An article appeared in last month's ABI Journal¹ on the Trenwick² opinion regarding deepening insolvency which was issued by the Delaware Chancery Court on Aug. 10, 2006. The article questioned whether Trenwick really rang the death knell for deepening insolvency claims in bankruptcy, highlighted several questions that may have been created by the Trenwick ruling and concluded by stating that potential defendants should refrain from doing a victory dance just yet, as there were sure to be further controversies in this area.

These predictions have certainly come true. The Trenwick decision has been appealed to the Supreme Court of the State of Delaware,³ and more courts have weighed in on the issue, some agreeing with Trenwick, while another issued an opinion determining that deepening insolvency is only a damage theory. In the end, the one thing that is clear is that the deepening insolvency battle rages on....

Trenwick Appeal and Cases Citing Trenwick

The application of Trenwick was discussed by the Delaware Chancery Court just two weeks after its release, with respect to the nature of the fiduciary duty directors may have to creditors of corporations in the zone of insolvency.⁴ Just three weeks after the Trenwick decision was issued, the U.S. Bankruptcy Court for the Central District of Illinois called it into question, specifically noting that since Trenwick was decided by the Delaware Chancery Court, and not the Delaware Supreme Court, there is still an open question as to whether Delaware will recognize a separate cause of action for deepening insolvency.⁵

Only one month later, the U.S. Bankruptcy Court for the District of Columbia issued an opinion "circling back" and retreating from its earlier decision, which had determined that deepening insolvency was in fact a separate cause of action.⁶ The court was very troubled by the opinion issued by Third Circuit in CitX.⁷ Since Lafferty⁸ was the case upon which many courts based their opinions that deepening insolvency was in fact a separate cause of action, including the court when issuing its earlier decision,⁹ and since CitX¹⁰ has been interpreted by many to "reign in" the Lafferty decision, the court said it had "serious pause" when now asked to recognize a separate cause of action.¹¹ The court noted that although CitX involved different facts, and although the decision is not binding on the court, the Third Circuit' s "reinterpretation" of Lafferty contradicts the conclusions reached by the court in its earlier opinion, and thereby called into question the court' s reliance on that case in the prior opinion.¹² The court concluded that deepening insolvency is a damage theory, not a separate independent tort, and therefore fraud must not be proven as a prerequisite to recovery. The court stated: "Rather than attempt to 'discover' a separate common law tort which must then neutered, this court prefers to treat deepening insolvency as the theory of harm that it was always meant to be, and will rely on other, more established (not to mention less convoluted) common law causes of action to ascertain whether the defendants...engaged in a legal wrong for which [the plaintiff] is entitled to recover."¹³ Ultimately, the court concluded that since deepening insolvency was nothing more than a damage theory, and not an independent cause of action, it was not necessary to establish fraud.¹⁴ The court stated that: "if deepening insolvency were treated as a separate cause of action rather than a theory of damages, it would make sense to require a higher threshold of scienter than mere negligence lest the tort expose directors and third parties to a standard of care that they otherwise would never have owned in the first place."¹⁵

Now, nearly three months after the Trenwick opinion was issued, it is clear that questions are bubbling to the surface about the extent of the precedential value of the case, its application to pending cases and the effect it may have on previously decided cases in which bankruptcy courts predicted that the Delaware state court would reach a different conclusion than this chancery court ultimately concluded. Further, although it does not appear that it has been raised in case to date, Trenwick is sure to have an effect on the choice of law to be applied in a bankruptcy case for the purposes of resolving breach of fiduciary duty or deepening insolvency claims.

Are Courts Bound by the Decision in Trenwick?

Are federal courts, when applying Delaware law, bound to follow the Trenwick decision that Delaware does not recognize a separate tort for deepening insolvency? When called to apply substantive state law with respect to an issue that the state' s highest court has not addressed, a federal court must predict how the state's highest court would resolve the issue.¹⁶ It is likely that since it was the Delaware Chancery Court that issued the decision in Trenwick and not the Delaware Supreme Court, federal courts will not view the case as the ultimate word on the subject. In fact, only a few weeks after the Trenwick decision was issued, the U.S. Bankruptcy Court for the Central District of Illinois, when called to interpret Delaware law, specifically acknowledged the Trenwick decision, but determined that resolving the impact of Trenwick was not properly addressed on the motion to strike before the court.¹⁷

