Third Circuit Issues Precedential Decision on Deepening Insolvency Cause of Action Under Pennsylvania Law

The Third Circuit reaffirmed that creditor claims against corporate directors and officers for fiduciary duty and related breaches under the “deepening insolvency” theory are alive and well, at least under Pennsylvania law, in Official Committee of Unsecured Creditors, on Behalf of the Estate of Lemington Home for the Aged v. Baldwin, Case No. 10-4456 (3d Cir., September 21, 2011). The case involved an appeal from the District Court’s grant of summary judgment in favor of the D&O defendants, predicated on that Court’s finding that (i) the business judgment rule and the in pari delicto defense barred recovery on fiduciary duty claims; and (ii) the Committee failed to establish a material issue of fact as to whether the defendants committed the fraud necessary to sustain a deepening insolvency claim.

The debtor, as its name suggests, was an elder care facility in Pittsburgh whose origins date to the post-Civil War period. The Third Circuit’s opinion recites the Home’s long history of financial struggles and what can be charitably described as mismanagement. In April 2005, the debtor filed a chapter 11 petition, and the Committee was promptly appointed. Ultimately, the Committee filed an adversary proceeding seeking recovery from the D&O defendants for breaches of fiduciary duty and on claims based on the deepening insolvency of the debtor.

The Third Circuit’s analysis started with a citation to Pennsylvania statutory authority imposing on corporate officers and directors fiduciary duties and duties of care and stated that “[t]hese fiduciary duties are owed not only to the corporation and its shareholders, but also to the creditors of an insolvent entity.” Based on the statutes, the Court opined that material to the analysis was (i) whether the directors relied on information provided by management reasonably and in good faith; and (ii) whether the officers “exercised ‘reasonable inquiry, skill and diligence’ in performing their duties.”

With respect to the business judgment rule defense to the fiduciary duty claims, the Third Circuit held that the existence of “evidence to support a rational conclusion that the directors did not exercise reasonable diligence” precluded application of the rule on a summary judgment motion. As to the in pari delicto defense, the Court found that the “considerable evidence that the alleged breaches of fiduciary duty were from [sic] the defendants’ self-interest and did not benefit the Home.” As such, the Court held that the “adverse interest” exception to the defense, applicable where a defendant’s misfeasance runs contrary to the interests of the debtor, presented a genuine issue of fact that precluded summary judgment.

Finally, the Third Circuit addressed the Committee’s deepening insolvency claim and stated that Pennsylvania courts have not formally recognized this cause of action. However, the Third Circuit cited the analyses in its prior opinions in Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340 (3d Cir. 2001) and In re Citx Corp., 448 F.3d 672 (3d Cir. 2006) for the conclusion that the Supreme Court of Pennsylvania would recognize the cause of action, defined as “‘an injury to [a debtor’s] corporate property from the fraudulent expansion of corporate debt and prolongation of corporate life.’” The Court stated that, in order to maintain this claim, a plaintiff must “demonstrate that the directors’ actions caused the deepening insolvency” and that fraud is necessary to support the claim, with mere negligence being insufficient. Based upon the record introduced by the Committee on the summary judgment motion in the District Court, the Third Circuit concluded that a genuine issue of material fact existed as to whether the defendants “fraudulently contributed to deepening the insolvency of the Home.”

The Third Circuit’s jurisprudence on the viability of deepening insolvency claims under Pennsylvania law thus stands in stark contrast to the Delaware Supreme Court’s decisions in North American Catholic Educ. Programming Fund, Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007) and Trenwick America Litigation Trust v. Ernst & Young LLP, 906 A.2d 168 (Del. Ch. 2006), affirmed 931 A.2d 438 (Del. 2007). As stated in Gheewalla, under Delaware law, “the creditors of a Delaware corporation that is either insolvent or in the zone of insolvency have no right, as a matter of law, to assert direct claims for breach of fiduciary duty against the corporation’s directors.” Similarly, in Trenwick, the Delaware Chancery Court held below that “[p]ut simply, under Delaware law, ‘deepening insolvency is no more a cause of action when a firm is insolvent that a cause of action for ‘shallowing profitability’ would be when a firm is solvent. . . . Refusal to embrace deepening insolvency as a cause of action is required by settled principles of Delaware law.”

Lemington Home indicates that the Third Circuits’ ongoing assessment of the deepening insolvency cause of action, at least under Pennsylvania law, has not been influenced by the Delaware Courts’ groundbreaking reversal of the trend in this area under Gheewalla and Trenwick. Choice of law is thus a critical threshold issue in analyzing the viability of such claims in the Third Circuit.