• Fiduciary Duties in the Zone of Insolvency and in Deepening Insolvency
  • July 11, 2008 | Authors: Scott R. Bauer; Elizabeth H. Getches
  • Law Firm: Moye White LLP - Denver Office
  • Creditors and their counsel have increasingly attempted to push the envelope with respect to claims against directors of insolvent corporations and managers of insolvent limited liability companies. Directors and managers are often attractive targets in creditors’ actions because they are viewed as a viable source of recovery based upon their own financial status or because they are the designated representatives of private equity funds or other investors.
    It is commonly accepted that directors’ fiduciary duties shift from shareholders to creditors once an entity is insolvent. Even in this arena, many unanswered questions arise. What insolvency test should be applied? How will goodwill, which can often be a significant asset for a going concern, be valued? Defense counsel can be assured that a plaintiff’s expert will determine that the goodwill carried on the company’s books was overvalued when that expert opines on balance sheet insolvency. These and many other issues can be difficult ones for directors and their counsel, particularly when viewed through the lens of 20-20 hindsight after a company fails.
    These difficulties are magnified when a plaintiff claims that directors’ duties shift to creditors and even expand in scope when a company is in the amorphous “zone of insolvency.” In addition, creditors are increasingly alleging a separate claim for “deepening insolvency” based upon the assertion that directors’ actions after insolvency made a bad situation worse, thereby increasing the amount of debt owed to the company’s creditors. This article will summarize significant recent decisions in these two areas and will highlight issues for counsel to consider when defending these claims.

    The Zone of Insolvency
    The “zone of insolvency” issue traces its origins to a decision by Vice Chancellor Allen in Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., 1991 WL 277613 (Del. Ch. Dec. 30, 1991). Although the holding of that decision was that directors should be afforded the traditional protection of the business judgment rule even when a risky strategy might ultimately prove harmful to creditors, a single footnote in that opinion spawned considerable debate over directors’ duties in the zone of insolvency. In footnote 55 of the Credit Lyonnais opinion, Vice Chancellor Allen noted that “[t]he possibility of insolvency can do curious things to incentives, exposing creditors to risks of opportunistic behavior and creating complexities for directors.” Id. at *34, n. 55. A number of courts and commentators have suggested that the Credit Lyonnais decision created new and expanded fiduciary duties when a company is in the zone of insolvency that may be enforced by creditors through direct claims. See, e.g., Weaver v. Kellogg, 216 B.R. 563, 582-84 (S.D. Tex. 1997); Official Comm. of Unsecured Creditors of Buckhead America Corp. v. Reliance Capital Group, Inc. (In re Buckhead Am. Corp.), 178 B.R. 956, 968 (D. Del. 1994); Royce de R. Barondes, Fiduciary Duties of Officers and Directors of Distressed Corporations, 7 GEO. MASON L. REV. 45, 65-70 (1998) (“the duties owed by directors of solvent, distressed corporations can be affirmatively enforced by creditors”).

    Vice Chancellor Stine’s November 17, 2004 decision in Production Resources Group, L.L.C. v. NCT Group, Inc., 863 A.2d 772 (Del. Ch. 2004), provided much-needed guidance in this troubling area. First, the court in Production Resources held that, with limited exceptions (such as where directors demonstrate a “marked degree of animus” toward a particular creditor), creditors’ claims for breach of fiduciary duty claims are derivative claims, not direct claims. Id. at 791-93. Declaring that such claims are derivative has several important implications:

    1. A single creditor may not be inclined to expend the time and expense of bringing a lawsuit that will benefit all creditors and may, therefore, attempt to bring claims on its own behalf. Any such direct claims should be the subject of a motion to dismiss.
    2. Exculpation clauses in articles of incorporation and other entity formation documents will limit or perhaps even eliminate directors’ liability for claims that creditors bring derivatively. For example, Section 102(b)(7) of the Delaware Corporate Code authorizes corporate charter provisions that insulate directors from personal liability to the corporation or to its shareholders for breaches of the duty of due care (as opposed to the duty of loyalty). 8 Del. C. § 102(b)(7). The Delaware Chancery Court in Production Resources held that exculpation clauses under that section of the statute apply to “all claims belonging to the corporation itself, regardless of whether those claims are asserted by stockholders or by creditors.” Prod. Resources, 863 A.2d at 793; accord Pereira v. Farace, 413 F.3d 330, 342 (2d Cir. 2005). In support of this decision, Vice Chancellor Stines noted that fiduciary duty claims brought by creditors should “at most be coextensive with, and certainly not superior to,” the claims that a solvent firm itself could bring against its directors. Id. at 794. Indeed, “[i]t would be puzzling if, in insolvency, the equitable law of corporations expands the rights of firms to recover against their directors so to better protect creditors, who unlike shareholders, typically have the opportunity to bargain and contract for additional protections to secure their positions.” Id.

    Second, the court in Production Resources held that directors defending against breach of fiduciary duty claims are entitled to the protection of the business judgment rule. Id. at 788-89. The court even noted that circumstances may exist where directors, in the exercise of their judgment, appropriately prefer one or more creditors over others of equal priority, so long as that decision is not motivated by self-interest. Id. at 797. Counsel representing distressed companies, therefore, should consider ways to maximize the utility of the business judgment rule, including:

    1. Board decisions--The general rule is that the business judgment rule applies to decisions made by the board of directors, as opposed to corporate officers or other representatives. Thus, to the extent possible, all significant decisions should be made, or ratified, by the board. Even a decision NOT to take a particular action should, if significant, be made by the board in order to maximize the efficacy of the business judgment rule.
    2. Informed actions--The business judgment rule protects informed decisions made by the board. Distressed companies should remain vigilant in ensuring that directors are adequately informed on all issues brought before them.
    3. Documentation--Many companies and their counsel find it difficult to expend the time and money needed to document the information made available to board members fully, or even to complete board minutes when a company is teetering on insolvency. However, a good record of the information provided to the board and the decisions that it makes will be critically important in any subsequent litigation. Incomplete and unsigned board minutes make it considerably more difficult for defense counsel to argue that the board appropriately made an informed decision.

