).
With the certified questions answered, the Delaware Supreme Court issued a decision applying the reasoning of this court's report and the New York Court of Appeals. As a technical matter, the Delaware Supreme Court's decision reversed the original dismissal of the complaint. Quadrant Structured Prods. Co. v. Vertin,
The defendants' motion seeks to dismiss the Complaint for failing to state a claim on which relief can be granted. See Ch. Ct. R. 12(b)(6). In a Delaware state court, the pleading standards for purposes of a Rule 12(b)(6) motion "are minimal." Cent. Mortg. Co. v. Morgan Stanley Mortg. Capital Hldgs. LLC, 27 A.3d 531, 536 (Del.2011).
Id. (footnote omitted). The operative test in a Delaware state court thus is one of "reasonable conceivability." Id. at 537 (footnote and internal quotation marks omitted). This standard asks whether there is a "possibility" of recovery. Id. at 537 n. 13. The test is more lenient than the federal "plausibility" pleading standard, which invites judges to "`determin[e] whether a complaint states a plausible claim for relief' and `draw on . . . judicial experience and common sense.'" Id. (alteration in original). Under the Delaware test, a trial court commits reversible error by assessing plausibility. See Cambium Ltd. v. Trilantic Capital P'rs III L.P., 36 A.3d 348, 2012 WL 172844, at *2 (Del. Jan. 20, 2012) (ORDER) ("The Court of Chancery erred by applying the federal `plausibility' standard in dismissing the amended complaint.").
In Counts I and II of the Complaint, Quadrant asserts claims for breach of fiduciary duty derivatively on behalf of the Company against the directors and EBF. Count I alleges that the directors breached their duty of loyalty and committed corporate waste by (i) continuing to pay interest on the Junior Notes held by EBF, (ii) paying excessive service and license fees to EBF or ASIA, and (iii) changing the Company's business model to take on greater risk under a strategy where EBF will benefit from any upside as the sole holder of the Junior Notes and the Company's equity, but the Company's more senior creditors including Quadrant will bear the cost of any downside. Count II alleges that EBF has breached its duty of loyalty by engaging in the same actions that are the subject of Count I. The challenges to the failure to defer interest and the payment of excessive fees state claims. The challenge to the Board's change in business strategy does not.
Count I and II constitute an attempt by Quadrant, a corporate creditor, to assert claims for breach of duty against corporate fiduciaries. The directors of a Delaware corporation owe fiduciary duties to the corporation they serve. When determining whether directors have breached their fiduciary duties, Delaware corporate law distinguishes between the standard of conduct
"[T]he standard of conduct for directors requires that they strive in good faith and on an informed basis to maximize the value of the corporation for the benefit of its residual claimants, the ultimate beneficiaries of the firm's value." Id. at 40-41. In a solvent corporation, the residual claimants are the stockholders. Consequently, in a solvent corporation, the standard of conduct requires that directors seek prudently, loyally, and in good faith to "to manage the business of a corporation for the benefit of its shareholder[ ] owners." N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 101 (Del.2007).
As residual claimants and the ultimate beneficiaries of the fiduciary duties that directors owe to the corporation, stockholders have standing in equity to bring claims derivatively on behalf of the corporation for injury that the corporation has suffered. When a corporation is insolvent, its creditors become the beneficiaries of any initial increase in the corporation's value. Id. at 101. The stockholders remain residual claimants, but they can benefit from increases in the corporation's value only after the more senior claims of the corporation's creditors have been satisfied. "The corporation's insolvency makes the creditors the principal constituency injured by any fiduciary breaches that diminish the firm's value." Id. at 101-102 (internal quotation marks omitted). Because the creditors of an insolvent corporation join the class of residual claimants, "equitable considerations give creditors standing to pursue derivative claims against the directors of an insolvent corporation." Id. at 102.
Before the Delaware Supreme Court's landmark decision in Gheewalla, it was not clear whether directors of an insolvent corporation owed fiduciary duties directly to creditors. In what had long been the Delaware Supreme Court's leading pre-Gheewalla decision, the high court stated that:
Bovay v. H.M. Byllesby & Co., 38 A.2d 808, 813 (Del.1944). The Bovay decision could be interpreted to hold that upon insolvency, the beneficiaries of the directors' fiduciary duties shifted from the corporation's stockholders to its creditors, and that after insolvency directors had a
In 1991, Chancellor Allen penned his famous footnote 55 in the Credit Lyonnais opinion. Credit-Lyonnais Bank Nederland, N.V. v. Pathe Commc'ns Corp., 17 Del. J. Corp. L. 1099, 1055 n. 55, 1991 WL 277613 (Del.Ch. Dec. 30, 1991). The influential aside stated:
Expected Value of
Judgment on Appeal Expected Value
25% chance of affirmance $51mm $12.75
70% chance of modification $4mm $2.8
5% chance of reversal $0 $0
Thus, the best evaluation is that the current value of the equity is $3.55 million.
Id.
Read against the backdrop of Bovay and the trust fund doctrine, footnote 55's expression
In a decision issued in 2004, then-Vice Chancellor, now Chief Justice Strine sought to clarify matters. See Prod. Res. Grp., L.L.C. v. NCT Grp., Inc., 863 A.2d 772 (Del.Ch.2004). He explained that Chancellor Allen had "attempted to emphasize that directors [of an insolvent corporation] have discretion to temper the risk that they take on behalf of the equity holders." Id. at 788. "The Credit Lyonnais decision's holding and spirit clearly emphasized that directors would be protected by the business judgment rule if they, in good faith, pursued a less risky business strategy. . . ." Id. "In other words, Credit Lyonnais provided a shield to directors from stockholders who claimed that the directors had a duty to undertake extreme risk so long as the company would not technically breach any legal obligation." Id.
As to claims by creditors, the Chief Justice explained that even after insolvency, "directors continue to have the task of attempting to maximize the economic value of the firm." Id. at 791. He noted that "the fact of insolvency does necessarily affect the constituency on whose behalf the directors are pursuing that end," and that after insolvency, creditors become the initial residual claimants. Id. If directors breach their duties by harming the firm, then creditors have standing to assert the firm's derivative claim.
Id. He held out the possibility, however, that under limited circumstances a creditor (or class of creditors) might be able to
In Gheewalla, the Delaware Supreme Court settled the debate over whether directors of an insolvent corporation owe fiduciary duties directly to creditors. The high court held creditors of an insolvent corporation may sue derivatively, but they "have no right to assert direct claims for breach of fiduciary duty against corporate directors." 930 A.2d at 103 (emphasis in original). Creditors of a solvent corporation have no right to assert direct claims for breach of fiduciary duty either, so as a practical matter Gheewalla holds that directors never owe fiduciary duties directly to creditors. See id. As the Delaware Supreme Court explained, creditors do not need direct fiduciary protection because "creditors are afforded protection through contractual agreements, fraud and fraudulent conveyance law, implied covenants of good faith and fair dealing, bankruptcy law, general commercial law and other sources of creditor rights." Id. at 99. In addition, the high court explained that recognizing a direct fiduciary duty to creditors "would create uncertainty for directors who have a fiduciary duty to exercise their business judgment in the best interest of the insolvent corporation [and] create a conflict between those directors' duty to maximize the value of the insolvent corporation for the benefit of all those having an interest in it, and the newly recognized direct fiduciary duty to individual creditors." Id. at 103.
In light of Gheewalla, I do not believe it is accurate any longer to say that the directors of an insolvent corporation owe fiduciary duties to creditors. It remains true that insolvency "marks a shift in Delaware law," but
Robert J. Stearn, Jr. & Cory D. Kandestin, Delaware's Solvency Test: What Is It and Does It Make Sense? A Comparison of Solvency Tests Under the Bankruptcy Code and Delaware Law, 36 Del. J. Corp. L. 165, 171 (2011). The fiduciary duties that creditors gain derivative standing to enforce are not special duties to creditors, but rather the fiduciary duties that directors owe to the corporation to maximize its value for the benefit of all residual claimants. Gheewalla, 930 A.2d at 101.
