Third Circuit Revives Committee's Deepening Insolvency and Breach of Fiduciary Duty Claims

In a recent opinion issued in the Chapter 11 case of In re Lemington Home for the Aged, — F.3d –, 2011 WL 4375676 (3d Cir. Sept. 21, 2011), the Third Circuit Court of Appeals revived claims of breach of fiduciary duty and deepening insolvency against directors and officers of a nonprofit Pennsylvania corporation. This decision touches upon the operation of the business judgment rule and the doctrine of in pari delicto in an insolvency context, and provides important guidance to officers and directors leading a business concern toward a potential Chapter 11 filing.

Facts

In 1877, Mary Peck Bond, the daughter of African-American abolitionist and minister John Peck, established a care center for elderly and infirm members of Pittsburgh's African-American community. On July 4, 1883, “The Home for the Aged and Infirm Colored Women” was incorporated and dedicated; the facility was later known as the Lemington Home for the Aged and the Lemington Center (Lemington Home). Lemington Home and Lemington Elder Care Service (Lemington Care), an affiliated entity, shared an interlocking Board of Directors. Additionally, certain officers were paid employees of both Lemington Home and Lemington Care.

After Lemington Home relocated to a larger facility in 1983, it began experiencing a number of financial and managerial setbacks that eventually resulted in it seeking Chapter 11 bankruptcy protection on April 13, 2005. Despite repeated “going-concern” warnings that accompanied audits of its finances, periodic assistance from public and private organizations did not ameliorate its troubles. Lemington Home's accounting records were discovered to be in complete disarray and there had been no meaningful oversight of its financial operations from November 2003 to January 2005. In particular, over $450,000 in Medicare payables were not billed during at least a one-year period. Further, Lemington Home's hired administrator was frequently absent from the facility, lacked the necessary qualifications and knowledge of state regulations to operate the facility and had used a private grant ' which had intended to be used to hire a replacement administrator ' for unauthorized purposes.

To further compound Lemington Home's predicament, it had been cited for numerous nursing care deficiencies, due in part to several patient deaths on its watch, and had been repeatedly investigated by the Pennsylvania Department of Health. In addition, Lemington Home's own Board of Directors failed to operate in conformity with its by-laws, in ways that included incomplete or nonexistent minutes, meeting attendance of less than 50%, and the lack of a board treasurer in place.

In January 2005, the Board of Directors voted to immediately cease the admissions of new patients, close the nursing facilities and pursue a possible merger of its operations with a solvent healthcare concern. During a meeting held on March 15, 2005, the Board of Directors discussed plans to transfer Lemington Home's principal charitable assets, the Lemington Home Fund, to its affiliate, Lemington Elder Care. Consistent with its decisions, the Board of Directors drafted a transition plan that called for the closure, sale and possible bankruptcy filing of Lemington Home, the shifting of the Lemington Home Fund to Lemington Elder Care and the restructuring of Lemington Elder Care. Despite this vote, however, Chapter 11 protection was not actually sought until months later, and in the meantime, the financial condition of the Lemington Home continued to deteriorate.

After Lemington Home sought bankruptcy protection in April 2005 in the U.S. Bankruptcy Court for the Western District of Pennsylvania (Bankruptcy Court), the Committee of Unsecured Creditors (Committee) was appointed. The Bankruptcy Court subsequently ordered Lemington Home to obtain a viability study from its retained healthcare management firm. The study noted, in part, that Lemington Home could not continue operations under its current condition and would be insolvent by August 2005, without the receipt of anticipated Medicare Recovery Funds. However, if Lemington Home could improve its image, recruited and developed qualified staff and secured approximately $2 million in working capital, it could continue its operation.

After no interest was expressed during a hearing in June 2005 to either fund operations or purchase the business, the Bankruptcy Court approved a request from certain officers and directors (Officers and Directors) to close Lemington Homes.

The Committee then commenced an adversary proceeding on behalf of the bankruptcy estate against the Officers and Directors for deepening insolvency and breaches of their fiduciary duties under state law. The Committee alleged that the Officers and Directors breached their fiduciary duties of loyalty and care under Pennsylvania law because they were simultaneously affiliated with both Lemington Home and Lemington Care, provided services to both entities to the detriment of Lemington Home and grossly mismanaged and failed to oversee operations. The Committee further maintained that the Officers and Directors' acts and omissions rose to the level of fraud since they kept Lemington Home open for the purpose of implementing their closure and transfer plan unbeknownst to creditors while they continued to incur more debt to the creditors' detriment. The Committee sought damages in an amount of not less than $5 million.

