Trenwick America

A publicly traded holding company, the Trenwick Group, Inc. was primarily in the business of specialty insurance and reorganization. A sizeable company to start, Trenwick nonetheless decided to embark on a growth strategy by acquiring several other insurance companies. Beginning in 1998, Trenwick acquired three insurance companies, all in arms'-length transactions approved by a majority of Trenwick's independent board and stockholder base.

In the later stages of this strategy, Trenwick re-domiciled itself to Bermuda for tax reasons. At the same time, it reorganized the entire company into what amounted to national lines of insurance, creating subsidiary organization operating in the United States, the United Kingdom and Bermuda itself. Trenwick America Corporation, a wholly owned subsidiary of Trenwick, in turn became the parent of all the U.S. operations.

As part of the reorganization, Tren-wick America increased its guarantor obligations as to the parent company, Trenwick. Adding to the $260 million of bank debt it was already obligated under, Trenwick America assumed responsibility for $190 million of debt securities. Trenwick's strategy failed to pan out as expected. Instead, Trenwick and Trenwick America were forced to seek bankruptcy protection in the United States Bankruptcy Court for the District of Delaware. One of the primary causes of the company's failure was its erroneous estimations as to the necessary insurance reserves for one of the acquisition targets, which was subsequently overwhelmed by insured claims.

The Trenwick America Litigation Trust, spawned by Trenwick's Chapter 11 reorganization plan, sued the directors and officers of Trenwick (the parent holding company) and Trenwick America (the subsidiary operating the American insurance line) on the basic premise that the majority independent board of the holding company engaged in an imprudent business strategy by acquiring other insurers who had underestimated their potential claims exposure. As a result of that strategy, the holding company and its top U.S. subsidiary were eventually rendered insolvent to the detriment of their creditors. Further, because Trenwick America took on obligations to support its parent's debt and actually assume some of that debt, the top U.S. subsidiary and its creditors suffered even greater injury than the holding company and its creditors.

The Litigation Trust more specifically alleged that the Trenwick directors breached their fiduciary duties of care and loyalty owed ' because Trenwick was insolvent ' to the creditors of Trenwick and its subsidiaries. Similarly, as to Trenwick America, the Trust accused the directors of misconduct and conspiring with company directors. The Trenwick America directors allegedly injured the creditors of Trenwick America by causing its assets to be pledged to support other subsidiaries owned by Trenwick, at a time when Trenwick America was insolvent. In effect, then, the Trenwick America directors violated their fiduciary duties because their focus had to be solely upon making sure the company could satisfy as many of legal claims of its creditors as possible, with the desires of the equity owner and parent, Trenwick, being secondary because of that insolvency. Further, the Trust also asserted deepening insolvency claims against the Trenwick America directors and officers.

The Court's Decision

The directors and officers moved to dismiss the complaint for failure to state a claim, giving rise to the Court's decision. Addressing the motion, the court first turned to defendant's argument that the Trust lacked standing to assert creditor claims, but could instead only assert claims of Trenwick America. Agreeing with defendants, the court held that the Trust lacked standing to bring claims on behalf of creditors, relying on Caplin v. Marine Midland Grace Trust Co., 406 U.S. 416 (1972), and ruled Trenwick's plan failed to transfer the right to pursue creditor claims to the Trust.

The court likewise granted the Motion to Dismiss as to the claims of breached fiduciary duty against directors and officers. Because the Litigation Trust had the ability to assert a claim only on behalf of Trenwick America, the Trust would have to show that the directors of a corporate parent ' here Trenwick ' breached fiduciary duties owed to the parents' wholly-owned subsidiary, Trenwick America. But that would be contrary to Delaware law, which holds that a parent corporation does not owe fiduciary duties to its wholly owned subsidiaries or their creditors. Citing Anadarko Petro. Corp. v. Panhandle Eastern Corp., 545 A. 2d 1171, 1174 (Del. 1988).

The court also noted that, had the claim been brought by Trenwick itself, it would fail to state a claim for breach of fiduciary duty because Trenwick's Delaware charter contained an exculpatory charter provision under ' 102(b)(7). Thus, neither the company nor its stockholder could bring an action against its directors for damages resulting from the breach of duty of care.

