In what may become a precedential analysis of the cardinal principles of Delaware corporate and bankruptcy law, the Delaware Court of Chancery recently issued a decision in Quadrant Structured Products Co., Ltd. v. Vertin, extensively discussing the rights of an insolvent company’s creditors to pursue derivative claims against the company’s directors and provided guidance to directors of distressed companies on the fiduciary duties they owe to the corporation and its stakeholders.

As a result of the financial crisis, Athilon Capital Corp, which guaranteed credit default swaps on collateralized debt obligations, suffered severe financial distress and became insolvent. A former note holder, EBF & Associates LP, subsequently acquired all of Athilon’s equity and as a result also gained control of Athilon’s board. Following this acquisition, Quadrant Structured Products Company, a creditor and note holder of Athilon, filed a derivative lawsuit in the Delaware Court of Chancery against Athilon’s directors alleging that they had breached their fiduciary duties by adopting a high risk investment strategy for the sole benefit of EBF at the expense of Athilon’s other creditors. After the filing, Athilon structured several financial transactions with EBF, which, according to the defendants, returned Athilon to balance-sheet solvency. The directors then moved for summary judgment and argued that Quadrant could only have standing to bring a derivative lawsuit if it could show that (i) Athilon was insolvent at the time the lawsuit was commenced and continuously thereafter, and (ii) Athilon was “irretrievably insolvent,” i.e., with no reasonable prospect of returning to solvency.

Noting that the question was one of first impression under Delaware law, the court rejected continuous insolvency as a requirement for creditor standing. The court explained that a continuous insolvency requirement was ill-advised because, during the course of litigation, “a troubled firm could move back and forth across the insolvency line such that a continuing insolvency requirement would cause creditor standing to arise, disappear, and reappear again.” Further, to require continuing insolvency for creditor standing would allow conflicted directors to prevent the corporation and its creditors from pursuing valid claims by restoring the corporation back to solvency and would result in a “failure of justice.” Therefore, to have standing to sue derivatively, a creditor need only establish that a corporation was insolvent at the time the creditor filed suit; whether the corporation was continuously insolvent thereafter is irrelevant.[1] The court also rejected the more onerous “irretrievable insolvency” requirement because the great weight of Delaware authority uses the traditional “balance sheet test,” which deems an entity insolvent when it has liabilities in excess of a reasonable market value of assets. The court noted that the balance sheet test was also consistent with both the test under the Bankruptcy Code for recovery of allegedly preferential or fraudulent transfers,[2] and Delaware’s statutory standard for determining whether a Delaware corporation has a cause of action against its directors for declaring an improper dividend or improperly repurchasing stock.[3]

The ruling in Quadrant Structured Products Co., Ltd. v. Vertin should be of interest for board members whose company is already, or faces the prospect of, insolvency. Although the Delaware Court of Chancery rejected the continuous insolvency and “irretrievable insolvency” requirements, the ruling does not significantly expand derivative plaintiffs’ rights—they still may not bring direct claims to enforce fiduciary duties against an insolvent corporation, do not have a “deepening insolvency” cause of action, may only gain standing to derivatively sue the board when the corporation is insolvent rather than in the “zone of insolvency” and enjoy the broad protections of the business judgment rule. Quadrant may have removed a single arrow from the quiver of a director defending against derivative suits, but the quiver still remains full.

[1]       In reaching these conclusions, Vice Chancellor Laster elaborated on the legal principles underpinning the regime for creditor-derivative litigation in light of the Delaware Supreme Court’s 2007 decision in North American Catholic Educational Programming Foundation v. Gheewalla, 930 A.2d 92 (Del. 2007), and its progeny, namely that:

  • Creditors do not gain derivative standing when a corporation operates in a “zone of insolvency.” The corporation’s “insolvency itself” is the only factor conferring standing to creditors.
  • Regardless of the corporation’s solvency or insolvency, creditors may only bring derivative claims – as opposed to direct claims – to enforce fiduciary duties.
  • The directors of an insolvent corporation do not owe any particular duties to creditors and continue to owe fiduciary duties to the corporation for the benefit of its residual claimants, which includes creditors. Therefore, the directors (a) may continue to operate the insolvent entity and refuse to transfer or distribute all of its assets to the creditors, and (b) may exercise their good faith judgment to favor non-insider creditors over other creditors of similar priority.
  • There is no theory of “deepening insolvency” in Delaware. Directors may continue 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.

