Deepening Insolvency Claims in Disguise: Delaware Bankruptcy Court Revisits Trenwick Decision
May 13, 2008
Insolvency Notes
Linda M. Leali,
Cheryl Tedeschi Sloane
Directors and officers of troubled companies are already keenly cognizant of their potential liability for any breaches of fiduciary duty, negligence and fraud. In the June 2006 issue of Insolvency Notes (PDF), we discussed the controversy surrounding another basis for potential liability of directors and officers — "deepening insolvency." The theory of deepening insolvency is that recovery may be had from wrongdoers for an injury to a corporation caused by the fraudulent or negligent expansion of corporate debt and prolongation of corporate life. For example, a deepening insolvency claim might be brought against directors and officers whose actions caused an already insolvent company to continue to incur additional losses, driving the company deeper into insolvency and causing damage to the company.
Historically, there has been a significant debate among courts as to whether deepening insolvency is its own independent cause of action, simply a theory of damages, or neither. A state law question, this debate was partially settled in Delaware last year when the Delaware Supreme Court affirmed the Court of Chancery's decision in Trenwick Litigation Trust v. Ernst & Young L.L.P.1, which held that Delaware does not recognize deepening insolvency as an independent cause of action. This state court decision prompted a sigh of relief in many boardrooms across the country, particularly those of corporations incorporated in Delaware. Trenwick did not resolve, however, the issue of whether deepening insolvency is an appropriate theory of damages. This question has recently been addressed by the Bankruptcy Court for the District of Delaware in In re Brown Schools2, which held that deepening insolvency may be used as a theory of damages when breach of duty of loyalty claims are brought against directors and officers.
Brown Schools involved an action by a chapter 7 trustee against the debtors' controlling shareholder, McCown De Leeuw & Co. Inc. ("MDC"), and certain of MDC's affiliates and principals. The trustee alleged that (i) MDC used its power as a majority shareholder of the parent debtor to cause its representatives to serve on the debtors' board of directors and executive committee; (ii) the MDC defendants engaged in self-dealing and breached their fiduciary duties of good faith, honest governance and loyalty when they wrongfully prolonged the debtors' existence so that MDC could profit at the expense of the debtors and their creditors; (iii) MDC breached its fiduciary duty to the debtors' creditors when it restructured certain of the debtors' debt in order to prefer MDC over non-insider creditors; (iv) MDC engaged in corporate waste in accepting certain fees from the debtors; and (v) MDC engaged in a civil conspiracy when, acting through its director-representatives, it caused the debtors to obtain counsel who subsequently advised the debtors to engage in transactions that preferred MDC over the claims of the debtors' other unsecured creditors.
The MDC defendants filed a motion to dismiss the trustee's claims, arguing that the trustee failed to allege legally cognizable claims or damages because the claims were, at their core, disguised deepening insolvency claims. The bankruptcy court rejected this argument and recognized that, while Trenwick bars deepening insolvency claims as independent causes of action, Trenwick does not bar traditional claims for breach of fiduciary duty, aiding and abetting breach of fiduciary duty, corporate waste or civil conspiracy. The court found that the trustee's claims for breach of the fiduciary duty of loyalty in the form of self-dealing constituted valid traditional claims, not untenable deepening insolvency claims in disguise.
The MDC defendants also argued that the trustee improperly used deepening insolvency as a measure of damages where the complaint sought damages based on the allegation that the debtors' insolvency increased by more than $22 million due to the wrongful perpetuation of the debtors' existence. The court rejected this argument as well, concluding that deepening insolvency is a viable theory of damages for a claim based on breach of the duty of loyalty.
Brown Schools tells us that any sigh of relief following the Trenwick decision may have been premature for directors and officers of debtor corporations. Brown Schools signals that bankruptcy courts in Delaware are willing to apply deepening insolvency as a theory of damages in an action for breach of the duty of loyalty, notwithstanding the fact that deepening insolvency cannot be maintained as an independent cause of action. Thus, as long as a creditor or trustee can frame a claim against a corporate officer or director for wrongfully prolonging the existence of the corporation to the detriment of its creditors as a claim for breach of the duty of loyalty, the trustee or creditor may be able to recover damages as if deepening insolvency remained a viable cause of action.
Follow these links for additional articles from the May 13 2008 Insolvency Notes:
1 See Trenwick Am. Litig. Trust v. Billet, No. 495,2006, 2007 Del. LEXIS 357 (Del. Aug. 14, 2007), aff'g Trenwick Am. Litig. Trust v. Ernst & Young L.L.P., 906 A.2d 168 (Del. Ch. 2006).
2 McCown De Leeuw & Co., Inc. v. Miller (In re Brown Schools), No. 06-50861, -- B.R. -- , 2008 WL 1849790 (Bankr. D. Del. Apr. 24, 2008).
This Alert may include links to websites other than the White & Case website. White & Case LLP has no responsibility for any websites other than its own, and does not endorse the information, content, presentation or accuracy, or make any warranty, express or implied, regarding any other website.
The White & Case Insolvency Notes is prepared for the general information of our clients and other interested persons. It should not be acted upon in any specific situation without appropriate legal advice.
This Alert is protected by copyright. Material appearing herein may be reproduced or translated with appropriate credit.
© 2008 White & Case LLP