Moreover, the Trust could not overcome the exculpation provisions because the Trust's complaint failed to plead facts supporting a gross negligence claim. To the contrary, the Trenwick board was dominated by independent directors, all the deals were at arms' length and supported by a diverse base of shareholders and after more than adequate due diligence. In the Chancery Court's view, to allege that a corporation has suffered a loss as a result of a lawful transaction, within the corporation's powers, authorized by corporate fiduciary acting in good faith pursuit of corporate purposes, does not state a claim for relief, no matter how foolish the investment may appear in retrospect. Citing Gagliardi v. TriFoods Int'l, Inc., 683 A. 2d 1049, 1052 (Del. Ch. 1996). And expressing his own philosophical position on this issue, Vice-Chancellor Strine added:

[B]usiness failure is an ever-present risk. The business judgment rule exists precisely to insure that directors and managers acting in good faith may pursue risky strategies that seem to promise great profit. If the mere fact that a strategy turned out poorly is in itself sufficient to create an inference that the directors who approved it breached their fiduciary duties, the business judgment rule will have been denuded of much of its utility.

Simply put, all the Trust did was allege that Trenwick's strategy was a foolhardy one, but failed to allege facts that supported breach of fiduciary duty claim. Further, the Trust's strategy of suing Trenwick's directors and officers had no legal basis. The Trust could only sue Trenwick itself, and not its board of directors, without piercing its corporate veil. If there was a breach of fiduciary duty by conduct at the Trenwick-level toward Trenwick America, then the proper defendant would be Trenwick itself, the parent corporation. To hold otherwise would effectively allow the Trust to 'end run' Trenwick's exculpatory provisions.

Also, the court ruled that the mere incantation of the word insolvency does not change the breach of fiduciary duty analysis, and referred to the recently-decided In re Scott Acquisition Corp. in support of this proposition.

No Deepening Insolvency In Delaware

Turning next to the Trust's Deepening Insolvency claims, the court joined the growing judicial consensus against the very existence of such a cause of action. Delaware law, the court held, imposes no absolute obligation on the board of a company that is unable to pay its bills to cease operations and to liquidate.

Even when a company is insolvent, its board may pursue, in good faith, strategies to maximize the value of the firm. What is more, the board of an insolvent corporation, acting with due diligence and good faith, may pursue a business strategy that it believes will increase the corporation's value and even incur additional debt, without becoming a guarantor of that strategy's success. The business judgment rule continues to protect the board members. Summarizing its cold criticism of the theory, the court noted that 'the concept of deepening insolvency has been discussed at length in federal jurisprudence, perhaps because the term has the kind of stentorious academic ring that tends to dull the mind to the concept's ultimate emptiness.'

And finally, the court dismissed the Trust's fraud claims for, among other things, failing to meet the specificity requirements under Court of Chancellery Rule 9(b), which requires fraud claims be supported by particularized facts. In particular, the court condemned the broad-brush allegations in the complaint and its failure to identify exactly what aspects of Trenwick or Trenwick America's financial statements were tainted by improper accounting practices, when those statements were made public, and the circumstances that suggest that any inaccuracies were intentional, rather than good faith mistakes in estimation.

Conclusion

Trenwick America, like Production Resources, In re Global Services Group, LLC, 316 B.R. 451 (Bankr. S.D. N.Y. 2004), and In re Scott Acquisition Corp., before it, continues the trend towards a more rational approach to sorting liability in a post-insolvency period.

These cases all emphasize that the mere failure of a business cannot be sufficient to support a cause of action. Rather, plaintiffs, even creditors of a bankrupt company, must overcome the defenses established under prevailing corporate law, including the protections of the business-judgment rule and exculpation clauses, to establish actual liability on the part of officers and directors. To hold otherwise, these cases posit, would discourage directors and officers from exercising their judgment and pursuing strategies to maximize the enterprise value for all involved.

Luis Salazar is a shareholder with the international law firm of Greenberg Traurig, and a member of its Business Reorganization & Bankruptcy Department. He is based in the firm's Miami office and can be reached at [email protected].

The September Issue of this newsletter discussed the Delaware Bankruptcy Court's recent decision, In re Scott Acquisition Corp., 2006 WL 1732277 (Bankr. D. Del. 2006), which ruled that directors and officers of insolvent subsidiary companies owe fiduciary duties to both its creditors and the subsidiary itself. Hot on the heels of that decision, the Delaware Chancery Court, Vice-Chancellor Leo E. Strine presiding, has again waded into the breach of fiduciary duty and zone of insolvency arena with its decision in Trenwick America Litigation Trust v. Ernst & Young, L.L.P., et al., ___ A. 2d ___, 2006 WL 2434228 (Del. Ch. 2006).

