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...

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Oct 2006

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citation: ABI Journal, Vol. XXV, No. 8, p. 32, October

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An
article in September's ABI Journal announced: "Deepening the Blows
Against Deepening Insolvency? The Third Circuit's CitX Opinion and the Post-CitX
Opinions."1 The premise of the article was that the CitX2
and Verestar3 decisions followed the trend of recent cases
making it increasingly difficult to maintain a cause of action for deepening
insolvency. Just a few months later, a decision issued by the Delaware Chancery
Court on Aug. 10, 2006, may have rung the final death knell for claims of deepening
insolvency.4 However, things may not be as clear as they seem.

In Trenwick, the Delaware Chancery Court, in an opinion authored by
Vice-Chancellor Strine, determined that Delaware recognizes no claim for deepening
insolvency. In the court's view, existing causes of action for breach of fiduciary
duty, fraud or breach of contract sufficiently cover the landscape. The court
emphatically defended directors and other fiduciaries and their right to the
protection of the business judgment rule—specifically, the court stated
that "the words 'zone of insolvency' should not declare open season on
corporate fiduciaries."5
Recent Trend in Deepening Insolvency Cases 
The Trenwick decision comes on the heels of a handful of cases recently
reigning in the "cause of action" for deepening insolvency—most
notably, the CitX, Verestar and Oakwood Homes6
cases. The CitX case, discussed in last month's issue, determined that
in the Third Circuit, fraud must be pled to maintain a cause of action for deepening
insolvency. In the Verestar7 case, the U.S. Bankruptcy Court
for the Southern District of New York, interpreting Delaware law, determined
that proper exculpatory clauses in corporate charters pursuant to Delaware statutes
can bar claims against directors for claims of deepening insolvency. In the
Oakwood Homes8 case, the Delaware Bankruptcy Court followed
the Third Circuit case of Lafferty,9 which recognized deepening
insolvency under Pennsylvania law, but specifically noted that Delaware had
not yet spoken on the issue and that the nature of the debate was "rapidly
changing." Therefore, the court treated the deepening insolvency issue
as pending. Just a little over four months later, in Trenwick, the Delaware
state court specifically spoke on the issue.

The Lafferty decision was decided more than five years ago and has been
used by many courts as a basis for subsequent decisions allowing claims of deepening
insolvency against a variety of defendants, including, but not limited to, officers
and directors, professionals (attorneys and accountants) and secured creditors.10
By way of example, in the Oakwood Homes case, the sole defendant is a
lender being sued in dual capacities, both as a lender and a professional. Expanding
the deepening insolvency horizon further, one recent court even left open the
possibility of a claim for post-petition deepening insolvency.11
Given the degree of corporate leverage in the recent few years, the incentive
has perhaps never been greater for creditors' committees and trustees alike
to be more creative—and more aggressive—in seeking alternative causes
of action as the only means to obtain recoveries for creditors. As the creativity
and aggressiveness of plaintiffs expanded, and the pool of defendants became
deeper, the application and the use of deepening insolvency widened—and
so has the controversy. Decisions, almost entirely made at the summary-judgment
or motion-to-dismiss stage, began to focus on whether a particular state would
recognize an independent cause of action for deepening insolvency or whether
it was merely a measure of damages. The water began to get even murkier when
bankruptcy courts in one state were forced to issue opinions about what another
state's courts would likely do if asked to determine whether deepening insolvency
was in fact a separate cause of action. If a state had not spoken on the issue,
and none had, it became the role of the bankruptcy court to "predict"
what it thought the state court might find—a process that led one bankruptcy
court to recently state that bankruptcy courts had no business trying to make
such predictions.12 Trenwick is a particularly significant
decision because it is the first state court of note to actually speak for itself
on the issue of deepening insolvency.

