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Is Deepening Insolvency a Recognized Tort in Tennessee?
by Robert J. Mendes
There is remarkably little law in Tennessee about the tort theory of "deepening insolvency." The only case applying Tennessee law that addresses the tort is based, in part, on cases applying Delaware law. However, on August 14, 2007, the Delaware Supreme Court ruled that there is no cause of action under Delaware law for deepening insolvency. This article explores the impact of this decision on whether deepening insolvency is an actionable tort under Tennessee law.
I. What Is Deepening Insolvency?
The answer to this question depends largely on one's perspective. Proponents argue that deepening insolvency is an independent tort theory by which creditors should be able to recover from officers, directors, or outside professionals for causing an entity to become more insolvent than it otherwise would have been absent the defendants' actions or inactions. The theory is that, by deepening the insolvency, the control persons or advisors reduced or eliminated the return to creditors that would have been available if the defendants had acted more prudently. Others argue that there is no point to having an independent tort of deepening insolvency because the existing universe of fiduciary duties owed by officers, directors, and outside professionals are adequate to address any harm worth remedying.
Whichever side of this debate one is on, it is clear that for much of the last quarter century, momentum has built to recognize an independent tort for deepening insolvency. That is, until the Delaware Supreme Court issued Trenwick America Litigation Trust v. Billett, 2007 Del. LEXIS 357 (Del. Aug. 14, 2007) (not yet released for publication in permanent law reports). This two page order from the Delaware Supreme Court stated simply that "the final judgment of the Court of Chancery should be affirmed on the basis of and for the reasons assigned by the Court of Chancery in its opinion dated August 10, 2006." That Delaware Chancery Court opinion can be found at Trenwick America Litig. Trust v. Ernst & Young, L.L.P., 906 A.2d 168 (Del. Ch. 2006).
The result is that Delaware law is now clear. That state has come down firmly on the side that deepening insolvency is not an independent tort. Instead, Delaware "remits plaintiffs to the contents of their traditional toolkit, which contains, among other things, causes of action for breach of fiduciary duty and for fraud." Trenwick America, 906 A.2d at 205.
II. Existing Tennessee Law
There is only one case applying Tennessee law that directly discusses deepening insolvency, Limor v. Buerger (In re: Del-Met Corp.), 322 B.R. 781 (Bankr. M.D. Tenn. 2005). Del-Met was an automotive parts supplier. Its three largest customers were General Motors Corporation, Johnson Controls, Inc., and Lear Corporation. The trustee in Del-Met's Chapter 7 bankruptcy sued these three customers as well as outside management and accounting professionals. Among other theories, the trustee argued for breach of fiduciary duty in connection with an alleged deepening of insolvency. In summary, the trustee alleged that these parties essentially seized management and control of the debtor corporations, manipulated the debt structure of the companies, and required the companies to continue to service unprofitable contracts.
In considering the defendants' motion to dismiss, the bankruptcy court's initial inquiry was whether the trustee was asserting an independent cause of action for deepening insolvency or alleging a traditional breach of fiduciary duty. Del-Met, 322 B.R. at 807. In the trustee's brief and at oral argument, "counsel for the trustee reiterated that deepening insolvency was alleged as a breach of fiduciary duty by the Defendants, not as an independent tort." Id. Despite this disclaimer, when questioned by the court about the source of the duty owed by Del-Met's customers and professionals to Del-Met, the trustee argued that the court should acknowledge the viability of the deepening insolvency theory under Tennessee law. Id. In a nutshell, the trustee said that she sought to pursue a traditional fiduciary duty claim where the duty related to obligations arising in connection with the independent tort of deepening insolvency. Id.
The court stated that "[t]hese circular positions by the trustee speak volumes to the lack of definition of the developing theory of deepening insolvency." Id. The next step in the court's analysis was to observe that, whether the cause of action was characterized as a separate tort or a type of a breach of fiduciary duty, there must be a duty that was violated. Specifically, the court explained:
[T]he Trustee's deepening insolvency claim is cognizable only
if the Defendants owed duties to the debtor corporations
under nonbankruptcy law by virtue of their domination and
control such that the run up of debt, the performance of
unprofitable contracts, the selective payment of vendors
and other allegations in the complaint are actionable breaches.
Id. at 808. After framing the issue this way, the court separately analyzed whether the behavior alleged in the complaint was actionable under Tennessee law as a breach of fiduciary duty or as an independent tort.
Actionable as a Breach of Fiduciary Duty?
In thinking about the trustee's complaint against customers and outside professionals as a breach of fiduciary duty, the court examined a variety of situations where duties were found to be owed. Id. at 809-11. For example, Tennessee law is clear that a shareholder can become a fiduciary by exercising dominion and control over the affairs of a corporation. See, e.g., Intertherm, Inc. v. Olympic Homes Systems, Inc., 569 S.W.2d 467 (Tenn. Ct. App. 1978).
Del-Met also looked "beyond the immediate corporate family" in noting that "the Court of Appeals of Tennessee has acknowledged the possibility that breachable duties can arise in the context of a lending relationship when special facts and circumstances are present." Del-Met, 322 B.R. at 811, citing Oak Ridge Precision Industries, Inc. v. First Tennessee Bank N.A., 835 S.W.2d 25 (Tenn. Ct. App. 1992). After examining a range of Tennessee cases addressing fiduciary duties, the court concluded that the "extreme" facts alleged about the defendants exercising control over the debtor corporations "would support a cause of action for breach of fiduciary duty under Tennessee law." Id.
Actionable as an Independent Tort of Deepening Insolvency?