Under Gheewalla, Quadrant gains standing to bring a derivative claim by pleading that the Company is insolvent. A plaintiff can plead insolvency through allegations that meet either the "balance sheet" test or the "cash flow" test. See Klamath Falls, 864 A.2d at 947. See generally Stearn & Kandestin, supra, at 21. Under the balance sheet test, an entity is insolvent if it "has liabilities in excess of a reasonable market value of assets held." Trenwick, 906 A.2d at 195 n.74 (Del.Ch. 2006) (internal quotation omitted); accord Blackmore P'rs, 2005 WL 2709639, at *6; Geyer, 621 A.2d at 789. In a mature company, the existence of "a great disparity between assets and liabilities . . . at least
The Complaint's allegations support a reasonable inference that Athilon has been insolvent under the balance sheet test since before the EBF takeover. The Complaint alleges that the Company started with only $100 million in equity capital, borrowed six times that much in the form of long-term debt, and then leveraged its equity capital another 500 times writing credit default swaps. The Complaint describes substantial payments that the Company made to unwind two unsuccessful swap transactions for mortgage backed reference obligations, starting with a $48 million payment in 2008 that wiped out half of the Company's equity capital, followed by a $320 million payment in 2010 that exceeded six times its remaining equity capital. The Complaint explains that in light of the demise of the credit product company business model due to the financial crisis, the Company has no realistic prospect of returning to solvency. The Complaint further explains that by the end of 2008, the Company and Asset Acceptance lost their AAA/Aaa ratings and entered runoff, and by August 2010, the Company and Asset Acceptance no longer had any investment grade debt or counterparty credit ratings.
Focusing on the September 2011 Financials, the Complaint alleges that the Company had $600 million of outstanding bond debt and assets with a fair saleable value of only $426 million. Ironically, the Company in its reply brief disputes the accuracy of this allegation by asserting that the Company's liabilities were actually $747 million—$147 million greater than what the Complaint alleges.
These facts adequately plead insolvency under the balance sheet test. The defendants have sought on several occasions to introduce material outside of the Complaint which they say defeats the pleading-stage inference of insolvency. For the court to consider these submissions would require converting the motion to dismiss into a motion for summary judgment. They have not been considered.
Gheewalla indicates that the derivative claims that creditors gain standing to assert are no different than the derivative claims that stockholders could assert. The defendants reason that creditors therefore should have to comply with the same requirements that stockholders must meet, such as the contemporaneous ownership requirement. This decision need not determine whether creditor-plaintiffs should have to comply with other substantive legal doctrines, such as demand excusal or demand refusal, because the defendants have not raised them. The contemporaneous ownership requirement, however, is a statutorily imposed limitation that applies by its terms only to stockholder-plaintiffs. It does not apply to creditors.
Section 327 of the Delaware General Corporation Law imposes the contemporaneous ownership requirement. 8 Del. C. § 327. It states:
Id. The contemporaneous ownership requirement has a similarly sounding counterpart—
Section 327 is "the only statutory provision [in the Delaware General Corporation Law] dealing with derivative actions." 2 Edward P. Welch et al., Folk on the Delaware General Corporation Law § 327.1, at GCL-XIII-42 (5th ed. Supp.2007). It does not, however, provide stockholders with standing to assert derivative claims. Rather, Section 327 limits derivative standing to a subset of those stockholders who otherwise would have standing to sue at common law.
Court of Chancery Rule 23.1 implements Section 327 procedurally by requiring that a stockholder plaintiff plead compliance with the statute. Rule 23.1(a) provides that "the complaint shall allege that the plaintiff was a shareholder . . . at the time of the transaction of which the plaintiff complains or that the plaintiff's shares . . . devolved on the plaintiff by operation of law." Ch. Ct. R. 23.1(a). Through this procedural mechanism, compliance with Section 327 can be addressed on the pleadings rather than at a later stage of the case. Rule 23.1 does not create or provide an independent basis for the contemporaneous ownership requirement. By statute, a Court of Chancery Rule is not permitted to alter substantive law. See 10 Del. C. § 361(b) ("[R]ules shall be for the purpose of securing the just and, so far as possible, the speedy and inexpensive determination of every such proceeding. The rules shall not abridge, enlarge or modify any substantive right of any party.").
The General Assembly enacted Section 327 in 1945. In doing so, the General Assembly altered Delaware law by restricting a stockholder's ability to sue for fiduciary wrongs that pre-dated his stock ownership. "Under the Delaware Law as it existed prior to the enactment of this statute, in order to maintain a derivative action, a stockholder was not required to be the owner of the shares at the time of the transaction of which he complained." Rosenthal v. Burry Biscuit Corp., 60 A.2d 106, 110 (Del.Ch.1948) (Seitz, V.C.) (citing cases). The United States Supreme Court originally created the contemporaneous ownership requirement as a matter of equity in 1881 to prevent corporations from manufacturing diversity jurisdiction for claims against third parties. See Hawes v. Oakland, 104 U.S. 450, 461, 26 L.Ed. 827 (1881). That problem did not confront state courts (and it still doesn't). Consequently, "many courts, including Delaware, did not follow the rule of the Hawes case [viz., the contemporaneous ownership requirement]." Burry Biscuit, 60 A.2d at 111.
For Delaware courts at common law not to adopt the contemporaneous
Section 327 thus "effected a substantial change in the Delaware Corporation Law." Burry Biscuit, 60 A.2d at 110. Before its passage, a stockholder could sue for wrongs pre-dating the acquisition of stock. "After its passage, a stockholder filing a derivative action was required to allege and therefore to prove that he was a stockholder at the time of the transaction of which he complained, or that his stock devolved upon him by operation of law." Id. Thus, "[t]he equitable standing of a stockholder to bring a derivative action was judicially created but later restricted by [Section 327]." Schoon, 953 A.2d at 204; accord CML V, 28 A.3d at 1044.
"It is well-settled that unambiguous statutes are not subject to judicial interpretation." Leatherbury v. Greenspun, 939 A.2d 1284, 1288 (Del.2007). "If the statute as a whole is unambiguous and there is no reasonable doubt as to the meaning of the words used, the court's role is limited to an application of the literal meaning of those words." Id. (internal quotation marks omitted); accord Friends of the H. Fletcher Brown Mansion v. City of Wilmington, 34 A.3d 1055, 1059 (Del. 2011). By its terms, Section 327 applies only to stockholders. The plain language of the statute does not apply to other corporate constituencies, like creditors, who can under limited circumstances bring derivative claims. "[W]hile [Section 327] should be construed so as to reasonably effectuate its primary purpose—to discourage a type of strike suit—it should not be
For reasons that I have discussed elsewhere, I do not believe that a coherent and credible policy justification has ever been offered for Section 327's limitation on the ability of stockholders to assert pre-transfer claims. See J. Travis Laster, Goodbye to the Contemporaneous Ownership Requirement, 33 Del. J. Corp. L. 673 (2008). The purposes that have been proffered for Section 327's limitation on stockholder standing (i) ignore the two-fold nature of the derivative action, id. at 676-77, (ii) conflict with Delaware law on the assignability of claims, id. at 680-81, (iii) do not match up with how the statute operates, id. at 682-84, 688-91, or (iv) stand in tension with financial and economic theory, id. at 685-88. Section 327 is obviously the law of Delaware, and this court is bound to apply the law as enacted by the General Assembly. But applying Section 327 as enacted is a different thing than expanding it to apply to a class of plaintiffs that the language nowhere mentions. Rather than enforcing the literal meaning of the statute in accordance with its terms, applying it to creditors would re-write Section 327 expansively.
