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

Court of Chancery of Delaware, New Castle

May 4, 2015

QUADRANT STRUCTURED PRODUCTS COMPANY, LTD., Individually and Derivatively on behalf of Athilon Capital Corp., Plaintiff,
v.
VINCENT VERTIN, MICHAEL SULLIVAN, PATRICK B. GONZALEZ, BRANDON JUNDT, J. ERIC WAGONER, ATHILON CAPITAL CORP., ATHILON STRUCTURED INVESTMENT ADVISORS LLC, and EBF & ASSOCIATES, LP, Defendants

Submitted April 13, 2015.

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[Copyrighted Material Omitted]

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[Copyrighted Material Omitted]

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Lisa A. Schmidt, Catherine G. Dearlove, Russell C. Silberglied, Susan M. Hannigan, Matthew D. Perri, RICHARDS, LAYTON & FINGER, P.A., Wilmington, Delaware; Harold S. Horwich, Sabin Willett, Samuel R. Rowley, MORGAN, LEWIS & BOCKIUS 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, David Elsberg, Sean P. Baldwin, Nicholas F. Joseph, Rollo C. Baker IV, 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.

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

OPINION

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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 contends that Athilon is insolvent and has asserted derivative claims for breach of fiduciary duty against the individual defendants, who are members of Athilon's board of directors (the " Board" ). Earlier decisions in this action have dismissed some of Quadrant's claims. Quadrant's remaining counts assert that (i) the Board breached its fiduciary duties by transferring value preferentially to Athilon's controller, defendant EBF & Associates (" EBF" ), and to Athilon Structured Investment Advisors, LLC (" ASIA" ), an EBF affiliate, and (ii) the transactions constituted fraudulent transfers under the Delaware Uniform Fraudulent Transfer Act (" DUFTA" ).

The defendants have moved for summary judgment. They contend that for a creditor to have standing to maintain a derivative action, the corporation on whose behalf the creditor sues must be insolvent at the time of suit and continuously thereafter. According to them, there can be no dispute of material fact about Athilon's current solvency. They also contend that Athilon was solvent at the time of suit.

When defining solvency for purposes of their arguments, the defendants say that a plaintiff bears a greater burden to establish insolvency than the traditional balance sheet test, under which " an entity is insolvent when it has liabilities in excess of a reasonable market value of assets held." Geyer v. Ingersoll Publ'ns Co., 621 A.2d 784, 789 (Del. Ch. 1992). They say a plaintiff additionally must plead and later prove what historically has been required for a creditor to obtain the appointment of a receiver under Section 291 of the Delaware General Corporation Law (the " DGCL" ), 8 Del. C § 291, namely that the corporation has no reasonable prospect of returning to solvency.

This decision rejects the defendants' attempt to impose a continuous insolvency requirement for creditor derivative claims. To bring a derivative action, a creditor-plaintiff must plead and later prove that the corporation was insolvent at the time the suit was filed. This decision also rejects the defendants' attempt to establish irretrievable insolvency as the metric for determining when a creditor has standing to sue derivatively. To bring a derivative action, the creditor-plaintiff must plead and later prove insolvency under the traditional balance sheet or cash flow tests. See Geyer, 621 A.2d at 789.

For purposes of summary judgment, there is evidence which, when viewed in favor of the non-moving party, supports a reasonable inference that Athilon was insolvent at the time Quadrant filed suit. The defendants' motion for summary judgment on the breach of fiduciary duty claims is therefore denied.[1]

I. FACTUAL BACKGROUND

The facts are drawn from the materials submitted in connection with the defendants'

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motion for summary judgment. Rule 56 requires that the evidence be construed in favor of the non-movant, which is Quadrant. The court cannot weigh the evidence, decide among competing inferences, or make factual findings.

A. The Company

Athilon was formed before the financial crisis of 2008 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. Athilon guaranteed the credit swaps that Asset Acceptance wrote.

To fund its operations, Athilon 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 in Junior Subordinated Notes. Depending on the series, the Notes will mature in 2035, 2045, 2046, or 2047.

On the strength of its $700 million in committed capital, Athilon guaranteed more than $50 billion in credit default swaps written by Asset Acceptance. In the heady days before the financial crisis, the rating agencies gave Athilon and Asset Acceptance " AAA/Aaa" debt ratings and investment grade counterparty credit ratings.

B. Athilon Suffers Losses And EBF Sees An Opportunity.

Athilon suffered significant losses as a result of the financial crisis. It paid $48 million to unwind one credit default swap in 2008 and an addition $320 million to unwind another credit default swap in 2010. Athilon's GAAP financial statements showed a net worth of negative $513 million in 2010. As a result, Athilon and its subsidiary lost their AAA/Aaa ratings. Standard & Poor's gave the Company's Junior Subordinated Notes a credit rating of CC, indicating that default on the notes was a " virtual certainty." Athilon's securities traded at deep discounts, reflecting the widely held view that the Company was insolvent.

In 2010, EBF acquired significant portions of Athilon's debt. EBF's purchases included:

o Senior Subordinated Notes with a par value of $149.7 million, purchased for $37 million.

o Subordinated Notes with a par value of $71.4 million, purchased for $7.6 million.

o Junior Subordinated Notes with a par value of $50 million, purchased for $11.3 million, comprising the entire outstanding issuance.

