In Trenwick America Litigation Trust v. Ernst & Young, LLP, 906 A.2d 168 (Del. Ch. 2006), the Delaware Court of Chancery definitively weighed in on the tort claim that has become known by the popular name “deepening insolvency” when it dismissed a “deepening insolvency” claim brought by a litigation trust to recover money for the benefit of the creditors of a bankrupt estate. Although the issue of deepening insolvency had been touched upon previously by the federal courts, which had predicted that Delaware state courts would recognize the claim, the Trenwick decision was the first Delaware state court decision to address and then reject the tort. In the decision, the Court also took a closer look at whether additional duties are owed by directors to creditors when a company is in the “zone of insolvency” and determined that the proper exercise of the directors’ business judgment is all that is required.
The Delaware Court of Chancery was quick to point out in its opinion that the allegations in the complaint were deficient in numerous respects; however, it attempted to set forth a proper and extensive accounting of the most relevant facts in its 88-page opinion. The alleged facts most pertinent to the Court’s pronouncements relating to “deepening insolvency” and the so-called “zone of insolvency” involve the director defendants of a public global insurance holding company (“Trenwick”) executing a business plan in which it acquired three additional insurance companies in quick succession. After the acquisitions, the businesses reorganized themselves so that one of Trenwick’s U.S. subsidiaries (“Trenwick America”) became the intermediate parent to all of the holding companies of the U.S. operations. Trenwick America also became the guarantor of the overall debt of its parent, Trenwick. As guarantor, Trenwick America was the primary guarantor of $260 million of a $490 million line of credit for Trenwick and the secondary guarantor of the remaining debt on the line of credit. Trenwick America also became responsible for approximately $190 million in debt securities of Trenwick. In August 2003, Trenwick and its subsidiary, Trenwick America, filed for bankruptcy.
In the process of reorganizing Trenwick America, a plan of bankruptcy reorganization was agreed upon in which a litigation trust was formed and granted the right to prosecute claims belonging to the bankrupt estate of Trenwick America (the “Litigation Trust”). On September 20, 2005, the Litigation Trust filed a complaint on behalf of the creditors of Trenwick America against the former directors of Trenwick, the former directors of Trenwick America and various former professional advisors of Trenwick. The complaint named the following former professional advisors: Ernst & Young, L.L.P.; PricewaterhouseCoopers, L.L.C.; Baker & McKenzie, L.L.P.; and Milliman, L.L.P. The complaint alleged that Trenwick employed a bad business strategy when it acquired insurance companies that were in poor financial condition due to underestimation of insurance claims and that such bad business strategy caused Trenwick and its U.S. subsidiary, Trenwick America, to become insolvent, resulting in financial harm to Trenwick America’s credi- Delaware Court of Chancery Rules That “Deepening Insolvency” Is Not a Recognizable Cause Of Action In Delaware tors. The Litigation Trust further alleged that Trenwick America and its creditors were harmed to a greater extent than Trenwick and its creditors due to the debt obligations undertaken by Trenwick America on behalf of its parent Trenwick. In its most simple form, the complaint alleged that because the chosen business strategy failed and caused the company to file for bankruptcy, the process leading to the adoption and execution of the business strategy must have been flawed.
The Delaware Court of Chancery initially pointed out that the complaint was badly drawn and did not state a viable motive for Trenwick to cause itself or Trenwick America to become insolvent or to harm its creditors. The Court also found that the complaint did not specifically allege any facts indicating a lack of due diligence by the board of directors. As the Court stated, “had this claim been brought by a stockholder of the holding company, it would be easily stopped at the gate, because the complaint failed to plead a breach of fiduciary duty.” However, the Court was charged with determining if additional duties, beyond those owed to a stockholder, were owed to creditors of an insolvent company or one that was in the “zone of insolvency.”
“Zone of Insolvency” Is Not A Place Worth Defining Legally
At the core of “deepening insolvency” is the issue of insolvency itself. In many states, the fiduciary duties of officers and directors have been held to extend solely to the company’s shareholders unless the company is actually insolvent. However, courts in some states have ruled that fiduciary duties to creditors arise prior to actual insolvency, at the point at which a company moves into the so-called “zone of insolvency.”