Extending Section 327 to creditors also would stand in tension with the ability of creditors to assert claims that pre-date the point when they acquire standing to sue. For stockholders, standing to sue and stock ownership are synonymous, and Section 327 prevents stockholders from asserting claims that arose before they acquired their stock ownership. For creditors, standing to sue depends on two inputs: creditor status (analogous to stock ownership) and corporate insolvency. In his Production Resources decision, Chief Justice Strine explained while serving as a Vice Chancellor that creditors are not prevented from bringing derivative claims that pre-date the corporation's insolvency. After positing a situation in which a firm becomes insolvent "after the acts that are alleged to have been fiduciarily improper," he explained that a creditor in that situation would be included within "the class of those eligible to press the claim derivatively." Prod. Res., 863 A.2d at 792 (emphasis in original). Later in the same decision, the Chief Justice again posited situations when directors engaged in fiduciary wrongdoing before the firm became insolvent and noted that after the firm became insolvent, the claim could be "asserted by creditors" or by a trustee in bankruptcy. Id. at 794. This makes sense as a matter of policy because one of the rationales for conferring standing on creditors recognizes that once the corporation reaches the point of insolvency, the creditors become the primary beneficiary of any increase in the value of the corporation. Gheewalla, 930 A.2d at 102; Prod. Res., 863 A.2d at 792. Stockholders have less incentive to sue because the recovery is less likely to benefit them. Trenwick, 906 A.2d at 195 n.75. It is entirely possible, perhaps even likely, that breaches of fiduciary duty that cause, hasten, or otherwise contribute to insolvency will have occurred before the point of insolvency in fact. If creditors lack standing to assert claims that pre-dated the point of insolvency, then the number of possible plaintiffs will be few: stockholders will lack the incentive, and creditors will lack the ability. Because of how they gain standing to sue, creditors can and should be able to assert claims that arose before they gained standing. To extend Section 327 to creditors would conflict with this approach.
Although Rule 23.1 does not mention creditor-plaintiffs when addressing either contemporaneous ownership or demand futility and demand refusal, the underlying substantive rules do not preclude a requirement that creditor-plaintiffs comply with these doctrines. A corporate claim is an asset of the corporation, so authority over the claim ordinarily rests with the board of directors. See 8 Del. C. § 141(a); Zapata Corp. v. Maldonado, 430 A.2d 779, 782 (Del.1981). The doctrines of demand excusal and demand refusal protect the board's authority under Section 141(a) and prevent a derivative plaintiff from usurping the board's prerogative to decide how to handle a corporate claim.
Because Rule 23.1 is procedural, whether a creditor would need to satisfy the demand excusal or demand refusal requirements depends not on Rule 23.1 but rather on the underlying substantive principle of law, just as whether a creditor must satisfy Section 327 turns not on Rule 23.1 but on the substantive language of the statute. The requirements of demand futility or demand refusal flow from Section 141(a), which makes the authority of the board of directors paramount. Section 141(a) does not distinguish between stockholders, creditors, or other corporate constituencies. It is therefore possible that creditors could be required to comply with the doctrines of demand futility and demand excusal.
This court has previously declined to address whether a creditor seeking to bring a derivative action must comply with the requirement to show demand excusal or demand refusal, noting that arguments could be made both in favor of and against applying these doctrines to creditor-plaintiffs. Prods. Res., 863 A.2d at 796. This decision need not address this issue either, because the defendants did not raise demand futility or demand refusal as an objection to Quadrant's derivative claims. This decision discusses these doctrines only to make clear that its holding on Section 327 does not dictate the non-application of demand doctrines to creditor claims. This decision holds that Section 327 does not apply to creditor suits based on the plain language of the statute, and its analysis is limited to the contemporaneous ownership requirement that Section 327 imposes.
Counts I and II identify three decisions by which the members of the Board allegedly breached their duties to the Company. The first was the decision to continue paying interest on the Junior Notes. The allegations on this issue state a claim on which relief can be granted.
To determine whether directors have made a decision that breached their fiduciary duties, a Delaware court examines their actions through the lens of a standard of review. "Delaware has three tiers of review for evaluating director decision-making: the business judgment rule, enhanced scrutiny, and entire fairness." Reis v. Hazelett Strip-Casting Corp., 28 A.3d 442, 457 (Del.Ch.2011). Which standard of review applies will depend initially on whether the board members:
Trados II, 73 A.3d at 36.
Delaware's default standard of review is the business judgment rule, a principle of non-review that "reflects and promotes the role of the board of directors as the proper body to manage the business and affairs of the corporation." In re Trados Inc. S'holder Litig. (Trados I), 2009 WL 2225958, at *6 (Del.Ch. July 24, 2009). The rule presumes that "in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company." Aronson, 473 A.2d at 812. Unless one of its elements is rebutted, "the court merely looks to see whether the business decision made was rational in the sense of being one logical approach to advancing the corporation's objectives." In re Dollar Thrifty S'holder Litig., 14 A.3d 573, 598 (Del.Ch.2010) (Strine, V.C.). "Only when a decision lacks any rationally conceivable basis will a court infer bad faith and a breach of duty." In re Orchard Enters., Inc. S'holder Litig., 88 A.3d 1, 34 (Del.Ch.2014).
Entire fairness is Delaware's most onerous standard of review. It applies when a plaintiff rebuts one or more of the presumptions of the business judgment rule. It also applies "[w]hen a transaction involving self-dealing by a controlling shareholder is challenged. . . ." Ams. Mining Corp. v. Theriault, 51 A.3d 1213, 1239 (Del.2012). Unless the defendants implement protective procedural devices, they "bear the burden of proving that the transaction with the controlling stockholder was entirely fair to the minority stockholders." Id.
In the current case, the standard of review for evaluating the decision to continue paying interest on the Junior Notes is entire fairness with the burden of proof on the defendants. The Complaint alleges that the Board had the ability to defer interest payments on the Junior Notes, that the Junior Notes would not receive anything in an orderly liquidation, that EBF owned all of the Junior Notes, and that the Board decided not to defer paying interest on the Junior Notes to benefit EBF. A conscious decision not to take action is just as much of a decision as a decision to act. See Hubbard v. Hollywood Park Realty Enters., Inc., 1991 WL 3151, at *10 (Del.Ch. Jan. 14, 1991) ("From a semantic and even legal viewpoint, `inaction' and `action' may be substantive equivalents, different only in form."); accord Krieger v. Wesco Fin. Corp., 30 A.3d 54, 58 (Del.Ch.2011). A decision to act and a conscious decision not to act are thus equally subject to review under traditional fiduciary duty principles. See Spiegel, 571 A.2d at 773-74 ("[A] conscious decision by a board of directors to refrain from acting may be a valid exercise of business judgment. . . ."); Aronson, 473 A.2d at 813 (equating "a conscious decision to refrain from acting" with a decision to act).
By virtue of the decision not to defer interest, funds flowed from the Company to EBF. As the owner of 100% of the Company's equity, EBF controlled the Company and stood on both sides of the transaction. Delaware law imposes fiduciary duties on those who effectively control
A transfer of value from a solvent subsidiary to the holder of 100% of the equity cannot give rise to a fiduciary wrong. Before the transfer, the 100% stockholder owned the value indirectly and beneficially. After the transfer, the 100% stockholder owned the value directly. The sole residual claimant and exclusive beneficiary of the duties that the corporate fiduciaries owe is in the same position before and after the transaction. The sole residual claimant has not been harmed, and the transfer by every measure is entirely fair. But "[w]hen a corporation is insolvent, . . . its creditors take the place of the shareholders as the residual beneficiaries of any increase in value." Gheewalla, 930 A.2d at 101 (emphasis in original). Directors continue to have an obligation to maximize the value of the firm, but now a transfer of value to the sole stockholder does not inure to the ratable benefit of all of the residual claimants. The payment now transfers value previously owned beneficially and indirectly by all of the residual claimants to the party in control of the corporation.
