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By: Kelli E. Madigan

Quadrant v. Vertin

In Quadrant v. Vertin, a derivative action for breach of fiduciary duty was brought by Quadrant Structured Products Company, a creditor, against the directors of Athilon Capital Corp. (“Company”) and the Company’s controlling shareholder, EBF & Associates. Quadrant also asserted fraudulent transfer claims directly against Company and EBF, as the Company was insolvent at the time actions giving rise to the claims were taken.

 The facts in this case are somewhat convoluted. The Company guaranteed debts of its subsidiary and then both the subsidiary and Company fell on hard times during the 2008 financial crisis. EBF bought all of Company’s junior subordinated notes and all of its equity in 2010, thereby becoming a creditor and the sole shareholder of Company. EBF also replaced four of the five directors on Company’s board. Three of the replacements had significant affiliation with EBF. Thereafter, Quadrant acquired the senior subordinated loans and notes issued by Company, thereby also becoming a creditor.

This new board of directors, notwithstanding the financial crisis and its apparent insolvent position, elected to not exercise Company’s right to defer interest payments due on the junior notes held by EBF, but rather paid the interest on the junior notes to its sole shareholder. The board also approved payment of above market service and licensing fees to an affiliate of EBF and adopted a new, and riskier, business strategy involving highly speculative investments. It is these three actions that Quadrant, as a creditor, alleges were breaches of the board’s fiduciary duties.

The Complaint alleged that Company had been insolvent for some time before the EBF takeover, carrying $600 million in debt against assets with a saleable value of only $426 million. The Complaint further alleged that a well-motivated board facing these circumstances would minimize expenses during runoff, liquidate Company and return its capital to its investors.

Instead, the Complaint alleged, the EBF-controlled Board used Company’s assets to benefit EBF, to the detriment of the creditors, by:

  1. Continuing, unnecessarily, to make interest payments on junior notes owned by EBF;
  2. Causing Company to pay excessive fees to Athilon Structured Investment Advisors (“ASIA”), which EBF indirectly owned and controlled; and
  3. Changing Company’s business model to make highly speculative investments.

In support of these allegations, Quadrant noted that Company could defer the junior notes by five years, Company’s existing operating guidelines required Company to liquidate once the last credit swap expires, and that by the time the interest would be due, Company would have dissolved and liquidated with the junior note holders taking nothing.

Before the EBF takeover, Company entered into a services agreement with ASIA and paid $14 million in fees under the services agreement. After the runoff, ASIA’s services diminished, but the fees paid increased dramatically – $23.5 million in fees to ASIA, including a $2.5 million service fee to EBF. During this time period, Quadrant asserted that market rate would be $5-$7 million per year for the

services and, in fact, offered to provide comparable services for a flat fee of $5 million, but the board rejected the offer without investigating and did not reduce fees paid to ASIA.

Finally, under Company’s original operating guidelines, Company could only invest in highly-rated, short-term debt securities. After the downturn, the EBF-controlled board sought permission from the rating agencies to amend the guidelines to loosen investment restrictions. In fact, the board loosened the investment restrictions once it determined Company’s credit rating would not be lowered.

Quadrant argued that because EBF owned Company’s equity and junior notes, which were underwater, EBF did not bear any of the increased risk if the investment strategy failed as it was only Quadrant and other senior creditors bearing the risk. In other words, according to Quadrant, EBF would benefit from the strategy because it would enjoy the upside if the strategy succeeded while suffering none of the downside if the strategy failed.

Under Delaware law, directors owe a fiduciary duty to a corporation for the benefit of the residual claimants, that is, the shareholders. However, it was established in Gheewalla that if a corporation is insolvent, residuary claimants can include creditors and shareholders. Quadrant relied on this to bring not only the derivative suit against Company but also made direct claims against the directors for breach of fiduciary duties. The Court held that while creditors are residuary claimants of an insolvent corporation in that they have the standing to bring a derivative suit against the directors for breach of a fiduciary duty; such creditors do not have the right to assert direct claims against the corporate directors for breach of a fiduciary duty.

According to the Court, 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. Furthermore, creating a direct fiduciary duty to creditors could create a conflict where directors would have to decide between doing what is best for the corporation and maximizing the value of the insolvent corporation (read: picking shareholders over creditors or vice versa).

In evaluating the derivative action claims that the directors breached their fiduciary duties, the Court discussed three standards of review when looking at actions taken by a board of directors on behalf of a corporation. Which standard of review applies depends initially on whether the board members are disinterested and independent, or facing a potential conflict of interest, or confronted with an actual conflict of interest.

