This case summary comes to us courtesy of Maura Burke, one of our firm’s summer associates.
In Miller v. McCown De Leeuw & Co., Inc. (In re Brown Schools), 386 B.R. 37 (Bankr. D. Del. 2008), the Delaware bankruptcy court held that the theory of deepening insolvency may be used to measure damages in an action for breach of the fiduciary duty of loyalty. This opinion revives the concept of deepening insolvency as a significant bankruptcy issue in Delaware.
In Trenwick Am. Litig. Trust v. Billett, 931 A.2d 438 (Del. 2007), aff’g Trenwick Am. Litig. Trust v. Ernst & Young, LLP, 906 A.2d 168 (Del. Ch. 2006), the Delaware Supreme Court closed the door on deepening insolvency, or the wrongful prolonging of an insolvent company by increasing its debt load, as an independent cause of action in Delaware. The Trenwick court did not address deepening insolvency as a measure of damages. In re Brown Schools confirms the Trenwick court’s holding while providing guidance as to deepening insolvency’s role in measuring damages for specific causes of action.
Brown Schools involved an action by a Chapter 7 trustee against the debtors’ controlling shareholder, McCown De Leeuw & Co. Inc. (“MDC”). In 1997, MDC indirectly acquired more than 65% of the stock of The Brown Schools, Inc. (the “Company”). As part of the Company’s recapitalization, the Company obtained $100 million in loans from various banks, $15 million in capital from Teacher’s Insurance and Annuity Association of America (“TIAA”) and additional loans from MDC. Over the next several years, the Company unsuccessfully attempted to restructure its debt and eventually filed for Chapter 7 relief in 2005. The Company’s appointed Chapter 7 trustee filed suit against MDC and its affiliates (the “Defendants”) claiming among other things deepening insolvency, breach of fiduciary duty, fraudulent and voidable transfers, and civil conspiracy.
The Defendants moved to dismiss the trustee’s claims alleging that (a) Delaware does not recognize deepening insolvency as a valid cause of action and (b) each of the plaintiff’s additional claims were based upon deepening insolvency and therefore were invalid in their own right.
The bankruptcy court, following Trenwick, dismissed the deepening insolvency claim, however the court disagreed that the other causes of actions were merely “disguised deepening insolvency claims.”
The bankruptcy court, narrowly construing the Trenwick decision, found that Trenwick did not bar traditional claims for breach of fiduciary duty. Additionally, the court rejected the argument that In re Radnor Holdings Corp., 353 B.R. 820 (Bankr. D. Del. 2006), mandated dismissal of the claims. In Radnor, the court dismissed a duty of care violation claim because it was merely a “deepening insolvency claim by another name.” In this case, the court distinguished Radnor, holding that breach of fiduciary duty of loyalty related to issues of self-dealing and fairness, not deepening insolvency, therefore the claim was not dismissible.
Finally, the bankruptcy court, relying on Alberts v. Tuft (In re Greater Southeast Cmty. Hosp. Corp. I), 353 B.R. 324 (Bankr. D.C. 2006), found that deepening insolvency may be used as a theory of damages for a claim based on a breach of duty of loyalty. Under this theory, damages are measured by the dissipation of corporate assets and/or the company’s increased debt load. Thus, damages could exceed the amount invested in, or benefits actually received by, the company.
Brown Schools reestablished the concept of deepening insolvency as a consequential bankruptcy issue in Delaware. Although not recognized as a separate cause of action, deepening insolvency may be implemented as a theory of damages for breach of fiduciary duty of loyalty. Accordingly, Brown Schools quashes any hopes previously held by directors and officers of distressed companies that Trenwick eliminated entirely the issue of deepening insolvency in Delaware.