Delaware courts have held that challenges to similar transfers from an insolvent subsidiary to its controller state a derivative claim for breach of fiduciary duty. In Shandler v. DLJ Merchant Banking, Inc., 2010 WL 2929654 (Del.Ch. July 26, 2010), Chief Justice Strine, writing as a Vice Chancellor, held that a bankrupt corporation could sue its controlling stockholder and the directors affiliated with the controlling stockholder for breaching their fiduciary duty of loyalty by approving a transaction in which the corporation sold a business unit to an affiliate of its controlling stockholder. Id. at *1, *12. Similarly in Production Resources, then-Vice Chancellor Strine held that a complaint's allegations about specific transfers between an insolvent corporation and its de facto controller pled non-exculpated derivate claims, including allegations about payments to
Based on these authorities, Counts I and II state a derivative claim for breach of fiduciary duty to the extent they challenge the failure to defer interest on the Junior Notes. The defendants will have the burden of proving that the failure to defer interest on the Junior Notes was entirely fair.
The second act identified in Counts I and II as a breach of fiduciary duty is the Company's payment of excessive service and license fees to ASIA. These allegations state a claim, and the analysis parallels the explanation regarding the Junior Notes. The Complaint alleges that EBF, the Company's controller, owns ASIA, and that the payment of service and license fees to ASIA diverts value from the Company to EBF. Compl. ¶ 80. The Complaint alleges that the fees that the Company is paying exceed market rates. Id. ¶¶ 85-87. EBF stands on both sides of the transaction, making entire fairness the governing standard of review with the burden of proof on the defendants.
In their third variation, Counts I and II allege that the defendants breached their fiduciary duties by amending the Operating Guidelines to permit Athilon to invest in riskier securities and make speculative investments. Quadrant alleges that EBF benefits from this strategy because it will enjoy the upside if the strategy succeeds while suffering none of the downside if the strategy fails. Given the Company's insolvency, Quadrant alleges that faithful fiduciaries would pursue a conservative strategy and prepare for liquidation. In effect, this aspect of Counts I and II asserts a variant of Bovay's trust fund doctrine. In my view, this aspect of Count I and II does not state a claim.
Current Delaware law does not require the Board to shut down Athilon's business and manage towards a near-term dissolution for the benefit of creditors. Notwithstanding a company's insolvency, "[t]he directors continue to have the task of attempting to maximize the economic value of the firm." Prod. Res., 863 A.2d at 791.
Trenwick, 906 A.2d at 174. "Even when the firm is insolvent, directors are free to pursue value maximizing strategies, while recognizing that the firm's creditors have become its residual claimants." Id. at 175. "If the board of an insolvent corporation, acting with due diligence and good faith, pursues a business strategy that it believes will increase the corporation's value, . . . it does not become a guarantor of that strategy's success." Id. at 205. "Rather, in such a scenario the directors are protected by the business judgment rule." Id.; accord Shandler, 2010 WL 2929654, at *14. At the same time, Delaware law also recognizes that:
Prod. Res., 863 A.2d at 791 n.60. Here too the business judgment rule would protect a board's decision to pursue an efficient liquidation.
Quadrant does not appear to dispute that the business judgment rule could apply to the Board's decisions. Instead, Quadrant argues that the Board's risk-on business strategy will favor EBF and disfavor the Company's creditors because of their relative positions in the Company's capital stack. Quadrant contends that because EBF controls the Company, the defendants have the burden to prove that their decision to pursue a riskier strategy was entirely fair to the Company.
In a sense, this argument can be conceived of as a reverse-Trados theory. In Trados, this court examined the decision by a board of directors to enter into a merger agreement that triggered special rights held by preferred stockholders to receive a liquidation preference. See Trados I, 2009 WL 2225958, at *8 (treating directors as interested for pleading purposes in transaction that benefited preferred stockholders when "each had an ownership or employment relationship with an entity that owned Trados preferred stock"). Three of the directors on the board faced the dual-fiduciary problem that the Delaware Supreme Court identified in Weinberger v. UOP, Inc., 457 A.2d 701, 710 (Del.1983), where the Delaware Supreme Court held that there "[t]here is no dilution of [fiduciary] obligation where one holds dual or multiple directorships." Id. If the interests of the beneficiaries to whom the dual fiduciary owes duties are aligned, then there is no conflict of interest. See, e.g., Van de Walle v. Unimation, Inc., 1991 WL 29303, at *11 (Del.Ch. Mar. 7, 1991). But if the interests of the beneficiaries diverge, the fiduciary faces an inherent conflict of interest.
In a solvent corporation, the standard of conduct for directors requires that they act as fiduciaries "to promote the value of the corporation for the benefit of its stockholders."
As Quadrant sees it, when a corporation is insolvent, creditors become the principal residual claimants. This means that directors who are also fiduciaries for a sole or controlling stockholder, or even a large common holder, face the dual-fiduciary problem in a context where the interests of the primary residual claimants (the creditors) diverge from those of the equity. In a reverse of the situation in Trados, the duty of loyalty to the common stockholders creates the conflict. If a director held a material amount of common stock, the same argument would apply, although due to the director's personal financial interest rather than because of the dual-fiduciary problem.
The fault in this reasoning lies not in the theory, but in its application to business decisions that generally affect the value of the entity as a whole and which do not confer specific benefits on the directors themselves or, in dual-fiduciary situations, on the competing beneficiaries of fiduciary duties. When there are direct and specific benefits, the theory applies, as exemplified by cases like Shandler and Production Resources that have applied the entire fairness test to decisions approving transfers from an insolvent entity to its equity holders, and by this decision's analysis of the continued payments on the Junior Notes and the service and license fees. See Parts II.A.4 & 5, supra. But when
For solvent corporations, a similar principle can be seen in decisions holding that equal treatment of stockholders operates as a presumptive safe harbor for corporate fiduciaries, including controlling stockholders and directors, even when those fiduciaries allegedly have divergent economic interests. In Sinclair Oil Corp. v. Levien, 280 A.2d 717 (Del.1971), minority stockholders established at trial that all of the directors of a 97%-owned subsidiary were dual-fiduciaries who also served as directors, officers, or employees of the parent or other parent-controlled entities. Id. at 719. The plaintiffs showed that "[f]rom 1960 through 1966, Sinven paid out $108,000,000 in dividends ($38,000,000 in excess of Sinven's earnings during the same period)," and the Court of Chancery found that "Sinclair caused these dividends to be paid during a period when it had a need for large amounts of cash." Id. at 720-21. The plaintiffs argued that the dividends were paid with the bad faith motive of furthering the parent's need for cash rather than the best interests of all stockholders. The Court of Chancery applied the entire fairness test and held that the defendants had not met the test. Id. at 721.
On appeal, the Delaware Supreme Court reversed. In doing so, the high court distinguished between situations involving differential treatment of the controlling stockholder and situations involving equal treatment.
Id. at 721-22 (citations omitted).
