Directors Hit With $2.3 Million Judgment for Failing to Replace Incompetent Managers

Last week, the Third Circuit Court of Appeals upheld a $2.3 million jury verdict in favor of a Creditors’ Committee, finding that the directors of a failed Pittsburgh nursing home had breached their fiduciary duties to the corporation’s creditors by failing to remove the home’s administrator and chief financial officer when their mismanagement became apparent.  Official Committee of Unsecured Creditors v. Arthur Baldwin, et al. (In re Lemington Home for the Aged), 2015 U.S. App. LEXIS 1183. The court relied on the Pennsylvania corporation statutes which provide that a director shall “perform his duties as a director . . . in good faith, in a manner he reasonably believes to be in the best interests of the corporation and with such care, including reasonable inquiry, skill and diligence, as a person of ordinary prudence would use under similar circumstances.”   The court further found that the directors were liable for the tort of “deepening insolvency” in allowing the corporation to continue operating at a loss for over three months before filing bankruptcy, despite having made the decision to close the home and deplete the patient census.

Oregon and Washington corporation statutes contain language similar to the Pennsylvania statute.  Although the Oregon and Washington courts have yet to formally recognize an independent tort for “deepening insolvency”, the Ninth Circuit Court of Appeals has held, without deciding whether “deepening insolvency” is a separate tort, that corporate officers/directors who prolong an insolvent firm’s existence with spurious debts, rather than dissolve it in a timely manner, can be liable to the corporation for the resulting harm. Smith v. Arthur Andersen LLP, et al. (In re Boston Chicken), 421 F.3d 989 (9th Cir. 2005). These decisions highlight the scrutiny that may be placed on board decisions made while a corporation is insolvent, and the risks officers and directors face if they allow the business to continue operating and incurring debts that might not be paid.

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