The court next considered whether the alleged facts constituted the independent tort of deepening insolvency. Id. at 811-15. Because there were no applicable decisions by Tennessee courts, the court was required to predict "whether the Tennessee Supreme Court would recognize deepening insolvency as an actionable breach of duty." Id. at 813.
In analyzing how the Tennessee Supreme Court would resolve this issue, the Del-Met court was guided by a series of federal court cases interpreting Delaware, New York, and Pennsylvania law. For each of these states, a federal court had interpreted applicable law to conclude that the state would recognize an independent deepening insolvency tort. Id. at 811-15. Due to the developing nature of the subject, this constituted a comprehensive review of the case law at that time.
The court took particular guidance from Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340 (3rd Cir. 2001), which construed Pennsylvania law. To determine whether Pennsylvania would recognize the independent tort, the Third Circuit considered: (1) the soundness of the theory; (2) the growing acceptance of the theory; and (3) the remedial theme of the state's law. Lafferty, 267 F.3d at 349-51. In short, the Third Circuit concluded that the theory was sound, that it was indeed growing in acceptance, and that it was consistent with the concept in Pennsylvania jurisprudence that the law provides a remedy where there is an injury. Id.
In Del-Met, the court agreed with the Third Circuit's reasoning, and added that "the Tennessee Supreme Court has adopted the same jurisprudential principle as the Pennsylvania high court: where there is a tortious injury, the law will provide a remedy." Del-Met, 322 B.R. at 815, citing M'Farlane v. Moore, 1 Tenn. 174 (1805). Thus, the court held "that if presented with compelling facts, the Tennessee Supreme Court would recognize deepening insolvency as an actionable breach of duty to a corporation." Id.
In summary, the only case applying Tennessee law that directly addresses the deepening insolvency theory held that the "extreme" facts in that case successfully pled a cause of action whether construed as a traditional breach of fiduciary duty or an independent deepening insolvency tort.
III. How Does Trenwick Impact the Analysis?
As described above, regarding "deepening insolvency," it is now clear that "Delaware law does not recognize this catchy term as a cause of action, because catchy though the term may be, it does not express a coherent concept." Trenwick, 906 A.2d at 174. The Delaware Chancery Court elaborated:
Even when a firm is insolvent, its directors may, in the
appropriate exercise of their business judgment, take action
that might, if it does not pan out, result in the firm being
painted in a deeper hue of red. The fact that the residual
claimants of the firm at the time are creditors does not mean
that the directors cannot choose to continue the firm's
operations in the hope that they can expand the inadequate
pie such that the firm's creditors get a greater recovery.
By doing so, the directors do not become a guarantor of success.
Put simply, under Delaware law, "deepening insolvency" is no
more of a cause of action when a firm is insolvent than a cause of
action for "shallowing profitability" would be when a firm is
solvent. Existing equitable causes of action for breach of
fiduciary duty, and existing legal causes of action for fraud,
fraudulent conveyance, and breach of contract are the appropriate
means by which to challenge the actions of boards of insolvent
corporations.
Id. The Delaware court criticized "those federal courts that became infatuated with the concept" of deepening insolvency for "not look[ing] closely enough at the object of their ardor." Id. at 206.
So, what does that mean for Tennessee law? Remember, Del-Met analyzed the facts alleged from two perspectives – as a traditional breach of fiduciary duty and as an independent tort. It seems clear that Trenwick bears on the second of these. Because a federal court applying Tennessee law should consider the soundness of a new theory and whether the new theory is growing in acceptance, it should weigh heavily that Delaware, a state with a sophisticated body of commercial law, has rejected deepening insolvency as an independent tort. Further, while not catalogued at length here, it is fair to say that the trend nationally has turned away from recognizing deepening insolvency as a separate tort. See, e.g., In re: Amcast Industrial Corporation, 365 B.R. 91, 116-19 (Bankr. S.D. Ohio 2007) (reviewing trend over previous 24 months in deciding that Ohio would not recognize the independent tort). Thus, it appears that the status of deepening insolvency as a cognizable tort is in serious doubt.
However, the Del-Met analysis about whether the trustee's allegations properly pled a traditional breach of fiduciary duty are consistent with Trenwick. If Tennessee law recognizes a breach of fiduciary duty claim against persons outside the corporate family when they exercise dominion and control over the corporation, then the Del-Met trustee stated a cause of action. As Del-Met acknowledged, though, this requires an "extreme" set of facts. Del-Met, 322 B.R. at 811.
IV. Conclusion
There are no Tennessee decisions that directly address the deepening insolvency theory. In the author's opinion, if a federal court were to predict Tennessee law today, it may well conclude that Tennessee would not recognize the independent tort of deepening insolvency. However, it is clear that Tennessee courts will allow a party to assert a breach of fiduciary duty cause of action where the defendant is alleged to have exercised dominion and control over the corporation.
Robert J. Mendes is a business attorney practicing in the areas of litigation, insolvency, and planning. He represents businesses and business owners in a range of litigation matters including employment disputes, intellectual property disputes, directors' and officers' liability, contract disputes, internal investigations and crisis management, and general business disputes. A portion of his practice is devoted to representing debtors, creditors, creditors' committees, trustees, and purchasers of assets in business bankruptcy cases. He also acts as outside general counsel for a number of companies.
Mendes received his B.A. from the University of Illinois and his J.D. from the University of Chicago. He is licensed to practice law in Tennessee and Illinois and is admitted to practice in the U.S. District Courts for the Middle, Eastern, and Western Districts of Tennessee, the Northern District of Florida, and the Northern District of Illinois, the U.S. Court of Appeals for the Sixth Circuit, and the U.S. Supreme Court. |
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