The Third Circuit Court of Appeals recently passed on a chance to join numerous other federal and state jurisdictions in rejecting “deepening insolvency” as an independent tort, leaving the doctrine weakened, but still technically viable in the significant bankruptcy arena. However, in In re Lemington Home for the Aged, the Court did strongly indicate that the doctrine’s days are numbered, noting that its recognition of deepening insolvency as a tort “is problematic, and at the earliest appropriate opportunity . . . should be revisited.”

History of the Doctrine

Deepening insolvency refers to the wrongful prolongation of a corporation’s life, theoretically resulting in increased debt and lower recoveries for creditors. Whether deepening insolvency constitutes an independent cause of action has long been a controversial issue. The rise and fall of deepening insolvency, which the Third Circuit called a once “plausible argument gaining increasing acceptance,” but “has since been widely repudiated,” is interesting and instructive.

The origins of deepening insolvency can be traced to a 1980 decision by the district court of the Southern District of New York arising out of the bankruptcy case of Investors Funding Corporation. In Bloor v. Dansker (In re Investors Funding Corp. of New York Sec. Litig.), the bankruptcy trustee asserted various claims against certain insiders relating to their mismanagement of the company. The defendants asserted as a defense that such actions had kept the company alive longer, but the district court rejected this argument, noting that extending the life of a corporation may not always be beneficial. Shortly after Investors Funding, the Seventh Circuit coined the phrase “deepening insolvency” in Schacht v. Brown. The Schacht court held that the mere prolongation of a corporation’s life did not necessarily equate to a corporate benefit because “the corporate body is ineluctably damaged by the deepening of its insolvency.”

From there, the concept morphed into a theory of recovery. In 2001, the Third Circuit rendered one of the first decisions to uphold the validity of deepening insolvency as an independent cause of action, Official Comm. Of Unsecured Creditors v. R.F. Lafferty & Co. In Lafferty, the Third Circuit predicted that the Pennsylvania Supreme Court would recognize deepening insolvency as an independent tort. At that time, no Pennsylvania court had addressed the issue. The Court observed that “[i]n recent years, a number of federal courts have held that ‘deepening insolvency’ may give rise to a cognizable injury in corporate debtors[,]” and noted that the “[g]rowing acceptance of the deepening insolvency theory confirms its soundness.” Thus, the Court determined that “if faced with the issue, the Pennsylvania Supreme Court would determine that ‘deepening insolvency’ may give rise to a cognizable injury.”

In the years after Lafferty, deepening insolvency was subject to much scrutiny, and courts and commentators began to question its viability. The doctrine gradually fell out of favor, and courts began to reject the theory. In 2006, the Third Circuit reexamined the issue in In re CitX Corp. While the Third Circuit panel that decided CitX did not overturn Lafferty (indeed, the panel could not overturn the decision as it was not sitting en banc, which was also an issue in Lemington, as discussed below), it limited the holdings of Lafferty by (i) limiting claims for deepening insolvency to conduct involving fraud, (ii) rejecting deepening insolvency as a theory of damages, and (iii) restricting the decision to matters governed by Pennsylvania law. Later that year, the Delaware Chancery Court, as state court within the Third Circuit, affirmatively rejected the doctrine as a stand-alone cause of action in a persuasive decision in Trenwick Am. Litig. Trust v. Ernst & Young, LLP.

The Trenwick decision (which was affirmed by the Delaware Supreme Court) effectively sounded the death knell for deepening insolvency. The Chancery Court held that rejecting deepening insolvency was:

consistent with a growing body of federal jurisprudence, which has recognized that those federal courts that became infatuated with the concept, did not look closely enough at the object of their ardor . . . None of those decisions [recognizing deepening insolvency] explains the rationale for concluding that deepening insolvency should be recognized as a cause of action or how such recognition would be consistent with traditional concepts of fiduciary responsibility.

