James M. Lawniczak on Deepening Insolvency and Pennsylvania Law as Predicted by the Third Circuit

Excerpt:

The majority of courts that have considered whether there is a cause of action for deepening insolvency have determined that there is no such thing. Some of those courts have been very vocally outspoken in opposition to the very existence of such a cause of action, with good reasons discussed below. No court in the state of Pennsylvania has even suggested that there is a cause of action for deepening insolvency under Pennsylvania law.

Despite these rulings, in a series of three cases over the last ten years-Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., Inc., 267 F.3d 340, 2001 U.S. App. LEXIS 21609 (3d Cir. 2001) [an enhanced version of this opinion is available to lexis.com subscribers / unenhanced version available from lexisONE Free Case Law]; Seitz v. Detweiler, Hershey & Assocs., P.C. (In re Citx Corp., Inc.), 448 F.3d 672, 2006 U.S. App. LEXIS 13141 (3d Cir. 2006) [enhanced version / unenhanced version]; and Official Committee of Unsecured Creditors v. Baldwin (In re Lemington Home for the Aged), 2011 U.S. App. LEXIS 19312 (3d Cir. Sept. 21, 2011) [enhanced version / unenhanced version] -the Court of Appeals for the Third Circuit has predicted that there is a cause of action for deepening insolvency in Pennsylvania. (The three cases together are sometimes referred to as the "Third Circuit Trilogy"). In the meantime, there has been no Pennsylvania reported case on the issue. Perhaps the only way to get a Pennsylvania court decision on the issue would be if the Third Circuit would certify the issue to the Pennsylvania Supreme Court, as recommended later in this commentary.

The Facts of Lemington

The Lemington case began when an unsecured creditors' committee brought a proceeding against the officers and directors of the Pennsylvania debtor not-for-profit corporation, alleging causes of action for breach of fiduciary duty and deepening insolvency. The District Court applied the business judgment rule and in pari delicto and granted summary judgment in favor of the defendants. The Third Circuit reversed the grant of summary judgment and remanded for trial, including on the deepening insolvency count.

What Is Deepening Insolvency?

There has been much recent discussion in the literature and case law as to whether there is either a cause of action or an element of damages for "deepening insolvency." The theory is that a director might be liable for allowing an insolvent corporation to continue in business and thus deepening its insolvency. In Fehribach v. Ernst & Young LLP, 493 F.3d 905, 908-09 (7th Cir. 2007) [enhanced version / unenhanced version], the court gave a good description of deepening insolvency, noting that it is a "controversial theory." In general, the court pointed out that the theory "allows damages sometimes to be awarded to a bankrupt corporation that by delaying liquidation ran up additional debts that it would not have incurred had the plug been pulled sooner." 493 F.3d at 908.

A cause of action solely for deepening insolvency, if it exists, is counterintuitive to general principles that businesses should be encouraged to do all they can to rehabilitate themselves when operational and financial problems impair the very existence of the entity. If there were such a cause of action, it would likely engulf every director of a business entity that ended up liquidating or filing a bankruptcy proceeding because it is almost impossible to stop on a dime and shut down an entity's operations exactly at the minute it becomes insolvent. It would thus significantly chill all restructuring efforts. See generally 2 Asset Based Financing § 16A.11[2] (Lexis 2011); and 12 Business Organizations with Tax Planning § 156.08[4] (Lexis 2011).

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