More recent Delaware cases have applied Sinclair in cases involving solvent corporations, while recognizing that equal treatment is not an absolute safe harbor. A fiduciary's personal motives
Cases like Shandler, Production Resources, Trenwick, and Gheewalla 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. In Shandler, then-Vice Chancellor Strine dismissed a claim that director-defendants affiliated with a controlling stockholder breached their fiduciary duties by causing an insolvent corporation "to take a reckless and value-destroying gamble so as to provide a chance for [the controlling stockholder] to recoup value for its . . . equity." 2010 WL 2929654, at *13. The Chief Justice explained that "the mere fact that the company was not able to avoid ultimate insolvency does not, in itself, mean that there was not a good faith basis to take a chance on survival if the board viewed that as the best option to maximize [the insolvent entity's] value." Id. at *14 n.127. Although a majority of the directors were employees of the controlling stockholder, the Chief Justice held that "[e]ven when [the entity] was insolvent, the board was entitled to exercise a good faith business judgment to continue to operate the business if it believed that was what would maximize [the entity's] value." Id. at *14. The decision affected the value of the entity as a whole and did not confer any direct or specific benefits on a fiduciary, a party affiliated with a fiduciary, or on a particular class of residual claimants. Neither the directors' affiliation with the controller, nor the allegation that the controller benefitted generally from continuing to operate the business was sufficient to rebut the business judgment rule and elevate the standard of review to entire fairness.
In Production Resources, again writing as a Vice Chancellor, Chief Justice Strine considered claims that the directors and officers of Production Resources Group, L.L.C. ("PRG"), an insolvent entity, were operating the company for the benefit of Carole Salkind, the company's de facto controlling stockholder. 863 A.2d at 775, 781. Two of the four directors were members of management, earned substantial salaries, and were deemed beholden to Salkind. The complaint alleged specific transfers of value to Salkind, but also alleged that PRG's board and officers had acted improperly by continuing to operate the firm for Salkind's benefit. Notwithstanding the presence of a controlling
Id. at 788 n.52. By contrast, as noted previously, the Chief Justice held that the complaint's challenges to specific transactions with Salkind pled non-exculpated derivative claims, including regarding payments to Salkind's family companies, the payment of hefty salaries to insiders, the continued subordination of other creditors to Salkind, and the issuance of excessive shares to Salkind beyond the number authorized by the company charter. Id. at 777, 799-800.
In Trenwick, then-Vice Chancellor Strine did not actually rule on the viability of derivative claims asserted by a litigation trustee appointed in a bankruptcy proceeding, because he held that the complaint had not adequately pled facts supporting a rational inference that the subsidiary on whose behalf the plaintiff sought to assert the claims was insolvent. 906 A.2d at 195. The litigation trustee had sought to sue the subsidiary's sole stockholder in its capacity as the subsidiary's controller and the members of the subsidiary's board, all of whom were executive officers of the parent. Id. at 200. In an extensive footnote, the Chief Justice explained that the business judgment rule would protect the business decisions made by the board of an insolvent firm.
Id. at 195 n.75. The complaint had alleged dual-fiduciary status on the part of all of the subsidiary directors, so if entire fairness applied simply because (i) the directors of the insolvent corporation were dual fiduciaries and (ii) the complaint alleged that the board chose a riskier business strategy to benefit its sole equityholder, it seems likely that the Chief Justice would have mentioned it. Instead, he spoke consistently in terms of the business judgment rule as the operating standard of review.
Finally, to hold otherwise and treat directors as interested in pursuing a riskier business decision that allegedly benefitted the equity holder such that the standard of review would escalate to entire fairness would be inconsistent with the explanation the Delaware Supreme Court gave in Gheewalla for declining to recognize the existence of fiduciary duties owed directly to creditors.
930 A.2d at 103. If a creditor-plaintiff could sue derivatively and establish a lack of director independence and disinterestedness by alleging that the director who owned equity or who owed duties to a large stockholder adopted a risky business strategy to benefit the common stock, the directors of an insolvent corporation would face precisely the same type of fiduciary conflict that Gheewalla sought to avoid.
Given these authorities, I do not believe that Quadrant can rebut the business judgment rule by alleging that the Board has decided to pursue a relatively more risky business strategy to benefit its sole common stockholder, EBF. Although the Company is insolvent, and although the directors are dual-fiduciaries, the Board does not face a conflict between the interests of the primary residual claimants (the creditors) and the interests of secondary residual claimants (the stockholders). The fact that Vertin is a principal of EBF and Sullivan is an employee of EBF makes their dual-fiduciary status all the more readily apparent, but it does not alter the analysis. Under this court's precedents, the directors are not deemed conflicted on the theory that a riskier business strategy will benefit EBF and harm Athilon's creditors.
As an alternative basis for rebutting the business judgment rule, Quadrant makes the more traditional argument that the Complaint alleges facts supporting an "inference that rational persons acting in good faith as the directors of an insolvent firm would not proceed in this manner." Prod. Res., 863 A.2d at 800. The Complaint does not support an inference that no rational person would take on additional risk in the form of potentially higher yielding investments. Depending on the nature of the investments, a riskier strategy could return greater value for the Company and all of its residual claimants, including its creditors. The Complaint does not contain sufficient allegations to call into question the rationality of a riskier investment approach.
Counts I and II also contend that the foregoing actions constitute waste. "That the complaint states a loyalty claim does not mean that it also states a claim for waste." In re The Student Loan Corp. Deriv. Litig., 2002 WL 75479, at *4 (Del. Ch. Jan. 8, 2002) (Strine, V.C.). "The pleading burden on a plaintiff attacking a corporate transaction as wasteful is necessarily higher than that of a plaintiff challenging a transaction as `unfair' as a result of the directors' conflicted loyalties. . . ." Harbor Fin. P'rs v. Huizenga, 751 A.2d 879, 892 (Del.Ch.1999) (Strine, V.C.). For a waste claim to survive a motion to dismiss, a plaintiff must show "economic terms so one-sided as to create an inference that no person acting in a good faith pursuit of the corporation's interests could have approved the terms." Sample v. Morgan, 914 A.2d 647, 670 (Del.Ch.2007) (Strine, V.C.).
Counts I and II do not state claims for waste to the extent they challenge the Board's alleged risk-on business strategy. As stated in the previous section, a rational person could choose to take on greater
By contrast, Counts I and II state claims for waste to the extent they challenge the non-deferral of interest on the Junior Notes and the excessive fees paid under services agreement and software license. According to the Complaint, the Board could have charted a course that would result in the Company never having to pay anything to EBF as the sole holder of Junior Notes, making the non-deferral of interest an act of beneficence. Whether that proves to be the case will be determined at a later stage. If the Complaint's theory is correct, then it is reasonably conceivable that the non-deferral of interest could constitute waste. Similarly, the excessive fees could fall so far beyond market standards as to amount to waste. While that seems improbable, it is reasonably conceivable.
As a practical matter, it is unlikely that waste will be a relevant theory of relief. It is hard to conceive of a situation where the challenged transactions would not constitute a breach of fiduciary duty, but would constitute waste. Conversely, if the challenged transactions are found to constitute a breach of fiduciary duty, then the waste claim becomes superfluous. Nevertheless, as a strict pleading matter, the waste claims can proceed.
For the reasons stated, Counts I and II state well-pled claims for breach of fiduciary duty and waste to the extent they challenge the non-deferral of interest payments on the Junior Notes and the payment of excessive fees for services and software. The defendant directors seek dismissal of these claims on the ground that they are exculpated from liability by a provision in the Athilon Charter. See 8 Del. C. § 102(b)(7). Three of the directors cannot invoke Section 102(b)(7) because the Complaint pleads that they were not independent of EBF. For the other two directors, the court cannot now determine whether they are entitled to exculpation.
Section 102(b)(7) authorizes the certificate of incorporation of a Delaware corporation to eliminate or limit "the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty," subject to enumerated exceptions. Id. (emphasis added). When creditors assert derivative claims for breach of fiduciary duty, they are seeking to impose personal liability on directors of the corporation, so Section 102(b)(7) potentially applies. Prod. Res., 863 A.2d at 793-95.