The Facts of Trenwick 
The facts of Trenwick are complex and contain a sense of drama. However,
the facts are almost irrelevant because, on its face, the holding of the Delaware
Chancery Court is in no way limited to the facts. It can be argued that it is
a broad holding that applies Delaware law, especially corporate law concerning
internal corporate affairs, very generally. However, to provide a complete understanding,
the facts are these.
Trenwick, along with its corporate parent and subsidiaries, filed a chapter
11 petition in the U.S. Bankruptcy Court for the District of Delaware. Prior
to filing, like many debtors, Trenwick pursued an aggressive expansion strategy
that ultimately failed. In the end, the expansion strategy not only increased
the asset holdings of Trenwick, but also the debt obligations. Trenwick America
was a primary and secondary obligor on the various debt obligations of Trenwick
to finance the acquisitions. Through various internal restructurings, a portion
of the acquired assets and debt were transferred to Trenwick America.13
As part of the confirmed plan, a litigation trust received the power to investigate
and pursue claims and causes of action against Trenwick America. A multi-count
complaint was filed by the trust against former directors of Trenwick and Trenwick
America, as well as certain former advisors of Trenwick America, alleging, among
other things, breaches of fiduciary duty, deepening insolvency, aiding and abetting,
breach, fraud and conspiracy to breach fiduciary duties.14 Deepening-insolvency
allegations were made against the Trenwick America directors. As is the case
with many "kitchen sink" complaints, the defendants filed a motion
to dismiss for failure to state a claim upon which relief can be granted. The
Delaware Chancery Court granted the motion in an 88-page opinion.
The Delaware Chancery Court's Opinion in Trenwick

The Delaware Chancery Court's opinion makes for interesting reading and is
rife with entertaining commentary; for example, the court states: "The
concept of deepening insolvency has been discussed at length in federal jurisprudence,
perhaps because the term has the kind of stentorious academic ring that tends
to dull the mind to the concept's ultimate emptiness."15 In
another example, "although the complaint is full of inflammatory adjectival
assaults on the motives of the holding company board, they are all entirely
conclusory and unsupported nature [sic]."16 The opinion also
includes a noteworthy discussion on fiduciary duties of officers and directors
and fraud claims, but it is beyond the scope of this article.
With respect to deepening insolvency, the court stated: "Delaware law
imposes no absolute obligation on the board of a company that is unable to pay
its bills to cease operations and liquidate."17 The court discussed
the necessary ability of the directors to act in good faith to attempt to reorganize
rather than liquidate—in fact, the court notes that such activities are
consistent with the underlying goals of chapter 11.18 The court cited
a bankruptcy court decision from the Southern District of New York and referred
to the decision as "thoughtful" in recognizing that an insolvent corporation's
creditors (and society as a whole) may benefit if the corporation continues
to conduct operations in the hope of turning things around.19 The
court did note that such freedom to act on the part of officers and directors
is not without accountability. The court then discussed the traditional principles
of fiduciary duty, fraud and fraudulent conveyance laws as well as others and
the accountability built into those causes of action.20 The court
took care to highlight that the "contours" of such causes of action
had been "carefully shaped by generations of experience, in order to balance
societal interests in protecting investors and creditors against the exploitation
by directors and in providing directors with sufficient insulation so that they
can seek to create wealth through the good-faith pursuit of business strategies
that involve the risk of failure."21 "[O]ur law already
requires directors of an insolvent corporation to consider, as fiduciaries,
the interests of the corporation's creditors who, by definition, are owed more
than the corporation has the wallet to repay."22 It seems the
court did not see that any additional accountability would be added by recognizing
a claim for deepening insolvency under Delaware law.

