Tide Has Turned on Deepening Insolvency
Courts Now Rejecting Theory as Valid Cause of Action

(TMA International Headquarters)

Sixteen years ago, the Delaware Chancery Court’s decision in Credit Lyonnais Bank Nederland v. Pathe Communications Corp. , 1991 WL 277613 (Del. Ch. 1991), helped introduce the terms “vicinity of insolvency” and “zone of insolvency” into the lexicon of the legal and business communities.

Based in part on this decision, the 3d U.S. Circuit Court of Appeals in 2001 rendered its decision in Official Committee of Unsecured Creditors v. R.F. Lafferty & Co. Inc., 267 F.3d 340 (3d Cir. 2001), one of the first decisions to uphold the validity of deepening insolvency as an independent cause of action. In the years since Lafferty was decided, deepening insolvency as a cause of action has been oft-criticized and controversial.

At its essence, the theory of deepening insolvency refers to the prolongation of a corporation’s life or expansion of its debt while it is in the zone or vicinity of insolvency in a manner that results in further dissipation of assets and, in some circumstances, a costly bankruptcy filing. Since the Lafferty decision was published, courts have dealt with the evolving theory of deepening insolvency in several ways.

Several federal courts, interpreting state law, have recognized deepening insolvency as a valid cause of action. See, e.g., OHC Liquidation Trust v. Credit Suisse First Boston (In re: Oakwood Homes Corp.), 340 B.R. 510, 531 (Bankr. D. Del. 2006) (holding that Delaware, New York, and North Carolina courts would recognize deepening insolvency as a cause of action); In re LTV Steel Co., Inc. et al., 333 B.R. 397, 422 (Bankr. N.D. Ohio 2005) (determining that deepening insolvency would be a valid cause of action under Delaware and New Jersey law). Significantly, however, a growing number of courts have regarded with disapproval causes of action based on deepening insolvency and creditor lawsuits against directors of companies operating in the zone of insolvency generally.

Indeed, two important recent decisions of the Delaware Supreme Court have curtailed the ability of creditors to bring suit successfully against an insolvent company’s directors, officers, and lenders based on the theory of deepening insolvency. These decisions have been seized upon by courts that have rejected deepening insolvency as an independent cause of action. This emerging body of decisional authority may well foretell the end for deepening insolvency as a valid cause of action.[1]

Delaware Decisions

In September 2006, the Delaware Court of Chancery issued a decision in North American Cath. Educ. Programming, Inc. v. Gheewalla, et al. , 2006 WL 2588971 (Del. Ch. Sept. 1, 2006), holding that creditors could not bring a direct action for breach of fiduciary duty against directors of a corporation in the zone of insolvency. In May 2007, the Delaware Supreme Court affirmed the Chancery Court’s decision and made three key rulings:

• When a corporation is in the zone of insolvency, creditors may not bring a direct action against the directors for breach of fiduciary duty
• When the corporation is in fact insolvent, creditors have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties
• Even when a corporation is insolvent, creditors have no right to assert direct claims for breach of fiduciary duty against the directors. See Cath. Educ. Programming, Inc. v. Gheewalla, et al., 930 A.D.2d, 92, 94 (Del. 2007).

In so doing, the court noted that Delaware courts traditionally had been reluctant to expand existing fiduciary duties owed by directors to creditors.

[C]reditors are afforded protection through contractual agreements, fraud and fraudulent conveyance law, implied covenants of good faith and fair dealing, bankruptcy law, general commercial law and other sources of creditors rights… Accordingly, the general rule is that directors do not owe creditors duties beyond the relevant contractual terms.
Id. at 99 (internal quotations omitted).

In addition, the court noted that when a solvent corporation is navigating in the zone of insolvency, the focus of Delaware directors should not change. The court stated that “directors must continue to discharge their fiduciary duties to the corporation and its shareholders by exercising their business judgment in the best interests of the corporation for the benefit of its shareholder owners.” Id. at 101.

Although it did not address deepening insolvency directly, the court’s decision in Gheewalla signaled, for the first time, the Delaware Supreme Court’s willingness to definitively address the issue and to provide guidance to corporate directors with respect to their potential liability within the zone of insolvency.

In August 2007 the Delaware Supreme Court released a two-page order affirming the Delaware Chancery Court’s decision in Trenwick America Litigation Trust v. Billet, 906 A.D.2d 168 (Del. Ch. 2006), which held that there is no valid cause of action for deepening insolvency in Delaware. Rather than write its own opinion, the Delaware Supreme Court ratified the Delaware Chancery Court’s decision “on the basis and for the reasons assigned by” the Chancery Court.

The Delaware Chancery Court’s decision held that Delaware law does not recognize deepening insolvency as an independent cause of action “because catchy though the term may be, it does not express a coherent concept.” Id. at 174. The court noted that the concept of deepening insolvency has been discussed at length in federal jurisprudence, “perhaps because the term has the kind of stentorious academic ring that tends to dull the mind to the concept’s ultimate emptiness.” Id. at 204.

