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Continuous Insolvency Requirement and Irretrievable Insolvency Test Held By Delaware Chancery Court Inapplicable in Creditor-Derivative Claims

Quadrant Structured Prods. Co. v. Vertin, No. 6990-VCL, 2015 WL 2062115 (Del. Ch. May 4, 2015)

In this Opinion, Vice Chancellor Laster addressed two questions with respect to a derivative claim asserted by a creditor on behalf of a corporation – namely (1) whether such claims may be maintained only during the time that a corporation is actually insolvent and (2) whether to establish the insolvency of the corporation, such creditor must show that the corporation has “a deficiency of assets below liabilities with no reasonable prospect that the business can be successfully continued in the face thereof.”  Answering both questions in the negative, the Chancery Court held that a creditor will have standing to sue derivatively if it establishes that the corporation was insolvent at the time the derivative suit was filed and that insolvency may be proven under either one of the two traditional insolvency tests – the balance sheet test or the cash flow test.

Delaware case law is clear – after a corporation becomes insolvent, creditors may assert claims derivatively for breach of fiduciary duty.  N. Am. Catholic Educ. Programming Found., Inc. v. Gheewalla, 930 A.2d 92, 101 (Del. 2007).  Until then, it is only a corporation’s shareholders who may assert derivative claims.  See, e.g.Harden v. E. States Pub. Serv. Co., 122 A. 705, 706-07 (Del. Ch. 1923).  For a shareholder to have standing, however, it must beneficially own an interest in at least one share of common stock at the time of filing and continuously throughout the litigation.  Parfi Hldg., AB v. Mirror Image Internet, Inc., 954 A.2d 911, 935 (Del. Ch. 2008).  Attempting to analogize to such continuous ownership requirement, the Quadrant defendants asserted that a corporation must not only be insolvent at the time a creditor commences a derivative action but that it must remain insolvent until judgment.  The Court, however, rejected this so-called “Continuous Insolvency Requirement”, pointing out that such a requirement would cause a lack of predictability and allow misconduct to “evade review” given that a corporation’s insolvency could fluctuate over time.

Like the bright-line rule of continuous share ownership, creditor-derivative standing only requires that the plaintiff hold a debt claim against the corporation at the time of filing and continuously throughout the litigation.  Insolvency must be pled and later proven, but the plaintiff must only establish that the corporation was insolvent at the time the suit was filed.  Insolvency may be established under one of two traditional tests the Court opined – the balance sheet test or the cash flow test.  While the Quadrant defendants urged the Vice Chancellor to adopt a more stringent test applicable to creditor actions seeking to obtain the appointment of a receiver, i.e., “a deficiency of assets below liabilities with no reasonable prospect that the business can be successfully continued in the face thereof” (the “Irretrievable Insolvency Test”), the Court would not abandon the ample amount of governing case law.  The Irretrievable Insolvency Test applies only in receivership cases and has never governed creditor-derivative claims.