Delaware Chancery Court Denies Creditor Plaintiff’s Breach of Fiduciary Duty, Fraudulent Transfer, and Breach of Covenant Claims

By Scott Waxman and Dotun Obadina

In Quadrant Structured Products Company v. Vertin, plaintiff creditor Quadrant Structured Products Company, Ltd. (“Quadrant”) asserted claims against defendant Athilon Capital Corporation (“Athilon” or the “Company”), challenging transactions made by Athilon in which Athilon purchased securities and notes from Merced Capital, L.P. and its affiliates (together, “Merced”), owners of 100% of the Athilon’s equity and significant amounts of Athilon’s publicly-traded junior and senior notes.[1]  Quadrant contended at trial that the repurchase of Merced’s notes breached express covenants in the indenture governing the notes and also violated the implied covenant of good faith and fair dealing.  Quadrant also contended that the repurchases of the notes constituted a fraudulent transfer.  Finally, relying on its status as a creditor of an insolvent company, Quadrant claimed derivatively that the repurchases of the notes and securities constituted breaches of fiduciary duty by Merced and the individual defendants, who comprised Athilon’s board of directors.  The court rejected all of Quadrant’s claims.

Athilon was formed in 2004 to be in the business of writing credit default swaps on senior tranches of uncollateralized debt obligations.  To finance its operations, Athilon raised $600 million in long term debt, $350 million of Senior Notes, $200 million of Mezz Notes, and $50 million of Junior Notes (collectively, the “Notes”).  All of the Notes were issued pursuant to and are governed by indentures.

The Company’s certificate of incorporation incorporated rating agency-approved operating guidelines (the “Operating Guidelines”), which provide that, upon the occurrence of certain events described as “Suspension Events,” Athilon no longer could write new swaps until the Suspension Event was cured and, if the Suspension Event continued for more than six months, the ban on writing swaps became permanent and Athilon was required to run-off its existing swaps as they matured.  In late 2008, the market for uncollateralized swaps vanished, and Athilon lost its triple-A rating, which was considered a Suspension Event.  By June of 2009, the ban on writing swaps became permanent and Athilon entered the required run-off of the existing swaps and became insolvent.

In 2009 and 2010, Merced purchased, at a steep discount, substantial amounts of Senior, Mezz and Junior Notes of Athilon and 100% of the equity of Athilon.  In early 2011, plaintiff Quadrant also purchased Senior Notes and Mezz Notes at a steep discount.

In October of 2011, Quadrant filed suit against Merced and its directors, seeking to compel Athilon to liquidate and distribute its cash.  Quadrant contended that Athilon, per the terms of its certificate of incorporation, could only engage in the defunct business of writing uncollateralized credit default swaps.  Because that business was no longer viable, Quadrant contended that Athilon had to sit on its cash until its last swap rolled off, at which point, the Company would be required to liquidate.  Quadrant also continued to press fraudulent transfer and breach of fiduciary duty claims challenging transactions between Athilon and Merced, including Athilon’s payments of allegedly excessive service and licensing fees to an affiliate of Merced and Athilon’s failure to defer the payment of interest on the Junior Notes, which were held by Merced. These claims have since been dismissed by the court or mooted by Merced.

During the litigation, Quadrant learned about purchases of certain securities and Notes by Athilon from Merced and filed a supplemental complaint challenging those transactions.  From 2011 through 2013, Merced sold nearly $300 million in par value of insurance-linked securities to Athilon (the “Ins. Securities”).  In December of 2014, Athilon became solvent, as evidenced by its audited financial statements showing GAAP solvency.  Following the determination of solvency by the Board, Athilon purchased $179 million of Senior Notes with a par value of $194.6 million, paying 92% of par (the “January 2015 Repurchase”).  In March of 2015, Quadrant learned about Athilon’s purchase of the Ins. Securities and the January 2015 Repurchase and promptly filed a supplemental complaint, challenging those transactions.   In the supplemental complaint, Quadrant sued derivatively, as a creditor plaintiff, for breach of fiduciary duty and contended that Athilon and Merced made fraudulent transfers.  Quadrant also brought direct claims premised on an alleged violation of the senior indenture governing the Senior Notes.

