Client Alert
Recent Delaware Court Rulings Clarify Standing Issues in Creditor Derivative Litigation Against Allegedly Insolvent Corporation ’s Directors or Officers
May 18, 2015
By Kevin C. Logue, Shahzeb Lari & Kevin P. Broughel
Since at least the Delaware Supreme Court’s 2007 landmark decision in N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007) (“Gheewalla”), it has been clear that under Delaware law, corporate directors do not owe fiduciary duties directly to corporate creditors, irrespective of whether the corporation is solvent, insolvent, or in the so-called “zone of insolvency.” However, the Gheewalla decision held that while creditors of an insolvent corporation have no right to assert direct claims for breach of fiduciary duty against corporate directors, the corporation’s creditors gain standing upon insolvency to bring derivative claims against directors or officers on behalf of the corporation for breach of fiduciary duties owed to the corporation to maximize value for the benefit of all residual claimants.
Two recent decisions from Vice Chancellor Laster of the Court of Chancery of the State of Delaware shed light on important issues of scope and standing related to such creditor derivative litigation—in particular, the extent to which the “contemporaneous ownership” standing requirement applicable in stockholder derivative litigation applies to creditor derivative litigation. In stockholder derivative litigation, the stockholder plaintiff must generally have been a stockholder at the time of the transaction or matter of which the stockholder complains and remain a stockholder from commencement of the lawsuit through completion of the litigation.
First, last fall in Quadrant Structured Products Company, Ltd v. Vertin, et al., 102 A.3d 155 (Del. Ch. Oct. 1, 2014), Vice Chancellor Laster ruled that the “contemporaneous ownership” standing requirement does not apply to creditors. Noting that in the creditor derivative context, creditors do not acquire standing to bring a derivative claim on behalf of the corporation until the corporation is insolvent, the Court rejected the argument that the creditor must have been a creditor at the time of the alleged wrongdoing. As the Court explained in that October 2014 decision, “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.” Id. at 180. Thus, the Court held that a creditor plaintiff, upon acquiring derivative standing in insolvency, could pursue claims based on alleged breaches of fiduciary duty to the corporation that pre-dated insolvency. In so doing, the Court declined to rule on an issue not raised in the litigation as to whether a creditor plaintiff, like a stockholder derivative plaintiff, would have to show that it made pre-suit demand on the board or that such demand would have been futile; while expressly not deciding that issue, the Court’s opinion does acknowledge that it is possible that creditors could be required to comply with those demand or futility/excusal doctrines prior to pursuing a derivative action. Id. at 183.
Second, earlier this month, in the course of the same litigation, Vice Chancellor Laster addressed in the context of a summary judgment motion a different standing issue which he described as an issue of first impression, i.e., whether a continuous insolvency requirement should be imposed for creditor derivative claims. Quadrant Structured Products Company, Ltd. v. Vertin, 2015 Del. Ch. LEXIS 129 (Del. Ch. May 4, 2015). While defendants disputed that the company was insolvent at the time of commencement of the litigation, they contended that the corporation was currently solvent and argued that for a creditor to have standing to proceed with a derivative litigation against corporate fiduciaries, the corporation on whose behalf the creditor sues must be insolvent not only at the time of suit but continuously thereafter. The Court rejected imposition of a continuous insolvency requirement and found that the time for measuring insolvency for purpose of determining a creditor’s standing to pursue derivative claims is at the time the suit was filed.
In rejecting the notion that a corporation must be continuously insolvent during pursuit of the creditor derivative litigation, the Court found unpersuasive the analogy of “continuous insolvency” to the contemporaneous ownership requirement in stockholder derivative litigation. Instead, Vice Chancellor Laster stated that the “proper analogy to the continuous ownership requirement is a continuous creditor requirement. If the creditor no longer holds a debt claim against the corporation, regardless of whether the divestiture was voluntary or involuntary, then the creditor loses standing to sue.” Id. at *40.
Lastly, Vice Chancellor Laster’s May 2015 opinion rejected the argument that “irretrievable insolvency” be established as the metric for determining when a creditor has standing to sue derivatively on behalf of a corporation. According to the Court, while a creditor-plaintiff must plead and ultimately prove insolvency at the time of commencement of suit under the traditional balance sheet flow test, it need not plead or prove that such insolvency was irretrievable.
Conclusion
In the May 2015 Opinion, Vice Chancellor Laster acknowledged that the Delaware Supreme Court has not addressed these issues, and that, of course, that Court “may well disagree” with his opinion. Vice Chancellor Laster also acknowledged that the approach adopted creates the possibility that during the course of a derivative action, both stockholders and creditors could gain standing to sue over the same breach of fiduciary duty to the corporation, but suggested that a supervising court has the tools to manage such litigation and any resulting conflicts. The Court also stressed that creditors of an insolvent corporation have no greater right to challenge a disinterested, good faith business decision than stockholders of a solvent firm, and that the business judgment rule continues to protect directors in connection with such decisions. These recent opinions highlight a number of challenges encountered in attempting to apply classic stockholder derivative litigation principles to this comparatively undeveloped area of fiduciary duty litigation.
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