Over the past few years, a number of bankruptcy and other federal courts have held that plaintiffs, often bankruptcy trustees or other bankruptcy estate representatives, could pursue a cause of action against a corporation’s directors and others for "deepening insolvency." What has made a deepening insolvency claim so attractive to plaintiffs and troubling to defendants is the lack of clarity about what conduct might give rise to such a claim, how damages for it might be calculated, and whether it would allow for expanded recoveries under other causes of action.
What is deepening insolvency? Courts have described deepening insolvency as the "fraudulent prolongation of a corporation’s life beyond insolvency," resulting in "damage to the corporation caused by increased debt" and similarly as the “fraudulent expansion of corporate debt and prolongation of corporate life.” A more colorful way of putting it might be, under some circumstances, "better dead than (deeper in the) red."
A question of state law. Since federal courts apply state law to many substantive issues, those federal courts that have recognized a deepening insolvency cause of action have done so by predicting how state courts would rule on the question. With so many companies incorporated there, Delaware’s view on deepening insolvency may be the most important. For that reason, many attorneys took note when in the past few years bankruptcy courts in Delaware allowed deepening insolvency claims to go forward, based on their prediction that Delaware state courts would also recognize the cause of action.
The new Delaware decision. Although federal courts had issued rulings, no Delaware state court had decided whether a cause of action for deepening insolvency exists under Delaware law. Well, that changed on August 10, 2006, when Delaware’s corporate law court, the Court of Chancery, issued a decision in a case called Trenwick America Litigation Trust v. Ernst & Young LLP, et al. Click here to read the court’s decision.
In Trenwick America, Vice Chancellor Strine squarely held, in unusually strong language, that no cause of action for deepening insolvency exists under Delaware law. The court also elaborated on how the business judgment rule can protect directors when a corporation is insolvent or in the zone of insolvency. Since the decision is almost 90 pages long, I’ve quoted below from the key deepening insolvency discussion (although I left out the extensive footnotes). It makes for interesting reading — even if you’re not a lawyer.
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.
You might find Professor Larry Ribstein’s discussion of the new decision interesting, as well as the comments made by Francis Pileggi, who publishes the Delaware Corporate and Commercial Litigation Blog. They also discuss another aspect of the decision, the holding that directors of a wholly owned subsidiary corporation did not breach their fiduciary duties by taking on debt for the benefit of the parent corporation, even though both the parent and subsidiary ended up in bankruptcy.
Echoes of Production Resources. Some of you may recall that Vice Chancellor Strine was also the author of the November 2004 Production Resources decision, which interpreted Delaware law more favorably for directors of corporations that are insolvent or in the "zone of insolvency." The Production Resources decision was the subject of an earlier post.
This new decision builds on Production Resources and, in so doing, follows an approach similar to one recently taken by a bankruptcy court in New York in In re Verestar, Inc. The June 2006 Verestar decision cited to Production Resources and predicted that Delaware courts would reject deepening insolvency as a cause of action. Click here for a copy of the Verestar decision; its deepening insolvency discussion starts at page 41.
Conclusion. With a clear voice from the Delaware Court of Chancery, the Trenwick America decision reinforces a recent trend among some federal courts to step away from recognizing deepening insolvency as a separate cause of action. As with any new decision, however, the real test of its influence will be the extent to which other courts, including Delaware’s highest court, the Delaware Supreme Court, follow its holding and reasoning.