Of particular note and debate in Delaware was the case of Credit Lyonnais Bank of Netherland, N.V. v. Pathe Communications Corp., 1991 WL 277613 (Del. Ch. Dec. 30, 1991). That case was interpreted by some to state that fiduciary duties to creditors arise prior to actual insolvency or when a company is in the “zone of insolvency.” However, in late 2004, the Delaware Court of Chancery revisited the Credit Lyonnais decision in the case of Production Resources, LLC v. NCT Group, Inc., 863 A.2d 772 (Del. Ch. 2004). In its obiter dicta footnote discussion of Credit Lyonnais, the Court questioned whether Credit Lyonnais had been misunderstood and whether the amorphous concept of “zone of insolvency” was being used improperly to expand to creditors fiduciary duties ordinarily owed to shareholders only. The debate was picked up again by the Delaware Court of Chancery and fleshed out in Trenwick. The Court noted that the use of the words “insolvency, or more amorphously, the words zone of insolvency should not declare open season on corporate fiduciaries. Directors are expected to seek profit for stockholders, even at risk of failure.” As the Court further stated:
The general rule embraced by Delaware is the sound one. So long as directors are respectful of the corporation’s obligations to honor the legal rights of its creditors, they should be free to pursue in good faith profit for the corporation’s equityholders. Even when the firm is insolvent, directors are free to pursue value maximizing strategies, while recognizing that the firm’s creditors have become its residual claimants and the advancement of their best interests have become the firm’s principal objective.
“Deepening Insolvency” Is Not A Cause of Action
A much discussed topic for the past several years is a theory of legal liability known as “deepening insolvency.” Litigation targets have included directors and officers, lenders, financial advisors, turnaround consultants, accountants, and attorneys. Many of the claims were alleged widely, often against vague factual backdrops, resulting in inconsistent—or at least evolving—judicial determinations, making it difficult to predict with certainty what may constitute actionable “deepening insolvency” in a particular situation and jurisdiction.
Deepening insolvency claims against lenders and professionals who manage, direct or advise companies typically allege that a company, while actually insolvent or within the “zone of insolvency,” incurred, or was caused to incur, additional debt, and/ or its corporate life was prolonged by artificially maintaining liquidity and concealing its true financial condition, causing damage to the company, its shareholders and its creditors. Asserted damages might include all unsecured creditor claims plus bankruptcy administrative costs, potentially amounting to many millions of dollars.
Insolvency continued from page 5 State law determines whether a claim based on “deepening insolvency” may be brought against likely targets. Until Trenwick, it was unclear whether a cause of action based on claims of “deepening insolvency” would be sustained by a Delaware state court because the most notable decisions on the topic have been rendered by federal courts predicated upon their view of how a particular State, including Delaware, might rule.
With regard to the “deepening insolvency” claim, Trenwick stated in the first instance that the complaint failed to plead insolvency before or after the transactions at issue. However, even if insolvency had been properly pled, the Delaware Court of Chancery held unequivocally that “Delaware law does not recognize this catchy term as a cause of action, because catchy though the term may be, it does not express a coherent concept.” In making its point, the Court further stated:
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. Existing equitable causes of action for breach of fiduciary duty, and existing legal causes of action for fraud, fraudulent conveyance, and breach of contract are the appropriate means by which to challenge the actions of boards of insolvent corporations.
Also, and again assuming the complaint had properly pled facts of insolvency, a parent causing its subsidiary to accrue additional debt to support the parents’ business strategy does not create a claim in and of itself. As the Delaware Court of Chancery stated, “wholly-owned subsidiary corporations are expected to operate for the benefit of their parent corporation; that is why they are created. Parent corporations do not owe such subsidiaries fiduciary duties. That is established Delaware law.” With respect to “deepening insolvency,” the Court held that: If the board of an insolvent corporation, acting with due diligence and good faith, pursues a business strategy that it believes will increase the corporation’s value, but that also involves the incurrence of additional debt, it does not become a guarantor of that strategy’s success. That the strategy results in continued insolvency and an even more insolvent entity does not in itself give rise to a cause of action. Rather, in such a scenario the directors are protected by the business judgment rule. To conclude otherwise would fundamentally transform Delaware law.
Further, creditors of Delaware subsidiaries have significant rights with which to protect themselves. Creditors are actually in a better position than equity holders and other corporate classes such as employees because of their contractual rights. On this point, the Delaware Court of Chancery noted: Delaware has a potent fraudulent conveyance statute enabling creditors to challenge actions by parent corporations siphoning assets from subsidiaries. Delaware public policy is strongly supportive of freedom of contract, thereby supporting the primary means by which creditors protect themselves – through the negotiation of toothy contractual provisions securing their rights to seize on the assets of the borrowing subsidiary.