In support of this conclusion, the court noted that (i) Delaware law imposes no obligation on the board of a company that is unable to pay its debts to liquidate its assets; and (ii) Chapter 11 of the Bankruptcy Code recognizes that an insolvent corporation’s creditors may benefit if the corporation continues to operate in hopes of turning things around. Id.

The court ruled that “even when a firm is insolvent, its directors may, in the appropriate exercise of their business judgment, take action that might, if it does not pan out, result in the firm being painted in a deeper hue of red.” Id. at 174. “The fact that the residual claimants of the firm at that time are creditors,” the court reasoned, “does not mean that the directors cannot choose to continue the firm’s operations in the hope that they can expand the inadequate pie such that the firm’s creditors get a greater recovery.” Id. The court then concluded that, under Delaware law, deepening insolvency “is no more of a cause of action when a firm is insolvent than a cause of action for ‘shallowing profitability’ would be when a firm is solvent.” Id.

In so ruling, the court made clear that when operating in the zone of insolvency, directors should not be held liable for damages incurred by creditors as a result of the company’s failure to remain profitable, even though the directors’ fiduciary duty extends to the company’s creditors:

The incantation of the word insolvency, or even more amorphously, the words zone of insolvency, should not declare open season on corporate fiduciaries. Directors are expected to seek profit for stockholders, even at a risk of failure. With the prospect of profit often comes the potential for defeat.

So long as directors are respectful of the corporation’s obligation to honor the legal rights of its creditors, they should be free to pursue in good faith profit for the corporation’s equityholders. Even when the firm is insolvent, directors are free to pursue value maximizing strategies, while recognizing that the firm’s creditors have become its residual claimants and the advancement of their best interests has become the firm’s principal objective. Id. at 174-75.

The Chancery Court justified its ruling in part by observing that “[c]reditors are better placed than equityholders and other corporate constituencies (think employees) to protect themselves against the risk of firm failure.” Id . Indeed, the court noted that existing equitable causes of action for breach of fiduciary duty and existing legal causes of action for fraud, fraudulent conveyance, and breach of contract “are the appropriate means by which to challenge the actions of boards of insolvent corporations.” Id.

Trenwick’s Impact

The impact of the Delaware Chancery Court’s decision in Trenwick already has been felt, as federal courts throughout the country have rejected the theory of deepening insolvency as an independent cause of action. In concluding that Ohio law would not recognize deepening insolvency as a cause of action, a Bankruptcy Court remarked:

Deepening insolvency as a cause of action remains vague and convoluted. Certainly, the central ideology of the theory is true: actions taken which worsen the financial condition of an already insolvent corporation may harm the business and its constituents. However, recognizing that a condition is harmful and calling it a tort are two different things.

In re Amcast Indus. Corp. et al., 365 B.R, 91, 118 (Bankr. S.D. Ohio 2007) (characterizing the tort of deepening insolvency as a “complete redundancy”).

Likewise, the court in In re James River Coal Co. et al, 360 B.R. 139 (Bankr. E.D. Va. 2007) ruled that Virginia law does not recognize the tort of deepening insolvency, noting that “[t]he Board of Directors must remain free to exercise its good faith business judgment that will allow it to pursue strategies the board views as sound to turn it around.” Id. at 179.

The Trenwick decision and its progeny signal that the tide has turned and courts are increasingly reluctant to recognize deepening insolvency as a legitimate stand-alone cause of action. Accordingly, creditors seeking to bring claims against the directors and officers of a corporation in the zone of insolvency likely must base their claims on traditional causes of action, such as breach of fiduciary duty, fraud, fraudulent conveyance, and breach of contract.

The decisions cited in this article also provide clarity and a degree of comfort for directors and officers operating a corporation in the zone of insolvency. Indeed, the Delaware Supreme Court and other courts following its lead have endorsed the trend to limit the post Credit Lyonnais expansion of liability for directors of nearly insolvent corporations.

Although questions regarding the validity of deepening insolvency as a viable measure of damages remain unanswered, these recent decisions provide meaningful guidance on how directors of financially troubled corporations should discharge their fiduciary duties.

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[1] This is not to express a view regarding the continued viability of deepening insolvency as a measure of damages. See e.g. In re Amcast Indus. Corp. et al., 365 B.R, 91, 119 n.19 (Bankr. S.D. Ohio 2007)(“While declining to recognize deepening insolvency as a valid cause of action, the court believes that the concept may be useful as a measure of damages for breach of fiduciary duty or commission of an actionable tort.”); Alberts v. Tuft (In re Greater Southeast Cmty. Hosp. Corp.), 353 B.R. 324, 338 (Bankr. D.D.C. 2006) (“Unless and until this court is told differently by a higher court in its own circuit, deepening insolvency will remain a viable theory of damages in this jurisdiction[.]”); In re Southwest Florida Heart Group P.A., 2006 Bankr. LEXIS 1556 at *5 (Bankr. M.D. Fla. July 6, 2006) (stating that issues of deepening insolvency are relevant only to the measure of damages).