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Fiduciary Duties and Deepening Insolvency in the Non-Profit Context

Friday, December 9, 2011

Contributed by Mark S. Chehi, Anthony W. Clark and Robert A. Weber, Skadden, Arps, Slate, Meagher & Flom LLP

Differences between the laws of different states can materially impact the outcome of fiduciary duty and "deepening insolvency" claims asserted in bankruptcy, as a recent Third Circuit Court of Appeals decision illustrates. In Official Committee of Unsecured Creditors v. Baldwin (In re Lemington Home for the Aged), 659 F.3d 282 (3d Cir. Sept. 21, 2011), as amended by 2011 BL 270076 (Oct. 20, 2011), the Third Circuit addressed breach of fiduciary duty and deepening insolvency claims asserted in bankruptcy litigation against former officers and directors of a bankrupt Pennsylvania non-profit corporation. Because a company's state of incorporation dictates the body of law applicable to such claims under the “internal affairs” doctrine, lawyers must understand how the laws of different states differ in their application to such claims.1 The Third Circuit's ruling in Lemington demonstrates the need for proper corporate governance of financially troubled organizations, because business judgment rule protection may not be available to officers and directors if facts support allegations that they acted without reasonable care and diligence, or with self-interest. The Third Circuit opinion also continues to recognize a deepening insolvency cause of action under Pennsylvania law -- even though that cause of action has only been recognized in Pennsylvania federal (not state) courts, and other jurisdictions including Delaware have declined to recognize the cause of action. Lemington also states that officer and director duties "are owed not only to the corporation and its shareholders, but also to the creditors of an insolvent entity."

Factual Background

The Lemington Home for the Aged, a non-profit Pennsylvania corporation (the "Home"), provided residential elder care services in Pittsburgh, Pennsylvania. By 1999, after years of financial difficulties, the Home was insolvent and subsequently received going concern qualifications from its auditors. The Home's financial records and the Board itself were in disarray, and its chief financial officer failed to maintain a general ledger and other financial records. The Board had a history of informal action, did not maintain proper minutes of meetings, failed to fill its required Treasurer position, and did not provide meaningful oversight of the Home's financial operations. The Board was on notice of numerous nursing home deficiencies and citations; it continued to employ and rely on the Home's administrative officer after a study recommended that she be replaced with a qualified professional; and the Board relied on the advice of the Home's chief financial officer even after learning that he was not maintaining customary financial records. Before bankruptcy, the Board discussed and documented a plan to transfer the Home's principal charitable asset (a fund held by a foundation) to an affiliated entity, which had overlapping directors with the Home. In April 2005, the Home commenced a voluntary chapter 11 case. The bankruptcy court subsequently approved closure of the Home and authorized the official committee of unsecured creditors (the "Committee") to commence an action against the Home's officers and directors asserting breach of fiduciary duties of care and loyalty, and for deepening insolvency. The district court granted the officers' and directors' summary judgment motion, finding that the business judgment rule and the doctrine of in pari delicto applied to shield the directors and officers from liability on the breach of fiduciary duty claims, and that the Committee would be unable to show that there was fraud necessary to support a deepening insolvency claim. The Committee appealed.

The Third Circuit Decision

The Third Circuit vacated the district court's grant of summary judgment in favor of the officers and directors and remanded the case for trial. The appellate court determined that material facts remained in dispute on all the claims, and held that Pennsylvania's business judgment rule protection for directors is overcome by evidence of their negligence. The Third Circuit observed that a different result might have occurred if the entity had been incorporated under Delaware law.

— Fiduciary Duties

Fiduciary duties of care and good faith owed by directors and officers of a Pennsylvania non-profit corporation2 are defined by statute. See 15 Pa. Cons. Stat. Ann. § 5712(a) - (c) (2011). Directors must use "reasonable inquiry, skills and diligence in the performance of their duties." Id. They are "entitled to rely in good faith on information, opinions, reports or statements . . . proposed or presented" by corporate officers and employees "whom the director reasonably believes to be reliable and competent" and by counsel, public accountants and others on matters "which the director reasonably believes to be within the professional or expert competence of such person." Id. The Third Circuit stated such "fiduciary duties are owed not only to the corporation and its shareholders, but also to the creditors of an insolvent entity." 659 F.3d at 290 (citing Citicorp Venture Capital, Ltd. v. Committee of Creditors Holding Unsecured Claims, 160 F.3d 982, 987-88 (3d Cir. 1998)). This statement highlights a difference between Pennsylvania and Delaware law. Under Delaware law, fiduciary duties of corporate officers and directors are not owed to creditors, even when the entity is insolvent. When solvent, only the corporation itself and shareholders may bring claims for breach of fiduciary duties owed to them. See North American Catholic Educational Programming Foundation, Inc. v. Gheewalla, 930 A.2d 92 (Del. 2007). Upon corporate insolvency, creditors may assert only derivative claims for breaches of fiduciary duties that are owed to the corporation itself. Id. at 101.