Trenwick' s Effect on Pending Cases

In the Greater Southeast case, the bankruptcy court had issued an opinion based on its interpretation of Lafferty. When presented with the issue at a later time, the court indicated that it had "great pause" because it had relied "heavily" on Lafferty and the Global Services cases, and since the original decision by the bankruptcy court less than a year before, the Third Circuit had issued its ruling in CitX, in which that court made it significantly more difficult to establish a claim for deepening insolvency by necessitating that fraud be proven and pled. The Greater Southeast court recognized that it was not bound by the Third Circuit' s decision and ultimately concluded, at odds with a prior decision just 10 months before, that deepening insolvency was a theory of damages and as such did not require proof of fraud.¹⁸

Possible Choice-of-Law Implications of Trenwick

In prior cases, it was not uncommon for bankruptcy courts, when presented with motions to dismiss, summary judgment motions or settlements, to analyze the viability of deepening insolvency as a separate cause of action in all possible jurisdictions applicable to the case, rather than to definitively settle the choice-of-law issue. If Trenwick establishes that Delaware does not recognize a separate tort of deepening insolvency, it is likely that bankruptcy courts will be spending significantly more time resolving choice-of-law issues because the stakes will be much higher.

Does Trenwick Apply to Non-officer and Director Defendants?

Whether the Trenwick decision will be limited in its application only to claims against officers and directors for deepening insolvency remains to be seen. Since the Trenwick court appeared to base its findings in large part on not only the duplicative nature of deepening-insolvency and breach-of-fiduciary-duty claims, but also the availability of the defense of the business-judgment rule, does the Trenwick decision only apply to cases against defendants that have a fiduciary duty to the debtor/corporation and/or those defendants can avail themselves of the business-judgment rule? Further, deepening-insolvency claims against professionals or secured lenders are in a sense based on aiding and abetting the breach of a fiduciary duty of another that has such a duty. If under Delaware law there is no deepening-insolvency claim against the primary actor with the fiduciary duty, logically it should follow that there can be no deepening-insolvency claim against the alleged aider/abettor.

The Fleming court noted the question of whether Trenwick could be used by federal courts interpreting Delaware law since it was not an opinion of the highest court in Delaware, also stated: "It is worth nothing that a director 'acts' as a director through official board action... An officer acts within the scope of authority conferred by the office, as an agent of the company."¹⁹ The Fleming court also discussed the strong presumption in Delaware in favor of officers and directors and that it is not the job of the court to apply 20/20 hindsight and second-guess decisions made by the officers and directors.²⁰

Non-officer and director defendants such as secured lenders or professionals do not have the kind of authority conferred to officers and directors as discussed in Fleming. Further, they certainly do not have the affirmative defense of the business-judgment rule and the protection from the court from second-guessing their decisions. Since the Trenwick decision relied so heavily on the duplicative nature of breach of fiduciary duty and deepening-insolvency causes of action, as well as the availability of the business-judgment rule, there is a significant question as to whether Trenwick will apply to non-officer and director defendants—most significantly, and most recently, the most frequent defendant in deepening insolvency actions, secured lenders.

Must Fraud Be Proven if Deepening Insolvency Utilized as a Theory of Damages?

As noted previously, cases such as Oakwood Homes²¹ and CitX recently decided that fraud was a necessary element in cases where deepening insolvency was a separate cause of action. However, what happens when deepening insolvency is determined to be a theory of damages? Should fraud be a necessary element in those cases as well? The bankruptcy court in Greater Southeast recently said no. The court concluded that the link the CitX court made between fraudulent intent and deepening insolvency was an "arbitrary one unless one makes the equally arbitrary determination that deepening insolvency is a tort of its own, in which case officers and directors who, without engaging in fraud, grossly breach their duty of care in a harmful manner would be insulated from wrongdoing." The court concluded that if deepening insolvency was to be used as a measure of damages, it should be used whether the injury occurred as a result of negligence or fraud.²² Case law in the area of deepening insolvency remains in flux. While on its face Trenwick appeared to ring the final death knell for deepening-insolvency claims in Delaware ... defendants are not completely out of the woods yet.