District Court Decision

After extensive discovery, the Committee's adversary proceeding was transferred to the U.S. District Court for the Western District of Pennsylvania (District Court) for trial and final pretrial matters. Prior to trial, the Officers and Directors filed a joint motion for summary judgment. In granting this motion, the District Court found that the business judgment rule and the doctrine of in pari delicto barred recovery on the Committee's breach of fiduciary duty claims.

The District Court further concluded that the Committee was unable to demonstrate a material issue of fact concerning whether the Officers and Directors committed fraud appurtenant to a claim of deepening insolvency, and therefore entered summary judgment in the Officers and Directors' favor.

Reversal of District Court's Decision

In its decision, the Third Circuit vacated the District Court's decision and remanded for trial on the Committee's claims. In so holding, the Third Circuit determined that there were genuine issues of material fact precluding summary judgment in the Officers and Directors' favor on the Committee's breach of fiduciary duty and deepening insolvency claims.

As an initial matter, the Third Circuit held that the District Court erroneously decided on the application of the business judgment rule on summary judgment. Under Pennsylvania law, the business judgment rule provides that “[a]bsent breach of fiduciary duty, lack of good faith or self-dealing, any act of 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). This presumption, however, can be overcome by showing that a board or an individual officer or director committed a breach of fiduciary duty. Indeed, where a board's decision is not accompanied by reasonable diligence, such as assistance by counsel, an adequate and independent investigation, and a written report, application of the business judgment cannot be decided on summary judgment. (Opinion, p. 19 (citing Cuker v. Mikalauskas, 692 A.2d 1042, 1046 (Pa. 1997)).

Here, the Third Circuit held that there was evidence to support a conclusion that reasonable diligence was not employed by the Officers and Directors, such that summary judgment in their favor was in error. Among other things, the court noted the repeated managerial failings of Lemington Home's administrator and chief financial officer ' all of which were known to the board of directors, the board's failure to conduct a pre-bankruptcy viability study, and strong evidence of the board's favoring of Lemington Elder Care over Lemington Home. These facts, in the Third Circuit's view, overcame any evidence of diligence propounded by the Officers and Directors. (Opinion, p. 19).

The Third Circuit similarly held that a genuine issue of material fact existed as to the applicability of the in pari delicto doctrine to the Committee's claims. The doctrine of in pari delicto prohibits a plaintiff from having claims against a defendant adjudicated where the plaintiff is “an active, voluntary participant in the wrongful conduct or transaction(s) for which it seeks redress, and bear 'substantially equal [or greater] responsibility for the underlying illegality' as compared to the defendant.” (Opinion, p. 20 (quoting Official Comm. of Unsecured Creditors of Allegheny Health Educ. & Research Found v. PricewaterhouseCoopers, LLP, 989 A.2d 313, 329 (Pa. 2010) (quoting Bateman Eichler, Hill Richards, Inc. v. Berner, 472 U.S. 299, 306 (1985)). In a bankruptcy context, because a trustee stands in the shoes of a debtor, it is subject to those defenses that could be asserted by a defendant if the action had been instituted by the debtor ' including those arising under in pari delicto.

In awarding summary judgment in favor of the Officers and Directors, the District Court held that in pari delicto precluded the Committee's breach of fiduciary duty claims. The Third Circuit, however, held that the District Court erred, and found that a genuine issue of material fact existed as to whether the so-called “adverse interest exception” to the in pari delicto doctrine applied. Under the adverse interest exception, where an officer or director “acts in his own interest, and to the corporation's detriment,” rather than to the corporation's benefit, “imputation [of the agent's conduct to the corporation] will not apply.” (Opinion, p. 21 (quoting PricewaterhouseCoopers, 989 A.2d at 334)).

Here, the Third Circuit noted the “considerable” evidence set forth by the Committee that the Officers and Directors' alleged breaches of fiduciary duty benefitted themselves and not Lemington Home, which rendered inappropriate summary judgment in the Officers and Directors' favor.