— Business Judgment Rule

If officers and directors satisfy their fiduciary duties, the “business judgment” rule protects their decisions from judicial challenge. The business judgment rule insulates officers and directors from judicial intervention and liability in the absence of fraud or self-dealing, and presumes that directors are duly informed before they act, and that their official acts are in good faith and in the honest belief that such acts are in the corporation's best interests. See Edward P. Welch, Andrew J. Turezyn and Robert S. Saunders, Folk on the Delaware General Corporation Law § 141.2.2.1 (5th ed., 2011 supp.). "As a substantive rule of law, the business judgment rule provides that there is no liability for an injury or loss to the corporation arising from corporate action when the directors, in authorizing such action, proceeded in good faith and with appropriate care." Id. § 141.2.2.2. Pennsylvania has codified the business judgment rule by providing that "[a]bsent breach of fiduciary duty, lack of good faith or self-dealing, any act as the board of directors, a committee of the board or an individual director shall be presumed to be in the best interests of the corporation." 15 Pa. Cons. Stat. Ann. § 5715(d). See also 15 Pa. Cons. Stat. Ann. § 515(d) (business judgment rule in context of for-profit Pennsylvania corporations). In Lemington, the Third Circuit observed that "underlying the [business judgment] rule is the assumption that reasonable diligence has been used in reaching the decision which the rule is invoked to justify." 659 F.3d at 292 (quoting Miller v. American Telephone & Telegraph Co., 507 F.2d 759, 762 (3d Cir. 1974)). It is thus "material whether the directors' reliance upon the information provided by one or more officers or employees was in 'good faith,' and whether there was a reasonable basis for relying upon officers and employees of the corporation. It is likewise material whether the officers have exercised 'reasonable inquiry, skill and diligence' in performing their duties." Id. at 290. The Third Circuit identified factors bearing on whether a board has exercised reasonable diligence in making a decision: "whether the board . . . was disinterested, whether it was assisted by counsel, whether it prepared a written report, whether it was independent, whether it conducted an adequate investigation, and whether it rationally believed its decision was in the best interests of the corporation." Id. at 292 (quoting Cuker v. Mikalauskas, 692 A.2d 1042, 1046 (Pa. 1997)). In vacating the district court's grant of summary judgment the Third Circuit held, "[w]here . . .there is evidence to support a rational conclusion that the directors did not exercise reasonable diligence, application of the business judgment rule cannot be decided on a summary judgment motion." Id. The appellate court held that evidence of "gross negligence" is not required to overcome Pennsylvania's business judgment rule because that state's law "recognizes directors' and officers' liability for negligent breach of fiduciary duty." Id. at 292, n. 5 (citing Wolf v. Fried, 373 A.2d 734, 735 (Pa. 1977) (emphasis in original)). On this point, the court noted a difference between Pennsylvania and Delaware law. Id. Under Delaware law, mere negligence is not sufficient to overcome the business judgment rule’s presumption that directors properly reached their decision; instead, "under the business judgment rule director liability is predicated upon concepts of gross negligence…" Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984) (overruled on other grounds). The Third Circuit did not suggest that the conduct at issue in Lemington rose to the level of gross negligence. Although the record on appeal in Lemington showed that the Board was assisted by counsel, conducted several meetings and pursued various options before approving the Home's bankruptcy filing, the Third Circuit found sufficient evidence to show that the Board breached its duties of care during the pre-bankruptcy period and in approving the Home's bankruptcy filing. There was evidence sufficient to show that the Board "did not have a reasonable basis to believe" that the Home's officers were "reliable and competent"; there were "numerous red flags" calling into question the officers' competence and diligence; and the Board declined to authorize a "viability study" of the Home's business. Moreover, evidence of plans to "divert" the Home's charitable fund to an affiliate was sufficient to support a breach of loyalty claim. Lemington, 659 F.3d at 291-92. Accordingly, the Third Circuit held that application of the business judgment rule could not be decided on summary judgment on the record in Lemington. Id. at 292.

"Deepening Insolvency" Cause of Action Under Pennsylvania Law

The Third Circuit concluded in Lemington that it remained bound by its own precedents to recognize a deepening insolvency cause of action under Pennsylvania law even though Pennsylvania's high court has not yet spoken on the issue. Id. at 293-94 (citing Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., Inc., 267 F.3d 340, 349 (3d Cir. 2001)(predicting that Pennsylvania Supreme Court would recognize cause of action for deepening insolvency) and In re Citx Corp., 448 F.3d 672, 677 (3d Cir. 2006) (deepening insolvency is claim for "an injury to the Debtors’ corporate property from the fraudulent expansion of corporate debt and prolongation of corporate life")). It remains unclear whether Pennsylvania state courts will follow Third Circuit predictions and actually recognize a deepening insolvency cause of action. The Third Circuit acknowledged that the deepening insolvency doctrine has been criticized or rejected as a cause of action in other jurisdictions, including Delaware. Id. at 294, n. 6. In Trenwick America Litigation Trust v. Ernst & Young, L.L.P., 906 A.2d 168 (Del. Ch. 2006), aff'd, Trenwick America Litigation Trust v. Billet, 931 A.2d 438 (Del. 2007), the Delaware Court of Chancery refused to recognize deepening insolvency as a separate cause of action under Delaware law. The court of appeals confirmed that fraud is a key element of a deepening insolvency claim, and that fraud under Pennsylvania law includes affirmative statements intended to deceive as well as less direct intentional conduct.3 Lemington, 659 F.3d at 294. The Third Circuit found sufficient evidence in Lemington to support a triable issue as to whether the officers and directors fraudulently deepened the insolvency of the Home. That evidence included the Board's failure to disclose to creditors and the bankruptcy court its decision made in early 2005 to close the Home, cease admitting new patients and file for bankruptcy while delaying the bankruptcy filing by several months in a manner that the Committee alleged caused further deterioration of the Home's finances to the detriment of creditors, as well as the officers' alleged failure to collect Medicare receivables, commingling of Home funds with related entities, directing of transfers of Home assets to related entities, and continuing to do business with vendors when the officers knew the Home was insolvent.