EBF decided initially not to purchase Athilon's equity. Vincent Vertin, the EBF partner responsible for the investment, perceived that Athilon was insolvent and did not see any value in its stock. He wrote in June 2010, " What would I pay for this equity? Probably zero."

Later in 2010, EBF revisited this decision and decided to acquire all of Athilon's equity. The reason? Control. As an internal EBF document explained, " [e]quity ownership along with significant related party debt ownership affords the opportunity to control exit strategies, including the timing and size of any debt repayments, asset management fees and future dividends."

Using the control conferred by its status as Athilon's sole stockholder, EBF reconstituted the Board. At the time Athilon filed suit, the Board members were Vertin, Michael Sullivan, Patrick B. Gonzalez, Brandon Jundt, and J. Eric Wagoner.

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Vertin was a partner at EBF, and Sullivan was an in-house attorney for EBF. Both concentrated on EBF's investments in credit derivative product companies. Gonzalez was the CEO of Athilon. Jundt was a former employee of EBF. He and Wagoner appear at this stage to be independent directors.

C. Quadrant Sues.

Quadrant filed this derivative action on October 28, 2011. In its original complaint, Quadrant alleged that Athilon was insolvent, that its business model of writing credit default swaps had failed, and that the constitutive documents governing Athilon and Athilon Acceptance prohibited the entities from engaging in other lines of business. At the time of suit, Athilon's business consisted of a legacy portfolio of guarantees on credit default swap contracts written by Asset Acceptance that would continue to earn premiums until the last contracts expired in 2014 or shortly thereafter. Quadrant contended that given this situation, a well-motivated board of directors would maximize the Company's economic value for the benefit of its stakeholders by minimizing expenses during runoff, then liquidating the Company and returning its capital to its investors.

Quadrant alleged that instead, the Board transferred value to EBF by continuing to make interest payments on the Junior Subordinated Notes, which the Board had the authority to defer without penalty. Quadrant alleged that the Board did not exercise its authority to defer the payments because EBF owned the Junior Subordinated Notes. The Complaint also alleged that the Board transferred value from Athilon to EBF by causing the Company to pay excessive fees to ASIA, which EBF indirectly owns and controls.

Finally, Quadrant alleged that the Board changed the Company's business model to make speculative investments for the benefit of EBF. As an example of the shift in investment strategy, Athilon increased its holdings of auction rate securities in the first quarter of 2011. Athilon's assets previously consisted of mainly of cash, cash equivalents, blue-chip corporate equities, and a limited amount of illiquid auction rate securities. Athilon sold liquid securities with a par value of $25 million and purchased additional illiquid auction rate securities.

The Complaint alleged that by adopting an investment strategy that involved greater risk, albeit with the potential for greater return, the Board acted for the benefit of EBF and contrary to the interests of the Company's more senior creditors. The strategy benefited EBF because EBF owned the Company's equity and Junior Subordinated Notes, which were underwater and would not bear any incremental losses if the investment strategy failed. If the riskier investment strategy succeeded, then these securities would rise in value and EBF would capture a substantial portion of the benefit.

D. The Dismissal Ruling

The defendants moved to dismiss the Complaint, arguing among other things that Quadrant failed to comply with the 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 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.

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Quadrant appealed. Before the Delaware Supreme Court, Quadrant advanced new arguments about specific language of the no-action clauses in the Athilon notes that differed from the 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 directed this court to write a report addressing the newly raised arguments. Quadrant Structured Prods. Co. v. Vertin, 2013 WL 8858605, at *1 (Del. Feb. 12, 2013) (ORDER).

After additional briefing on remand, this court issued its report. Quadrant Structured Prods. Co. v. Vertin, 2013 WL 3233130 (Del. Ch. June 20, 2013). Based on the new arguments, the 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.

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, 106 A.3d 992 (Del. 2013). The New York Court of Appeals issued an opinion agreeing 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 as adopted by the New York Court of Appeals. As a technical matter, the Delaware Supreme Court reversed the original dismissal of the complaint. Quadrant Structured Prods. Co. v. Vertin, 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.

With the case remanded for a second time, this court evaluated the defendants' other arguments. The court held that Quadrant's complaint stated a derivative claim for breach of fiduciary duty as to the defendants' decision not to defer interest payments on the Junior Subordinated Notes and the payments of fees to ASIA, but that the complaint failed to state a claim as to the Board's adoption of a riskier business strategy. Quadrant Structured Prods. Co. v. Vertin, 102 A.3d 155 (Del. Ch. 2014). Quadrant moved for reconsideration, which the court denied. Quadrant Structured Prods. Co. v. Vertin, 2014 WL 5465535 (Del. Ch. Oct. 28, 2014).

E. The Motion For Summary Judgment

In February 2015, the defendants moved for summary judgment on the theory that Athilon had returned to solvency. Citing an unaudited balance sheet, they argued that as of December 31, 2014, on a GAAP basis, Athilon's total assets were valued at $593,909,343 and its total liabilities at $441,699,117, resulting in positive stockholder equity of $152,210,225. After the completion of ...


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