Court Opinion

ID: 2745955
Source: CourtListenerOpinion
Date Created: 2014-10-28 14:02:30.854759+00
Date Added: 2024-06-11T12:12:19.708555
License: Public Domain

IN THE COURT OF CHANCERY OF THE STATE OF DELAWARE

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

Plaintiffs,
V53-

)
)
)
)
)
)
)
) CA. No. 6990-VCL
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.

MEMORANDUM OPINION

Date Submitted: October 15, 2014
Date Decided: October 28, 2014

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 Plaintijf 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, Atnilon 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. -

 

Plaintiff Quadrant Structured Products Company, Ltd. (“Quadrant”) owns debt
securities issued by defendant Athilon Capital Corp. (“Athilon”). Quadrant alleges that
Athilon is insolvent, which gives Quadrant standing to sue derivatively. Quadrant
contends that the individual defendants, who are members of Athilon’s board of directors
(the “Board”), have breached their ﬁduciary duties by seeking in various ways to beneﬁt
Athilon’s controller, defendant EBF & Associates (“EBF”).

Importantly for present purposes, Quadrant contends that the Board has sought to
beneﬁt EBF by investing Athilon’s assets in riskier securities. EBF owns all of Athilon’s
equity and junior notes, which Quadrant alleges are currently underwater and would not
receive anything in an orderly liquidation. If the risk-on strategy succeeds, the securities
that EBF owns will become valuable. If the strategy fails, more senior creditors like
Quadrant will suffer the loss. Quadrant contends that because two of the members of the
Board are agents of EBF and a third is not independent of EBF, a majority of the ﬁve
member Board was interested in the decision to favor EBF such that the defendants must
prove that the change in investment strategy was entirely fair. This argument presents a
case-speciﬁc version of the general theory that a director who holds a material amount of
common stock, or who wears two hats as a ﬁduciary for the corporation and for a large
common stockholder, faces a conﬂict of interest when the corporation becomes insolvent.
The conﬂict arises because the class of residual risk bearers expands to include creditors,
and the directors must decide between two groups—creditors and stockholders—whose

inherently different risk preferences give them inherently different interests, at a time

 

 

In its motion, Quadrant argues that investing in riskier assets is not rationally
designed to increase the value of the ﬁrm, even if the riskier assets may yield a higher
return. Quadrant offers the elementary observation that “[t]he possibility of a higher
return must be discounted for the riskier asset proﬁle and by the costs that will be
incurred in continuing the investment function.” Dkt. 129 at 6-7. While that is true, it
does not mean that investing in riskier assets is not rationally designed to increase the
value of the ﬁrm. Risk is a double-edged sword, offering the potential for greater return
but with an increased possibility of loss. Directors, not courts, are charged with weighing
the costs and beneﬁts of risk and making a decision about how much risk the ﬁrm should
assume. See In re Citigroup Inc. S ’holders Deriv. Litig, 964 A.2d 106, 131 (Del. 
2009). Taking on increased risk was one rational business strategy for Athilon. The
decision may turn out poorly, or it may increase the value of the entity. The Board’s
decision to increase the risk proﬁle of Athilon’s investment portfolio was not so far
beyond the bounds of judgment that it supports an inference of bad faith.

Pointing out that the Board amended the Operating Guidelines to authorize greater
risk did not alter the analysis. That step was consistent with and necessary to facilitate the
Board’s risk-on strategy. It did not add sufﬁcient weight to the allegations to rebut the

presumption of good faith conferred by the business judgment rule. The court did not

 

 

 

the substance of a business decision made by an apparently well motivated board for the
limited purpose of assessing whether that decision is so far beyond the bounds of
reasonable judgment that it seems essentially inexplicable on any ground other than bad
faith”) (emphasis in original).

10

 

misapprehend the allegations Quadrant made in an effort to rebut the business judgment
rule, so Quadrant’s second argument does not provide grounds for reconsideration either.
Quadrant closes its motion by asking that if the Rule 59(e) motion is denied, then
the Rule 12(b)(6) Opinion be modiﬁed to specify that the dismissal is without prejudice.
Quadrant posits that discovery may uncover evidence which will permit Quadrant to
plead a claim sounding in bad faith. Under Rule 15(aaa), the dismissal is with prejudice.

