Commercial Advisor

• 5.1.2004

Introduction

Directors owe a duty of care and a duty of loyalty to the corporation on whose board they serve, and to the corporation’s stockholders. Generally, the actions of a director are protected under the business judgment rule, provided that the director acts on an informed basis, in good faith and in the honest belief that the action taken is in the best interests of the corporation. When an entity is operating in the “vicinity” or on the “brink” of insolvency, however, many courts have extended the obligations of directors to include duties to creditors as well. Some courts have also suggested that a director of an insolvent corporation is a fiduciary of the creditors, obligated to exercise the same care with the corporation’s assets as the director would exercise with his or her own assets. Whether decisions made by the directors of a company that is operating in the vicinity of insolvency are protected by the business judgment rule is unresolved. That unresolved issue could be preempted by the continuing expansion of the “deepening insolvency” theory of liability, which subjects directors, officers and third-party professionals to close scrutiny and potential liability for their actions and decisions when an entity becomes insolvent.

The deepening insolvency doctrine holds that the debtor’s property is “damaged” if an officer, director or third-party professional prolongs the life of a corporation after it has become insolvent, to the detriment of creditors and other interest holders. According to the deepening insolvency doctrine, such harm to the corporation can be averted, and the value of an insolvent corporation salvaged, if the corporation is dissolved in a timely manner, rather than continuing losing operations that have the effect of increasing losses and thereby “deepening” the company’s insolvency.

By characterizing deepening insolvency as an injury to the debtors’ corporate property, and only indirectly as harm to creditors, the claim of deepening insolvency becomes an asset
of the bankruptcy estate rather than the claim of an individual creditor. What is not clear from the case law is whether a deepening insolvency cause of action need only allege insolvency and failure to promptly dissolve, or whether the cause of action also includes as an essential element otherwise actionable conduct such as fraud or misrepresentation.

Cut loose from the traditional and well-established rules for assessing the conduct of a director, including the time-honored business judgment rule, directors of a corporation in the vicinity of insolvency are left with uncertain guideposts for their decisions. Not only does the deepening insolvency doctrine create an estate cause of action rather than a creditor cause of action, it may preempt the debate over whether directors of an insolvent corporation are entitled to the protection of the business judgment rule if otherwise actionable conduct is not an element of the claim. Read broadly, the deepening insolvency cause of action may bring United States jurisprudence into line with, or at least very close to, the longstanding English rule of strict liability for directors who allow a company to “trade while insolvent.”

Deepening Insolvency Recently Recognized in Delaware

The decision of the United States Bankruptcy Court for the District of Delaware, which recently recognized the tort of deepening insolvency under Delaware law in the case of In re Exide Technologies, Inc. (Official Committee of Unsecured Creditors v. Credit Suisse First Boston), 299 B.R. 732 (Bankr. D. Del. 2003) (Exide), has done little to clarify the elements of the deepening insolvency cause of action. In Exide, the official committee of unsecured creditors sued the company’s prepetition secured lenders on a number of theories, including a claim that the prepetition lenders caused the company to continue in business after it became insolvent, as a result of which the company became more insolvent. Applying the Third Circuit’s analysis of the deepening insolvency theory under Pennsylvania law in Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., Inc., 267 F.3d 340 (3d Cir. 2001), the Exide court held that the committee’s allegations that the secured lenders caused the company to continue to operate while insolvent stated a claim under the deepening insolvency cause of action.

Background

In 1997, a syndicate of lenders established a $650 million credit facility for the company and its subsidiaries. In 2000, the lenders loaned the debtors an additional $250 million to finance the acquisition of a competitor. After the acquisition closed, the company’s financial condition deteriorated quickly. The company and the lenders negotiated a series of amendments to the terms of the loans, including a temporary suspension of certain financial covenants and a forbearance for a period just days longer than the 90-day non-insider preference period. Despite these actions, the company collapsed and filed for relief under Chapter 11 of the Bankruptcy Code, 11 U.S.C. § 101 et seq. Thereafter, the official committee of unsecured creditors sued the lenders, alleging, among other claims, that the lenders forced the debtors to fraudulently continue in business for nearly two years, resulting in the dissipation of assets and the company’s deepening insolvency. In re Exide Technologies, Inc., 299 B.R. at 750–51. The lenders moved to dismiss the claim of deepening insolvency. Concluding that the Delaware Supreme Court would recognize a claim based on actions that caused the deepening of a corporation’s insolvency, the United States Bankruptcy Court for the District of Delaware denied the defendants’ motion.

