Delaware law regarding creditors’ abilities to bring successful breach of fiduciary duty claims has evolved significantly over the past 15 years — from creditors once being able to assert direct claims to now being able only to assert derivative claims on behalf of all creditors in “rare” circumstances.
In a recent Delaware Chancery Court opinion, Vice Chancellor J. Travis Laster held that lenders — particularly sophisticated financial institutions — must look to the enforcement of their contractual rights with borrowers as their predominant (if not sole) remedy and source of collection. The evolving law in this area should influence the way lenders address distressed credit situations. Lenders who previously might have been cautious about taking aggressive actions to enforce their contractual remedies might fairly take a cue from the recent trends in the case law — trends suggesting aggressive policing of rights and remedies in loan agreements is the expected first response course of action.
This article first examines the history of Delaware fiduciary duty law and then discusses the most recent developments in Delaware in Quadrant Structured Products Co. v. Vertin, C.A. No. 6990-VCL, 2015 WL 6157759 (Del. Ch. Oct. 20, 2015) (Quadrant II). Finally, the article analyzes the Quadrant II decision and suggests how lenders might approach their recovery efforts after defaults by their borrowers who are insolvent or nearly insolvent.
Before 2007, practitioners generally believed that directors of a Delaware corporation owed fiduciary duties to the corporation’s creditors beginning when the corporation entered the “zone of insolvency.”1 Because those duties were owed directly to creditors, a creditor could potentially bring a direct action against corporate directors for breach of fiduciary duty.2 The duties owed to creditors included an obligation to manage the corporation conservatively as a trust fund for the creditors’ benefit.3 Additionally, directors could be held liable for continuing to operate an insolvent entity and incurring greater losses for creditors under a theory called “deepening insolvency.”4
Yet, the law remained unsettled. First, the theory that a director owed fiduciary duties to creditors once the corporation entered the “zone of insolvency” had never been addressed by the Delaware Supreme Court.5 Second, given that directors continued to owe traditional fiduciary duties to the corporation, inherent conflicts arose between the directors’ various obligations.6 To provide clarity, the Supreme Court of Delaware addressed these questions in 2007 in North American Catholic Educational Programming Foundation, Inc. v. Gheewalla.
In Gheewalla, the court rejected the notion that directors owed fiduciary duties directly to creditors at any point, recognizing the “general rule” that “directors do not owe creditors duties beyond the relevant contractual terms.”7 Rather, the court held, a creditor only acquires rights to enforce a director’s fiduciary duties through a derivative action on behalf of all creditors when the corporation is insolvent.8 Because directors of Delaware corporations owe fiduciary duties of care and loyalty to the corporation, creditors could only sue derivatively “over acts of self-dealing and other examples of self-interested or bad-faith conduct.”9
Post-Gheewalla, Delaware courts have continued to offer guidance on these issues.10 First, directors do not have an inherent duty to shut down an insolvent firm and marshal its assets for distribution to creditors.11 Second, directors can, as a matter of business judgment, favor certain non-insider creditors over others of similar priority. Third, directors cannot be held liable for continuing to operate an insolvent entity in the good faith belief that they may achieve profitability, even if their decisions ultimately lead to greater losses for creditors. Finally, when directors of an insolvent corporation make decisions affecting lenders/creditors differently only due to their relative priority in the capital stack, directors do not face a conflict of interest simply because they own common stock or owe duties to large common stockholders.12
Against this backdrop, the Delaware Chancery Court in Quadrant II further limited lenders’ derivative standing to the point that their only source of recovery may be through enforcing their contractual rights with the borrower. In that case, Merced Capital acquired Athilon Capital Corporation—which wrote uncollateralized credit default swaps on senior tranches of collateralized debt obligations—during a period when Athilon had become insolvent following the 2008 financial crisis.13
Between 2004 and 2007 Athilon issued a series of notes, including two series of subordinated deferrable interest notes (mezz notes) and senior subordinated deferrable interest notes (senior notes).14 In early 2011, Quadrant Structured Products Company, Ltd. purchased senior notes and mezz notes. Merced, however, did not liquidate Athilon after the last swap matured; rather, Merced continued operating Athilon and restored it to solvency by the end of 2013.15 Thereafter, Quadrant filed suit against Athilon, Merced, and others, alleging claims for breach of fiduciary duty (brought derivatively under the theory that Athilon was insolvent), fraudulent transfer, and breach of the implied covenant of good faith and fair dealing.16
Based on the post-Gheewalla trend of Delaware cases limiting noncontractual remedies available to creditors, the court offered future litigants a road map: “A creditor’s principal source of protection is its agreement with its debtor…. A creditor should look next to statutory remedies designed for the benefit of creditors,” such as fraudulent transfer law, and finally, to “derivative claims for fiduciary duty.”17 Because Athilon was solvent when Quadrant raised the breach of fiduciary duty claim, the court held Quadrant lacked standing to sue on that issue.18
Nevertheless, the court warned lenders in future cases to not rely on such claims for recovery. “Deploying fiduciary duties to protect creditors,” the court stated, “should be a final resort, not a first response.”19 Citing the “panoply of remedies”20 available to creditors, the court cautioned that “when creditors are unable to prove that a corporation or its directors breached any of the specific legal duties owed to them, one would think that the conceptual room for concluding that the creditors were somehow, nevertheless, injured by inequitable conduct would be extremely small, if extant.”21 Thus, the court emphasized that recovery under equitable theories should be rare for lenders.