Further, clearly the concepts of good faith and the business-judgment rule
were in the forefront of the court's mind in reaching its conclusion concerning
deepening insolvency. The court stated: "[T]he mere fact that a business
in the red gets redder when a business decision goes wrong and a business in
the black gets paler does not explain why the law should recognize an independent
cause of action based on the decline in enterprise value in the crimson setting
and not in the darker one."23 The court noted that the board
of an insolvent corporation, acting in due diligence and good faith, pursuing
a business strategy that it believes will increase the corporation's value but
that also involves incurring additional debt, does not become the "guarantor"
of that strategy's success.24 The court also noted that the business-judgment
rule must protect such a board and that to "conclude otherwise would fundamentally
transform Delaware law."25 Finally, in concluding that no separate
cause of action exists under Delaware law for deepening insolvency, the court
jabbed: "In so ruling, I reach a result consistent with a growing body
of federal jurisprudence, which has recognized that those federal courts that
became infatuated with the concept [of deepening insolvency] did not look closely
enough at the object of their ardor."26
Where Does the Trenwick Opinion Leave Deepening Insolvency?

Clearly, now, post-Trenwick, no cause of action for deepening insolvency
is recognized under Delaware law against officers and directors of a corporation.
However, whether the Trenwick decision will have such clear application
and whether it will be limited in its application only to deepening insolvency
claims against officers and directors, remains to be seen.
The Trenwick court based its findings in large part on not only the
duplicative nature of a deepening-insolvency action and a breach-of-fiduciary-duty
claim, but also the availability of the defense of the business-judgment rule.
So does the Trenwick decision only apply to cases against defendants
who have not only a fiduciary duty to the debtor/corporation, but also the availability
of the defense of the business-judgment rule? For example, professionals and
secured lenders27 are not protected by the business-judgment rule.
Accordingly, it can be argued that Trenwick does not apply in either
of those cases. However, 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 who 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.

Can Trenwick Be Used by Federal Courts in Applying Delaware Law?

Another issue is that other bankruptcy courts in the Third Circuit courts are
not bound by the holding in Trenwick. 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.28 It is possible that because it was the Delaware Chancery
Court that issued the decision in Trenwick and not the Delaware Supreme
Court,29 that bankruptcy courts in the Third Circuit are still bound
to use the decision of Lafferty when applying Delaware law. However,
while it is also true that federal courts when interpreting Delaware law are
not bound by the decision in Trenwick because it was not issued by the
state's highest court, it is likely that the federal court would find extremely
persuasive what the Delaware Chancery Court has said on this issue-particularly
from such a scholar as Vice-Chancellor Strine.

Trenwick's Possible Effect on "Zone of Insolvency" Case
Law 
While an in-depth discussion of the so called "zone of insolvency"
and the scope of officers and directors' duties in the zone is beyond the breadth
of this article, deepening insolvency clearly is a close relative to zone-of-insolvency
issues.30 In fact, this author would go so far as to state that the
expansion of the use of deepening insolvency as a cause of action can be partially
attributed to the decisions of courts, in particular the Delaware Chancery Court,
embracing and expanding the theory of the zone of insolvency and the case law-imposed
duties of officers and directors to creditors. Trenwick could be a powerful
sword in cases in which the zone of insolvency, and the duties of the officers
and directors to creditors as opposed to shareholders, are at issue. In Trenwick,
the Delaware Chancery Court dropped to a footnote a discussion of a prior case
authored by the same vice-chancellor, which is often cited for the proposition
that the director's duties shift from the shareholders to the company's creditors.31
The footnoted discussion goes on to further explain the nature of the duty to
creditors and the type of claim creditors may have (derivative). This discussion
has made it absolutely clear that the business-judgment rule applies even during
the zone of insolvency—a point that the same vice-chancellor did not make
as clearly in the original decision of Production Resources.32
While the Production Resources court did cite Angelo, Gordon
& Co. v. Allred Riser Com. Co. for the proposition that the business-judgment
rule applies,33 it was discussed in a footnote only, and then only
as part of a more general discussion. Vice-Chancellor Strine did not clearly
make the point in the body of the opinion.34 This author suggests
that perhaps the Trenwick court purposefully revisited Production
Resources (and in a sense Lyonnais)35 to restrict the
expanded duty cited often as created in Production Resources to ensure
that litigants are aware that the business-judgment rule applies. In fact, a
case issued by the Delaware Chancery Court a few weeks after Trenwick
narrowly construes the zone-of-insolvency duties and cites to Trenwick,
stating: "A recent decision of this court suggested that cases following
Credit Lyonnais, which have been the subject of considerable academic
debate, are more of a 'judicial method of attempting to reinforce the idea that
the business judgment rule protects the directors of solvent, barely solvent
and insolvent corporations, and that the creditors of an insolvent firm have
no greater rights to challenge a disinterested, good-faith business decision
than the stockholders of a solvent firm.'"36 Accordingly, parties
to future cases in which zone-of-insolvency duties are involved may be able
to cite to Trenwick (as well as North American Catholic Educ'l Programming)
to expressly limit, based on business-judgment principles, the notion of expanded
duties during the zone of insolvency. Finally, with respect to zone-of-insolvency
duties, if nothing else, perhaps Trenwick will focus litigants on the
fact that "the words 'zone of insolvency' should not declare open season
on corporate fiduciaries."37

