The Delaware Supreme Court recently issued a long-awaited decision on whether a cause of action asserting deepening insolvency exists under Delaware law. Sitting en banc and following oral argument, the court in Trenwick America Litigation Trust v. Billet, 2007 WL 2317768  (Del. Aug. 14, 2007), held that there was no such cause of action under Delaware law. The court did not issue its own decision but relied on the lengthy August 10, 2006 decision of Vice Chancellor Strine in Trenwick America Litigation Trust v. Ernst & Young, L.L.P., 906 A.2d 168 (Del. Ch. 2006).

This Update provides a summary of the key points from this decision and offers practical guidance.

A Summary of the Deepening Insolvency Theory

The decision in Kittay v. Atlantic Bank of New York (In re Global Serv. Group LLC) referred to deepening insolvency as a "'fraudulent prolongation of a corporation's life beyond insolvency'," resulting in damage to the corporation caused by increased debt. 316 B.R. 451, 456 (Bankr. S.D.N.Y. 2004) (quoting Schacht v. Brown, 711 F.2d 1343, 1350 (7th Cir. 1983)). Under the deepening insolvency theory, an insolvent corporation suffers a distinct and compensable injury when it continues to operate and incurs more debt after it becomes insolvent. Although originally a damages theory, the concept grew and a number of courts have recognized deepening insolvency as an independent cause of action, including in Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340, 349-52 (3d Cir. 2001) (construing Pennsylvania law), and Official Committee of Unsecured Creditors v. Credit Suisse First Boston (In re Exide Technologies, Inc.), 299 B.R. 732, 750-52 (Bankr. D. Del. 2003) (construing Delaware law). However, other courts held that it remained a damages remedy and not an independent action: Bondi v. Bank of America Corp. (In re Parmalat), 383 F. Supp. 2d 587, 601-02 (S.D.N.Y. 2005) (dismissing deepening insolvency claim as duplicative where breach of fiduciary duty was also alleged), and In re Greater Southeast Community Hospital Corp., 333 B.R. 506, 517 (Bankr. D.D.C. 2005) (rejecting deepening insolvency as duplicative while allowing other related counts).

Chancery Court's Decision in Trenwick Rejects Deepening Insolvency Cause of Action

In the Chancery Court opinion adopted by the Delaware Supreme Court, Vice Chancellor Strine explicitly held that there is no cause of action for deepening insolvency under Delaware law. In reaching his decision, Vice Chancellor Strine looked carefully at the underlying theory and other available causes of action and concluded that the deepening insolvency theory was incoherent.

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.

Trenwick Am. Litig. Trust v. Ernst & Young, L.L.P., 906 A.2d 168, 174 (Del. Ch. 2006).

In a strong show of support for directors and fiduciaries of corporations, Vice Chancellor Strine further held that

[t]he 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 equity holders. 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.

Id. at 174-75.

Vice Chancellor Strine found no basis in existing Delaware law that would embrace the logical result advocated by parties asserting a theory of deepening insolvency: that when a company was insolvent it was required to terminate its operations and close down. Instead, he found that so long as directors, through the exercise of their fiduciary duties, felt that there were potential strategies that could change the corporation's fortunes, they were free to pursue those options without the risk of liability. Id. at 204.

The Court's Ruling Benefits Directors of Financially Troubled Delaware Corporations

The Delaware Supreme Court's ruling comes at an opportune time as many predict that the U.S. economy is heading for a correction. The court's ruling should give directors some confidence that if they properly exercise their fiduciary duties they will not be held liable even if the corporation ultimately goes further into debt as a result of their actions. Although this decision only binds other Delaware courts and only applies directly to corporations organized under Delaware law, the significant role Delaware law plays in the realm of corporate governance will undoubtedly influence courts in other jurisdictions.

Practical Tip

Directors of Financially Troubled Companies Should Even More Carefully Document Deliberations and Decisions. As with all decisions by boards of corporations that are struggling financially or in the zone of insolvency, the key will be for the directors to create a clear record of the various alternatives explored by the board and the bases for their determination.

Additional Information

You can find the full text of the Delaware Supreme Court's two-page order at http://courts.delaware.gov/opinions/(slz0n545lnuqjkyghjtcz22f)/download.aspx?ID=95790. You can find the full text of Vice Chancellor Strine's decision at http://courts.delaware.gov/opinions/(1223ulekbvsw0f45qalbcjyd)/download.aspx?ID=80090. You can find discussions of other recent cases, laws, regulations and rule proposals of interest to public companies on our website.