Finally, the Third Circuit held that the award of summary judgment against the Committee on its claim of deepening insolvency was in error. While the viability of an independent cause of action for deepening insolvency ' defined by the Third Circuit as “an injury to [a debtor's] corporate property from the fraudulent expansion of corporate debt and prolongation of corporate life” ' has come under attack by courts and commentators across the country, the Third Circuit opined that a cognizable claim under this theory may be recognized under Pennsylvania law. (Opinion, at p. 23 (citing Official Comm. of Unsecured Creditors v. R. F. Lafferty & Co., 267 F.3d 340, 349 (3d Cir. 2001); quoting In re Citx Corp., 448 F.3d 672 (3d Cir. 2006)).

In order to sustain a claim for deepening insolvency under Pennsylvania law, a plaintiff must successfully plead that the defendant committed fraud in the actions giving rise to the claim. (Opinion, at p. 24). Here, the Third Circuit held that the Committee had presented sufficient evidence to give rise to a genuine issue of material fact concerning whether the Officers and Directors committed fraud, given, among other things, the omissions of Lemington Home to disclose certain payments made during the Chapter 11 case, and the board of directors' decision to cease admitting new patients ' and eliminating a source of income ' months before the Chapter 11 filing.

Lemington Home's Impact

While it may be a stretch to read the Third Circuit's decision beyond the particular facts and circumstances of the Lemington Home case ' particularly with respect to its holdings regarding deepening insolvency, which is not a recognized independence cause of action in many jurisdictions ' the opinion deftly underscores the vital importance of strong, independent corporate governance of entities facing a potential bankruptcy or insolvency scenario. Indeed, the Third Circuit's opinion should serve as a strong message to officers and directors of insolvent or nearly insolvent companies that their actions will be heavily scrutinized by the creditors of those companies, to whom fiduciary duties may run, and that officers and directors cannot blindly hide behind the business judgment rule or the in pari delicto doctrine, which are subject to attack when appropriate diligence is not employed.

Thomas Fawkes is a partner, and Wendy Morris is an associate in the Chicago-based Bankruptcy, Reorganization and Creditors' Rights practice group of Freeborn & Peters LLP. They may be reached at [email protected] and [email protected] respectively.

In a recent opinion issued in the Chapter 11 case of In re Lemington Home for the Aged, — F.3d –, 2011 WL 4375676 (3d Cir. Sept. 21, 2011), the Third Circuit Court of Appeals revived claims of breach of fiduciary duty and deepening insolvency against directors and officers of a nonprofit Pennsylvania corporation. This decision touches upon the operation of the business judgment rule and the doctrine of in pari delicto in an insolvency context, and provides important guidance to officers and directors leading a business concern toward a potential Chapter 11 filing.

Facts

In 1877, Mary Peck Bond, the daughter of African-American abolitionist and minister John Peck, established a care center for elderly and infirm members of Pittsburgh's African-American community. On July 4, 1883, “The Home for the Aged and Infirm Colored Women” was incorporated and dedicated; the facility was later known as the Lemington Home for the Aged and the Lemington Center (Lemington Home). Lemington Home and Lemington Elder Care Service (Lemington Care), an affiliated entity, shared an interlocking Board of Directors. Additionally, certain officers were paid employees of both Lemington Home and Lemington Care.

After Lemington Home relocated to a larger facility in 1983, it began experiencing a number of financial and managerial setbacks that eventually resulted in it seeking Chapter 11 bankruptcy protection on April 13, 2005. Despite repeated “going-concern” warnings that accompanied audits of its finances, periodic assistance from public and private organizations did not ameliorate its troubles. Lemington Home's accounting records were discovered to be in complete disarray and there had been no meaningful oversight of its financial operations from November 2003 to January 2005. In particular, over $450,000 in Medicare payables were not billed during at least a one-year period. Further, Lemington Home's hired administrator was frequently absent from the facility, lacked the necessary qualifications and knowledge of state regulations to operate the facility and had used a private grant ' which had intended to be used to hire a replacement administrator ' for unauthorized purposes.

To further compound Lemington Home's predicament, it had been cited for numerous nursing care deficiencies, due in part to several patient deaths on its watch, and had been repeatedly investigated by the Pennsylvania Department of Health. In addition, Lemington Home's own Board of Directors failed to operate in conformity with its by-laws, in ways that included incomplete or nonexistent minutes, meeting attendance of less than 50%, and the lack of a board treasurer in place.