The Trenwick court supported its conclusion with some detail, attacking the theoretical underpinnings of the doctrine. First, the court found that recognizing deepening insolvency was inconsistent with traditional fiduciary concepts. The court concluded that there is no “duty to liquidate” under Delaware law, as such a duty would be at odds with Delaware corporate law. Even when the company is insolvent, the board may pursue, in good faith, strategies to maximize the value of the firm. The notion that a financially troubled company is afforded an opportunity to turn itself around is supported by the existence of chapter 11 of the Bankruptcy Code, which expresses a societal recognition that an insolvent corporation’s creditors may benefit if the corporation continues. Thus the recognition of deepening insolvency, which the court called “a loose phrase,” as a cause of action “would be inconsistent with the principles shaping [Delaware’s] corporate law.”

Second, the Chancery Court found deepening insolvency to be redundant of existing causes of action. The court asserted that “[t]he rejection of an independent cause of action for deepening insolvency does not absolve directors of insolvent corporations of responsibility. Rather, it remits plaintiffs to the contents of their traditional toolkit, which contains, among other things, causes of action for breach of fiduciary duty and for fraud.” The court went on to say that “[i]f a plaintiff cannot state a claim that the directors of an insolvent corporation acted disloyally or without due care in implementing a business strategy, it may not cure that deficiency simply by alleging that the corporation became more insolvent as a result of the failed strategy.”

After Trenwick rejected the doctrine, a number of other courts followed suit, including the highest court of the state of New Jersey (another Third Circuit state) as well as the Commonwealth Court of Pennsylvania, one of Pennsylvania’s intermediate appellate courts. Despite this, the Pennsylvania Supreme Court, the court which Lafferty had predicted would recognize deepening insolvency, has yet to address the issue.

Lemington

The Lemington case has what the Third Circuit called a “tortuous procedural history[.]” The case arose out of the mismanagement of the eponymous Lemington Home for the Aged, a not-for-profit Pennsylvania corporation which was established in 1883. In particular, the Home’s administrator and chief financial officer engaged in some very questionable conduct, which was not prevented or remedied by the board of directors. This conduct led to the Home’s bankruptcy, and eventually to an adversary proceeding commenced by the Creditors’ Committee alleging a breach of the fiduciary duties of care and loyalty by the officers and directors, as well as deepening insolvency. After a trial, the jury awarded plaintiffs both compensatory and punitive damages. Following the verdict, the defendants moved for a judgment as a matter of law, a new trial, or a remitturer. When the district court denied that motion in its entirety, defendants appealed to the Third Circuit.

The Third Circuit affirmed the majority of the decision below, vacating only a punitive damages award against the directors. Most relevant to this discussion, the Third Circuit affirmed the jury’s verdict of deepening insolvency. Because the Pennsylvania Supreme Court has not opined on the validity of deepening insolvency, and Lafferty is still good law, the Third Circuit was bound to follow Lafferty unless overturned by the Circuit sitting en banc. Shortly after this decision was rendered, the defendants filed a petition for a rehearing en banc, which was denied. It was then in a concurrence in the denial of the petition, that Circuit Judge Jordan, joined by three other Circuit Judges, gave a glimpse into the Third Circuit’s thinking on deepening insolvency.

Circuit Judge Jordan stated that “much has changed in the acceptance of deepening insolvency since Lafferty” and that deepening insolvency has since been “widely repudiated.” The concurrence cited to Trenwick’s “cogent[] rebutt[al]” of the theoretical underpinnings of deepening insolvency, as well as authority within Pennsylvania (as noted above) which rejected its primary premise. Circuit Judge Jordan concluded that “while the Pennsylvania Supreme Court has not weighed in on the topic, there is reason to believe that our prediction in Lafferty . . . has been undermined and ought to be reconsidered.” The concurrence suggested that given the Court’s internal operating procedures, the best route forward might be certification of the question to the Pennsylvania Supreme Court “when next a claim of ‘deepening insolvency’ rears its head in a case governed by Pennsylvania law.”

Takeaways

Despite the fact that the Third Circuit declined to finally adjudicate the issue presently, it seems clear that the viability of deepening insolvency as an independent tort in the Third Circuit is near an end. For the time being, the doctrine limps on as a cognizable injury in the state of Pennsylvania. While this decision may have little practical effect, it serves to highlight the birth and death of a novel legal theory, which is a reminder of the constantly evolving nature of the law. Less than 15 years ago, deepening insolvency was the object of courts’ “ardor.” This ardor gave way to questions, and then the ultimate turning of the tide against the doctrine, which has now nearly come full circle.