Delaware Chancery Court Addresses When a Corporation is “Insolvent” for Purposes of a Creditor Derivative Action

Delaware Chancery Court Addresses When a Corporation is “Insolvent” for Purposes of a Creditor Derivative Action

      In a decision issued earlier this month, the Delaware Chancery Court defined the test to be employed in determining whether or not a corporation is insolvent such that a creditor will have standing to bring a derivative action. Quadrant Structured Products Company, Ltd. v. Vertin, C.A. No. 6990-VCL, 2015 WL 2062115 (Del. Ch. May 4, 2015).

      Quadrant held debt securities issued by Athilon Capital Corp. Premised upon Athilon’s insolvency, Quadrant brought a derivative action alleging that certain Athilon transactions were approved by the Athilon on Board of Directors in violation of its fiduciary duties, as well as alleging that those transactions violated the Delaware Fraudulent Transfer Act. Under Delaware law:

[T]he creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the Corporation for breaches of fiduciary duties.

North American Catholic Education Programming Foundation, Inc. v Gheewalla, 930 A.2d 92, 101 (Del. 2007).

      Athilon resisted, asserting that a high bar is necessary with respect to insolvency to exist, and further positing that that high bar had not been met. Specifically, Athilon asserted that insolvency required all of:

(i) that the corporation was insolvent at the time the derivative action was filed;

(ii) that the corporation continues to be insolvent throughout the pendency of the derivative action; and

(iii) with respect to insolvency, such should be more than a mere balance sheet or cash flow analysis, as well satisfy the requirement for the appointment of a receiver, “namely that the corporation has no reasonable prospect of returning to solvency.”

      The Chancery Court rejected these tests, finding it sufficient that the plaintiff demonstrate the corporation was insolvent at the time the suit was filed, with insolvency measured under either the balance sheet or the cash flow test.

      In explaining its decision, the Court began with an analysis of the purpose of the derivative action (a theme I recently considered in the context of Kentucky law in Who Will Watch the Watchers?: Derivative Actions in Nonprofit Corporations, 103 Kentucky Law Journal Online 31 (2015)), it was determined that:

The derivative action exists to prevent injustice by facilitating a lawsuit that otherwise would not have been or could not be pursued, and stockholders have standing to assert a corporation’s claim derivative because they can be regarded as the ultimate beneficial owners of the corporate assets, including litigation assets, and therefore have an interest in pursuing the claim.

      Rejecting the assertion that the corporation must remain insolvent throughout the pendency of the action, the Court observed that this “attempt to impose a continuous insolvency requirement tries to build by analogy on the contemporaneous ownership requirement” applicable with respect to shareholder derivative action. This the Court rejected in favor of a requirement that the creditor bringing the action continue to hold the debt claim against the corporation throughout the action.

       With respect to the sought requirement that the corporation remain insolvent throughout the course of the action, it was observed that a corporation could, during the term of the proceeding, move back and forth across the line of insolvency. Recognizing this could give rise to fact situations in which both the shareholders and the creditors could bring derivative actions, it was concluded that a court under its general supervisory authority of the derivative action would be able to weigh and balance the conflicting interests of the claims of equity holders versus creditors.

      The Court then turned its attention to determining whether Athilon was actually insolvent, ultimately determining that the balance sheet test was the most appropriate measure. Based upon the facts put forth by the plaintiffs, the Court determined that Athilon was insolvent as of the time the derivative action was filed, and on that basis it was allowed to proceed.