Because EBF is interested in the payment of interest on the Junior Notes, the Complaint sufficiently pleads that Vertin, Sullivan, and Gonzalez lacked independence from EBF. A plaintiff may allege a lack of independence by pleading facts showing that directors depend on an interested controller for their income or employment. See Student Loan Corp., 2002 WL 75479, at *3 n.3 ("[T]he remuneration a person receives from her full-time job is typically of great consequence to her."); see also Shandler, 2010 WL 2929654, at *12 (finding that complaint pled duty of loyalty claim against director-defendants who "derived their primary source of income" by working for controller and who approved an interested transaction with the controller).
The Complaint alleges that Vertin is an EBF partner and that his compensation is tied to the performance of EBF's investments in credit derivative product companies. Compl. ¶ 7. The Complaint alleges that Sullivan is an attorney employed by EBF and depends on EBF for his primary
The Complaint does not plead facts that would be sufficient to rebut the business judgment rule as to Jundt and Wagoner. In a transaction governed by the business judgment rule, the plaintiff has the burden at the pleadings stage to allege facts sufficient to rebut the presumptions of loyalty and good faith that protect the directors. Absent well pled facts supporting a breach of the duty of loyalty, a court can apply Section 102(b)(7) summarily at the pleadings stage. Malpiede v. Townson, 780 A.2d 1075, 1094-96 (Del.2001); see Emerald P'rs v. Berlin (Emerald II), 787 A.2d 85, 90 (Del.2001) (describing Malpiede as addressing the proper application of a Section 102(b)(7) provision "in a pretrial procedural context, when the applicable standard of judicial review was the business judgment rule.").
The claims that have survived are not governed by the business judgment rule. Under controlling Delaware Supreme Court precedent, entire fairness governs interested transactions between a corporation and its controller, even if a special committee of independent directors or a majority-of-the-minority vote is used, because of the risk that when push comes to shove, directors who appear to be independent and disinterested will favor or defer to the interests and desires of the majority stockholder. See Lynch, 638 A.2d at 1116-17.
In re Pure Res., Inc., S'holders Litig., 808 A.2d 421, 436 (Del.Ch.2002) (Strine, V.C.). Particularly in controlling stockholder transactions, there is the risk that "that the outside directors might be more independent in appearance than in substance." In re Cox Commc'ns, Inc. S'holders Litig., 879 A.2d 604, 619 (Del.Ch.2005) (Strine, V.C.); accord Kahn v. Tremont Corp. (Tremont I), 1996 WL 145452, at *7 (Del. Ch. Mar. 21, 1996) (Allen, C.) (noting that a controlling stockholder transaction "of course is the context in which the greatest risk of undetectable bias may be present"), aff'd in pertinent part, rev'd on other grounds, Kahn v. Tremont Corp. (Tremont II), 694 A.2d 422 (Del.1997).
The entire fairness test helps uncover situations where facially independent and disinterested directors have failed to act loyally and in good faith to protect the interests of the corporation and the stockholders as a whole and instead have given in to or favored the interests of the controller. See Tremont II, 694 A.2d at 428-29. By independently reviewing the procedural and substantive fairness of the transaction with the burden of proof on the defendant directors, the court can identify those situations and, if necessary, impose a remedy. Id. What this means for purposes of Section 102(b)(7) is that when a case involves a controlling stockholder with entire fairness as the standard of review, and when there is evidence of procedural and substantive unfairness, a court cannot summarily apply Section 102(b)(7) on a motion to dismiss to enter judgment in favor of facially independent
There are no indications in this case that the defendants deployed any procedural protections to limit the influence of EBF and its representatives on the Board over the challenged decisions regarding the non-deferral of interest on the Junior Notes or the excessive fees paid under the services agreement and software agreement from the influence of EBF. It is reasonably conceivable at this procedural stage that the alleged breaches of fiduciary duty that Jundt and Wagoner committed by making the challenged decisions were not "exclusively attributable to a violation of the duty of care," Emerald II, 787 A.2d at 98, making it reasonably conceivable that exculpation could be unavailable for these directors. The motion to dismiss is therefore denied as to Jundt and Wagoner as well.
In Counts IV and V, Quadrant asserts claims under the Delaware Uniform Fraudulent Transfer Act ("DUFTA") based on the non-deferral of interest on the Junior Notes and the payment of excessive fees under the services agreement and software license agreement. In asserting its fraudulent transfer claims, Quadrant relies on Section 1304 of DUFTA, which provides a cause of action to both present and future creditors. Quadrant also relies on Section 1305 of DUFTA, which provides a cause of action only to present creditors.
Section 1304(a) identifies two grounds on which a transfer could be fraudulent as to both present and future creditors. Quadrant relies only on the first ground, set forth in Section 1304(a)(1), which states:
6 Del. C. § 1304(a)(1). Section 1304(b) of DUFTA identifies a non-exclusive list of factors for a court to consider when evaluating "actual intent." They include whether:
Id. § 1304(b).
Section 1305 identifies two additional grounds on which a transfer could be fraudulent as to present creditors. Quadrant relies only on both. Section 1305(a) states that:
Id. § 1305(a). Section 1305(b) states that "[a] transfer made by a debtor is fraudulent as to a creditor whose claim arose before the transfer was made if the transfer was made to an insider for an antecedent debt, the debtor was insolvent at that time and the insider had reasonable cause to believe that the debtor was insolvent." Id. § 1305(b).
Quadrant challenges the non-deferral of interest payments on the Junior Notes under Section 1304(a)(1) and Section 1305(b). Both theories state claims.
Taking the theories in reverse order, a cause of action under Section 1305(b) will exist if (i) the transfer flowed from a debtor to an insider, (ii) the debtor was insolvent at the time of the transfer, (iii) the insider had reasonable cause to believe that the debtor was insolvent, and (iv) the plaintiff was a creditor at the time of the transfer. The definition of "insider"
For purposes of DUFTA, a plaintiff can establish insolvency by showing that "the sum of the debtor's debts is greater than all of the debtor's assets, at a fair valuation." Id. § 1302(a). This test is the same as Delaware's common law balance sheet test. For reasons previously discussed, the Complaint adequately pleads that Athilon is insolvent under the balance sheet test and has been since Lehman's bankruptcy and the onset of the financial crisis. See Part II.A.2., supra.
The Complaint contains allegations supporting a reasonable inference that EBF knew that Athilon was insolvent. Athilon had lost its AAA/Aaa ratings and been in runoff pursuant to its Operating Guidelines since at least 2009, before EBF acquired Athilon's equity in 2010. Compl. ¶ 54. EBF used this opportunity to purchase Athilon's outstanding Junior Notes, which were trading at a steep discount. Id. ¶¶ 45, 46. When EBF later acquired control of 100% of Athilon's equity, Athilon had a negative net worth. Id. ¶ 48. When the Complaint was filed, Athilon had a sub-investment grade issuer credit rating of BB and a sub-investment grade counterparty credit rating of Ba1 from S & P and Moody's respectively. Id. ¶ 57. These allegations support the inference that EBF had reasonable cause to believe that Athilon was insolvent. Since acquiring control over Athilon, EBF has maintained representatives on its Board, giving EBF detailed insight into Athilon's financial performance. See id. ¶ 49.
Finally, the Complaint pleads that Quadrant has been a creditor "at all relevant times." Compl. ¶ 3. In an earlier version of the Complaint, Quadrant alleged that it became a creditor of Athilon in May 2011. Section 1305 only provides a cause of action to plaintiffs who were already creditors at the time of the transfer. The defendants read DUFTA as imposing the equivalent of a contemporaneous creditor requirement that would bar Quadrant from asserting claims that arose before it owned the notes.
