DC Bankruptcy Court Rejects Deepening Insolvency Claims as Duplicative, But Allows Other Related Counts in Trustee's Serpentine Complaint Against Debtors' Former D&O's and Lawyers

The Bankruptcy Court for the District of Columbia has released about 16 opinions for publication this year, and five of them have related to the litigation spawned by the Greater Southwest Community Hospital Corp. ("GSCH") bankruptcy. GSCH's bankruptcy case commenced in November 2002, and its reorganization plan was confirmed in April, 2004. Under the plan, the debtor's operations vested in the "Reorganized Debtors," and the debtor's litigation assets vested for the benefit of pre-confirmation creditors in the "DCHC Liquidating Trust" (the "Trust"). Sam J. Alberts was named Trustee, and the Trust was funded with $1 million to cover some of the litigation expense.

Judge Teel, the bankruptcy judge assigned to the case, recently issued a lengthy opinion in the case, Alberts v. Tuft (In re Greater Southeast Community Hospital Corp.), 2005 WL 3036507 (Bankr. D.D.C., 10/31/05), in which he addressed the defendants' Rule 12(b)(6) motion to dismiss for failure to state a claim upon which relief can be granted.

The Court summarized the complaint's allegations as follows:

The Trust alleges that DCHC's former directors and officers (the "D & O Defendants"), with assistance from two law firms (collectively the "Law Firm Defendants"), Epstein Becker & Green P.C. ("Epstein Becker") and Kutak Rock LLP ("Kutak Rock"), negligently and in some instances intentionally drove the Debtors further into debt in furtherance of a Ponzi scheme perpetrated by the Debtors' primary if not sole lender, National Century Financial Enterprises ("NCFE"), and its subsidiary and affiliated lenders (collectively the "NCFE Entities"). It seeks recovery not only for assets actually drained out of the Debtors' estates prior to their bankruptcy filings, but also for the debt accumulated by the Debtors in the years leading up to DCHC's bankruptcy filing--an amount totaling $242 million.

The Trust's Complaint contained a total of twenty-one counts, broken down as follows as to the various defendants:

As Against All Defendants: (A) Deepening insolvency claims (Counts X-XII); (B) Claims as a hypothetical judgment lien creditor under § 544(a) (which, according to the complaint, "permits it to (1) to pursue claims that such creditors would hold for breach of fiduciary duty and (2) garnish or 'seize' the Trust's own claims and prosecute those claims as a creditor rather than as a representative of the estate") (Count XV)


As Against the D&O Defendants: (A) Breach of fiduciary duty (Counts I-V); (B) Corporate waste (Counts V-IX)

As Against the Law Firm Defendants: (A) Aiding and abetting fiduciary duty (Count XIII); (B) Malpractice (Count XIV); (C) Aiding and abetting "deepening insolvency" (Count XI); (D) Fraudulent conveyance (Counts XVI-XXI)

As to the defendants' motion to dismiss, the Court's holdings are summarized as follows:

(1) The Court dismissed the "deepening insolvency" claims (Counts X-XII), stating that they were a mere "re-packaging" of the breach of fiduciary claims with respect to the D&O Defendants and the malpractice claims with respect to the Law Firm Defendants.

(2) The Court further dismissed the Section 544(a) claim (Count XV), stating that "the Trust cannot use § 544(a) to bring claims separate from those of the estate or to constructively "seize" the estate's claim in the guise of a creditor."

(3) The Court dismissed the breach of fiduciary duty claims with respect to the D&O Defendants relating to the NCFE Entities' lending practices (Counts I and I-V), as well as the claims alleging corporate waste (Counts V-VII and IX).

(4) The Court did not dismiss Count VIII with respect to loans made to officers for which no consideration was provided in exchange.

(5) The legal malpractice claim (Count XIV), which challenged the sufficiency of the opinion letters that the Law Firm Defendants prepared, survived the motion to dismiss. The Court stated that the allegations regarding these opinion letters were "far from precise," but that they were sufficient at this stage of litigation to state a claim for malpractice.

(6) Finally, the Court rejected the Law Firm Defendants' res judicata and judicial estoppel arguments, as well as the statute of limitations and in pari delicto affirmative defenses that were common to all Defendants.

Excerpts from the Court's opinion on the Court's dismissal of the "deepening insolvency" and section 544 claims follow:

1. "Deepening Insolvency" claims

Counts X-XII of the Complaint plunge this court into the on-going debate over the existence and nature of the so-called "deepening insolvency" cause of action. Briefly stated, the theory "refers to the 'fraudulent prolongation of a corporation's life beyond insolvency,' resulting in damage to the corporation caused by the increased debt." Originally a theory of damages, the concept has taken on a life of its own, with several courts treating it as an independent cause of action. Under either permutation, the sine qua non of the concept is that the defendant breached some pre-existing duty of care owed to the corporation in deepening its insolvency. See In re Global Serv. Group, LLC, 316 B.R. at 458 ("[O]ne seeking to recover for 'deepening insolvency' must show that the defendant prolonged the company's life in breach of a separate duty, or committed an actionable tort that contributed to the continued operation of a corporation and its increased debt.") (collecting cases). (Certain citations omitted).


