Deepening Insolvency: Reports of Its Death Were Greatly Exaggerated

On May 18, the Delaware Supreme Court issued a major ruling on so-called “deepening insolvency” liability of corporate officers and directors. For those of you who haven’t heard of this by now, “deepening insolvency” is shorthand for a question that presents itself in many forms, both before and after bankruptcy. In an insolvent company, the shareholders have no equity and nothing to lose. In the past, the law has told us that the responsibility of corporate officers and directors was to the shareholders only. Do officers and directors face liability to creditors by running that company into deeper debt?

In North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 2007 WL 1453705 (Del. May 18, 2007), the Delaware Supreme Court ruled that no direct cause of action exists which would permit creditors of an insolvent company to sue directors. However, the Court held that creditors could sue derivatively for damages suffered by the insolvent corporation. The Court stated:

It is well settled that directors owe fiduciary duties to the corporation. When a corporation is solvent, those duties may be enforced by its shareholders, who have standing to bring derivative actions on behalf of the corporation because they are the ultimate beneficiaries of the corporation's growth and increased value. When a corporation is insolvent, however, its creditors take the place of the shareholders as the residual beneficiaries of any increase in value.

Consequently, the creditors of an insolvent corporation have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties. The corporation's insolvency “makes the creditors the principal constituency injured by any fiduciary breaches that diminish the firm's value.” Therefore, equitable considerations give creditors standing to pursue derivative claims against the directors of an insolvent corporation. Individual creditors of an insolvent corporation have the same incentive to pursue valid derivative claims on its behalf that shareholders have when the corporation is solvent.

In the Ninth Circuit, bankruptcy trustees already had the green light to sue officers and directors who run a failing corporation into the ground for their own ends. See, Smith v. Arthur Andersen LLP, 421 F.3d 989 (9th Cir. 2005). The Gheewalla case now makes clear that “deepening insolvency” is a harm suffered by the corporation, not by shareholders or by any individual creditor. The trick in these cases will be to find the conflict of interest that takes the case outside the aegis of the business judgment rule.