The Rule 12(b)(6) Opinion, however, is an interlocutory ruling. See Siegman v. Columbia

Pictures Entm't, Inc., 1993 WL 10969, at *3 (Del. Ch. Jan. 15, 1993) (“Preju'dgment 

orders remain interlocutory and can be reconsidered at any time, but efﬁcient disposition
of the case demands that each stage of the litigation build on the last, and not afford an
opportunity to reargue every previous ruling.” (quoting 1B MOORE'S FEDERAL PRACTICE
11 0.404[1], at 117—18 (1992)). Subject to the law of the case doctrine, it can be revisited
should future developments, including evidence generated by the discovery process,
provide a compelling reason for doing so. See Zirn v. VLI Corp, 1994 WL 548938, at *2
(Del. Ch. Sept. 23, 1994) (Allen, C.) (“Once a matter has been addressed in a
procedurally appropriate way by a court, it is generally held to be the law of that case and
will not be disturbed by that court unless compelling reason to do so appears”)...
Quadrant has not carried its burden of demonstrating that the court overlooked a
principle of law that would have controlling effect or misapprehended the law or the facts

so that the outcome of the decision would be affected. The Rule 59(e) motion is denied.E

11

 

when both groups can claim legitimately to be the proper subject of the director’s
decisional ministrations.

In an opinion dated October 1, 2014, this court dismissed the challenge to the
Board’s risk-on business strategy. Quadrant Structured Prods Co. v. Vertin, 2014 WL
5099428 (Del. Ch. Oct. 1, 2104) (the “Rule 12(b)(6) Opinion”). The Rule 12(b)(6)
Opinion analyzed Quadrant’s argument and reviewed pertinent case law, including
Shandler V. BL] Merchant Banking, Inc., 2010 WL 2929654 (Del. Ch. July 26, 2010)
(Strine, V.C.); T renwick Am. Litig. Trust v. Ernst & Young, L.L.P., 906 A.2d 168 (Del.
Ch. 2006) (Strine, V.C.), aﬂ'd sub nom. T renwick Am. Litig. Trust v. Billett, 931 A.2d 438
(Del. 2007) (TABLE), and Production Resources Group, LL. C. v. NCT Group, Inc, 863
A.2d 772 (Del. Ch. 2004) (Strine, V.C.). These decisions recognized the conﬂict on
which Quadrant grounds its argument. For example, in Production Resources, Chief
Justice Strine, then a Vice Chancellor, noted that

[b]ecause creditors have no interest beyond the debts owed to them, they

have no incentive (and much to risk) by encouraging business strategies

that would risk the payment of the bulk of their claims but provide some

hope that the ﬁrm's value will increase to the level at which there could be a
return for the equity.

863 A.2d at 790 n.57; see Credit Lyonnais Bank Nederland, N.V. v. Pathe Commc’ns
Corp, 1991 WL 277613, at *34 n.55 (Del. Ch. Dec. 30, 1991) (describing divergence of
interests). Opinions such as Shandler, T renwick, and Production Resources nevertheless
spoke of the business judgment rule as providing the operative standard of review for

decisions made by the board of an insolvent corporation that would help or hurt the ﬁrm

as a whole. Rule 12(b)(6) Op., 2014 WL 5099428, at *20-25. From these cases, the Rule

12(b)(6) Opinion derived the principle that “when directors make decisions that appear
rationally designed to increase the value of the ﬁrm as a whole, Delaware courts do not
speculate about whether those decisions might beneﬁt some residual claimants more than
others.” Id. at *21._._

Based on this principle, the Rule 12(b)(6) Opinion held that an allegedly risky
shift is not sufﬁcient to elevate the standard of review from the business judgment rule to
entire fairness when a plaintiff challenges a business decision that will increase or
decrease the value of the entity as a whole, as opposed a decision that transfers value to a
particular person or class of security holders. Other than the potentially favorable
implications of the risk-on strategy for the junior tranches of the capital stack owned by
EBF, Quadrant’s complaint did not identify a basis for rebutting the presumptions of the
business-judgment rule. When evaluated under the business judgment rule, the allegations
of the complaint did not raise a reasonably conceivable inference that the Board’s
decision to take on additional risk was so extreme as to be irrational and suggestive of
bad faith. Consequently, the Rule 12(b)(6) Opinion dismissed the risk-on claim.

