Quadrant Structured Prods. Co. v. Vertin

• Decision Date: 01 October 2014
• Docket Number: C.A. No. 6990–VCL.
• Citation: 102 A.3d 155
• Parties: QUADRANT STRUCTURED PRODUCTS COMPANY, LTD., Individually and Derivatively on behalf of Athilon Capital Corp., Plaintiffs, 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.
• Court: Court of Chancery of Delaware

102 A.3d 155

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

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.

C.A. No. 6990–VCL.

Court of Chancery of Delaware.

Submitted: July 22, 2014.

Decided: Oct. 1, 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 Plaintiff 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, Athilon 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.

OPINION

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 alleges that Athilon is insolvent and that the individual defendants, who are members of Athilon's board of directors (the “Board”), should wind up the Company's business and dissolve the entity. Quadrant contends that instead, the Board has found ways to transfer value preferentially to Athilon's controller, defendant EBF & Associates (“EBF”). In this action, Quadrant has asserted breach of fiduciary duty claims derivatively against the Board and EBF. Quadrant has also asserted fraudulent transfer claims directly against EBF and its affiliate, Athilon Structured Investment Advisors, LLC (“ASIA”). The defendants have moved to dismiss the complaint. Their motion is denied to the extent that Quadrant has challenged specific transfers of value to EBF or ASIA. To the extent that Quadrant has challenged the Board's business decision to take on greater risk, the motion to dismiss is granted.

I. FACTUAL BACKGROUND

The facts are drawn from Quadrant's verified amended complaint (the “Complaint” or “Compl.”) and the documents it incorporates by reference. At this procedural stage, the Complaint's allegations are assumed to be true, and Quadrant receives the benefit of all reasonable inferences.

A. The Company And Its Business Model

Athilon is a credit derivative product company created 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. The Company guaranteed the credit swaps that Asset Acceptance wrote. In a typical transaction, Asset Acceptance sold protection to a bank in the form of a credit swap that referred to a designated pool of investment grade debt securities, known as “Reference Obligations.” If the pool of Reference Obligations suffered net losses that exceeded a contractually defined figure, then Asset Acceptance was liable up to a fixed limit. The Company was liable as the guarantor of Asset Acceptance's performance.

To obtain and maintain a AAA/Aaa credit rating, which was essential to the Company's business model, the ratings agencies required the Company to have a limited business purpose and to adopt and follow operating guidelines for its business (the “Operating Guidelines”). The Amended and Restated Certificate of Incorporation for the Company (the “Athilon Charter”) limits its business to “guaranteeing or providing other forms of credit support for the obligations of its subsidiaries” and activities related to that business. The Amended and Restated Certificate of Incorporation for Asset Acceptance (the “Asset Acceptance Charter”) limits its business to “transactions judged by [Asset Acceptance] to be credit default swaps” and activities related to that business.

Both the Athilon Charter and the Asset Acceptance Charter require that their businesses be “conducted in compliance with the Operating Guidelines.” The Operating Guidelines:

• limit the business activities of the Company and Asset Acceptance;

• impose structural, portfolio, and leverage constraints on their operations;

• establish ratings categories for the collateralized debt obligations covered by the credit swaps written by Asset Acceptance and guaranteed by the Company;

• cap the aggregate notional amount of any single credit swap;

• limit the permissible maturity of credit swaps;

• limit the nature of credit events that could give rise to payment obligations under the credit swaps;

• restrict the Company to investing in short-term, low-risk securities, such as U.S. government and agency securities, certain Euro-dollar deposits, bankers' acceptances, commercial paper, repurchase transactions, money market funds, and money market notes with high short-term ratings;

• require that its portfolio contain sufficient assets to cover all liabilities; and

• define certain Suspension Events relating to capital shortfalls, leverage ratios, downgrades in counterparty credit ratings, and the insolvency, bankruptcy, or reorganization of the Company or Asset Acceptance.

The Operating Guidelines provide that if a Suspension Event is not timely cured, then the Company enters runoff. Once in runoff, the Company can no longer pay dividends or write new guarantees for credit swaps. While in runoff, its operations are limited to paying off outstanding swap transactions as they mature. After the runoff process is complete, the Operating Guidelines obligate the Company to liquidate.

B. The Company's Capital Structure And Financial Difficulties

To fund its business, the Company 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 of the Junior Subordinated Notes. Depending on the series, the Notes will mature in 2035, 2045, 2046, or 2047. Interest payments on all of the Notes are deferrable at the Company's option for up to five years. Each class of Notes is subordinate to the Company's credit default swap obligations. On the strength of its $700 million in committed capital, the Company guaranteed more than $50 billion in credit default swaps written by Asset Acceptance.

Two of the credit swaps that Asset Acceptance wrote referenced residential mortgage-backed securities, rather than corporate debt obligations. In late 2008, the Company paid $48 million to unwind the first swap. In 2010, the Company paid $320 million to unwind the second swap. The termination payments wiped out over half of the Company's committed capital, including all of its equity capital and 65% of its long-term debt.

The effects of the 2008 financial crisis inflicted broader and more permanent damage on the Company. After Lehman Brothers filed for bankruptcy in September 2008, financial institutions no longer entered into credit swaps with entities that lacked substantial capital and could not post adequate collateral. As a result of the financial crisis, the Company and Asset Acceptance no longer could engage in the only business that their charters and the Operating Guidelines permitted them to pursue.

At the end of 2008, the Company and Asset Acceptance lost their AAA/Aaa ratings. By August 2010, the Company and Asset Acceptance no longer had any investment grade debt or counterparty credit ratings. Under the Operating Guidelines, the loss of its AAA/Aaa ratings and significant capital deficiencies forced the Company into runoff.

C. EBF Takes Over An Insolvent Company

The collapse of the credit derivative industry caused the Company's securities to trade at deep discounts, reflecting the widely held view that the Company was insolvent. EBF purchased all of the Company's Junior Subordinated Notes, then bought all of the Company's equity in 2010. By doing so, EBF gained control over the Company and its Board.

After acquiring control over the Company, EBF placed Vincent Vertin on the Board. Vertin is a partner at EBF who concentrates on EBF's investments in credit derivative product companies, and the Complaint alleges that Vertin's compensation is tied to the performance of EBF's in credit derivative product companies.

EBF also placed Michael Sullivan on the Board. Sullivan is an in-house attorney for EBF. Like Vertin, Sullivan concentrates on EBF's investments in credit derivative product companies.

EBF placed two other individuals on the Board whom EBF designated as independent directors. One is Brandon Jundt, a former employee of EBF. The other is J. Eric Wagoner.

The fifth and final Athilon director is Patick B. Gonzalez, the CEO of the Company.

Quadrant purchased debt securities issued by the Company after the EBF takeover. Quadrant acquired Senior Subordinated Notes in May 2011 and Subordinated Notes in July 2011.

D. Transfers Of Value From The Company To EBF

The Complaint alleges that the Company had been insolvent for some time before the EBF takeover. The Complaint alleges that the Company continues to be insolvent and cannot return to solvency because the credit default industry has collapsed, and the Athilon Charter, the Asset Acceptance Charter, and the Operating Guidelines prohibit the Company from engaging in other lines of business. At this point, the Company consists of a legacy portfolio of guarantees on credit default swap contracts written by Asset Acceptance that will continue to earn premiums until the last contracts expire...