The plain language of the statute, however, refers to the time when the claim arose, not when the party challenging the transfer acquired the claim. DUFTA defines a claim expansively as a right to payment, whether or not the right is reduced to judgment, liquidated, unliquidated, fixed, contingent, matured, unmatured, disputed, undisputed, legal, equitable, secured or unsecured. 6 Del. C. 1301(3). The right to payment under the Notes arose when the Company issued them. The creditor referred to in the statute is simply the current holder of the claim. As long as the claim itself arose prior to the transfer, the current holder can be a transferee or assignee of the claim. "The right to attack a conveyance as being in fraud of creditors is not personal to the original creditor, but may be exercised by his or her successors or assignees."
Quadrant also challenges the non-deferral of interest under Section 1304(a)(1). A cause of action under this section will exist if the transfer was made with "actual intent to delay, hinder or delay any creditor of the debtor." 6 Del. C. § 1304(a)(1). Intent is a question of fact. 37 C.J.S. Fraudulent Conveyances § 76. The Complaint must plead facts from which it is reasonably conceivable that the defendants acted with the requisite intent. Section 1304(b) provides a non-exclusive list of indicia that can be considered for that purpose.
"In all averments of fraud . . ., the circumstances constituting fraud . . . shall be stated with particularity." Ch. Ct. Ch. R. 9(b). "Intent," however, "may be averred generally." Id. "Rule 9(b) does not require an exhaustive cataloguing of facts but only sufficient factual specificity to provide assurance that the plaintiff has investigated . . . the alleged fraud and reasonably believes that a wrong has occurred." Bernstein v. IDT Corp., 582 F.Supp. 1079, 1085 (D.Del.1984) (internal quotation marks omitted). "The actual intent of the parties to the conveyance is of no consequence since [6 Del.Code § 1304] establishes an external test of constructive or legal fraud. . . ." China Res. Prod. (U.S.A) Ltd. v. Fayda Int'l, Inc., 788 F.Supp. 815, 818 (D.Del.1992) (internal quotation marks omitted). In order to state a fraudulent transfer claim, Quadrant must generally plead facts showing intent to defraud with specific supporting facts describing the circumstances of the transfer. See Geyer, 621 A.2d at 792 n.5.
The allegations of the Complaint adequately support a pleading stage inference of fraudulent intent. The Complaint alleges that EBF sought to deprive creditors, including Quadrant, of access to the Company's assets that would otherwise be available to satisfy their claims. Compl. ¶ 160. The Complaint further alleges that EBF knew that any transfers would have the effect of hindering and defrauding the Company's creditors. Id. The Complaint identifies several indicia of fraud, including (i) the Company's insolvency, (ii) EBF's insider status, and (iii) the lack of any need to continue paying interest on the Junior Notes. Id. ¶¶ 160, 165, 166.
Quadrant challenges the service and license fees under Section 1304(a)(1), Section 1305(a), and Section 1305(b). All three theories state a claim. Much of the analytical work already has been done in connection with analyzing the continuing
Proceeding again in reverse order, Quadrant challenges the service and license fees as fraudulent transfers in violation of Section 1305(b). To reiterate, a cause of action under Section 1305(b) will exist if (i) the transfer flowed from a debtor to an insider, (ii) the debtor was insolvent at the time of the transfer, (iii) the insider had reasonable cause to believe that the debtor was insolvent, and (iv) the plaintiff was a creditor at the time of the transfer. With one exception, the same analysis that governs these elements for purposes of the deferred interest payments applies to the service and license fees. The only difference is that the transfers flowed from the debtor to ASIA rather than directly to EBF. The question is therefore whether ASIA should be treated as an insider for pleading purposes.
Section 1301(7)(d) defines "insider" as "[a]n affiliate or an insider of an affiliate as if the affiliate were the debtor". 6 Del. C. § 1301(7)(d). Section 1301(1)(b) defines "affiliate" as:
Id. § 1301(1)(b). ASIA is an insider for purposes of Section 1305(b) because Quadrant has adequately alleged that ASIA is an affiliate of EBF. The Complaint alleges that ASIA is ultimately owned and indirectly controlled by EBF. Compl. ¶ 80. The Complaint further alleges that EBF owns 100% of Athilon's equity. Id. ¶ 48. As such, ASIA is "[a] corporation, 20 percent or more of whose outstanding voting securities are directly or indirectly owned, controlled or held with power to vote by. . . [EBF] who directly or indirectly owns, controls or holds with power to vote 20 percent or more of the outstanding voting securities of [Athilon]." 6 Del. C. § 1301(1)(b). ASIA is, therefore, an insider for purposes of Section 1305(b), and Quadrant has stated a claim that payments which took place on or after October 28, 2010, constituted a fraudulent transfer in violation of Section 1305(b).
Continuing in reverse order, a cause of action under Section 1305(a) will exist if (i) the debtor made the transfer or incurred the obligation without receiving a reasonably equivalent value in exchange, (ii) the debtor was insolvent at the time of or rendered insolvent by the transfer, and (iii) the plaintiff was a creditor at the time of the transfer. The same analysis that governed the issues of insolvency and creditor status continues to apply. The only question is whether the Complaint sufficiently alleges that Athilon did not receive "reasonably equivalent value" for the service and license fees.
The Complaint adequately alleges that Athilon did not receive reasonably equivalent value for its service fees transferred to ASIA. The Complaint alleges that, after Athilon entered runoff mode, the scope of ASIA's services diminished yet ASIA's fee increased after the EBF takeover. Compl. ¶¶ 84-85. Athilon allegedly transferred $23.5 million in annual service fees to ASIA in 2010, which included a $2.5 million service fee paid directly to EBF. Id. ¶ 86. The Complaint alleges that these service fees exceed market rates of approximately $5-$7 million annually. Id. ¶¶ 87-88. The Complaint further alleges that the Board rejected Quadrant's
Similarly, the Complaint adequately alleges that Athilon did not receive reasonably equivalent value for the annual software license fee transferred to ASIA. The Complaint alleges that the annual software license fee increased from $1.25 million in 2009 to $1.5 million in 2010. ¶ 94. This annual fee allegedly exceeds the cost of contracting a third party to build software from scratch. ¶ 95. The disparity between the fees paid to ASIA and the value of the software license received by Athilon support an inference that Athilon did not receive reasonably equivalent value in return. Therefore, the Complaint states a claim that the payment of these fees constituted a fraudulent transfer in violation of Section 1305(a).
Finally, a cause of action under Section 1304(a)(1) will exist if the transfer was made with "actual intent to delay, hinder or delay any creditor of the debtor." 6 Del. C. § 1304(a)(1). As noted, intent is a question of fact, so the Complaint must plead facts from which it is reasonably conceivable that the defendants acted with the requisite intent when paying the service and license fees. In doing so, the Complaint may refer to the non-exhaustive list of factors enumerated in Section 1304(b) that support a finding of intent. See id. § 1304(b).
The Complaint states sufficient facts about the service and license fees paid to plead a claim. Quadrant alleges facts supporting an inference that the value of the services and software received by Athilon was not reasonably equivalent to the value of the fees it paid to ASIA. See id. § 1304(b)(8). Quadrant alleges that these fees far exceeded market pricing. Compl. ¶¶ 80-98, 159, 165-168. According to the Complaint, the annual market rate for service fees was $5-7 million, yet the Company paid $23.5 million. Id. ¶¶ 88-92. The Company also pays in excess $1 million to use ASIA's software when it could have built the models from scratch for less. Id. ¶¶ 94-95.
