Examining Tennessee’s Traditional Toolkit as the Deepening Insolvency Debate Subsides

By Robert J. Mendes

In the last few years, the debate regarding deepening insolvency as an independent tort has grown quieter. Creditors are returning their focus to the traditional toolkit of business torts to address insolvency-related injuries. This article explores recent developments regarding the fiduciary duties that insiders, lenders and other third parties owe to an insolvent corporation and its creditors under Tennessee law.

I.   What Happened to Deepening Insolvency as an Independent Tort?

The idea that there should be an independent tort of deepening insolvency is based on the notion that fraudulently expanding corporate debt or improperly prolonging corporate life causes cognizable harm to a corporation and its creditors. Although the origins of deepening insolvency can be traced to the early 1980s, the theory entered the mainstream with the Third Circuit's opinion in Official Comm. of Unsec. Creditors v. R.F. Lafferty, 267 F.3d 340 (3d Cir. 2001). Lafferty acted as a catalyst for some courts to recognize deepening insolvency as an independent cause of action.

The theory's popularity continued to build momentum for several years. This was despite the fact that some argued that it was poorly defined and did not address any wrong not already addressed by other traditional business tort theories. Then, the tide began to turn as some courts questioned the soundness of deepening insolvency as an independent action.¹

In 2007, the Supreme Court of Delaware issued an Order affirming a Chancery Court's holding that Delaware would not recognize an independent cause of action for deepening insolvency. Trenwick Am. Litig. Trust v. Billett, 931 A.2d 438 (Del. 2007), affirming 906 A.2d 168 (Del. Ch. 2006). The Chancery Court's holding explained that rejecting deepening insolvency does not absolve insiders of insolvent corporations of responsibility. Instead, creditors can use causes of action for breach of fiduciary duty and other tools in the traditional toolkit to hold such parties responsible. Several other courts deciding the issue have followed Delaware's lead in rejecting the theory of deepening insolvency as an independent tort, some relying on the Chancery Court's opinion and some on the Order affirming it.²

Today, there are still no Tennessee state court decisions directly addressing deepening insolvency. However, considering Trenwick's holding and a survey of subsequent cases, it is clear that the theory is in decline. In 2009, a Tennessee Bankruptcy Court held that "Tennessee courts would probably not spring forward to embrace" deepening insolvency as an independent tort. Official Comm. of Unsecured Creditors of Propex Inc. v. BNP Paribas (In re Propex Inc.), 415 B.R. 321, 351 (Bankr. E.D. Tenn. Mar. 5, 2009). The Court cited the recent scholarly criticism of the theory of deepening insolvency and the growing number of courts rejecting it as an independent tort as support for its holding.

It is implicit in rejecting deepening insolvency as an independent tort that the constellation of existing remedies (i.e., the "traditional toolkit") is adequate to address any injury worth remedying. Further, as the Chancery Court in Trenwick noted, the existing remedies have been carefully shaped by generations of experience, unlike deepening insolvency.

II.   Examining the Toolkit - Breach of Fiduciary Duty

In order to properly assess the traditional toolkit's adequacy, it is important to understand how far an action for breach of fiduciary duty reaches. Two recent Tennessee cases show that the cause of action for breach of fiduciary duty can extend to a range of indirect relationships.

Fiduciary Duties Applied Outside the Defendant's Corporate Entity

Critics of deepening insolvency as a tort argue that the cause of action for breach of fiduciary duty is an adequate remedy because it covers both corporate actors, and also any outsiders exercising enough control over the entity to warrant liability. On the other hand, advocates of the independent tort argue that the cause of action for breach of fiduciary duty is inadequate because it casts too narrow a net, possibly missing some bad actors. Specifically, they would argue that lenders, affiliates and other third parties can too easily avoid liability for breach of fiduciary duty even when they had a hand in increasing the entity's liabilities. They would argue that, while fiduciary duties can be imputed to non-corporate actors in some circumstances, such duties are rarely enforced in practice. A recent Tennessee Court of Appeals case reminds us that outsiders can be susceptible to a breach of fiduciary duty claim and that dominion and control is still the key. See Foster Bus. Park, LLC v, Winfree, 2009 WL 113242 (Tenn. Ct. App. Jan. 15, 2009).

In Foster, the maker of a promissory note brought an action for breach of fiduciary duty against his former loan officer. The Chancery Court granted summary judgment for the defendant. The Court of Appeals concurred with the Chancery Court that there was no per se fiduciary relationship between a lender and his customer. However, a fiduciary relationship can exist, the Court held, if one party has exercised dominion and control over the other. Because the maker of the note admitted the loan officer had never exercised control over him, the Court found no fiduciary relationship existed and affirmed summary judgment for the defendant-loan officer. This case is important because it shows that fiduciary duties can be imputed to lenders, affiliates or other third parties who exercise sufficient dominion or control over an entity.

The application of fiduciary duties to outsiders is not limited to Tennessee courts. A recent Delaware Chancery Court applied a similar analysis to find that a controlling affiliate of an LLC's managing member can itself owe fiduciary duties to the LLC and its other members. See Bay Center Apartments Owner, LLC v. Emery Bay PKI, LLC, 2009 WL 1124451 (Del. Ch. Apr. 20 2009). In Bay Center, PKI and Bay Center, both limited liability companies, formed a third entity, Emery Bay, LLC ("Emery Bay"). Emery Bay's LLC Agreement designated PKI as the managing member. PKI's individual owner and manager, Alfred Nevis, was not a member or officer of Emery Bay, but he was involved in the day-to-day management of the project for which Emery Bay was formed. After the project went sour, Bay Center filed a lawsuit which included a claim for breach of fiduciary duty against Nevis. The Court acknowledged that Nevis was not a member or officer of Emery Bay and was thus beyond the normal scope of those who owe fiduciary duties in the corporate context. However, the Court, held that an affiliate of the managing member of an LLC has a duty not to use control over the LLC's assets to benefit himself at the LLC's expense. Thus, Nevis had a duty not to use his control over Emery Bay's assets (which control he obtained by his position at PKI) to benefit himself at Emery Bay's expense. The Court held that Bay Center had adequately pled a breach of this duty by showing that Nevis renegotiated a loan to his own advantage and at the expense of Emery Bay.

