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Quadrant Structured Prods. Co., Ltd. v. Vertin

Court of Chancery of Delaware

October 1, 2014

QUADRANT STRUCTURED PRODUCTS COMPANY, LTD., Individually and Derivatively on behalf of Athilon Capital Corp., Plaintiffs,

Submitted July 22, 2014.

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Lisa A. Schmidt, Catherine G. Dearlove, Russell C. Silberglied, Susan M. Hannigan, RICHARDS, LAYTON & FINGER, P.A., Wilmington, Delaware; Harold S. Horwich, Sabin Willett, Samuel R. Rowley, BINGHAM McCUTCHEN LLP, Boston, Massachusetts; Attorneys for Plaintiff Quadrant Structured Products Company, Ltd.

Philip A. Rovner, Jonathan A. Choa, POTTER ANDERSON & CORROON LLP, Wilmington, Delaware; Philippe Z. Selendy, Nicholas F. Joseph, Sean P. Baldwin, QUINN EMANUEL URQUHART & SULLIVAN, LLP; New York, New York; Attorneys for Defendants Vincent Vertin, Michael Sullivan, Patrick B. Gonzalez, Brandon Jundt, J. Eric Wagoner, Athilon Capital Corp., and Athilon Structured Investment Advisors LLC.

Collins J. Seitz, Jr., Garrett B. Moritz, Eric D. Selden, SEITZ ROSS ARONSTAM & MORITZ LLP, Wilmington, Delaware; Attorneys for Defendant Merced Capital, L.P., formerly known as EBF & Associates, LP.


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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.

A. The Company And Its Business Model

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

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Acceptance] to be credit default swaps" and activities related to that business.

Both the Athilon Charter and the Asset Acceptance Charter require that their businesses be " conducted in compliance with the Operating Guidelines." The Operating Guidelines:

o limit the business activities of the Company and Asset Acceptance;

o impose structural, portfolio, and leverage constraints on their operations;

o establish ratings categories for the collateralized debt obligations covered by the credit swaps written by Asset Acceptance and guaranteed by the Company;

o cap the aggregate notional amount of any single credit swap;

o limit the permissible maturity of credit swaps;

o limit the nature of credit events that could give rise to payment obligations under the credit swaps;

o 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;

o require that its portfolio contain sufficient assets to cover all liabilities; and

o 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.

B. The Company's Capital Structure And Financial Difficulties

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

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only business that their charters and the Operating Guidelines permitted them to pursue.

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.

C. EBF Takes Over An Insolvent Company

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.

D. Transfers Of Value From The Company To EBF

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 Ba1 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.

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The Complaint alleges that instead, the EBF-controlled Board is using the Company's assets to benefit EBF.

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

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sold securities with a par value of $25 million and purchased other securities that were not as highly rated and did not carry the short-term maturities that Athilon's original Operating Guidelines required.

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.

E. Procedural History

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 1, 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 (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, 16 N.E.3d 1165 (N.Y. 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,

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93 A.3d 654 (Del. 2014) (TABLE). The Delaware Supreme Court did not reach the other, independent grounds that the defendants had advanced in favor of dismissal. The case returned again to this court for a decision on those other arguments.


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).

When considering a defendant's motion to dismiss, a trial court should accept all well-pleaded factual allegations in the Complaint as true, accept even vague allegations in the Complaint as " well-pleaded" if they provide the defendant notice of the claim, draw all reasonable inferences in favor of the plaintiff, and deny the motion unless the plaintiff could not recover under any reasonably conceivable set of circumstances susceptible of proof.

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." ).

A. Counts I and II: Breach Of Fiduciary Duty Against The Directors And EBF

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.

1. Creditor Standing To Assert A Breach Of Fiduciary Duty Claim

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

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and the standard of review.[1] " The standard of conduct describes what directors are expected to do and is defined by the content of the duties of loyalty and care. The standard of review is the test that a court applies when evaluating whether directors have met the standard of conduct." In re Trados Inc. S'holder Litig. (Trados II), 73 A.3d 17, 35-36 (Del. Ch. 2013).

" [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:

An insolvent corporation is civilly dead in the sense that its property may be administered in equity as a trust fund for the benefit of creditors. The fact which creates the trust is the insolvency, and when that fact is established, the trust arises, and the legality of the acts thereafter performed will be decided by very different principles than in the case of solvency.

Bovay v. H.M. Byllesby & Co., 27 Del. Ch. 381, 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

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fiduciary obligation to preserve value for the benefit of creditors that creditors could enforce.[2] Interpreted in this manner, Bovay 's trust fund doctrine would resemble English law, which imposes personal liability on directors for wrongful trading, which occurs when the directors have continued to operate the company after the point they knew, or should have known, that there was no reasonable prospect of the company avoiding liquidation.[3]

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, 1159 n.55 (Del. Ch. Dec. 30, 1991). The influential aside stated:

The possibility of insolvency can do curious things to incentives, exposing creditors to risks of opportunistic behavior and creating complexities for directors. Consider, for example, a solvent corporation having a single asset, a judgment for $51 million against a solvent debtor. The judgment is on appeal and thus subject to modification or reversal. Assume that the only liabilities of the company are to bondholders in the amount of $12 million. Assume that the array of probable outcomes of the appeal is as follows:

Expected Value of


Judgment on Appeal


25% chance of affirmance



70% chance of modification



5% chance of reversal



Thus, the best evaluation is that the current value of the equity is $3.55 million.

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($15.55 million expected value of judgment on appeal--$12 million liability to bondholders). Now assume an offer to settle at $12.5 million (also consider one at $17.5 million). By what standard do the directors of the company evaluate the fairness of these offers? The creditors of this solvent company would be in favor of accepting either a $12.5 million offer or a $17.5 million offer. In either event they will avoid the 75% risk of insolvency and default. The stockholders, however, will plainly be opposed to acceptance of a $12.5 million settlement (under which they get practically nothing). More importantly, they very well may be opposed to acceptance of the $17.5 million offer under which the residual value of the corporation would increase from $3.5 to $5.5 million. This is so because the litigation alternative, with its 25% probability of a $39 million outcome to them ($51 million - $12 million ' $39 million) has an expected value to the residual risk bearer of $9.75 million ($39 million x 25% chance of affirmance), substantially greater than the $5.5 million available to them in the settlement. While in fact the stockholders' preference would reflect their appetite for risk, it is possible (and with diversified shareholders likely) that shareholders would prefer rejection of both settlement offers.
But if we consider the community of interests that the corporation represents it seems apparent that one should in this hypothetical accept the best settlement offer available providing it is greater than $15.55 million, and one below that amount should be rejected. But that result will not be reached by a director who thinks he owes duties directly to shareholders only. It will be reached by directors who are capable of conceiving of the corporation as a legal and economic entity. Such directors will recognize that in managing the business affairs of a solvent corporation in the vicinity of insolvency, circumstances may arise when the right (both the efficient and the fair) course to follow for the corporation may diverge from the choice that the stockholders (or the creditors, or the employees, or any single group interested in the corporation) would make if given the opportunity to act.


Read against the backdrop of Bovay and the trust fund doctrine, ...

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