In January 2005, the Board of Directors voted to immediately cease the admissions of new patients, close the nursing facilities and pursue a possible merger of its operations with a solvent healthcare concern. During a meeting held on March 15, 2005, the Board of Directors discussed plans to transfer Lemington Home's principal charitable assets, the Lemington Home Fund, to its affiliate, Lemington Elder Care. Consistent with its decisions, the Board of Directors drafted a transition plan that called for the closure, sale and possible bankruptcy filing of Lemington Home, the shifting of the Lemington Home Fund to Lemington Elder Care and the restructuring of Lemington Elder Care. Despite this vote, however, Chapter 11 protection was not actually sought until months later, and in the meantime, the financial condition of the Lemington Home continued to deteriorate.

After Lemington Home sought bankruptcy protection in April 2005 in the U.S. Bankruptcy Court for the Western District of Pennsylvania (Bankruptcy Court), the Committee of Unsecured Creditors (Committee) was appointed. The Bankruptcy Court subsequently ordered Lemington Home to obtain a viability study from its retained healthcare management firm. The study noted, in part, that Lemington Home could not continue operations under its current condition and would be insolvent by August 2005, without the receipt of anticipated Medicare Recovery Funds. However, if Lemington Home could improve its image, recruited and developed qualified staff and secured approximately $2 million in working capital, it could continue its operation.

After no interest was expressed during a hearing in June 2005 to either fund operations or purchase the business, the Bankruptcy Court approved a request from certain officers and directors (Officers and Directors) to close Lemington Homes.

The Committee then commenced an adversary proceeding on behalf of the bankruptcy estate against the Officers and Directors for deepening insolvency and breaches of their fiduciary duties under state law. The Committee alleged that the Officers and Directors breached their fiduciary duties of loyalty and care under Pennsylvania law because they were simultaneously affiliated with both Lemington Home and Lemington Care, provided services to both entities to the detriment of Lemington Home and grossly mismanaged and failed to oversee operations. The Committee further maintained that the Officers and Directors' acts and omissions rose to the level of fraud since they kept Lemington Home open for the purpose of implementing their closure and transfer plan unbeknownst to creditors while they continued to incur more debt to the creditors' detriment. The Committee sought damages in an amount of not less than $5 million.

District Court Decision

After extensive discovery, the Committee's adversary proceeding was transferred to the U.S. District Court for the Western District of Pennsylvania (District Court) for trial and final pretrial matters. Prior to trial, the Officers and Directors filed a joint motion for summary judgment. In granting this motion, the District Court found that the business judgment rule and the doctrine of in pari delicto barred recovery on the Committee's breach of fiduciary duty claims.

The District Court further concluded that the Committee was unable to demonstrate a material issue of fact concerning whether the Officers and Directors committed fraud appurtenant to a claim of deepening insolvency, and therefore entered summary judgment in the Officers and Directors' favor.

Reversal of District Court's Decision

In its decision, the Third Circuit vacated the District Court's decision and remanded for trial on the Committee's claims. In so holding, the Third Circuit determined that there were genuine issues of material fact precluding summary judgment in the Officers and Directors' favor on the Committee's breach of fiduciary duty and deepening insolvency claims.

As an initial matter, the Third Circuit held that the District Court erroneously decided on the application of the business judgment rule on summary judgment. Under Pennsylvania law, the business judgment rule provides that “[a]bsent breach of fiduciary duty, lack of good faith or self-dealing, any act of 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). This presumption, however, can be overcome by showing that a board or an individual officer or director committed a breach of fiduciary duty. Indeed, where a board's decision is not accompanied by reasonable diligence, such as assistance by counsel, an adequate and independent investigation, and a written report, application of the business judgment cannot be decided on summary judgment. (Opinion, p. 19 (citing Cuker v. Mikalauskas , 692 A.2d 1042, 1046 (Pa. 1997)).

Here, the Third Circuit held that there was evidence to support a conclusion that reasonable diligence was not employed by the Officers and Directors, such that summary judgment in their favor was in error. Among other things, the court noted the repeated managerial failings of Lemington Home's administrator and chief financial officer ' all of which were known to the board of directors, the board's failure to conduct a pre-bankruptcy viability study, and strong evidence of the board's favoring of Lemington Elder Care over Lemington Home. These facts, in the Third Circuit's view, overcame any evidence of diligence propounded by the Officers and Directors. (Opinion, p. 19).