Other Considerations 
The intersection of state law and bankruptcy law with respect to this issue
presents complex questions. While bankruptcy courts are clearly authorized and
capable of applying state law (which may not be the law of the jurisdiction
in which the case is pending), how is it that bankruptcy courts are engaged
in the practice of predicting what state courts might do, even though that state
court had not addressed the issue? As stated above, 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.38 However, it is not the role of a federal court to expand
state law in ways not foreshadowed by state precedent39—a limitation
noted by the Delaware District Court just last year.40
As a further consideration, this author also wonders whether state courts across
the country, most specifically, the Delaware Chancery Court, had any idea that
bankruptcy courts were predicting what might be done in that particular state
court. The Delaware courts have taken great pains to define the roles of fiduciaries,41
especially in the arena of the so-called "zone of insolvency," as
well as to develop and define the application of the business-judgment rule
under Delaware law.42 Should a bankruptcy court be allowed to interfere
with such careful and thoughtful development of a specific area of state law?
The decision in Trenwick seems clearly to follow the evolution of the
business-judgment rule as previously interpreted by the Delaware courts, and
does not seem overly concerned by prior bankruptcy court decisions that determined
that a cause of action for deepening insolvency may exist under Delaware state
law.43 It appears that the Delaware Chancery Court was not influenced
by the "rapidly changing nature of the debate" in bankruptcy courts
over deepening insolvency.

Another issue that remains with respect to deepening-insolvency causes of action
relates to the choice of law for application to such possible causes of action.
The Trenwick court took it as a given that Delaware law applied in this
case because the case involved a breach of fiduciary duty and rests on the internal
corporate-affairs doctrine. Future cases seeking a choice of law other than
Delaware to avoid the application of the Trenwick holding are sure to
follow.
A final question is this: What happens to those cases where the bankruptcy
court predicted that a cause of action existed under Delaware (or other) state
law when, in fact, no such cause of action exists? In the case of Oakwood
Homes, Judge Walsh left the deepening-insolvency count pending in the face
of the recognition of the "rapidly changing nature of the debate."44
Time will tell how bankruptcy courts procedurally will "go back" and
revisit these issues.
If Deepening Insolvency Is Recognized, Then What?
 As discussed above, certain questions exist as to the application of the Trenwick
decision to nonfiduciary defendants. Moreover, choice of law and the application
of the Trenwick decision to pending causes of action questions must be
resolved.