In Pari Delicto

The Third Circuit also identified record evidence of possible self-dealing by the officers and directors substantial enough to support the "adverse interest" exception to the in pari delicto defense asserted by the defendant officers and directors. The in pari delicto doctrine is a defense under Pennsylvania law and in other jurisdictions against wrongful conduct claims asserted by or in the right of a corporation if the corporation was "an active, voluntary participant in the wrongful conduct for which it seeks redress" and was at least as responsible as the defendant for such wrongful conduct. Lemington, 659 F.3d at 292 (citing Official Committee of Unsecured Creditors of Allegheny Health Education & Research Foundation v. Pricewaterhousecoopers, LLP, 989 A.2d 313, 329 (Pa. 2010)). The "adverse interest" exception to the in pari delicto defense applies and negates the defense if the underlying wrongful conduct benefited the defendant rather than the corporation itself. Id. at 293. The adverse interest exception to the applicability of in pari delicto applies when an agent of the corporation "acts in his own interest, and to the corporation's detriment." Id. (citing PricewaterhouseCoopers, 989 A.2d at 333-34). The Third Circuit ruled it was error for the district court to find on summary judgment that the "adverse interest" exception to the in pari delicto defense doctrine did not apply because there were genuine issues of material fact. The court determined that the Committee had presented sufficient evidence that the directors' and officers' alleged breaches of fiduciary duty did not benefit the Home but instead benefited and advanced their own self-interest. Lemington, 659 F.3d at 293. The Third Circuit focused on evidence showing that the officers and directors were simultaneously affiliated with an affiliate of the Home as to which the defendants discussed and planned to transfer the Home's primary financial asset; that the Home's chief financial officer served as a trustee of another entity during the time the other entity was being pursued by the Board as a possible purchaser of the Home; that the chief financial officer failed to maintain any financial records of the Home during his tenure; and that another officer of the Home resisted a recommendation to replace her. The Third Circuit's opinion did not mention that the in pari delicto defense is not generally available to officers and directors for clams asserted against them by or in the right of their corporation. It seems this issue was not raised below or on appeal by the Committee.4 A number of Delaware decisions have concluded the in pari delicto defense is not available to corporate insiders. See, e.g., In re HealthSouth Corp. Shareholders Litigation, 845 A.2d 1096, 1107 (Del. Ch. 2003) ("because corporations must act through living fiduciaries . . . the application of the in pari delicto doctrine has been rejected in situations when corporate fiduciaries seek to avoid responsibility for their own conduct vis-a-vis their corporations"); American International Group, Inc. Consolidated Derivative Litigation, 965 A.2d 763, 778 (Del. Ch. 2009) ("Under Delaware law, where insiders have a disabling conflict that gives them a reason to hide information from the corporation's independent directors and stockholders, their knowledge is not imputed to the corporation for purposes of a suit seeking to hold the insiders who committed wrongdoing accountable for the harm they caused to the corporation."); In re Granite Partners, L.P., 194 B.R. 318, 332 (Bankr. S.D.N.Y. 1996) (“In pari delicto bars claims against third parties, but does not apply to corporate insiders or partners. Otherwise, a trustee could never sue the debtor's insiders on account of their own wrongdoing.”). * * * * * Lemington highlights the importance of best corporate governance practices in the insolvency context. Officers and directors should remain informed, diligent and proactive in their governance, business oversight and management activities. They should seek and rely on the advice of counsel and other independent advisors, undertake adequate investigations as necessary, insist upon good recordkeeping, and avoid participation in transactions where a conflict of self- or affiliate interests exists. Mark S. Chehi is a partner in Skadden, Arps, Slate, Meagher & Flom LLP's Corporate Restructuring Group. He has represented numerous public and private companies in out-of-court restructurings, "prepackaged" bankruptcies, negotiated workouts, traditional Chapter 11 cases, and related transactions, strategy and governance issues.Anthony W. Clark heads Skadden's Corporate Restructuring and Bankruptcy Litigation practice in Wilmington, Delaware, and represents debtors, creditors and acquirers. He also handles corporate, securities and general litigation matters.Robert A. Weber is a counsel in the firm's Corporate Restructuring Group. His practice focuses primarily on complex bankruptcy and commercial litigation matters.

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