This court has recognized that the deepening of a company's insolvency is harmful. See Drabkin v. L & L Constr. Associates, Inc. (In re Latin Inv. Corp.), 168 B.R. 1, 5 (Bankr. D.D.C. 1993) (considering "damages inflicted in perpetuating the debtor's existence past the point of insolvency in order to loot"). As the Third Circuit explained in Lafferty:

[T]he incurrence of debt can force an insolvent corporation into bankruptcy, thus inflicting legal and administrative costs on the corporation.... When brought on by unwieldy debt, bankruptcy also creates operational limitations which hurt a corporation's ability to run its business in a profitable manner.... In addition, prolonging an insolvent corporation's life through bad debt may simply cause the dissipation of corporate assets.

Lafferty, 267 F.3d at 349-50 (citations omitted).

However, recognizing that a condition is harmful and calling it a tort are two different things. The District of Columbia courts have not yet recognized a cause of action for deepening insolvency, and this court sees no reason why they should. As District Judge Kaplan recently noted in a similar situation, "[i]f officers and directors can be shown to have breached their fiduciary duties by deepening a corporation's insolvency, and the resulting injury to the corporation is cognizable, ... that injury is compensable on a claim for breach of fiduciary duty." Bondi v. Bank of America Corp. (In re Parmalat), 2005 WL 1923839 (S.D.N.Y. Aug.5, 2005) (dismissing deepening insolvency claim as duplicative where breach of fiduciary duty was also alleged).
The Trust's allegations bear out Judge Kaplan's thesis. The Trust already alleges that the D & O Defendants breached their fiduciary duties to the Debtors by allowing them to fall deeper into debt for the benefit of the Defendants and NCFE. Its claim for "deepening insolvency" against those same defendants alleges the exact same wrong. Similarly, the Trust's deepening insolvency claim against the Law Firm Defendants is really just a re-packaging of its separate malpractice claim. And the Trust's claim for "aiding and abetting deepening insolvency" is almost a word-for-word recapitulation of its claim for aiding and abetting breach of fiduciary duty.
There is no point in recognizing and adjudicating "new" causes of action when established ones cover the same ground. The Trust's duplicative claims will be dismissed.

2. Claims under 11 U.S.C. § 544(a)

Count XV of the Complaint is also largely duplicative of other counts (specifically, Counts I-XIV), but this is by the Trust's design. The "claim" alleges that the Trust stands in the shoes of a hypothetical judgment creditor with a judicial lien or creditors' bill under § 544(a) of the Bankruptcy Code, which, according to the Trust, permits it to (1) pursue claims that such creditors would hold for breach of fiduciary duty, and (2) garnish or "seize" the Trust's own claims and prosecute those claims as a creditor rather than as a representative of the estate. (Compl. ¶¶ 318-320). The Defendants argue that § 544(a) cannot be used in this manner under Caplin v. Marine Midland Grace Trust Co., 406 U.S. 416, 92 S.Ct. 1678, 32 L.Ed.2d 195 (1972). The Trust points to a series of cases applying § 544(a) notwithstanding that decision....
The key question is whether whether the phrase "rights and powers" encompasses the ability to file any claim that a creditor with a judicial lien or creditors' bill against the property of the estate might possess as opposed to only those rights that are attained by virtue of the hypothetical status of a judicial lien creditor or an execution creditor. A handful of courts have held that it does....
In Caplin, the Supreme Court held that a chapter X trustee under the old Bankruptcy Act could not assert creditors' claims of misconduct against an indenture trust on behalf of the holders of debentures issued pursuant to an indenture. The Court held that the Bankruptcy Act did not confer upon the trustee standing to represent the interests of these creditors for three reasons. First, nothing in the Act suggested that the trustee should "assume the responsibility of suing third parties on behalf of debenture holders [i.e., creditors]." Second, the bankrupt corporation had no claim against the indenture trustee, and the claims brought by the chapter X trustee might be subject to subrogation by other creditors because the bankrupt corporation might be subject to the doctrine of in pari delicto. Finally, a suit by the trustee would not preempt suits by other creditors, and would raise concerns as to the binding effect of the actions taken by the trustee on those creditors.
Although Caplin was decided before the enactment of the Bankruptcy Code, numerous courts, including this one, have recognized its continuing vitality. See In re Latin Investment Corp., 168 B.R. at 4. Generally speaking, these courts have continued to honor the decision because (1) nothing in the text or legislative history of the Code contradicts directly the Caplin opinion; and (2) many of the concerns that informed the Supreme Court's opinion still exist.... (Citations omitted).
[T]here is nothing in the language of § 544(a) that compels this court to disregard the well-reasoned holding in Caplin. As the district court noted in In re Miller, the "clear import of the statutory language" is to "confer the status " of a creditor with a judicial lien or creditors' bill on the trustee, not to make the trustee "an agent of the creditors." In other words, the statute vests the trustee with the ability of a judgment lien creditor to attach or seize both tangible and intangible property transferred by the debtor to a third party prior to filing for bankruptcy, but it does not transform the trustee into a "super creditor" with the ability to raise causes of action separate from those possessed by the estate.... (Citations omitted).
In sum, the Trust cannot use § 544(a) to bring claims separate from those of the estate or to constructively "seize" the estate's claim in the guise of a creditor, and even if it could, such action would not benefit it in the slightest. Count XV will be dismissed.

Steve Jakubowski


Thanks to Ryan Zeller for his contributions to this post.

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