The Bankruptcy Court’s Ruling

To reach its conclusion, the court determined that (1) a claim for deepening insolvency is cognizable under Delaware law and (2) the committee had adequately pleaded the tort for purposes of surviving a motion to dismiss.

The Delaware courts had not addressed the deepening insolvency doctrine. The Exide court looked to federal case law interpreting deepening insolvency claims for guidance. In particular, the court relied on the Third Circuit’s analysis in Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., Inc., 267 F.3d 340 (3d Cir. 2001). In Lafferty, the Third Circuit concluded that the deepening insolvency cause of action was sound, that acceptance of the cause of action was growing among courts and that the remedial theme in Pennsylvania law would persuade the Pennsylvania Supreme Court to recognize deepening insolvency as a cause of action.

Without elaborating on the Third Circuit’s reasoning, the Exide court held that the deepening insolvency theory was sound and accepted among courts. The court went on to observe that the Delaware Supreme Court adhered to the principle of providing a remedy for an injury. Finding that the theory was logically sound, judicially accepted and in accord with Delaware jurisprudence, the court concluded that the “Delaware Supreme Court would recognize a claim for deepening insolvency when there has been damage to corporate property.” In re Exide Technologies, Inc., 299 B.R. at 752. Thus, the court let stand a claim against the lenders for any deepening of the debtors’ insolvency resulting from the lenders’ financing of the company’s acquisition of its competitor.

The court does not state clearly the necessary elements of a claim for deepening insolvency. The committee alleged that the lenders forced “the Debtors fraudulently to continue its business for nearly two years at ever-increasing levels of insolvency.” Id. at 750–51. Does the reference to fraud refer to conduct of the lenders or conduct of the company? What was the fraud? Was the fact of insolvency or ongoing losses hidden from creditors or were creditors affirmatively misled? Is fraud a necessary element of the cause of action? The answers to these questions are critical because they will determine whether deepening insolvency is really just a way to convert a fraud claim that would be held by an individual creditor into an estate cause of action because of harm to the company or whether it is a new cause of action that has few, if any, limits.¹

Other Deepening Insolvency Cases

In addition to the Third Circuit, the Seventh Circuit and several lower courts have recognized deepening insolvency as a cause of action. See Schacht v. Brown, 711 F.2d 1343, 1348 (7th Cir. 1983); see also Hannover Corp. of Am. v. Beckner, 211 B.R. 849, 854-55 (M.D. La. 1997); Allard v. Arthur Andersen & Co., 924 F. Supp. 488, 494 (S.D.N.Y. 1996); Feltman v. Prudential Bache Sec., 122 B.R. 466, 473 (S.D. Fla. 1990). Acknowledging the growing trend toward recognizing deepening insolvency as a cause of action, the Fifth Circuit has declined to speculate on whether the Texas Supreme Court would recognize deepening insolvency as a viable, independent legal theory. Fla. Dep’t of Ins. v. Chase Bank of Tex. Nat’l Ass’n, 274 F.3d 924 (5th Cir. 2001). Other courts, however, have not analyzed deepening insolvency as a separate and distinct tort, but rather as a measure of damages in an action for negligence or fraud. See, e.g., Bookland of Maine v. Baker, Newman & Noyes, LLC, 271 F. Supp. 2d 324, 326 n.3 (D. Me. 2003); Tabas v. Greenleaf Ventures, Inc. (In re Flagship Healthcare, Inc.), 269 B.R. 721, 728-29 (Bankr. S.D. Fla. 2001); Breeden v. Sphere Drake Ins., Plc (In re The Bennett Funding Group, Inc.), No. 96-61376, 2000 Bankr. LEXIS 1693, at *18 n.4 (Bankr. N.D.N.Y. Mar. 3, 2000).

Summary

The growing recognition of deepening insolvency as a separate and distinct tort seriously expands the claims creditors may bring against officers and directors. What started as a theory for calculating damages for otherwise actionable conduct may be transformed into a cause of action without articulated limits that imposes liability on any person responsible for causing or permitting a company in the vicinity of insolvency to continue to operate and incur losses. If courts do not require proof of otherwise actionable conduct as part of the claim, the deepening insolvency cause of action will drive companies operating in the vicinity of insolvency to prematurely file bankruptcy rather than risk liability for any failed attempts to salvage their business.

CommAdvMay04