The Third Circuit similarly held that a genuine issue of material fact existed as to the applicability of the in pari delicto doctrine to the Committee's claims. The doctrine of in pari delicto prohibits a plaintiff from having claims against a defendant adjudicated where the plaintiff is “an active, voluntary participant in the wrongful conduct or transaction(s) for which it seeks redress, and bear 'substantially equal [or greater] responsibility for the underlying illegality' as compared to the defendant.” (Opinion, p. 20 (quoting Official Comm. of Unsecured Creditors of Allegheny Health Educ. & Research Found v. PricewaterhouseCoopers, LLP , 989 A.2d 313, 329 (Pa. 2010) (quoting Bateman Eichler, Hill Richards, Inc. v. Berner , 472 U.S. 299, 306 (1985)). In a bankruptcy context, because a trustee stands in the shoes of a debtor, it is subject to those defenses that could be asserted by a defendant if the action had been instituted by the debtor ' including those arising under in pari delicto.

In awarding summary judgment in favor of the Officers and Directors, the District Court held that in pari delicto precluded the Committee's breach of fiduciary duty claims. The Third Circuit, however, held that the District Court erred, and found that a genuine issue of material fact existed as to whether the so-called “adverse interest exception” to the in pari delicto doctrine applied. Under the adverse interest exception, where an officer or director “acts in his own interest, and to the corporation's detriment,” rather than to the corporation's benefit, “imputation [of the agent's conduct to the corporation] will not apply.” (Opinion, p. 21 (quoting PricewaterhouseCoopers, 989 A.2d at 334)).

Here, the Third Circuit noted the “considerable” evidence set forth by the Committee that the Officers and Directors' alleged breaches of fiduciary duty benefitted themselves and not Lemington Home, which rendered inappropriate summary judgment in the Officers and Directors' favor.

Finally, the Third Circuit held that the award of summary judgment against the Committee on its claim of deepening insolvency was in error. While the viability of an independent cause of action for deepening insolvency ' defined by the Third Circuit as “an injury to [a debtor's] corporate property from the fraudulent expansion of corporate debt and prolongation of corporate life” ' has come under attack by courts and commentators across the country, the Third Circuit opined that a cognizable claim under this theory may be recognized under Pennsylvania law. (Opinion, at p. 23 (citing Official Comm. of Unsecured Creditors v. R. F. Lafferty & Co. , 267 F.3d 340, 349 (3d Cir. 2001); quoting In re Citx Corp. , 448 F.3d 672 (3d Cir. 2006)).

In order to sustain a claim for deepening insolvency under Pennsylvania law, a plaintiff must successfully plead that the defendant committed fraud in the actions giving rise to the claim. (Opinion, at p. 24). Here, the Third Circuit held that the Committee had presented sufficient evidence to give rise to a genuine issue of material fact concerning whether the Officers and Directors committed fraud, given, among other things, the omissions of Lemington Home to disclose certain payments made during the Chapter 11 case, and the board of directors' decision to cease admitting new patients ' and eliminating a source of income ' months before the Chapter 11 filing.

Lemington Home's Impact

While it may be a stretch to read the Third Circuit's decision beyond the particular facts and circumstances of the Lemington Home case ' particularly with respect to its holdings regarding deepening insolvency, which is not a recognized independence cause of action in many jurisdictions ' the opinion deftly underscores the vital importance of strong, independent corporate governance of entities facing a potential bankruptcy or insolvency scenario. Indeed, the Third Circuit's opinion should serve as a strong message to officers and directors of insolvent or nearly insolvent companies that their actions will be heavily scrutinized by the creditors of those companies, to whom fiduciary duties may run, and that officers and directors cannot blindly hide behind the business judgment rule or the in pari delicto doctrine, which are subject to attack when appropriate diligence is not employed.

Thomas Fawkes is a partner, and Wendy Morris is an associate in the Chicago-based Bankruptcy, Reorganization and Creditors' Rights practice group of Freeborn & Peters LLP. They may be reached at [email protected] and [email protected] respectively.