Third Circuit: In Pennsylvania, Creditors’ Deepening Insolvency Claims Still Fair Game

In September of this year, 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, the court considered an appeal from the District Court’s grant of summary judgment in favor of the D&O defendants, predicated upon 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 chapter 11 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 upon the deepening insolvency of the debtor.

After finding that the evidence created a genuine issue of fact precluding application of either the business judgment rule or the in pari delicto defense on summary judgment, the court turned to the viability of the Committee’s deepening insolvency claims. Noting that Pennsylvania courts have not formally recognized this cause of action, the Third Circuit cited the analyses in its prior opinions in Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., and In re Citx Corp., 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, and Trenwick America Litigation Trust v. Ernst & Young LLP. 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 than 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 Circuit’s 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.

Dale E. Barney is a Director in the Gibbons Financial Restructuring & Creditors’ Rights Department.
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