Even if the hurdle of getting recognition of a state law cause of action for
deepening insolvency is cleared (a not-so-insignificant hurdle), the recent
decisions of CitX and Oakwood Homes appear to require allegations
of fraud in order to be successful. If a plaintiff must prove all five elements
of fraud and survive the pleading requirements of Rule 9(b)45 to
prevail on a deepening-insolvency claim, the question must be raised: Does deepening
insolvency have any continuing utility, or does it merely become an "add
on" to fraud counts in complaints? Indeed, apparently it will be even more
difficult to prevail on a deepening-insolvency cause of action than a fraud
claim, because in addition to proving all five elements of fraud, presumably
one would also have to prove, in the words of Lafferty, "an injury
to the debtors' corporate property from the fraudulent expansion of corporate
debt and prolongation of corporate life."46 Thus, it appears
that a plaintiff asserting deepening insolvency as a cause of action must prove
(1) fraud (with all five sub-parts noted above), (2) that the fraud caused the
expansion of corporate debt and (3) that the fraud also caused the prolongation
of the corporation's (pre-bankruptcy) life. Additionally, some cases suggest
that a plaintiff must prove a pre-existing duty to the company.47
While this does not create an extra burden where the defendant is a fiduciary
of the debtor, such as a director or officer, or as in CitX, the debtor's
professionals, it does place an extra obstacle on claims against certain defendants,
such as lenders.48

In last month's issue, an article stated that the logical conclusion after
CitX would be that plaintiffs, even if they get over the requirement
of recognition under state law, would prefer not to take on these additional
hurdles with respect to fraud, and perhaps deepening insolvency will not be
included in complaints as an additional allegation (along with aiding/abetting
breach of fiduciary duty, recharacterization, etc.) with the same frequency
in which it has been in the past few years. The article concluded: "While
deepening insolvency claims are not likely to go away immediately, it appears
that the case law continues to develop and to rein in deepening insolvency's
broad stroke." The Trenwick decision may be perceived as the final
nail in the coffin for deepening-insolvency actions. However, while the frequency
with which deepening insolvency actions may be brought may diminish, those that
are brought may now necessitate the adjudication of additional issues above
the traditional state law recognition issue—such as the application of
Trenwick to nonfiduciaries, choice-of-law analysis and interpreting state
law hierarchal issues. Accordingly, defendants should not be so quick to run
that victory lap just yet.
Stay tuned for next month's issue for an article digging deeper into jurisdictional
and choice-of-law issues, which were raised in Trenwick, and what it
all may practically mean to deepening insolvency claims going forward.
<blockquote>
<blockquote>  </blockquote>
</blockquote>

<hr>
<h3>Footnotes</h3>
 1 Brighton, Jo Ann J., ABI Journal, Vol. XXV, No. 7, September 2006.

2 448 F.3d 672 (3rd Cir. 2006). 
3 343 B.R. 444 (Bankr. S.D.N.Y. 2006). 
4 See Trenwick America Litigation Trust v. Ernst & Young L.L.P. et al.,
C.A. No. 1571-N (Delaware Chancery Court, New Castle County 08/10/06) 2006 WL
2333201.

5 Id. at *4. 
6 340 B.R. 510 (Bankr. D. Del. 2006). 
7 333 B.R. 444 (Bankr. S.D.N.Y. 2006) (interpreting Delaware law). 
8 340 B.R.510 (Bankr. D. Del 2006). 
9 267 F.3d 340 (3d Cir. 2001). 
10 Official Committee of Unsecured Creditors v. Lafferty, 267 F.3d 340
(3d Cir. 2001). For expansion of the theory, see, e.g., In
re Exide Tech. Inc., 299 B.R. 732 (Bankr. D. Del. 2003) (opening the door
for the possibility of deepening-insolvency claim against secured lenders);
In re Parmalat, 383 F. Supp. 2d 587 (S.D.N.Y. 2005) (citing Lafferty
in support of a position that deepening insolvency is a separate cause of action
in certain jurisdictions). Other courts have subsequently disagreed with Lafferty
and found that deepening insolvency is merely a theory of damages for the breach
of some independent tort. See, e.g., In re Global Serv.,
316 B.R. 451 (Bankr. S.D.N.Y. 2004); In re Vartec Telecom Inc., 335 B.R.
631 (Bankr. N.D. Tex. 2005).