Deepening Insolvency Not a Tort or a Measure of Damages

The Oklahoma Court of Civil Appeals recently held that not only was deepening insolvency not a separate tort, but "deeper insolvency" is not even a recognized measure of damages in Oklahoma.²³ It will be interesting to see if other courts will follow this rationale and/or be as anxious to get the deepening-insolvency debate out of the state courts once and for all. The Oklahoma Appeals Court referred to deepening insolvency as an "amorphous concept found especially in bankruptcy literature."²⁴ It is clear that the Oklahoma Court of Appeals viewed deepening insolvency as a creature of bankruptcy courts and federal courts only—a view that is directly at odds with all of the cases with respect to deepening insolvency to date that treat deepening insolvency purely as an issue of state law.

Conclusion

Case law in the area of deepening insolvency remains in flux. While on its face Trenwick appeared to ring the final death knell for deepening-insolvency claims in Delaware, as outlined in last month's article, defendants are not completely out of the woods yet. Not only is Trenwick on appeal, but many questions remain as to whether courts are bound by the decision of Trenwick and what effect Trenwick may have on previously decided cases. Moreover, many new issues may arise as to the choice-of-law issues in resolving deepening insolvency claims and its applicability to nonfiduciary defendants. More developments in this area are sure to follow.

In addition, for those courts which continue to recognize the cause of action, questions remain. Although it appeared that in cases such as CitX, Verestar and Oakwood Homes, that bankruptcy courts were moving toward a trend that fraud was a necessary element to prove a claim for deepening insolvency, it is not clear that fraud would be required when a claim for deepening insolvency is brought in a jurisdiction that views it as nothing more than a damage theory. While not an issue in the Trenwick decision, the discussion of the requirement of fraud in deepening-insolvency cases as a measure of damages makes sense, and it will be interesting to see future cases in this regard.

 

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Footnotes

1 Brighton, Jo Ann J., "The Trenwick Decision—The Death Knell for Deepening Insolvency? 'Zone of Insolvency' Case Law Reigned In? Delaware State Court Says No Action for Deepening Insolvency in Delaware, but....," ABI Journal, Vol. XXV, No. 8 (October 2006).

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

3 Trenwick America Litigation Trust v. James F. Billett, et al., Case No. 495, 2006 (Delaware Supreme Court Sept. 14, 2006).

4 N. Am. Catholic Educ. Programming Found. Inc. v. Gheewalla, 2006 WL 2588971 (Del. Ch. Sept. 1, 2006).

5 In re Fleming Packaging Corp., 2006 WL 2587916 *5 n. 3 (09/08/06 Bankr. C.D. Ill. 2006).

6 In re Greater Southeast Community Hosp. Corp. I, 2006 WL 2793117 (Bankr. D. D.C. Sept. 21, 2006).

7 448 F.3d 672 (3rd Cir. 2006).

8 267 F.3d 340 (3d Cir. 2001).

9 See In re Greater Southeast Community. Hosp. Corp. I, 333 B.R. 506 (Bankr. D. D.C. 2005).

10 448 F.3d 672 (3rd Cir. 2006). See also, Brighton, Jo Ann J., "Deepening the Blows Against Deepening Insolvency—the Third Circuit's CitX and Post-CitX Opinions," ABI Journal, Vol. XXV, No. 7 (September 2006).

11 2006 WL 2793117 at * 3-4.

12 Id.

13 Id.

14 Id.

15 Id.

16 See, e.g., Jaasma v. Shell Oil Co., 412 F.3d 501, 507 n.5 (3d Cir. 2005).

17 In re Fleming Packaging Corp., 2006 WL 2587916 * 5.

18 In re Greater Southeast Community Hospital Corp.

19 In re Fleming Packaging Corp., 2006 WL 2587916 * 4-5.

20 Id. at *3.

21 OHC Liquidation Trust v. Credit Suisse First Boston (In re Oakwood Homes Corp.), 340 B.R. 510 (Bankr. D. Del. 2006).

22 2006 WL 2793177 at 4.

23 Commercial Financial Services Inc. v. J.P. Morgan Securities Inc. and Mayer Brown Rowe & Maw P.A., No. 103,053 (Ct. Civil App. Okla. Sept. 28, 2006).

24 Id. at p. 4.