The Complaint pleads additional facts that speak to other factors indicating actual intent under Section 1304(b). Quadrant alleges facts showing that the service and license fees were paid to an insider by virtue of ASIA's affiliate status. See Part II.B.2.a., supra; 6 Del. C. § 1304(b)(1) ("[t]he transfer or obligation was to an insider"). Quadrant adequately pleads that Athilon is insolvent under the balance sheet test and has been since the financial crisis in 2008. See Part II.A.2., supra; 6 Del. C. § 1304(b)(9) ("[t]he debtor was insolvent or became insolvent shortly after the transfer was made or the obligation was incurred"). As such, Quadrant has stated a claim that Athilon's payment of service and license fees to ASIA constituted a fraudulent transfer in violation of Section 1304(a)(1).
Count IX of the Complaint alleges that the Company's payment of excessive service and license fees to ASIA constitute constructive dividends paid indirectly to EBF, its sole equity holder. Count IX alleges that because the dividends were paid while the Company was insolvent, the payments violated Sections 170 and 174 of the DGCL.
When evaluating claimed violations of the DGCL, Delaware law takes a formal and technical approach.
Speiser v. Baker, 525 A.2d 1001, 1008 (Del. Ch.1987) (Allen, C.), appeal refused, 525 A.2d 582 (Del.1987) (TABLE). Although formalism across many domains has ceded the analytical high ground to legal realism or other more pragmatic approaches,
Uni-Marts, Inc. v. Stein, 1996 WL 466961, at *9 (Del.Ch. Aug. 12, 1996) (Allen, C.).
One of the formalistic methods of reasoning associated with statutory analysis under the DGCL is the "bedrock doctrine of independent legal significance." Warner Commc'ns Inc. v. Chris-Craft Indus., Inc., 583 A.2d 962, 970 (Del.Ch.1989) (Allen, C.), aff'd, 567 A.2d 419 (Del.1989) (TABLE). Under this doctrine, "action taken in accordance with different sections of that law are acts of independent legal significance even though the end result may be the same under different sections." Orzeck v. Englehart, 195 A.2d 375, 377 (Del.1963). "The mere fact that the result of actions taken under one section may be the same as the result of action taken
The declaration of a dividend is a specific corporate act governed by specific sections of the DGCL. 8 Del. C. §§ 170, 172, 173, 174. Other sections of the DGCL extend the restrictions governing the payment of dividends to redemptions of equity. 8 Del. C. §§ 160, 173, 174. No section of the DGCL extends the restrictions governing the payment of dividends to other transactions between a corporation and stockholders, including its sole stockholder. Rather than expanding the statutory sections governing dividends and stock redemptions to other types of transactions, Delaware law evaluates claims about improper transfer payments and self-dealing under the rubric of fiduciary duty. See Horbal v. Three Rivers Hldgs., Inc., 2006 WL 668542, at *3 (Del.Ch. Mar. 10, 2006) (rejecting effort to recast compensation to insiders as a "de facto dividend"; observing that "[n]o Delaware court has ever recast executive compensation as a constructive dividend nor (to my knowledge) has any Delaware court recognized such a cause of action to exist . . . ."); see also Keenan v. Eshleman, 2 A.2d 904, 912 (Del. 1938) (declining to treat management fees paid by corporation to entity controlled by directors "as a fund for a dividend in which the dissenting stockholders are to share").
Quadrant has identified one case in which a federal district court held that a transfer payment to a stockholder could be construed as an illegal dividend under Delaware law. Growe v. Bedard, 2004 WL 2677216 (D.Me. Nov. 23, 2004). The plaintiffs in Growe argued that a controlling stockholder used a services agreement to "pull[] large sums of money out of [a subsidiary] while it was insolvent" and that those payments "should be characterized as an illegal dividend ... under Section 174." Id. at *12 (internal quotation marks omitted). The Growe court denied the defendant directors' motion for summary judgment, finding that the payments "could be characterized as dividends" and noted further that the services agreement could be "simply a tool for vacuuming assets out of the failing [subsidiary] and into its shareholder. . . ." Id. To the extent the Growe court construed Section 174 to apply to the services agreement, I respectfully disagree with its analysis and do not believe the decision accurately reflects Delaware law. That does not mean that the plaintiffs in Growe had no remedy or that the services agreement in Growe could not aptly be regarded at the summary judgment stage as "simply a tool for vacuuming assets out of the failing [subsidiary] and into its shareholder. . . ." Id. It rather means that the framework Delaware law would use to evaluate such a claim is breach of fiduciary duty, not an expansive reading of the term "dividend" under Section 174.
Quadrant can challenge the payment of service and license fees to ASIA as breaches of fiduciary duty. The same allegations do not state a claim for a statutory violation of the provisions governing dividends.
In Counts III and VI, Quadrant pleads what purport to be separate claims seeking injunctive relief. Count III seeks a permanent injunction to the extent Quadrant prevails on the breach of fiduciary duty theories asserted in Counts I and II.
Injunctions are a form of relief, not a cause of action. This court will determine what remedy (if any) it will award after deciding the merits of Quadrant's claims, taking into account the wrongs (if any), the nature of the harm, the facts and circumstances, and any other equities of the case. As a technical matter, Counts III and VI are dismissed because they seek remedies rather than assert claims.
Other than cleaning up the pleadings, this ruling has no effect on the case. In the remedial stage of this action, Quadrant may seek injunctive relief, and the court has not ruled out the possibility of a permanent injunction, if warranted. The defendants have argued that all of the wrongs that Quadrant has identified could be remedied by an award of money damages, which negates the requirement of irreparable harm necessary to support injunctive relief. Given the allegations about Athilon's insolvency, it is possible that the Company would not have sufficient resources to pay a money judgment, making injunctive relief appropriate. See Gimbel v. Signal Co., 316 A.2d 599, 603-604 (Del.Ch.1974) (finding irreparable harm where defendant directors face large money damages claims and "it is doubtful that any damage claim against the directors can reasonably be a meaningful alternative [to a permanent injunction]"). A permanent injunction also may be appropriate under other circumstances, such as to halt a continuing wrong. It is premature at this stage to rule out the possibility of injunctive relief.
In Count X, Quadrant alleges a civil conspiracy involving the members of the Board, EBF, and ASIA. This count is a fall-back theory designed to impose secondary liability on any of the alleged wrong-doers who can avoid liability under one of the primary theories, but who still knowingly participated in the underlying wrong. Only Counts I, II, IV, and V have survived the motion to dismiss, so only those counts are relevant to Count X.
Counts IV and V assert fraudulent transfer theories. Under Delaware law, a "conspiracy cannot be predicated on fraudulent transfer. . . ."
This leaves Counts I and II, which assert claims for breach of fiduciary duty against the members of the Board and EBF. A claim for conspiracy to commit a breach of fiduciary duty is usually pled as a claim for aiding and abetting, and although there are differences in how the elements of the two doctrines are framed, it remains unclear to me how the two diverge meaningfully in substance or purpose.
ASIA has not been sued for breach of fiduciary duty. The Complaint adequately alleges that ASIA is controlled by EBF such that for pleading purposes, the EBF's knowledge should be imputed to ASIA. The Complaint also adequately alleges that Vertin and Sullivan are employees and agents of EBF, such that their knowledge would be imputed for pleading purposes both to EBF and to its controlled affiliates, like ASIA. Counts I and II of the Complaint plead claims for breach of fiduciary duty against the individual defendants and EBF. Count X therefore pleads a claim against ASIA for aiding and abetting, at least to the extent that Counts I and II relate to ASIA's alleged role as a conduit for the tunneling of value from Athilon to EBF.
The motion to dismiss Count X is therefore denied to the extent it seeks to impose secondary liability on the individual defendants, EBF, and ASIA for the underlying wrongs pled in Counts I and II, and to the extent the individual defendants and EBF are not held liable as fiduciaries on the primary claims.
Counts I, II, IV, and V state claims on which relief can be granted to the extent