11 In re LTV Steel, 333 B.R. 397 (Bankr. N.D. Ohio 2005). 
12 In re Vartec Telecom Inc., 335 B.R. 631 (Bankr. N.D. Tex. 2005).

13 See, generally, Trenwick and Harner, Michelle M., "Delaware
Chancery Court Refuses to Recognize Deepening Insolvency as Independent Cause
of Action," Cracking the Code, Aug. 21, 2006.

14 Id. 
15 Trenwick at *28-29. 
16 Id. 
17 Trenwick at *28-29.

18 Id. at *28-30. See also supra note 14. 
19 Trenwick at *29-30, citing In re Global Services, 316 B.R.
451 (Bankr. S.D.N.Y. 2004). 
20 Id.

21 Id. at *28-30. 
22 Id. 
23 Id. *29. 
24 Trenwick at *28.

25 Id. 
26 Id. at *29. 
27 Such as the defendant in Oakwood Homes. 
28 See, e.g., Jaasma v. Shell Oil Co., 412 F.3d 501, 507
n.5 (3d Cir. 2005) (emphasis added).

29 There is no intermediate court of appeal in Delaware—an efficient
system that has appealed to many corporations and that has caused many contracts
to contain a choice-of-law provision in favor of Delaware. 
30 See, e.g., Production Resources Group LLC v. NCT Group
Inc., 863 A.2d 772 (Ct. Chanc. Del. 2004), Credit Lyonnais Bank Netherland
N.V. v. Pathe Communication Corp., 1991 WL 277613 (Del. Ch. Dec. 30, 1991).

31 Trenwick at *29 n. 104, citing Production Resources Group LLC
v. NCT Group Inc., 863 A.2d 772 (Ct. Chanc. Del. 2004); Credit Lyonnais
Bank Netherland N.V. v. Pathe Communication Corp., 1991 WL 277613 (Del.
Ch. Dec. 30, 1991).

32 Trenwick at *29 n. 104 (other citations omitted). 
33 805 A.2d 221, 229 (Del. Ch. 1999). 
34 883 A.2d 272 *53. 
35 Perhaps due to the facts of the cases and nature of the court's discussion.

36 North American Catholic Educ'l Programming Foundation Inc. v. Gheewalla
et al., C.A. No. 1456-N (Delaware Chancery Court Sept. 1, 2006) at p. 35
n. 105 (citing Trenwick at *22 n. 75).

37 Trenwick at *4. 
38 See, e.g., Jaasma v. Shell Oil Co., 412 F.3d 501, 507
n. 5 (3d Cir. 2005). 
39 In re Student Finance Corp., 335 B.R. 539, 550 (D. Del. 2005) (other
citations omitted).

40 Id. 
41 See, e.g., Production Resources Group LLC v. NCT Group
Inc., 863 A.2d 772 (Ct. Chanc. Del. 2004)—in fact, also decided by
Vice-Chancellor Strine, who wrote the Trenwick decision. 
42 Id. See, also, Cede & Co. v. Technicolor Inc.,
634 A.2d 345, 360-62 (Del. S.Ct. 1994); White v. Panic, 2001 Del. Lexis
421 (Del. S.Ct. 2001); Malpede v. Townson, 2001 Del. Lexis 371 (Del.
S.Ct. 2001).

43 See, e.g. Exide, 299 B.R. at 732. 
44 340 B.R. at 537. 
45 Which contains the pleading requirements for fraud and is incorporated into
the Bankruptcy Rules at Fed. R. Bankr. P. 7009. 
46 Lafferty, 267 F.3d at 347. 
47 See, e.g., Global Serv. Group, 316 B.R. at 458.

48 See, e.g., Oakwood Homes, 340 B.R. at 530 ("simply
lending to an insolvent corporation, without more, cannot possibly be a tort").

Journal Authors

Jo Ann J. Brighton

Journal Date

Sunday, October 1, 2006 - 12:00

Bankruptcy Rule

2006

none