Restructuring

Contributed by Edward Wu
Amid a current of cases in the past several years that seemed to foretell the demise of deepening insolvency claims, a three-judge panel of the Third Circuit recently held in In re Lemington Home for the Aged that deepening insolvency remains a valid cause of action under Pennsylvania law.  The panel reasoned that it was bound to recognize the claim due to its own precedent, which, even if erroneously decided, could only be overturned by an en banc decision of the entire court.
Deepening insolvency is a claim that was catapulted into prominence by the Third Circuit nearly a decade ago in Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co.  Throughout its nascent development and more recent decline, the claim has been difficult to grasp by courts and restructuring professionals alike.  Some courts have characterized deepening insolvency as an independent cause of action while others regard it as a theory of damages.  Among courts construing it to be a claim in its own right, some require fraud as an element while other courts require only negligence.  The Third Circuit characterizes deepening insolvency as a stand-alone claim under Pennsylvania law which arises where there is “an injury to [a debtor’s] corporate property from the fraudulent expansion of corporate debt and the prolongation of corporate life.”
In Lemington Home for the Aged, the debtor was a non-profit organization that operated a nursing home in Pennsylvania.  The Third Circuit’s opinion paints a picture of dysfunctional management and governance.  The administrator for the nursing home during the years preceding the debtor’s chapter 11 filing is alleged to have been an unqualified individual who was absent for weeks at a time.  The debtor’s chief financial officer allegedly failed to maintain a general ledger and the nursing home’s billing records were in disarray.  Meetings of the debtor’s board of directors often had less than a majority in attendance and minutes for those meetings were incomplete or non-existent.  Mismanagement of the debtor allegedly contributed to the death of one patient and the failure to resuscitate another.  In the midst of finding a solution for its financial distress, the debtor’s board of directors decided to stop admitting new patients.  The debtor ultimately filed for bankruptcy four months later.
Afterwards, the unsecured creditors’ committee asserted, among other things, deepening insolvency claims against the debtor’s officers and directors.  To satisfy the Third Circuit’s requirement of fraud for a deepening insolvency claim under Pennsylvania law, the creditors’ committee asserted that the board of directors caused the nursing home to stop admitting new patients in anticipation of an impending shutdown, even though, the directors knew the debtor’s financial condition would deteriorate without the insurance income from new patients.  The creditors’ committee argued the directors should have sooner caused the debtor to file for bankruptcy than continue operations in a way that they knew would ensure increasing losses.  With regard to the officers, the committee asserted they committed fraud by commingling the debtor’s funds with related entities, breaching their fiduciary duties, continuing to do business with vendors when they knew the debtor was insolvent, failing to collect Medicare receivables, and upholding the policy of denying admission to new patients.  The district court granted the motion by the directors and officers for summary judgment on the deepening insolvency claims.
On appeal, the Third Circuit reasoned that while the Pennsylvania Supreme Court has not ruled on the viability of deepening insolvency claims, Third Circuit precedent holds that deepening insolvency claims are valid under Pennsylvania law.  While acknowledging that subsequent courts and commentators have called into question the validity of deepening insolvency as a cause of action, the court determined that its own precedent could not be overturned, even if erroneous, except by an en banc decision (i.e. a decision by the entire court rather than a three-judge panel).  Finding that the deepening insolvency cause of action remained viable as long as the plaintiff asserted evidence giving rise to an inference of fraudulent conduct, the Third Circuit determined that the district court below had erred in granting summary judgment to the defendants because there remained disputed issues of material fact that, if resolved in the plaintiffs’ favor, would sustain the claim.
When the Third Circuit ruled on deepening insolvency ten years ago in Lafferty, the American economy was in a tumultuous period prompted by perceived failures in corporate governance amid the bankruptcies of Enron, WorldCom, Global Crossing and others.  The Lemington Home for the Aged decision now comes in another environment in which failures in corporate governance and regulation are alleged to have occurred, culminating in the recent financial crisis.  It will be interesting to see if deepening insolvency claims regain momentum in cases stemming from the 2008-09 financial crisis and the lackluster recovery in 2010-11.  Deepening insolvency ultimately is about when management and the board should pull the plug on a sick business.  In an environment of stubbornly high unemployment and public protests against financial institutions and other large corporations, there may be significant pressures on boards to continue operations in the hope of a turnaround rather than shut them down to avoid further losses.  At least for now, under Pennsylvania law a director or manager who presides over the deterioration of a corporation’s business may be liable to creditors who can make out a claim of fraud.