People who run a company that enters the "zone of insolvency" acquire a new set of duties. Surprise!

Instead of working only for the firm and its owners, they must now answer also to its creditors. And, if they let the outfit keep going when it should shut down to cut losses, they may expose themselves to claims by those creditors under the "deepening insolvency" theory of liability.

Blawgletter has written a couple of items about the theory (here and here). In the process, we've pointed out that two defenses most often vex a deepening insolvency claim — the business judgment rule (which applies to claims that someone breached the duty of care) and the doctrine of in pari delicto ("equally at fault"). A new ruling out of the Third Circuit shows how to get around both.

The case of In re Lemington Home for the Aged (Official Committee of Unsecured Creditors v. Baldwin), No. 10-4456 (3d Cir. Sept. 21, 2011), involved an odd set of facts. The officers and directors of the Lemington Home, a non-profit that started in 1883, let the record-keeping and financial condition of the Home fall into such bad shape that they at length chose to shut it down.

But they did many things wrong, according to the court. They didn't tell people who continued to provide goods and services of the impending closure. They also did next to nothing to collect — or even track — the large payments owing to the Home from Medicare. Nor had the Home's Administrator shown up to work more often than once in awhile (due to illness), and the Chief Financial Officer seems not to have known how to keep a general ledger or maintain billing records. Plus the directors opted to transfer assets from the Home to another non-profit in which many of them also served as directors.

Lots of other bad stuff happened, too.

The impending disaster came to a head after two of the Home's residents died. The Home soon after filed for bankruptcy. But even then it failed to file financial reports that would have disclosed to creditors the size of its ongoing losses.

The district court granted the directors and officers summary judgment. It relied on the business judgment rule and the in pari delicto doctrine.

The Third Circuit reversed. It rejected the business judgment defense because the evidence implied that the officers and directors knowingly did a deplorable job (by, for example, letting the Home go on with a largely absent Administrator and an, ahem, uncareful CFO). The panel also ruled that in pari delicto did not apply where the conduct of the officers and directors did not benefit the corporation.

What does the case mean? We think not that much. If you believe the Third Circuit's review of the facts, the people who controlled the destiny of the Home acted and failed to act in ways that we struggle to explain. The Home no doubt did a lot of good for many years. Maybe that blinded the defendants to how their conduct might look in the cool light of day. And yet they acted with astonishing dumbness.