Quadrant has moved for reconsideration of the dismissal. Rule 59(e) provides that
“[a] motion for reargument setting forth brieﬂy and distinctively the grounds therefor
may be served and ﬁled within 5 days after the ﬁling of the Court’s opinion or the receipt
of the Court’s decision.” Ch. Ct. R. 59(f). The moving party bears the burden of
demonstrating that the court “overlooked a decision or principle of law that would have

controlling effect” or “misapprehended the law or the facts so that the outcome of the

decision would be affected.” Miles, Inc. v. Cookson Am, Inc, 677 A.2d 505, 506 (Del.

Ch. 1995) (quoting Stein v. Orloﬁ: 1985 WL 21136, at *2 (Del. Ch. 1985)). A Rule 59(f)
motion is “not a mechanism for litigants to relitigate claims already considered by the
court.” Fisk Ventures, LLC v. Segal, 2008 WL 2721743, at *1 (Del. Ch. July 3, 2008),
aﬂ’d, 984 A.2d 124 (Del. 2009) (TABLE) (quoting Am. Legacy Found. v. Lorillarcg'
Tobacco Co., 895 A.2d 874, 877 (Del. Ch. 2005)). I.

In its motion for reconsideration, Quadrant argues that the Rule 12(b)(6) Opinion
overlooked or misapprehended the implications of restrictions on Athilon’s business
imposed by Athilon’s certiﬁcate of incorporation (the “Athilon Charter”). Under the
Athilon Charter, Athilon only can engage in the limited business of guaranteeing credit
default swaps written by its wholly owned subsidiary, Athilon Asset Acceptance Corp.
(“Asset Acceptance”). Since the ﬁnancial crisis of 2008, that business has no longer been
viable. Asset Acceptance has not written any new swaps, and Athilon has not written any
new guarantees. At present, Athilon’s business consists of two legacy portfolios. On the
liability side, Athilon has a portfolio of guarantees for swaps that will continue to earn
premiums until the last contracts expire in 2014 or shortly thereafter. On the asset side,
Athilon has a portfolio of investments in securities intended to provide funds to pay off
any guarantees that come due.

The Athilon Charter requires that Athilon conduct its business in compliance with
certain operating guidelines approved by the credit rating agencies (the “Operating

Guidelines”). The Operating Guidelines historically restricted Athilon to investing in

 short-term, low—risk securities, such as US. government and agency securities, certain

Euro—dollar deposits, bankers’ acceptances, commercial paper, repurchase transactions,

uumll-r4w-hW-Im.'uwn—.vv,.-.vmamyawmrlﬁaauu . _.

money market funds, and money market notes with high short—term ratings. In May 2011,
as part of implementing its risk-on strategy, the Board sought permission from the rating
agencies to amend the Operating Guidelines to loosen the investment restrictions and
expand its permitted investments. The rating agencies signed off, recognizing that the
amendments would not cause a downgrade in Athilon’s already bathic 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.

Based on these allegations, Quadrant’s Rule 59(e) motion makes two arguments.
First, Quadrant seeks to distinguish a limited purpose company from a general business
corporation. Quadrant argues that

[t]he question presented in this case is whether the directors of a limited

purpose company, whose sole purpose is entirely impossible, may seek

unilaterally to expand the Company’s purpose to engage in new business

activity previously prohibited by its Certiﬁcate of Incorporation and to

materially increase the risk proﬁle, when doing so would place risk only on

the creditors and beneﬁt only the out-of-the-money equity held entirely by

the defendants and their afﬁliates . . . . Plaintiff’s claim is, simply, that once

there is no operating business, the duty of loyalty to the enterprise itself is

breached by permitting interested directors to use their control over the

enterprise to deploy its assets for a different purpose, and to convert balance

sheet assets to riskier assets for the beneﬁt of the directors and their
afﬁliates . . . .

Okt. 129 at 3-4.3.

The Rule 12(b)(6) Opinion did not overlook or misapprehend this aspect of
Quadrant’s claim. This aspect of Quadrant’s motion highlight the difference between (i) a
claim for breach of the entity-speciﬁc contract that binds the corporation, its decision-

makers, and its stockholders, and (ii) a claim that implicates the context-speciﬁc ﬁduciary

 

 

duties owed by the corporation’s decision-makers when exercising their authority. As the
corporate scholar and statesman Adolf A. Berle explained,

in every case, corporate action must be twice tested: ﬁrst, by the technical
rules having to do with the existence and proper exercise of the power;
second, by equitable rules somewhat analogous to those which apply in
favor of a cestui que trust to the trustee's exercise of wide powers granted to
him in the instrument making him a ﬁduciary.

