The Third Circuit Court of Appeals has reversed a trial court and allowed a committee of unsecured creditors to sue the directors of a nonprofit nursing home personally for breach of fiduciary duty in administering the home during insolvency prior to bankruptcy.  The federal District Court in Pittsburgh had ruled that the directors were protected by the business judgment rule and granted summary judgment against the creditors.  (See Nonprofit Issues®, 12/1/10.) The Court of Appeals has held that there were sufficient questions of fact to require a trial. (In Re: Lemington Home for the Aged, No. 10-4456, 9/21/11.)

The recitation of facts in the Court of Appeals opinion presents a much bleaker picture than that in the District Court opinion.  There was basic agreement that the Lemington Home, which was founded in 1877 and predominantly served the African-American community, had been in financial difficulty for many years. But the Court of Appeals puts significantly more emphasis on the failure of the board to learn the facts and take action.

According to the Court of Appeals, the Home hired a new administrator in 1997, but was insolvent by 1999.  Its audits for fiscal years 2002 and 2003 carried “going concern” warnings.  The Pittsburgh Foundation, which held a fund for the benefit of the Home, made a grant of more than $175,000 for a study of each department, but the new administrator spent it for something else.

A new chief financial officer was hired in 2002 but failed to maintain a general ledger and the Home’s billing and financial records were in “deplorable condition.”  The administrator had health problems, and according to testimony in the case, was absent for periods up to six or eight weeks at a time.  The board had no treasurer from November 2003 until January 2005 and no oversight of the Home’s finances during that period.

The administrator recommended bankruptcy in May 2004, but the board put off the determination. Two residents died under circumstances suggesting insufficient care. The Home’s accountants quit in the fall of 2004 due to nonpayment of bills, shortly after a medical records and billing consultant had quit for the same reason.

The board itself was “in disarray,” the Court said. Minutes were incomplete or non-existent. Attendance was often below 50%. There was no treasurer even though the board chair testified that the board was aware the CFO was not maintaining adequate records.  The Home finally filed for bankruptcy protection in April, 2005. The creditors were granted leave to sue for breach of fiduciary duty.

Under Pennsylvania law, “fiduciary duties are owed not only to the corporation … but also to the creditors of an insolvent entity,” the Court said. “It is material whether the directors’ reliance upon the information provided by one or more officers or employees was in ‘good faith,’ and whether there was a reasonable basis for relying upon officers and employees of the corporation.  It is likewise material whether the officers have exercised ‘reasonable inquiry, skill and diligence’ in performing their duties.”

The Court cited the Pennsylvania Nonprofit Corporation Law for the business judgment rule that actions of directors “shall be presumed to be in the best interests of the corporation,” “absent breach of fiduciary duty, lack of good faith or self-dealing.”

“The District Court relied upon the fact that the Board was assisted by counsel, conducted several meetings, and pursued various options before approving the bankruptcy filing.  To be sure, this is the type of evidence that could support application of the business judgment rule as a matter of law. But it is countered by evidence that the Board received numerous red flags as to the competence and diligence of [the administrator and CFO]. The fact that the Board eschewed a viability study also calls into question the adequacy of a pre-bankruptcy investigation.  And finally, there is evidence that the directors favored Lemington Elder Care [on whose board they also served and which would become beneficiary of the Pittsburgh Foundation fund if the Home went out of business] over the Home.” It said the issues of good faith and reasonable care could not be decided on summary judgment.

The directors argued they should be protected by the doctrine of in pari delicto, under which they could not be liable if they got bad information from the officers. But the Court said that the rule was narrowed by the Pennsylvania Supreme Court (See Nonprofit Issues®, 2/16/10.) and does not apply when a person acts for a personal interest.  Since the directors had an interest in the Lemington Elder Care organization, it was an issue of material fact about whether the doctrine could be invoked.

Finally, the Court said that a claim of “deepening insolvency” would be recognized under Pennsylvania law although no Pennsylvania court had ruled on the question.  Deepening insolvency is defined as “an injury to a debtor’s corporate property from the fraudulent expansion of corporate debt or prolongation of corporate life.”  Because there was evidence that the board had concluded it had to file for bankruptcy several months before it did so, there was a material question of fact which also precluded summary judgment.

YOU NEED TO KNOW

The District Court’s decision in the case at the trial level gave directors significant comfort that they were not likely to be personally liable merely because a struggling organization ultimately has to file for bankruptcy protection.  If the rule of deepening insolvency stands as enunciated by the Court of Appeals, there will be a lot more personal concern, and a lot more sense that it is necessary to pull the plug on a failing organization at a much earlier time. Not every state has accepted the rule of deepening insolvency, which only clouds the issue in Pennsylvania and other states elsewhere where there is no decision on point by a state’s highest court.