05.30.2008
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Updates
In addition to running businesses and fulfilling their ordinary fiduciary duties, in recent years, officers and directors of financially troubled companies have had to worry about potential "deepening insolvency" claims. "Deepening insolvency" generally refers to liability imposed on officers and directors whose wrongful actions cause an insolvent company to plunge deeper into the red. In the 2006 Trenwick case, the Delaware Chancery Court eased the minds of officers and directors to some degree by holding that no independent claim for deepening insolvency exists in Delaware. In the recent case of In re Brown Schools, however, the U.S. Bankruptcy Court for the District of Delaware held that, although it is not an independent cause of action, deepening insolvency may be used to assess damages when breach of fiduciary duty claims are brought against officers and directors.
Background on the Trenwick Decision
No Independent Cause of Action for Deepening Insolvency. In the 2006 case of Trenwick Litigation Trust v. Ernst & Young L.L.P, a litigation trust had been formed during the prior reorganization of a subsidiary of a public insurance holding company. Trenwick Litigation Trust v. Ernst & Young, L.L.P., 906 A.2d 168 (Del. Ch. 2006). See our August 29, 2007 Update, "Delaware Courts Reject Deepening Insolvency Cause of Action." The litigation trust sued the former directors of both the subsidiary and the holding company on several grounds, including a claim for deepening insolvency. The Chancery Court held that no independent cause of action existed for deepening insolvency; rather, the actions of a board of directors of a solvent corporation must be challenged by existing equitable and legal causes of action, including breach of fiduciary duty, fraud, fraudulent conveyance and breach of contract. The Trenwick decision was affirmed by the Delaware Supreme Court.
Unclear Whether Courts May Consider Deepening Insolvency in Other Contexts. Although the Trenwick court clearly answered the question of whether a separate cause of action exists, it left unanswered whether deepening insolvency may be considered in the context of other causes of action.
Background on the Brown Schools Decision
Bankruptcy Court Finds Deepening Insolvency a Valid Theory of Damages. In the recent case of In re Brown Schools, the Bankruptcy Court for the District of Delaware reopened the deepening insolvency dialogue. In re Brown Schools, 2008 WL 1849790 (Bankr. D. Del. Apr. 24, 2008). In that case, a Chapter 7 trustee brought an adversary proceeding against shareholders and directors of the debtor and the debtor's parent company for breach of fiduciary duty and deepening insolvency, among other things. The trustee alleged that the defendants had prolonged the life of the debtor for the defendants' benefit and had preferred themselves over other creditors. The Bankruptcy Court dismissed the deepening insolvency claim based on the Delaware Supreme Court's affirmation of the Trenwick decision. The defendants argued that the breach of fiduciary duty claims were disguised deepening insolvency claims and, therefore, also should be dismissed. The Bankruptcy Court disagreed and held that deepening insolvency was a valid theory of damages for a breach of fiduciary duty claim.
| Practical Tip Officers and Directors or Financially Troubled Companies Should Keep Creditors in Mind. Although there is no independent cause of action in Delaware, the Brown Schools decision makes it clear that deepening insolvency may be considered by courts when determining damages on other causes of action, such as breach of fiduciary duty. Although the Brown Schools decision was issued by the Delaware Bankruptcy Court, other courts will likely be influenced by the ruling from that jurisdiction, as many courts are on matters of corporate law. When exercising their fiduciary duties and business judgment, officers and directors of financially troubled companies should carefully consider the ramifications of their actions on the company's creditors. It is imperative to consult with counsel experienced in advising the boards of troubled companies. |
Additional Information
This Update is only intended to provide a general summary of the Bankruptcy Court for the District of Delaware's decision in In re Brown Schools. Read the full text of the In re Brown Schools decision. You can find discussions of other recent cases, laws, regulations and rule proposals of interest on our website.