  • Where the directors are disinterested and independent, the business judgment rule applies.
  • Where faced with potential conflicts of interest because of the decisional dynamics present in particular recurring and recognizable situations, the standard of review requires enhanced scrutiny.

Where confronted with an actual conflict of interest such that the directors making the decision do not comprise a disinterested and independent board majority, the standard rises to the level of entire fairness.

The business judgment rules 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. Entire fairness puts the burden on the defendant to prove that the transaction was entirely fair to the stockholders and applies when one of the presumptions of the business judgment rule has been rebutted by the plaintiff. When a controller owns 100% of a solvent corporation, the fiduciary duties of the directors and officers require that the subsidiary be managed for the benefit of the controller; however, when a corporation is insolvent, its creditors take the place of the shareholders as the residual beneficiaries of any increase in value.

Consequently, Quadrant’s allegations that the defendants breached their duties by continuing to pay interest on the junior notes was sufficient to state a claim on which relief could be granted, and the Court held that the defendants bore the burden of proving that the failure to defer interest on the junior notes was entirely fair. Where EBF, as the sole shareholder of Company and controlling of three directors of the Company, stood on both sides of the transaction, the burden was entire fairness with the burden of proof being on the defendant. This was in line with other Delaware cases which held that challenges similar to transfers from an insolvent subsidiary to its controller state a derivative claim for breach of fiduciary duty.

Likewise, the allegations that the defendants breached their fiduciary duties when Company made excessive payments to ASIA for services and license fees was sufficient to state a claim on which relief could be granted, and the defendants bore the burden of proving entire fairness. Again, EBF stood on both sides of the transaction, making entire fairness the governing standard of review.

The third action, on the other hand, which alleged that the defendants breached their fiduciary duties by amending the operating guidelines to permit Company to invest in riskier securities and make speculative investments, was subject to the business judgment rule standard. The Court noted that, notwithstanding a company’s insolvency, the directors continue to have the task of attempting to maximize the economic value of the firm. The Court stated that 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 and, in such a scenario, the directors are protected by the business judgment rule. When directors make decisions that appear rationally designed to increase the value of the firm as a whole, courts are not prone to speculate about whether those decisions might benefit some residual claimants more than others. 

The Court went on to say that it is not enough for a plaintiff to argue that a particular director has a conflict of interest or is acting in bad faith – there must be specific allegations and later, actual evidence sufficient to permit a finding that the director faced a conflict. A plaintiff cannot rebut the business judgment rule by alleging that the board has decided to pursue a relatively more risky business strategy. Precedent detailed that the directors were not deemed conflicted on the theory that a riskier business strategy would benefit EBF and harm Company’s creditors.

In this case, a business decision intended to increase the insolvent corporation’s overall value without direct benefit to the insolvent corporation’s controlling shareholder (the new investment strategy) was subject to the business judgment rule (even though the creditor deemed the strategy to be risky and highly speculative). Decisions that specifically, actually transferred value of the corporation to the controlling shareholder (interest on junior notes and service fees) were subject to the entire fairness

standard. The question to be answered in reconciling these two standards is “where is the line between maximizing value to the corporation and simply transferring value to a shareholder?” In the end, it appears, in Delaware, at least, that decisions to maximize value are acceptable if the decisions fall within the business judgment rule, even if creditors are put at risk.

It should be noted that the Illinois Supreme Court routinely looks to decisions in other jurisdictions, particularly Delaware, on important issues related to corporate law.  The principle that corporate directors have a fiduciary duty to creditors once the corporation becomes insolvent has been recognized by Illinois courts in Schwendener, Inc. v. Juniper Electric Company, Inc. And the Bankruptcy Court in in the Northern District of Illinois in looking at the issue of whether an individual creditor has standing to sue a director in Illinois concluded that the Illinois Supreme Court is likely to agree with the Gheewalla holding in Delaware.  It seems to follow then, that given the opportunity, Illinois courts would follow the Quadrant holding, as well. Creditors beware of the business judgment rule.  

1. Quadrant Structured Products Co. v. Vertin, 102 A.3d 155 (Del. Ch. Oct. 1, 2014).
2. N. Am. Catholic Educ. Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007).
3. Schwendener, Inc. v. Juniper Electric Company, Inc., 358 Ill. App. 3d 65, 829 N.E. 2nd 818 (1st D 2005). 
4. In re Netzel, 442 B.R. 896, 901 (N.D. Ill. 2011).
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