In Trenwick America Litigation Trust v. Ernst & Young, LLP, et al, 906 A.2d 168, 2006 Del Ch. LEXIS 139 (Del. Ch. August 10, 2006), the Chancery Court firmly held that deepening insolvency is not a valid cause of action under Delaware law. It will be interesting to see how the Delaware Supreme Court rules on this matter, if and when the issue is before that Court.
The Trust created by the Chapter 11 Plan filed suit against former subsidiary directors for, inter alia, deepening insolvency. Specifically, the Court identified the following allegations that supported the claim —
- From 2000 until 2003, these [Trenwick America] Defendants fraudulently concealed the true nature and extent of [Trenwick America’s] financial problems by expanding the amount of debt undertaken by [Trenwick America].
- The [Trenwick America] Defendants knew that [Trenwick America] would not be able to repay this increased debt, but fraudulently represented to creditors and other outsiders that the debt would be repaid.
- By these actions, [Trenwick America’s] officers and directors prolonged the corporate life of [Trenwick America] and increased its insolvency, until [Trenwick America] was forced to file for bankruptcy on August 20, 2003.
- As a result of [those] actions, [Trenwick America] suffered damages to be proven at trail, which [the Litigation Trust] is entitled to recover.
The Court, in the introductory section, told readers where it was going, finding that deepening insolvency was not even a “coherent concept” —
In the complaint, the Litigation Trust also has attempted to state a claim against the former subsidiary directors for "deepening insolvency." As noted, however, the complaint fails to plead facts supporting an inference that the subsidiary was insolvent before or immediately after the challenged transactions. Equally important, however, is that Delaware law does not recognize this catchy term as a cause of action, because catchy though the term may be, it does not express a coherent concept. 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. The fact that the residual claimants of the firm at that time are creditors 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. By doing so, the directors do not become a guarantor of success. Put simply, 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. 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.
Refusal to embrace deepening insolvency as a cause of action is required by settled principles of Delaware law. So, too, is a refusal to extend to creditors a solicitude not given to equityholders. Creditors are better placed than equityholders and other corporate constituencies (think employees) to protect themselves against the risk of firm failure.
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 risk of failure. With the prospect of profit often comes the potential for defeat.
The general rule embraced by Delaware is the sound one. 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.
The Court continued the dismantling of deepening insolvency in the Conclusions of Law –
If the board of an insolvent corporation, acting with due diligence and good faith, pursues a business strategy that it believes will increase the corporation’s value, but that also involves the incurrence of additional debt, it does not become a guarantor of that strategy’s success. That the strategy results in continued insolvency and an even more insolvent entity does not in itself give rise to a cause of action. Rather, in such a scenario the directors are protected by the business judgment rule. To conclude otherwise would fundamentally transform Delaware law.
The rejection of an independent cause of action for deepening insolvency does not absolve directors of insolvent corporations of responsibility. Rather, it remits plaintiffs to the contents of their traditional toolkit, which contains, among other things, causes of action for breach of fiduciary duty and for fraud. The contours of these causes of action have been carefully shaped by generations of experience, in order to balance the societal interests in protecting investors and creditors against exploitation by directors and in providing directors with sufficient insulation so that they can seek to create wealth through the good faith pursuit of business strategies that involve a risk of failure. If a plaintiff cannot state a claim that the directors of an insolvent corporation acted disloyally or without due care in implementing a business strategy, it may not cure that deficiency simply by alleging that the corporation became more insolvent as a result of the failed strategy.
Moreover, the fact of insolvency does not render the concept of "deepening insolvency" a more logical one than the concept of "shallowing profitability." That is, the mere fact that a business in the red gets redder when a business decision goes wrong and a business in the black gets paler does not explain why the law should recognize an independent cause of action based on the decline in enterprise value in the crimson setting and not in the darker one. If in either setting the directors remain responsible to exercise their business judgment considering the company’s business context, then the appropriate tool to examine the conduct of the directors is the traditional fiduciary duty ruler. No doubt the fact of insolvency might weigh heavily in a court’s analysis of, for example, whether the board acted with fidelity and care in deciding to undertake more debt to continue the company’s operations, but that is the proper role of insolvency, to act as an important contextual fact in the fiduciary duty metric. In that context, our law already requires the directors of an insolvent corporation to consider, as fiduciaries, the interests of the corporation’s creditors who, by definition, are owed more than the corporation has the wallet to repay.
In this case, the Litigation Trust has not stated a viable claim for breach of fiduciary duty. It may not escape that failure by seeking to have this court recognize a loose phrase as a cause of action under our law, when that recognition would be inconsistent with the principles shaping our state’s corporate law. In so ruling, I reach a result consistent with a growing body of federal jurisprudence, which has recognized that those federal courts that became infatuated with the concept, did not look closely enough at the object of their ardor. Among the earlier federal decisions embracing the notion – by way of a hopeful prediction of state law – that deepening insolvency should be recognized as a cause of action admittedly were three decisions from within the federal Circuit of which Delaware is a part. [SR Note – See Lafferty] None of those decisions explains the rationale for concluding that deepening insolvency should be recognized as a cause of action or how such recognition would be consistent with traditional concepts of fiduciary responsibility. In a more recent decision, the Third Circuit has taken a more skeptical view of the deepening insolvency concept, a view consistent with the outcome reached in this decision. [SR Note – See CITX]. In fact, many of the decisions that seem to embrace the concept of deepening insolvency do not clarify whether the concept is a stand-alone cause of action or a measurement of damages (the extent of deepening) for other causes of action.
(bold emphasis mine). It will be interesting to see how the Delaware Supreme Court treats this issue, and how courts in other jurisdictions rule on the viability of deepening insolvency as a cause of action. Is there now a trend toward restricting such causes of action of deepening insolvency and alleged duties to creditors when a company enters the "zone of insolvency?" See, e.g. Rafool v. Goldfarb Corp. (In re Fleming Packaging Corp.), 2006 Bankr. LEXIS 2232 (Bankr. C.D. Ill. Sept. 8, 2006) (Trustee alleged a claim of deepening insolvency under Delaware law; court acknowledged Trenwick, but issue was not properly before the court on a motion to strike affirmative defenses). Alberts v. Tuft (In re Greater Southeast Cmty. Hosp. Co., 2006 Bankr. LEXIS 2419 (Bankr. D.C.Sep. 21, 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 regardless of whether the injury occurred as a result of negligence or fraud").
For more commentary on Trenwick, see Professor Ribstain, Deepening Insolvency = Shallow Profitability.