The Delaware Supreme Court has affirmed, without opinion, a ruling by a lower court that ‘deepening insolvency’ is not a cause of action under Delaware law. Trenwick America Litig. Trust v. Billett, 931 A.2d 438 (Del. 2007).

The ruling appears to be the strongest nail yet in the coffin of so-called “deepening insolvency” actions.

In 2001, the U.S. Court of Appeals for the Third Circuit recognized deepening insolvency as a valid cause of action under Pennsylvania law. Official Comm. Of Unsec. Creditors v. R.F. Lafferty, 267 F.3d 340 (3d Cir. 2001). Since that ruling, courts around the country have grappled with the issue of whether deepening insolvency should be recognized as a separate cause of action under state law, or whether it’s merely a factor to weigh in determining damages. Most courts have determined the latter, and the Third Circuit later qualified its ruling in Lafferty. See Commercial Restructuring & Bankruptcy Alert, October 2006, p. 3, “Deepening Insolvency Is Not a Cause of Action Under Del. Law.”

Trenwick Below

The Delaware Supreme Court’s decision in Trenwick follows a firm rejection of deepening insolvency by the Delaware Court of Chancery last year. Trenwick American Litig. Trust v. Ernst & Young, LLP, 906 A.2d 168 (Del. Ch. 2006).

Trenwick, a publicly listed insurance holding company, acquired several insurance companies, and restructured its operations so that its U.S. subsidiary became the intermediary parent of all the holding company’s U.S. operations. The U.S. subsidiary also assumed the  1role of guarantor of company-wide debt. Both the holding company and the U.S. subsidiary filed for bankruptcy.

Pursuant to the chapter 11 plan of the U.S. subsidiary, a Liquidation Trust was created to investigate and prosecute claims. The Liquidation Trust instituted an action against the directors of the holding company and the U.S. subsidiary, as well as certain of Trenwick’s advisers. The Liquidation Trust claimed that the holding company’s board engaged in an imprudent business strategy by acquiring insurers that underestimated their potential claims exposure.

In addition, the trust claimed that because the U.S. subsidiary took on obligations to support its parent’s debt, and assumed some of the debt, the U.S. subsidiary and its creditors suffered greater injury than the holding company and its creditors.

In its review, the Delaware Court of Chancery noted that “Delaware law imposes no absolute obligation on the board of a company that is unable to pay its bills to cease operations and to liquidate.” The board of an insolvent corporation may pursue a business strategy that involves the incurrence of additional debt as long as the board is “acting with due diligence and good faith,” the court stated.

Shallowing Profitability’

In dismissing the complaint, the court concluded, now famously: “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….”