This decision strongly upholds the business-judgment protection for directors and officers who appropriately exercise their duties, even in the face of subsequent and complete business failure, and eviscerates Deepening Insolvency as a viable cause of action under Delaware law, continuing the recent case law trend in this direction.

Trenwick America

A publicly traded holding company, the Trenwick Group, Inc. was primarily in the business of specialty insurance and reorganization. A sizeable company to start, Trenwick nonetheless decided to embark on a growth strategy by acquiring several other insurance companies. Beginning in 1998, Trenwick acquired three insurance companies, all in arms'-length transactions approved by a majority of Trenwick's independent board and stockholder base.

In the later stages of this strategy, Trenwick re-domiciled itself to Bermuda for tax reasons. At the same time, it reorganized the entire company into what amounted to national lines of insurance, creating subsidiary organization operating in the United States, the United Kingdom and Bermuda itself. Trenwick America Corporation, a wholly owned subsidiary of Trenwick, in turn became the parent of all the U.S. operations.

As part of the reorganization, Tren-wick America increased its guarantor obligations as to the parent company, Trenwick. Adding to the $260 million of bank debt it was already obligated under, Trenwick America assumed responsibility for $190 million of debt securities. Trenwick's strategy failed to pan out as expected. Instead, Trenwick and Trenwick America were forced to seek bankruptcy protection in the United States Bankruptcy Court for the District of Delaware. One of the primary causes of the company's failure was its erroneous estimations as to the necessary insurance reserves for one of the acquisition targets, which was subsequently overwhelmed by insured claims.

The Trenwick America Litigation Trust, spawned by Trenwick's Chapter 11 reorganization plan, sued the directors and officers of Trenwick (the parent holding company) and Trenwick America (the subsidiary operating the American insurance line) on the basic premise that the majority independent board of the holding company engaged in an imprudent business strategy by acquiring other insurers who had underestimated their potential claims exposure. As a result of that strategy, the holding company and its top U.S. subsidiary were eventually rendered insolvent to the detriment of their creditors. Further, because Trenwick America took on obligations to support its parent's debt and actually assume some of that debt, the top U.S. subsidiary and its creditors suffered even greater injury than the holding company and its creditors.

The Litigation Trust more specifically alleged that the Trenwick directors breached their fiduciary duties of care and loyalty owed ' because Trenwick was insolvent ' to the creditors of Trenwick and its subsidiaries. Similarly, as to Trenwick America, the Trust accused the directors of misconduct and conspiring with company directors. The Trenwick America directors allegedly injured the creditors of Trenwick America by causing its assets to be pledged to support other subsidiaries owned by Trenwick, at a time when Trenwick America was insolvent. In effect, then, the Trenwick America directors violated their fiduciary duties because their focus had to be solely upon making sure the company could satisfy as many of legal claims of its creditors as possible, with the desires of the equity owner and parent, Trenwick, being secondary because of that insolvency. Further, the Trust also asserted deepening insolvency claims against the Trenwick America directors and officers.

The Court's Decision

The directors and officers moved to dismiss the complaint for failure to state a claim, giving rise to the Court's decision. Addressing the motion, the court first turned to defendant's argument that the Trust lacked standing to assert creditor claims, but could instead only assert claims of Trenwick America. Agreeing with defendants, the court held that the Trust lacked standing to bring claims on behalf of creditors, relying on Caplin v. Marine Midland Grace Trust Co., 406 U.S. 416 (1972), and ruled Trenwick's plan failed to transfer the right to pursue creditor claims to the Trust.

The court likewise granted the Motion to Dismiss as to the claims of breached fiduciary duty against directors and officers. Because the Litigation Trust had the ability to assert a claim only on behalf of Trenwick America, the Trust would have to show that the directors of a corporate parent ' here Trenwick ' breached fiduciary duties owed to the parents' wholly-owned subsidiary, Trenwick America. But that would be contrary to Delaware law, which holds that a parent corporation does not owe fiduciary duties to its wholly owned subsidiaries or their creditors. Citing Anadarko Petro. Corp. v. Panhandle Eastern Corp. , 545 A. 2d 1171, 1174 (Del. 1988).