Adolf A. Berle, Corporate Powers As Powers In Trust, 44 Harv. L. Rev. 1049, 1049
(1931). Delaware law adheres to the twice-testing principle.1'

When evaluating corporate action for legal compliance, a court examines whether
the action contravenes the hierarchical components of the entity-specific corporate
contract, comprising (i) the Delaware General Corporation Law, (ii) the corporation’s
charter, (iii) its bylaws, and (iv) other entity-speciﬁc contractual agreements, such as a
stock option plan, other equity compensation plan, or, as to the parties to it, a stockholder

agreement.2 If the risk-on business strategy had violated the Athilon Charter, then

. 1 Sample v. Morgan, 914 A.2d 647, 673 (Del. Ch. 2007) (Strine, V.C.) (explaining
that corporate acts are “‘twice-tested’—once by the law and again by equity”); accord
Carsanaro v. Bloodhound T echs., Inc., 65 A.3d 618, 641 (Del. Ch. 2013) (“Corporate
acts are ‘twice-tested,’ once for statutory compliance and again in equity”); see Reis v.
Hazelett Strip-Casting Corp, 28 A.3d 442, 457 (Del. Ch. 2011) (“A reviewing court's
role is to ensure that the corporation complied with the statute and acted in accordance
with its fiduciary duties”).

2 See Boilermakers Local 154 Ret. Fund v. Chevron Corp, 73 A.3d 934, 940 (Del.
Ch. 2013) (“[O]ur Supreme Court has long noted that bylaws, together with the
certiﬁcate of incorporation and the broader DGCL, form part of a ﬂexible contract
between corporations and stockholders”); accord Airgas, Inc. v. Air Prods. & Chems.,
Inc., 8 A.3d 1182, 1188 (Del. 2010) (“Corporate charters and bylaws are contracts among
a corporation's shareholders . . . .”); STAAR Surgical Co. v. Waggoner, 588 A.2d 1130,
1136 (Del. 1991) (“[A] corporate charter is both a contract between the State and the

 

 

Quadrant would have stated a claim under Professor Berle’s legally oriented test.3
Alternatively, Quadrant might have stated a claim under Professor Berle’s equitably
oriented test by alleging that the directors caused Athilon to violate the terms of its entity-
speciﬁc contract by acting in a manner that breached their ﬁduciary duties.4

The problem for Quadrant was and remains the absence of a pled violation of the
entity-speciﬁc contract. The complaint recognized that the Board had the authority to
amend the Operating Guidelines, that the Board exercised its authority to authorize

investments involving greater risk, and that the ratings agencies approved the change as

 

ﬁ— — ——————-'—1——_.'=."_-_—-.;— __—__ — - — _ = _ STE-=Z-1

corporation, and the corporation and its shareholders”); Centaur P’rs, IV 12. Nail
Intergroup, Inc., 582 A.2d 923, 928 (Del. 1990) (“Corporate charters and by-1aws are
contracts among the shareholders of a corporation . . . .”); see also Fed. United Corp. v.
Havender, 11 A.2d 331, 333 (Del. 1940) (“It is elementary that [the Delaware General
Corporation Law’s] provisions are written into every corporate charter.”); cf. Lawson v.
Household Fin. Corp., 152 A. 723, 726 (Del. 1930) (“The same rules which govern the
construction of statutes, contracts and other written instruments, are made use of in
construing the provisions and determining the meaning of charters and grants of
corporate powers and privileges”).

3 See Grimes v. Donald, 673 A.2d 1207, 1213 (Del. 1996) (holding complaint
stated claim for violating DGCL); Grayson v. Imagination Station, Inc., 2010 WL
3221951, at *5 (Del. Ch. Aug. 16, 2010) (same); see also CA, Inc. v. AFSCME
Employees Pension Plan, 953 A.2d 227, 234 (Del. 2008) (“Bylaws, by their very nature,
set down rules and procedures that bind a corporation’s board and its shareholders”);
Allen v. El Paso Pipeline GP Co., 90 A.3d 1097, 1108 (Del. Ch. 2014) (“Boards of
directors have no discretion to exceed the intra-entity limitations on their authority. The
possession of discretionary authority is a prerequisite for the policy-based deference of
the business judgment rule”).