[2]       See 11 U.S.C. § 101(32)(A) (defining insolvency as a “financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at a fair valuation, exclusive of–(i) property transferred, concealed, or removed with intent to hinder, delay, or defraud such entity’s creditors; and (ii) property that may be exempted from property of the estate under section 522 of [the Bankruptcy Code].”).

[3]       See 8 Del. C. § 160(a)(1); SV Inv. P’rs, LLC v. ThoughtWorks, Inc., 7 A.3d 973, 982 (Del. Ch. 2010) (“[T]he [net assets] test operates roughly to prohibit distributions to stockholders that would render the company balance-sheet insolvent, but instead of using insolvency as the cut-off, the line is drawn at the amount of the corporation’s capital.”), aff’d, 37 A.3d 205 (Del. 2011).

In 2009, Judge Allan L. Gropper of the U.S. Bankruptcy Court for the Southern District of New York issued several remarkable rulings in the bankruptcy In re GGP Properties, Inc.[1](“GGP”).  Participants in structured credit markets initially expressed their “grave concern” regarding the potential “catastrophic impact” of the GGP rulings.[2]  While the ultimate effects of the rulings remain unsettled, they do demand that lenders reconsider the limits of protection manufactured through the use of “bankruptcy-remote” special purpose entities in structured-financing transactions.


Borrowers regularly use special purpose entities (“SPEs”) to increase access to structured credit markets.  The advantages of financing through an SPE are built into the operating documents, which typically include separateness covenants and limited recourse provisions that seek to make the SPE “bankruptcy-remote” to protect lenders from becoming entangled in insolvency proceedings in separate areas of an SPE’s Company.

GGP was a publicly-held shopping mall owner, and the second-largest mall operator in the United States.  Most of its real estate properties were held by individual SPE subsidiaries, who directly owed the debt for financing agreements on the properties but in a structure that kept the assets separate from credit risk elsewhere in the Company.  This enabled lenders to have their loans secured by the relatively predictable cash flows from specific real estate assets.

GGP had historically satisfied its capital funding needs through commercial mortgages, relying on the market for commercial mortgage-backed securities (“CMBS”).  GGP’s debt was typically secured by SPE-owned shopping center properties.  GGP’s CMBS funding model impelled it to regularly refinance SPE-held debt before exploding repayments scheduled near maturity became due.

Notable Rulings

Judge Gropper made two critical rulings that immediately reverberated across the credit markets: first, that the well-capitalized, solvent SPEs were included in GGP’s voluntary bankruptcy filing, and second, that GGP’s debtor-in-possession (“DIP”) financing facility could be secured by excess rents generated by the SPE subsidiaries.  Collectively, these rulings undermined the previously assumed effectiveness of SPEs’ structure to isolate its assets from affiliated entities.[3]

Although the GGP rulings addressed credit in the CMBS market, the implications of the rulings cast doubt on what were thought to be sacrosanct arrangements in structured financing markets more generally.  A more recent decision by the Seventh Circuit demonstrates that GGP is not an isolated instance of judicial skepticism of SPEs.  In Paloian v. LaSalle Bank, N.A., (“Paloian”), the Seventh Circuit reminded lenders that an SPE cannot be insulated from other creditors unless the SPE conducts bona fide business transactions with the debtor (such as a “true sale”), manages the assets it holds in its own interest rather than the debtor’s, and observes proper corporate formalities such as maintaining offices, phone numbers, e-mails, and bank accounts, preparing financial statements, and filing tax returns.[4]  Following these rulings, the extent of SPEs’ ability to isolate assets and limit risk for lenders remains uncertain.  The GGP rulings indicate that enhanced structures and other mechanisms may be needed to protect lenders from the risk posed by insolvency in an SPE’s affiliated Company.