The court also noted that, had the claim been brought by Trenwick itself, it would fail to state a claim for breach of fiduciary duty because Trenwick's Delaware charter contained an exculpatory charter provision under ' 102(b)(7). Thus, neither the company nor its stockholder could bring an action against its directors for damages resulting from the breach of duty of care.

Moreover, the Trust could not overcome the exculpation provisions because the Trust's complaint failed to plead facts supporting a gross negligence claim. To the contrary, the Trenwick board was dominated by independent directors, all the deals were at arms' length and supported by a diverse base of shareholders and after more than adequate due diligence. In the Chancery Court's view, to allege that a corporation has suffered a loss as a result of a lawful transaction, within the corporation's powers, authorized by corporate fiduciary acting in good faith pursuit of corporate purposes, does not state a claim for relief, no matter how foolish the investment may appear in retrospect. Citing Gagliardi v. TriFoods Int'l, Inc., 683 A. 2d 1049, 1052 (Del. Ch. 1996). And expressing his own philosophical position on this issue, Vice-Chancellor Strine added:

[B]usiness failure is an ever-present risk. The business judgment rule exists precisely to insure that directors and managers acting in good faith may pursue risky strategies that seem to promise great profit. If the mere fact that a strategy turned out poorly is in itself sufficient to create an inference that the directors who approved it breached their fiduciary duties, the business judgment rule will have been denuded of much of its utility.

Simply put, all the Trust did was allege that Trenwick's strategy was a foolhardy one, but failed to allege facts that supported breach of fiduciary duty claim. Further, the Trust's strategy of suing Trenwick's directors and officers had no legal basis. The Trust could only sue Trenwick itself, and not its board of directors, without piercing its corporate veil. If there was a breach of fiduciary duty by conduct at the Trenwick-level toward Trenwick America, then the proper defendant would be Trenwick itself, the parent corporation. To hold otherwise would effectively allow the Trust to 'end run' Trenwick's exculpatory provisions.

Also, the court ruled that the mere incantation of the word insolvency does not change the breach of fiduciary duty analysis, and referred to the recently-decided In re Scott Acquisition Corp. in support of this proposition.

No Deepening Insolvency In Delaware

Turning next to the Trust's Deepening Insolvency claims, the court joined the growing judicial consensus against the very existence of such a cause of action. Delaware law, the court held, imposes no absolute obligation on the board of a company that is unable to pay its bills to cease operations and to liquidate.

Even when a company is insolvent, its board may pursue, in good faith, strategies to maximize the value of the firm. What is more, the board of an insolvent corporation, acting with due diligence and good faith, may pursue a business strategy that it believes will increase the corporation's value and even incur additional debt, without becoming a guarantor of that strategy's success. The business judgment rule continues to protect the board members. Summarizing its cold criticism of the theory, the court noted that 'the concept of deepening insolvency has been discussed at length in federal jurisprudence, perhaps because the term has the kind of stentorious academic ring that tends to dull the mind to the concept's ultimate emptiness.'

And finally, the court dismissed the Trust's fraud claims for, among other things, failing to meet the specificity requirements under Court of Chancellery Rule 9(b), which requires fraud claims be supported by particularized facts. In particular, the court condemned the broad-brush allegations in the complaint and its failure to identify exactly what aspects of Trenwick or Trenwick America's financial statements were tainted by improper accounting practices, when those statements were made public, and the circumstances that suggest that any inaccuracies were intentional, rather than good faith mistakes in estimation.

Conclusion

Trenwick America, like Production Resources, In re Global Services Group, LLC, 316 B.R. 451 (Bankr. S.D. N.Y. 2004), and In re Scott Acquisition Corp., before it, continues the trend towards a more rational approach to sorting liability in a post-insolvency period.

These cases all emphasize that the mere failure of a business cannot be sufficient to support a cause of action. Rather, plaintiffs, even creditors of a bankrupt company, must overcome the defenses established under prevailing corporate law, including the protections of the business-judgment rule and exculpation clauses, to establish actual liability on the part of officers and directors. To hold otherwise, these cases posit, would discourage directors and officers from exercising their judgment and pursuing strategies to maximize the enterprise value for all involved.

Luis Salazar is a shareholder with the international law firm of Greenberg Traurig, and a member of its Business Reorganization & Bankruptcy Department. He is based in the firm's Miami office and can be reached at [email protected].