After the officers and directors of the Lemington Home for the Aged concluded that operation of the Home was no longer financially viable and decided to file for Chapter 11 bankruptcy, the Official Committee of Unsecured Creditors sought to increase the funds available for distribution by suing them for breach of fiduciary duty, self-dealing, and “deepening insolvency.”  A federal District Court in Pittsburgh has dismissed all three claims.  (Official Committee of Unsecured Creditors v. Baldwin, W.D. PA, No. 10cv800, 10/25/10.)

The home was originally founded in 1892 and for many years operated as a personal care facility and nursing home dedicated to caring primarily for African-American seniors.  Between 1998 and 2003 while facing financial difficulties, the Home authorized a series of consultant studies funded by the Pittsburgh Foundation, its principal source of charitable contributions, to improve its operations and help determine its future. 

In March 2004, a legal committee was formed to consider bankruptcy, and in January 2005, after two deaths of residents within six months that suggested less than adequate care, the Board decided to close the Home.  The Board continued to seek an affiliation partner, but ultimately closed the doors and filed for bankruptcy in April 2005.

On breach of the fiduciary duty, the Committee argued the directors had made poor financial decisions, provided poor management, and allowed more than $400,000 in Medicare receivables to go unbilled for a year.  The Committee also claimed that they were self-interested because they were also directors of Lemington Elder Care Services, a parent affiliate which would receive distributions from the Lemington Fund at the Pittsburgh Foundation upon the demise of the Home. The directors said they were entitled to the protection of the business judgment rule.

The Court said that the business judgment rule was developed because courts have recognized that directors and officers must be given wide discretion in the management of a corporation’s business affairs.  An officer or director is protected from liability for “a business decision made in good faith if he is not interested in the subject of the business judgment, is informed with respect to the subject … to the extent he reasonably believes to be appropriate under the circumstances, and rationally believes that the business judgment is in the best interests of the corporation.”

The rationale, it said, shields directors from liability for judgment errors and recognizes the risks inherent in business decision.  It gives directors “extensive discretion to set policies without judicial or shareholder interference, and keeps courts out of difficult business decisions that courts are not prepared to handle.”

The Court concluded that there was “simply no evidence to demonstrate that the Board acted in bad faith, and while their decisions, in hindsight, might have been less than perfect, they acted with reasonable diligence and attempted, with the advice of counsel and other consultants, for many years to ‘right’ the ship prior to the ultimate decision to close Lemington and file for bankruptcy.  The Board conducted regular meetings, recorded minutes, and required the Officers to report on the state of affairs at the meetings.  There is simply no evidence that the Board did not have the best interests of Lemington in mind when it discharged its responsibilities, including the ultimate closure of Lemington.”

The Court also ruled that the Committee had not shown the officers acted with reckless disregard or with gross negligence in discharging their duties.  “At most, the facts evidence mere negligence, but the standard of care required by the business judgment rule is greater than ordinary negligence.  The business judgment rule, therefore is applicable and therefore, shields the Officers from liability.”

The Court noted that the Pennsylvania Supreme Court has not decided whether there is an independent cause of action under state law for “deepening insolvency.”  It noted that the Third Circuit Court of Appeals had predicted that the state courts would permit such a claim against an organization that continued to run up debt and prolong its insolvency while dissipating its corporate assets.  But the Third Circuit had held that only conduct constituting fraud would be the basis for such a claim.  Since there was no evidence of any type of fraud in this situation, the claim was also dismissed.

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This decision seems to be an appropriate result based on the good faith efforts of the officers and directors to overcome the Home’s financial problems for several years and to find alternative affiliations that might permit it to continue.

The Court does not put much stock in the claim that the directors had a self-dealing conflict of interest in closing down the Home when grant funding would be transferred to the parent organization of the system on whose board they also served.  Perhaps the finding was based on overriding evidence that the Home could not make it on its own even with the funding.

The claim that directors have a duty to creditors when the organization becomes insolvent, sometimes called being within the zone of insolvency, has been supported in some states and not in others.  More recent decisions seem to question the doctrine, but the Court did not have to decide whether the cause of action actually exists in Pennsylvania.  It merely said there was no showing of fraud which would be necessary to support such a claim.