    Deepening Insolvency
    A few courts in the past several years have allowed plaintiffs to pursue a claim entitled “deepening insolvency.” The Third Circuit’s decision in Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., Inc., 267 F.3d 340 (3d Cir. 2001) is frequently cited as one of the early cases standing for this proposition. There, the court held that deepening insolvency was an injury sufficient to give a plaintiff standing in federal court and went on to predict (in dictum) that, even though the plaintiff there had not alleged such a claim, “the Pennsylvania Supreme Court would provide a remedy by recognizing a cause of action for that injury.” Id. at 351. Other courts, mainly federal courts predicting state law, followed suit. In 2003, the Bankruptcy Court for the District of Delaware predicted that such a cause of action would be recognized under Delaware and New York law. Official Comm. of Unsecured Creditors v. Credit Suisse First Boston (In re Exide Technologies), 299 B.R. 732, 751-52 (Bankr. D. Del. 2003); see also In re LTV Steel Co., 333 B.r. 397, 422 (Bankr. W.D. Ohio 2005) (collecting cases recognizing deepening insolvency as a tort in what is described there as “growing acceptance in recent years, particularly in federal courts”); Kittay v. Atlantic Bank of N.Y. (In re Global Service Group, LLC), 316 B.R. 451, 456-57 (Bankr. S.D.N.Y. 2004) (describing how the concept of deepening insolvency “morphed” into a separate cause of action).

    Recently, the notion that deepening insolvency is a cognizable and separate tort has been strongly criticized by courts and commentators as being ill-founded and inadequately supported by the reasoning of the few courts that have recognized it. See Sabin Willett, The Shallows of Deepening Insolvency, 60 Bus. Law. 549 (Feb. 2005). Just three months ago, Vice Chancellor Stines of the Delaware Chancery Court joined the ranks of those courts declining to recognize a tort of deepening insolvency, using extraordinarily strong language to criticize those courts that have done so:

    "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." Trenwick America Litig. Trust v. Ernst & Young, L.L.P., 906 A.2d 168, 204 (Del. Ch. 2006).

    Vice Chancellor Stines also recognized that the trend, even in federal courts, is now firmly against adoption of the tort: “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.” Id. at 206.

    Courts that have refused to recognize deepening insolvency as a tort do not dispute that deepening a company’s insolvency can be harmful. However, “recognizing that a condition is harmful and calling it a tort are two different things.” Alberts v. Tuft (In re Greater Southeast Community Hosp. Corp.), 333 B.R. 506, 517 (Bankr. D.D.C. 2005).

    The better-reasoned rule is that deepening insolvency may be an aspect of damages for an existing tort, but it is not a separate cause of action. As one court put it, “[p]rolonging an insolvent corporation’s life, without more, will not result in liability. . . Instead, one seeking to recover for ‘deepening insolvency’ must show that the defendant prolonged the company’s life in breach of a separate duty, or committed an actionable tort that contributed to the continued operation of a corporation and its increased debt.” In re Global Services Group, LLC, 316 B.R. 451, 459 (Bankr. S.D.N.Y. 2004). As Vice Chancellor Stines aptly stated in the Trenwick decision:

    "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 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 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." Trenwick, 906 A.2d at 205.

    Based upon this and similar reasoning, the majority of courts that have recently considered the issue have declined to recognize deepening insolvency as an independent tort. See, e.g., Official Comm. of Unsecured Creditors of Radnor Holding Corp. v. Tennenbaum Capital Partners, LLC. (In re Radnor Holdings Corp.), 2006 WL 3346191 (Bankr. D. Del. Nov. 17, 2006) (following Trenwick and rejecting deepening insolvency as an independent tort under Delaware law); Official Comm. of Unsecured Creditors of Vartec Telecom, Inc. v. Rural Tel. Fin. Coop. (In re Vartec Telecom., Inc.), 335 B.R. 631, 641-644 (N.D. Tex. 2005) (same under Texas law); In re Greater Southeast Community Hosp. Corp., 333 B.R. 506, 517 (Bankr. D.D.C. 2005) (same under District of Colombia law); In re Global Services Group, LLC, 316 B.R. 451, 459 (Bankr. S.D.N.Y. 2004) (same under New York law); see also Bondi v. Bank of America Corp. (In re Parmalat), 383 F. Supp. 2d 587, 602 (S.D.N.Y. 2005) (dismissing claim for deepening insolvency under North Carolina law as being duplicative of the plaintiff’s breach of fiduciary duty claim).

    Even the Third Circuit now appears to be taking a more skeptical view of the “tort” of deepening insolvency than it did in 2003 when it issued its decision in the Lafferty case. Earlier this year, the Third Circuit declined to extend Lafferty’s deepening insolvency doctrine beyond Pennsylvania and held that fraudulent conduct is required to sustain a claim of deepening insolvency under Pennsylvania law. In re CitX Corp., Inc., 448 F.3d 672, 680-81 (3d. Cir. 2006). The Third Circuit in CitX stated: “We know no reason to extend the scope of deepening insolvency beyond Lafferty’s limited holding. To that end, we hold that a claim of negligence cannot sustain a deepening-insolvency cause of action.” Id. at 681.

    Unless and until the highest courts of a significant number of states have weighed in, it would be premature to declare that the tort of deepening insolvency is dead, but the trend appears to be firmly against recognizing that doctrine as a separate cause of action.