4 Cf. In re Ebix, Inc. S’lzolder Litig, 2014 WL 3696655, at *21-22 (Del. Ch. July
24, 2014) (explaining that plaintiffs could state a claim that would survive dismissal
under Rule 23.1 if the board knowingly violated the terms of an equity compensation
plan); Pfeiﬁ’er v. Leedle, 2013 WL 5988416, at *5 (Del. Ch. Nov. 8, 2013) (same);
London v. Tyrrell, 2008 WL 2505435, at *6 (Del. Ch. June 24, 2008) (same).

 

 

the Operating Guidelines required. The complaint thus established that Athilon’s
governing documents authorized the risk-on business strategy that Quadrant has
challenged and that the Board was acting within the scope of the authority granted to it
under Athilon’s entity-speciﬁc contract when it decided to increase Athilon’s risk proﬁle.

Once analysis under the legal test has established that the corporate decision-
makers possessed the authority to act, the focus shifts to theyequitable test and examines
the discretionary exercise of that authority. To determine whether the Board properly
exercised the discretionary authority granted to it by the Athilon Charter and Delaware
law, the Rule 12(b)(6) Opinion had to evaluate the BOard’s actions through the lens of a
standard of review. As noted, precedents like Shandler, T renwick, and Production
Resources pointed to the business judgment rule as the applicable standard of review.
Because the Board had not violated the restrictions imposed by the Athilon Charter, those
restrictions were not pertinent to the ﬁduciary duty analysis and did not provide a basis
for elevating the standard of review. The court did not overlook Quadrant’s first
argument, and it does not provide grounds for reconsideration.

This leads to Quadrant’s second argument, which is that the Rule 12(b)(6) Opinion
failed to appreciate that the allegations of the complaint were' sufﬁcient to support a
reasonably conceivable inference of bad faith and rebut the business judgment rule. As
the speciﬁc allegations supporting an inference of bad faith that the Rule 12(b)(6)
Opinion ostensibly failed to consider, Quadrant points to its assertions regarding the risk-

on strategy and the amendment of the Operating Guidelines,

 

The Rule 12(b)(6) Opinion considered these allegations, holding that Quadrant
could not “rebut the business judgment rule by alleging that the Board has decided to
pursue a relatively more risky business strategy to beneﬁt its sole common stockholder,
EBF.” 2014 WL 5099428, at *25. The business judgment rule presumes that “in making

a business decision the directors of a corporation acted on an informed basis, in good

faith and in the honest belief that the action taken was in the best interests of the

company.”5 When the rule applies and a plaintiff contends that a business decision was

made in bad faith, “the court merely looks to see whether the business decision made was

rational in the sense of being one logical approach to advancing the corporation’s
objectives.” In re Dollar Thrifty S’holder Litig., 14 A.3d 573, 598 (Del. Ch. 2010). Only

when a decision lacks any rationally conceivable basis will a court infer bad faith and a

breach of duty.6

r_,-=E—_________._E._______.___,c.

5 Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984). In Brehm v. Eisner, 746 A.2d
244, 253-54 (Del. 2000), the Delaware Supreme Court overruled seven of its precedents,
including Aronson, to the extent. they reviewed a Rule 23.1 decision by the Court of
Chancery under an abuse of discretion standard or otherwise suggested deferential
appellate review. Id. at 253 n.13. Aronson and the partially overruled precedents
otherwise remain good law.

6 See William T. Allen, Jack B. Jacobs, & Leo E. Strine, Jr., Realigning the
Standard of Review of Director Due Care with Delaware Public Policy: A Critique of
Van Gorkom and its Progeny as a Standard of Review Problem, 96 Nw. U. L. Rev. 449,
452 (2002) (deﬁning an irrational decision as “one that is so blatantly imprudent that it is
inexplicable, in the sense that no well-motivated and minimally informed person could
have made it”); see also Brehm, 746 A.2d at 264 (“Irrationality is the outer limit of the
business judgment rule. Irrationality may be the functional equivalent of the waste test or
it may tend to show that the decision is not made in good faith, which is a key ingredient

of the business judgment rule.” (footnote omitted)); In re JP Stevens & Co., Inc.
S’holders Litig, 542 A.2d 770, 780-81 (Del. Ch. 1988) (“A court may, however, review