The Bottom Line:

In the recent case of In re Lemington Home For The Aged, 10-4456 (3d Cir. Sept. 21, 2011), the Third Circuit considered (i) whether the Official Committee of Unsecured Creditors (the “Committee”) was able to demonstrate material factual issues to support a “deepening insolvency” claim (which is a claim alleging the fraudulent increase in corporate debt or prolongation of the corporation’s existence after it is insolvent) and (ii) whether the application of the business judgment rule and the in pari delicto doctrine (as explained below) precluded a recovery against insiders on breach of fiduciary duty claims.  After reviewing the facts, the Third Circuit found material issues of fact with respect to the Committee’s alleged deepening insolvency and breach of fiduciary duty claims and remanded for trial.  Importantly, in doing so, the Third Circuit recognized the existence of a “deepening insolvency” cause of action under Pennsylvania state law – a cause of action which is not always upheld as an independent tort claim by courts — and liability for breach of fiduciary duties caused by the directors’ and officers’ negligence.

What Happened:

For background, Lemington Home for the Aged (“Lemington Home”) was a not-for-profit corporation built after the Civil War to serve indigent elderly members of the Pittsburgh, Pennsylvania African-American community.  Years later, it ran into serious financial problems beginning in the 1980s with significant operational losses, higher dependence upon its patients receiving Medicaid reimbursements, and ultimately, a month-long ban on new admissions and the necessity for locating qualified staff.  Lemington Home was insolvent in 1999.  Despite the hiring of a new administrator and chief financial officer, the financial condition worsened.  In 2003 and 2004, there were deficiencies in care and employee insurance premiums were not paid.  There were lapses in full-time staffing and positions on the board leading to patient oversight issues.  A recommendation was made in 2004 to file for bankruptcy, however, the board elected to pursue other options.  The board determined in early 2005 to transfer the principal charitable asset of Lemington Home to an affiliated entity, Lemington Elder Care.  Ultimately, Lemington Home filed for chapter 11 bankruptcy protection in April 2005.  During the chapter 11 case, the creditors hired a consultant to investigate Lemington Home’s financial situation and the bankruptcy court directed the Debtor to obtain a viability study.  After these investigations demonstrated financial and organizational disarray, the bankruptcy court authorized the Committee to commence a lawsuit against the officers and directors (“Defendants”) alleging damages under a claim of “deepening insolvency” and breach of the duties of the care and loyalty.

Deepening Insolvency

Despite the fact that Pennsylvania state courts have not formally recognized “deepening insolvency” as an independent cause of action, the Third Circuit previously determined that deepening insolvency could gave rise to “cognizable injury” when there is “an injury to a debtor’s corporate property from the fraudulent expansion of corporate debt and prolongation of corporate life.”  See Official Comm. of Unsecured Creditors v. R. F. Lafferty & Co., 267 F.3d 340, 349 (3d Cir. 2001); In re Citx Corp., 448 F.3d 672, 677 (3d Cir. 2006.  For a deepening insolvency based claim to succeed in Pennsylvania: (i) there must be fraud supporting the claim (i.e. negligence is not sufficient); (ii) the director’s or officer’s actions must have caused the deepening insolvency; and (iii) an injury to a debtor’s property must have occurred due to expanding corporate debt or prolonging corporate life.  See In re Citx Corp., 448 F.3d at 677-681.   

Applying this to Lemington Home, the Third Circuit found that there was sufficient evidence demonstrating material factual issues regarding whether the Defendants “fraudulently contributed to the deepening insolvency” of Lemington Home.  The Defendants, amongst other things, (i) failed to disclose to creditors the board’s decision to close the home three months prior to filing for bankruptcy and (ii) delayed filing Lemington Home’s monthly operating reports, from which key information was strategically omitted.  In short, the Third Circuit found that the District Court’s grant of summary judgment in favor of the Defendants was inappropriate because there were genuine issues of material fact as to whether the Defendants fraudulently caused further deterioration to Lemington Home’s financials by their action or inaction – to the detriment of its creditors. 

Fiduciary Duties

Reviewing applicable Pennsylvania law, the Third Circuit determined that there were sufficient facts supporting a colorable claim for breach of the duties of care and loyalty to defeat summary judgment, including the failure to maintain financial records and the potential benefit the officers could derive from the transfer of the charitable asset to Lemington Elder Care.  Therefore, the Third Circuit disagreed with the District Court’s application of two defenses to the Committee’s claims against the directors and officers for breach of the duty of care and loyalty: (i) the business judgment rule and (ii) the adverse interest exception to the in pari delicto doctrine. 

First, if applicable, the business judgment rule would have absolved the Defendants of liability for fiduciary duty claims.  Typically, business judgment of a director or officer is demonstrated if there were regular meetings, advice of counsel was sought, and options were evaluated.  However, at Lemington Home, there were questions as to the competency of the officers, the director and officer’s disregard for obtaining a viability study, and the desire to transfer the asset to the affiliated entity.  Therefore, the Third Circuit found ample evidence to suggest that the Defendants breached their fiduciary duties[1] and the business judgment rule’s applicability presented an issue of fact.

Second, the in pari delicto doctrine – which provides that courts will not mediate between two parties equally at fault – generally offers a defense to officers and directors from claims brought on behalf of the corporation when they are acting on behalf of that corporation because their actions are imputed to the corporation, making the corporation and the directors/officers equally responsible.  The in pari delicto doctrine would be applicable here where the Committee is bringing the claims for breach of fiduciary duties on behalf of the corporation’s bankruptcy estate, of which the Defendants are officers and directors. 

However, there is an exception to the in pari delicto doctrine - the adverse interest exception – which provides that if the directors or officers are actually acting in their own self interest, then the in pari delicto doctrine no longer provides protection.  While the District Court found that the Defendants did not personally benefit from their actions, the Third Circuit found sufficient contrary facts regarding the Defendants’ self dealing, including the affiliation between Lemington Home and Lemington Elder Care, the neglect to maintain financial records, and the resistance by a member of the senior staff to be replaced, which warranted the vacating of the District Court’s summary judgment ruling and remanding for trial. 

Why the Case is Interesting:

The Third Circuit's decision is of particular importance because of the Court’s recognition of an independent tort claim of “deepening insolvency” under Pennsylvania state law.  Courts differ on whether such an independent cause of action exists or whether the claim is part of a general breach of fiduciary duty claim.  The decision supports the opportunity for an independent tort claim if the facts support that the action of a company’s officers and board worsen the company’s financial situation.  In addition, the case highlights that certain defenses, such as the business judgment rule and the in pari delicto doctrine, might not apply when there is evidence of negligent action by directors and officers.  Lastly, the case is a reminder that these claims are based upon application of state law and, as such, results can vary based upon governing law affecting the company.