On August 14, 2007, the Delaware Supreme Court, sitting en Banc and following oral argument, issued its decision in the Trenwick America Litigation Trust v. Billet deepening insolvency case. Rather than write its own opinion, the Delaware Supreme Court released a two-page order affirming Vice Chancellor Strine's August 10, 2006 Chancery Court decision "on the basis of and for the reasons assigned by" the Chancery Court in its opinion. A copy of the Chancery Court opinion is available here.
The End Of Deepening Insolvency In Delaware. By adopting the basis and reasoning of the lower court's opinion, the Delaware Supreme Court ratified Vice Chancellor Strine's decision that there is no cause of action for deepening insolvency under Delaware law. Apparently concluding that no opinion of its own was necessary given the Chancery Court's clear opinion below, the Delaware Supreme Court has put to rest the cause of action for deepening insolvency under Delaware law. Prior to the lower court's decision in Trenwick, some bankruptcy and other federal courts had incorrectly predicted that Delaware would recognize this cause of action.
A Second Look At Vice Chancellor Strine's Trenwick Opinion. Now that the Delaware Supreme Court has affirmed the Chancery Court's decision and its reasons, the lower court's opinion merits further consideration. As discussed in this August 2006 post on the Chancery Court's decision, Vice Chancellor Strine held, in unequivocal terms, that there is no cause of action for deepening insolvency under Delaware law. To give context to the opinion's legal analysis, some of its more important sections are quoted below at length:
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.
Delaware law imposes no absolute obligation on the board of a company that is unable to pay its bills to cease operations and to liquidate. Even when the company is insolvent, the board may pursue, in good faith, strategies to maximize the value of the firm. As a thoughtful federal decision recognizes, Chapter 11 of the Bankruptcy Code expresses a societal recognition that an insolvent corporation’s creditors (and society as a whole) may benefit if the corporation continues to conduct operations in the hope of turning things around.
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 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. 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.
The Delaware Supreme Court's adoption of the basis and reasoning of the Chancery Court's strongly-worded opinion represents the end of the road for the deepening insolvency cause of action under Delaware law.
Hints In The Gheewalla Decision? Interestingly, in its brief order the Delaware Supreme Court dropped a footnote giving not only the citation for the Chancery Court's decision, Trenwick America Litig, Trust v. Ernst & Young, L.L.P., 906 A.2d 168 (Del. Ch. 2006), but also an intriguing comment: "Accord North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 2007 WL 1453705 (Del. Supr. 2007)." This was a reference to its own decision of May 18, 2007 (opinion available here) holding that creditors cannot bring a direct cause of action for breach of fiduciary duty against directors of corporations that are insolvent or in the zone of insolvency.
- As discussed in an earlier post on the Gheewalla decision, the Delaware Supreme Court opinion cited the lower court decision in Trenwick favorably, as well as the earlier Chancery Court decision in Production Resources (opinion available here), discussed in another earlier post.
- The "Accord" reference in its Trenwick order suggests that the Delaware Supreme Court believed that its May 2007 Gheewalla decision foreshadowed this week's affirmance of the Chancery Court's Trenwick decision and reasoning.
More Clarity For Directors. With the adoption of the Chancery Court's opinion in Trenwick, and its own opinion in Gheewalla, the Delaware Supreme Court has effectively endorsed the trend in recent Chancery Court decisions to limit certain efforts to expand the liability of directors of insolvent or nearly insolvent corporations. Nearly sixteen years have passed since the Chancery Court's decision in Credit Lyonnais Bank Nederland, N.V. v. Pathe Communications Corp., 1991 WL 277613 (Del. Ch. 1991), introduced us to the terms "vicinity of insolvency" and "zone of insolvency." Although the Delaware Supreme Court has left some questions open, these new decisions help provide meaningful guidance on how directors of financially troubled Delaware corporations should discharge their fiduciary duties.