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Del. High Court Hears 'Deepening Insolvency' Debate for First Time

The Delaware Supreme Court considered the theory of "deepening insolvency" for the first time in oral arguments over whether creditors can sue a bankrupt firm's directors for allegedly allowing the subsidiary to give a parent company all its assets and take on a $490 million debt.

The creditors of the defunct Trenwick America Corp., once the American operating subsidiary of worldwide insurance holding company Trenwick Group Inc., argue that a series of transactions ordered by TGI in 1999 and 2000 was the iceberg that caused Trenwick America to sink in a sea of red ink.

The plaintiff creditors say their lawsuit should be revived because as Trenwick America's insolvency began to deepen, the duty of its directors shifted from company shareholders to the creditors.

Attorneys for the defendant Trenwick America directors say the Delaware Chancery Court rightly dismissed both the lawsuit and the "deepening insolvency" theory because the directors of the subsidiary had no liability for following the business plan the parent had ordered.

The case has been closely watched by bankruptcy and corporate-governance specialists because creditors could get new clout in courtrooms and boardrooms nationwide if the country's most respected business court endorses the deepening-insolvency theory of liability for officers and directors.

Proponents of deepening insolvency, a controversial theory of liability that has appeared in bankruptcy cases, say directors and officers owe a duty to creditors from the point that their company begins its slide into insolvency.

The theory's detractors say if that shift of duty occurs at all it is not until the company is officially bankrupt.

When Trenwick America declared bankruptcy in 2003, it had very few assets.

A creditor trustee appointed by the bankruptcy judge sued the directors who allegedly rubber-stamped decisions that doomed the company.

The trustee sued in Delaware since that is where Trenwick America was chartered.

However, Vice Chancellor Leo Strine dismissed the breach-of-duty charges after finding that the directors owed no duty to the creditors. He said the deepening-insolvency theory of liability could not create such a duty in Delaware.

The trustee appealed to the state Supreme Court, arguing that the ruling would completely insulate directors of subsidiaries from liability.

The case was one of two appeals in major corporate cases to come before the en banc Delaware Supreme Court in an oral argument session held in the Moot Courtroom of the Widener Law School in Wilmington.

The high court revived its practice of holding one day of oral argument at the school for the benefit of the law students this year after a five-year absence.

The creditors' attorney, Paul Lackey of Lackey Hershman LLP in Dallas, told the justices that the series of transactions that emptied Trenwick America of cash and loaded it up with debt was all part of the same corporate shell game meant to fleece the creditors.

He said the Chancery Court wrongly ruled that only the shareholders had a stake in the company.

"It was the creditors' money that the officers and directors were recklessly gambling with," Lackey said.

He said Delaware's business-judgment rule, which normally gives officers and directors the benefit of the doubt even when their decisions have disastrous consequences, does not apply here because the defendants admit there was no decision-making process.

"They just handed everything to the parent company," Lackey said. "[Trenwick America] got nothing in this deal except debt."

On behalf of the defendant directors, attorney J. Travis Laster of Abrams & Laster in Wilmington, said Vice Chancellor Strine "got it right" when he found that the directors owed no duty to the creditors.

This is not a case where a parent company survives by sucking all the life blood out of a subsidiary, Laster said, adding that all the TGI-related companies eventually went bankrupt.

Justice Carolyn Berger asked whether the business-judgment rule would protect the Trenwick America directors if evidence showed that they made their decision without considering the interests of the creditors or the consequences of the transactions.

Laster answered that the Trenwick America directors, as directors of a wholly owned subsidiary, were entitled to rely on the parent's business plan, which had the blessing of numerous top-shelf legal and financial advisers.

Deepening insolvency is not a viable theory, he said.

However, even it were, the creditors' complaint does not sufficiently plead that Trenwick America was insolvent or becoming insolvent at the time the directors approved the transactions, Laster told the high court.

In rebuttal, Lackey argued that the suit must be revived so that directors will know they "cannot plunder their subsidiaries for the benefit of the parent company."

The high court usually renders a decision within four months of oral argument.