Direct Claims by Creditors for Breach of Fiduciary Duty After Insolvency

The effect of insolvency on a breach of fiduciary duty claim is also an important factor for assessing its adequacy as a remedy. Until recently, no Tennessee state court decision had addressed whether a creditor may bring a direct claim for breach of fiduciary duty against the officers and directors of an insolvent corporation. In North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92, 99 (Del. 2007), the Delaware Supreme Court had already held that "the creditors of a Delaware corporation that is either insolvent or in the zone of insolvency have no right, as a matter of law, to assert direct claims for breach of fiduciary duty against the corporation's directors." 930 A.2d at 94. The Court explained that "the general rule is that directors do not owe creditors duties beyond the relevant contractual terms." Id. at 99 (citations omitted). However, the Court continued, the creditors of an insolvent corporation do have standing to maintain derivative claims against directors on behalf of the corporation for breaches of fiduciary duties.

When the issue came before the Tennessee Court of Appeals, in Sanford v. Waugh, 2009 WL 1910957 (Tenn. Ct. App. 2009), the Court generally agreed with Gheewalla's holding that a creditor can assert only derivative actions against insiders of an insolvent corporation. However, Waugh took the analysis a step further by holding that a creditor of an insolvent corporation (or on the verge of insolvency) can bring a direct action against the corporation's insiders for breach of fiduciary duty if the insiders have engaged in self-dealing or preference.

The plaintiff in Waugh was a creditor of an insolvent corporation that owed him on a promissory note. After suing the corporation and its owner to enforce the note, the officers and directors of the corporation began winding down the corporation and disposing of assets in which the plaintiff claimed a security interest. Believing the officers and directors were acting for their own benefit and to avoid paying him under the note, he sued them for breach of fiduciary duty, among other things. The trial court dismissed the breach of fiduciary duty claim on summary judgment. The trial court had relied on Gheewalla in determining that the plaintiff could only proceed against the insiders through a derivative action.

In reversing summary judgment on the breach of fiduciary claim, the Court of Appeals relied on Intertherm, Inc. v. Olympic Homes Sys., Inc., 569 S.W.2d 467 (Tenn. Ct. App. 1978), for the proposition that "officers and directors of an insolvent corporation owe a fiduciary duty to creditors." Id. at 11-12. The Court then added:

a creditor to an insolvent corporation or a corporation on the verge of insolvency may assert an action for breach of fiduciary duty against officers or directors who are also creditors to the corporation when they have been given preference in their preexisting debt or have engaged in self-dealing conduct.

Id. at 13. The rationale behind this rule is that insiders cannot be allowed to use their position and superior inside knowledge to benefit themselves at the expense of third-party creditors. The Court acknowledged Gheewalla's concern that recognizing direct fiduciary duties to creditors could create uncertainty and conflicts of interest for directors. The Court explained that its holding avoided those concerns, however, because it is limited to cases involving self-dealing or preference. The Court distinguished Gheewalla, in part, by pointing out that the defendant-directors in Gheewalla were not accused of self-dealing. Waugh has made clear that, in Tennessee, creditors may bring direct claims of breach of fiduciary duty against self-dealing officers or directors.

III.   Conclusion

In Tennessee, the traditional toolkit appears equipped to handle a range of corporate insolvency situations. Under Foster, fiduciary duties apply to outside actors who exercise dominion and control over a corporate entity. Under Waugh, self-dealing insiders are not protected from direct liability during insolvency. Together, these cases show how the tools in the traditional toolkit can work together to tackle a wide variety of insolvency situations.

Acknowledgement: The idea for this article came from an excellent presentation by John E. Murdoch, III, Recent Developments in Commercial Law (Mid-South Commercial Law Institute Annual Conference, Dec. 4, 2009).

See Related Article: Is Deepening Insolvency a Recognized Tort in Tennessee?

¹ See, e.g., Official Comm. of Unsecured Creditors of Vartec Telecom, Inc. v. Rural Tel. Fin. Coop. (In re Vartec Telecom., Inc.), 335 B.R. 631, 641-644 (N.D. Tex. 2005) (rejecting deepening insolvency as an independent tort under Texas law); In re Greater Southeast Community Hosp. Corp., 333 B.R. 506, 517 (Bankr. D.D.C. 2005) (same under District of Colombia law); In re Global Services Group, LLC, 316 B.R. 451, 459 (Bankr. S.D.N.Y. 2004) (same under New York law); see also Bondi v. Bank of America Corp. (In re Parmalat), 383 F. Supp. 2d 587, 602 (S.D.N.Y. 2005) (dismissing claim for deepening insolvency under North Carolina law as being duplicative of the plaintiff's breach of fiduciary duty claim).

² See, e.g., Wooley v. Faulkner (In re SI Restructuring, Inc.), 532 F.3d 355, 363 (5th Cir. 2008) (rejecting deepening insolvency as both a cause of action and as a theory of damages); Schnelling v. Crawford, (In re James River Coal Co.), 360 B.R. 139 (Bankr. E.D. Va. 2007) (holding that deepening insolvency is not a viable cause of action under Virginia law); In re Amcast Indus. Corp. et al., 365 B.R, 91, 118 (Bankr. S.D. Ohio 2007) (characterizing the tort of deepening insolvency as a "complete redundancy").