The Bankruptcy Court for the District of Delaware Held That a Breach of the Fiduciary Duty of Loyalty Cause of Action Was Not a Disguised Deepening Insolvency Claim
Miller v. McCown De Leeuw & Co., Inc. (In re Brown Schools), No. 05-10841, Adv. No. 06-50861 (Bankr. D. Del. April 24, 2008) (Judge Mary F. Walrath)
The Bankruptcy Court reaffirmed that Delaware does not recognize a deepening insolvency cause of action. However, the Court determined that a breach of the duty of loyalty claim could still be asserted. Unlike a breach of the duty of care, a breach of the duty of loyalty is not a disguised deepening insolvency claim. Further, damages based on deepening insolvency could be used in the damages calculations. Finally, a claim for aiding and abetting fraudulent transfers is not a recognized cause of action in Delaware.
Defendant McCown De Leeuw & Co., Inc. (“MDC”) acquired more than 65% of Brown School, Inc.’s stock in 1997 and 1998. MDC, through subsidiaries, also entered into an Advisory Services Agreement (“ASA”) with the Debtors and pursuant to the ASA, received the greater of $400,000 or 0.3% of the Debtors’ net revenues (maximum of $800,000) as compensation. Debtors subsequently received loans from various institutions including MDC. The MDC notes were unsecured and subordinate to the other loans. In April 2003, the Debtors owed roughly (i) $47 million to Credit Suisse First Boston (“CSFB”), (ii) $18.4 million to Teachers Insurance and Annuity Association of America (“TIAA”), (iii) $12.5 million to MDC, and (iv) $22 million to other creditors. That same month, Debtors sold all of their residential treatment centers for $64 million. The proceeds satisfied the CSFB debt and were also used to pay fees and other costs including $1.7 million to MDC. The Trustee alleged that this payment to MDC unlawfully preferred MDC over the Debtors’ other creditors because MDC provided no compensable services related to this transaction beyond those services for which it was already being compensated for under the ASA. In July 2004, Debtors restructured their debt and granted TIAA first lien position and gave MDC a second lien on substantially all of its assets. On March 25, 2005, the Debtors filed voluntary petitions for relief under chapter 7 of the Bankruptcy Code and George Miller was appointed trustee (the “Trustee”).
The Trustee alleged various claims in his Second Amended Complaint (the “Complaint”) against the MDC defendants. The claims for deepening insolvency, breach of fiduciary duty and aiding and abetting fraudulent transfers by the MDC defendants are addressed in this summary. The first asserted claim included a claim for deepening insolvency. The Delaware Supreme Court in Trenwick Am. Litig. Trust v. Billett, 2007 LEXIS 357, at *1 (Del. 2007), held that Delaware does not recognize a cause of action for deepening insolvency. Hence, the Bankruptcy Court summarily held that this count of the Trustee’s Complaint was dismissed.
The Complaint also alleged a claim for breach of fiduciary duty against the MDC defendants. The Trustee contended that the MDC defendants’ conduct constituted self-dealing and that they had prolonged the Debtors existence for their own profit. The Trustee pointed to the $1.7 million MDC received for the sale of Debtors’ residential treatment centers as an example of the breach of loyalty. The Trustee also asserted that the July 2004 restructuring was done to prefer MDC over non-insider creditors. Further, the Trustee asserted a claim for aiding and abetting a breach of fiduciary duty against any MDC defendants that would be found not to have a fiduciary duty to the Debtors.
The MDC defendants argued that the Trustee’s claims for breach of fiduciary duty were merely disguised deepening insolvency claims and therefore, they should be dismissed. The Trustee countered, arguing that while Trenwick rejected an independent cause of action for deepening insolvency, it did not prevent holding directors of insolvent corporations responsible under fiduciary duty causes of action. The Trustee identified language in the Chancery Court’s opinion in Trenwick wherein the court noted that directors of an insolvent corporation owed fiduciary duties to its creditors. 906 A.2d 168, 205 (Del. Ch. 2006). Thus, the Trustee asserted that his claims were more than simply deepening insolvency claims. The Bankruptcy Court agreed with the Trustee’s arguments holding that Trenwick could not be so broadly construed as to require dismissal of all breach of fiduciary duty and aiding and abetting a breach of fiduciary duty claims.
The Bankruptcy Court also rejected the argument that the In re Radnor Holdings Corp., 353 B.R. 820 (Bankr. D. Del. 2006) case required dismissal of the Trustee’s claims. The Radnor court dismissed causes of action for breach of fiduciary duty and aiding and abetting breach of fiduciary duty because such claims were merely a deepening insolvency cause of action. The Bankruptcy Court in this case distinguished Radnor on the basis that Radnor dealt only with alleged duty of care violations, not breaches of the duty of loyalty as asserted in this case. The Court reasoned that duty of care violations more closely resemble deepening insolvency claims because they both relate to a board of director’s business decisions. Such decisions are generally protected by the business judgment rule. Thus, the Court concluded claims asserting a breach of the duty of care could be considered a disguised deepening insolvency claim.
The Bankruptcy Court contrasted a breach of the duty of loyalty claim because it merely requires proof that the defendant was on both sides of the transaction. Once such proof is demonstrated, the burden shifts to the defendant to show that the transaction was entirely fair. Thus, the requirements for demonstrating a cause of action for breach of the duty of loyalty are much less than those for a breach of the duty of care. The Court further distinguished duty of care violations from duty of loyalty violations by noting that duty of loyalty violations are not indemnifiable under 8 Del. C. § 102(b)(7). Consequently, the Bankruptcy Court held that the breach of the fiduciary duty of loyalty claims were not disguised deepening insolvency claims and would not be dismissed.
The MDC defendants also argued that deepening insolvency could not be used to measure damages for a claim of breach of fiduciary duty. In response, the Trustee asserted that his damage calculations did not rely exclusively on the amount by which Debtors’ insolvency was deepened. The Trustee also argued that even if it did rely solely on the amount by which the insolvency deepened, the damages should still be recoverable. The Trustee relied on the Alberts v. Tuft (In re Greater Southeast Cmty. Hosp. Corp. I), 353 B.R. 324 (Bankr. D.C. 2006) case where the court held that deepening insolvency could be used to calculate damages in a breach of fiduciary duty claim. The Bankruptcy Court agreed with the reasoning of the Tuft court and rejected the MDC’s defendants’ argument that the damages calculations were impermissible.
The MDC defendants also contended that the Trustee’s claim for aiding and abetting fraudulent transfers should be dismissed. The MDC defendants argued that the Third Circuit has never recognized a cause of action for aiding and abetting a fraudulent transfer. Further, they argued that Delaware Courts have held that such a cause of action does not exist. The Bankruptcy Court agreed with the MDC defendants, and held that aiding and abetting fraudulent transfers is not a cause of action that exists under Delaware law.
