CHAPTER 3 interplay between Breach of Fiduciary Duties and Deepening insolvency Liability

• Jurisdiction: United States

CHAPTER 3: interplay between Breach of Fiduciary Duties and Deepening insolvency Liability

1. Deepening insolvency Liability Resulting from a Breach of Fiduciary Duties

Officers and directors faced with the fiduciary duties discussed in Chapter 2 are the individuals making the business decisions that may result in a company continuing in business and incurring more debt. As those decisions are made, the insolvent position of a corporation may be deepened, and plaintiffs are quick to blame the officers and directors for those decisions. This chapter discusses criticisms of the application of deepening insolvency liability to the decision-makers and cases where courts have declined to impose liability on this basis.

2. Deepening insolvency Theory Overrides the Business Judgment Rule

The essence of deepening insolvency theory is a challenge to the decisions made by officers and directors of a corporation. Deepening insolvency seeks to hold officers and directors, among others, liable for decisions made with respect to the use of cash or other business decisions after the corporation has become insolvent. Such a finding regarding an officer's or director's decisions on how to use the corporate cash arguably ignores the possibility that those decision-makers might have legitimately been making an effort, post-insolvency, to try to save the corporation. "[I]n contrast to the laws of some foreign jurisdictions, including the United Kingdom, there is no absolute duty under American law to shut down and liquidate an insolvent corporation. The fiduciaries may, consistent with the business judgment rule, continue to operate the corporation's business."⁶⁶ Thus, some courts find that "a manager's negligent but good faith decision to operate an insolvent business will not subject him to liability for 'deepening insolvency[.]'"⁶⁷

The "business judgment rule," on the other hand, protects officers' and directors' business decisions that are in the best interest of the corporation. "The rule posits a powerful presumption in favor of actions taken by the directors [and officers] in that a decision made by a loyal and informed board [and the corporation's officers] will not be overturned by the courts unless it cannot be 'attributed to any rational business purpose.'"⁶⁸ The Seventh Circuit in In re Abbott Laboratories Derivative Shareholders Litigation stated that the business judgment rule codifies the presumption that in making a business decision, "the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company."⁶⁹

One of the bases for the refusal to apply a deepening insolvency theory of liability to officers and directors is that it runs directly counter to the business judgment rule. The business judgment rule is a source of protection serving to help attract competent officers and directors that might otherwise choose not to serve in such capacity but for the protection of that rule, which would protect them from good-faith⁷⁰ errors in judgment that are later determined to have prolonged the insolvency of the corporation.

In Trenwick America Litigation Trust v. Ernst & Young LLP, the Delaware Court of Chancery, affirmed by the Delaware Supreme Court, declined to find a cause of action for deepening insolvency, concluding that there is no obligation for a corporation to cease business and liquidate when it becomes insolvent.⁷¹ The Court concluded that a good-faith attempt to turn around the financial situation of an insolvent corporation, even if it fails, should be permissible so long as it complies with the business judgment rule. Also, the fact that creditors are unpaid "does not mean that the directors cannot choose to continue the firm's operations in the hope that they can expand the inadequate pie such that the firm's creditors get a greater recovery. By doing so, the directors do not become a guarantor of success."⁷²

The court in In re Amcast Indusustrial Corp. noted that "at its best, the deepening insolvency theory is redundant of traditional causes of action recognized under Ohio law [and at] its worst, the theory is inconsistent with ... the business judgment rule codified in Ohio."⁷³ The Amcast court further noted that "the deepening insolvency theory is in direct conflict with traditional concepts of corporate law that allow an insolvent business to continue operating in hopes of maximizing profits and turning its financial situation around rather than immediately ceasing operations and liquidating."⁷⁴ As one court noted:

[S]imply calling a discredited deepening insolvency cause of action by some other name does not make it a claim that passes muster. [It is] quite clear that under Delaware law, a board is not required to wind down operations simply because a company is insolvent, but rather may conclude to take on additional debt in the hopes of turning operations around.⁷⁵

3. Previously insolvent Corporations Cannot Be injured Despite Breach of Fiduciary Duties

One of the primary criticisms of the deepening insolvency theory is that by definition, an insolvent corporation cannot have been harmed by having its insolvent position worsened.⁷⁶ The Askanase v. Fatjo court held that the debtor was not damaged by deepening insolvency because shareholders had already lost their equity and could not be injured by the debtor growing more insolvent. Since shareholder equity was the only cognizable harm to the corporation, "[t]he shareholders, who comprise...