Having firmly established that negotiated contractual provisions are a creditor’s “primary source” of protection, the court rejected Quadrant’s allegation that Athilon’s repurchase of senior notes from Merced constituted a breach of the express contractual terms or an implied covenant of good faith and fair dealing. Finding that no provision of the applicable indenture restricted Athilon’s use of capital or required a mandatory redemption before the stated maturity dates, the court rejected Quadrant’s arguments, emphasizing that Quadrant’s other claims “should be taken with an extra grain of salt.”22
Clearly, under the current legal landscape in Delaware, lenders cannot look to fiduciary duty law as a reliable basis to protect their investments. Instead, they must look, almost exclusively, to enforcing the contractual rights and remedies contained in their loan documents. Logically, then, the same Delaware courts that have limited creditor fiduciary duty rights should give a similarly poor reception to claims by borrowers or other parties seeking to impose “lender liability” on lenders that aggressively pursue their contract rights.
Like most states, Delaware implies a duty of good faith and fair dealing in all contracts. In Delaware, evolving case law suggests that the implied covenant should be narrowly construed.23 For example, “the implied covenant ‘cannot properly be applied to give the plaintiffs contractual protections that they failed to secure for themselves.’”24 As one Delaware court summarized:
“Fair dealing” is not akin to the fair process component of entire fairness, i.e., whether the fiduciary acted fairly when engaging in the challenged transaction as measured by duties of loyalty and care. . . . It is rather a commitment to deal “fairly” in the sense of consistently with the terms of the parties’ agreement and its purpose. Likewise, “good faith” does not envision loyalty to the contractual counterparty, but rather faithfulness to the scope, purpose, and terms of the parties’ contract. Both necessarily turn on the contract itself and what the parties would have agreed upon had the issue arisen when they were bargaining originally.25
Fundamentally, the covenant is not intended to “appease a party who later wishes to rewrite a contract he now believes to have been a bad deal”26 or serve as a “catch-all that can be used to prevent any injustice.”27
Although perhaps not by design, these implied covenant decisions are consistent with the reasoning of Quadrant II. One would hope (if not expect) that additional restrictions on lenders’ rights to assert breach of fiduciary duty claims should engender similar restrictions on borrowers/debtors arguing that lenders have breached an implied covenant of good faith and fair dealing by aggressively pursuing their contractual rights.
Given these trends in the case law, how should lenders proceed when one of their borrowers is insolvent, is in distress, or has defaulted under its loan? The old wisdom of applying restraint in the exercise of remedies may no longer be warranted. And, given that lenders cannot expect to find recourse through breach of fiduciary duty claims against borrowers’ officers or directors, an aggressive pursuit of contractual rights and remedies is all the more justified.
Stated differently, the standard dance frequently engaged in by borrowers and lenders is outdated. The customary “breach of fiduciary duty” letter an agent lender’s counsel often sends to borrower’s counsel in the midst of restructuring negotiations rings hollow under current precedent. Similarly hollow is the typical threat of “lender liability” that a borrower’s counsel raises when the lender raises the specter of “enforcing remedies.” And it all makes sense, if we are appropriately taking our cues from recent Delaware precedent. Lenders should not rely on their borrower’s directors and officers to protect creditor interests, and borrowers should not expect lenders to treat them with any restraint. In other words, it is every man/woman/ lender/borrower for themselves.
As Quadrant II teaches, lenders’ primary remedy is to enforce their contractual rights — whether against a distressed borrower or a guarantor. Lenders should discount any statutory forms of recovery and, particularly, should disregard potential recovery on an alleged breach of fiduciary duty claim. Similarly, Delaware courts have recently begun narrowing parties’ ability to recover on account of breaches of an implied covenant of good faith and fair dealing. In light of these developments, lenders should feel more comfortable in aggressively pursuing and enforcing their contractual rights.