Practical Implications for Lenders

Despite the GGP and Seventh Circuit rulings that call into question bankruptcy-remote entities’ separateness, an SPE’s organizational and financing documents remain the most effective tools for isolating assets from an affiliated company’s bankruptcy.

Lenders should seek provisions in a special purpose borrower’s operating agreement that:

  1. Require independent directors, mandated to consider only the interests of the borrower and its creditors when considering bankruptcy filings, to the extent permitted under applicable law;
  2. Demand notice prior to a borrower’s dismissal or replacement of independent directors.  Notice would potentially allow lenders to seek further protections prior to an SPE’s bankruptcy filing and encourage consensual refinancing or restructuring of a borrower’s debt out of court; and
  3. Ensure adherence to corporate formalities.[5]

Further, the creditworthiness and default risk of an SPE’s sponsoring and affiliated Company is a factor that needs to be carefully scrutinized.  For example, a group that may face maturing debt concomitantly or who operates through a highly-leveraged capital structure should signal a potential need for additional guarantees or credit facilities.  Risky group-level debt structures indicate susceptibility to liquidity crunches and a group’s potential to upstream and pool SPEs’ cash flows when troubled.   Last, the operating agreement or loan documents should declare the governing law, both for establishing the SPE-transferee’s independence and for determining the presence of a “true sale.”

[1].      In re Gen. Growth Props., Inc., 409 B.R. 43 (Bankr. S.D.N.Y. 2009).

[2].      Amended Brief of Amici Curiae With Respect to the Filing of Voluntary Petitions in Bankruptcy by the Individual Property Owner Subsidiaries in the GGP Properties, Inc. Bankruptcy, Brief for Commercial Mortgage Securities Association and Mortgage Bankers Association, (“CMSA Amici Brief”), In re Gen. Growth Props, Inc., Case No. 09-11977 (ALG) (Bankr. S.D.N.Y. May 1, 2009), ECF No. 289, at 3.

[3].      Key determinations included:

  1. The bankruptcy court approved GGP’s DIP financing facility, secured by excess rents from SPE subsidiaries.  The court held that the SPE structure did not preclude up-streaming excess cash for the benefit of the GGP group.
  2. The court denied several motions to dismiss SPE-debtors’ voluntary bankruptcy filings for cause pursuant to § 1112(b) of the Bankruptcy Code.  Judge Gropper denied movants’ arguments that the SPEs’ filings were improper and in bad faith.  He predicated approval of the SPEs’ filings on aspects of (i) GGP’s course of funding and market conditions, (ii) boards’ duties under applicable law and (iii) provisions of the SPEs’ operating agreements, themselves.
  3. The court did not question the legal separateness of the SPEs and refused to substantively consolidate the SPEs’ bankruptcy estates with those of other affiliates or GGP.  In re GGP, 409 B.R. at 69 (“Nothing in this Opinion implies that the assets and liabilities of any of the Subject Debtors could properly be substantively consolidated with those of any other entity.”).

[4]       619 F.3d 688 (7th Cir. 2010).

[5].      The Seventh Circuit’s remand opinion in Paloian provides guidance regarding which corporate formalities lenders should include in formal documents.  See Paloian, 619 F.3d at 696 (listing attributes of separateness the court found lacking in the SPE’s operations); see also Samantha Rothman, Lessons from General Growth Properties: The Future of the Special Purpose Entity, 17 Fordham J. Corp. & Fin. L. 227, 257 (2012) (listing several corporate governance provisions to ensure an SPE abides by corporate formalities).