Challenge to January 2015 Repurchase Under the Senior Indenture
Quadrant asserted that by engaging in the January 2015 Repurchase, Athilon violated the express terms of the Senior Indenture and the implied covenant of good faith and fair dealing inherent in the Senior Indenture. The Senior Indenture is governed by, and was analyzed by the court under, New York law.  Regarding Quadrant’s claim that Athilon violated the express terms of the Senior Indenture, the court found that the January 2015 Repurchase did not violate the express terms of the Senior Indenture as it was not prohibited under the terms of the Senior Indenture (i.e., it was not considered a restricted redemption to an affiliate under the terms and conditions of the Senior Indenture).  With respect to the assertion that Athilon violated the implied covenant of good faith and fair dealing inherent in the Senior Indenture, the court found that Quadrant’s proposed term to be read into the Senior Indenture, that “with no business left to pursue, Athilon will return capital to its stakeholders, and will not return capital only to its insiders,” was inconsistent with terms expressly set forth in the indenture because (a) nothing in the Senior Indenture requires the Company to redeem the Senior Notes prior to their maturity and (b) so long as it obtained certain approvals, Athilon was permitted to expand its business and continue operating after winding down its swap book.

Challenges to the January 2015 Repurchase As a Fraudulent Transfer
Quadrant also asserted that the January 2015 Repurchase constituted a fraudulent transfer under Delaware’s version of the Uniform Fraudulent Transfer Act.  Quadrant challenged the January 2015 Repurchase as both an intentionally fraudulent transfer and a constructively fraudulent transfer.  A transaction only can be constructively fraudulent if the debtor was insolvent at the time or became insolvent as a result of the transaction.  The court found that the January 2015 Repurchase could not have been a constructively fraudulent transfer because Athilon returned to solvency at least by July 2014.  The court also found that the January 2015 Repurchase was not an intentionally fraudulent transfer because Athilon intended to comply with its obligations to its creditors and to meet its obligations under the Senior Indenture and the January 2015 Repurchase was not actually intended to hinder, delay, or defraud any creditor.

Challenges to the January 2015 Repurchase and the Purchases of the Ins. Securities as Breaches of Fiduciary Duty
Lastly, Quadrant asserted that the January 2015 Repurchase and the purchases of Ins. Securities were breaches of fiduciary duty, suing derivatively on behalf of Athilon as a creditor plaintiff.  To maintain a derivative claim, a creditor plaintiff must plead and later prove that the corporation was insolvent at the time suit was filed; however, a supplement to a pleading can relate back to the date of the original pleading when the claim arose out of the conduct or transaction or occurrence set forth in the original pleading.   The court found that Quadrant did not raise specific breach of fiduciary duty challenges to the January 2015 Repurchase or the purchases of the Ins. Securities until April 14, 2015, when Quadrant filed the supplemental Complaint, and at that point, Athilon was solvent.  The court also found that the supplemental complaint does not relate back to Quadrant’s original 2012 complaint, which was filed at a time when Athilon was insolvent, as the purchases of the Ins. Securities and the January 2015 Repurchase took place after the original complaint was filed and involved different facts and different wrongs.  Because of these facts, Quadrant lacked standing to assert its breach of fiduciary duty claims.

In sum, the court held that Athilon did not violate the express or implicit terms of the Senior Indenture, the defendants did not engage in fraudulent transfers, and Quadrant cannot pursue its remaining claims for breach of fiduciary duty.

[1] Merced formerly was known as EBF & Associates, L.P., and earlier decisions (and our earlier posts) regarding this litigation refer to Merced by that name.


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