Deepening Insolvency Into the Void
A Cause of Action?
The plain meaning of "deepening insolvency" is that a business that has become insolvent loses still more money. Absent acts of God or actionable wrongs by outsiders, the additional loss will be the result of the conduct of the business. Where the business is conducted by a corporation, the loss therefore may logically be laid at the feet of its managers: the directors and officers.
Although the managers may be responsible for the loss, they are not automatically held liable to make it good. Directors and officers are not guarantors of business success. In particular, they make no guarantee that an insolvent company will stop losing money. There is no absolute duty to liquidate a corporation upon insolvency.3 Creditors that do not wish the value of their claims to be diminished by a corporate debtor's slide into insolvency have remedies, including involuntary bankruptcy.4 Even that remedy does not necessarily avert deepened insolvency, however, for there is no duty to liquidate in bankruptcy where there is hope of rehabilitation.5 Indeed, chapter 11 corporate debtors commonly operate at a loss, deepening insolvency while attempting to reorganize.6 "Deepening insolvency" is not a strict-liability offense.
On the other hand, managers may be legally responsible for corporate losses if they engage in proscribed conduct. Directors owe duties to their corporation, including duties of loyalty and due care. Although these duties vary in particulars from state to state, as a general principle directors must put the company's interest above their own (loyalty) and act with the care of an ordinarily prudent person in pursuing what they believe to be the corporation's best interests (due care).7 They must also observe the law in dealing with third parties. They may not, for example, defraud those with whom they deal.
Courts that recognize a cause of action for "deepening insolvency" devote little space to whether and how it alters these traditional precepts.8 A seminal case described "deepening insolvency" as the "fraudulent prolongation of a corporation's life beyond insolvency,"9 and that description flags the problem. If the cause of action involves "fraudulent" activity, how is it different from, and what does it add to, fraud as a theory of liability? Similarly, a Delaware court has acknowledged that in insolvency, "[t]he directors continue to have the task of attempting to maximize the value of the firm," which "might require" them to undertake an efficient liquidation if "the procession of the firm as a going concern would be value-destroying."10 What does "deepening insolvency" add to that duty of due care?
Conduct proscribed by traditional precepts often seems to accompany deepening insolvency. Common examples include fraudulent representations to creditors that debts can be repaid, or fraudulent promises of repayment, when the debtor secretly knows there is no hope and/or has no intention to repay. When officers or directors engage in self-dealing or loot their corporations, insolvency sometimes occurs. In insolvency, it is a breach of fiduciary duty for management to gamble whatever assets are still available to pay creditors on risky strategies in the hope of restoring value to equity-holders.11
There is a pre-existing body of law to redress the injuries caused by such behavior. Despite language in some cases finding a cause of action for "deepening insolvency," in none of them has the alleged conduct been blameless under these traditional legal rubrics.12 In other words, as a cause of action, "deepening insolvency" is just a catchy phrase. It has added nothing to the law.
A Measure of Damage?
Before it morphed into a cause of action, courts had begun to think of "deepening insolvency" as a way to express the harm done by fiduciary chicanery. "[T]he corporate body is ineluctably damaged by the deepening of its insolvency, through increased exposure to creditor liability."13 According to some courts, such "damages are measured by the dissipation of assets or increased debt load occurring after the false representation of solvency."14 Other courts say the harm in a deepening insolvency case is "damage to the corporation caused by increased debt;"15 "[f]or example, to the extent that bankruptcy is not already a certainty, the incurrence of debt can force an insolvent corporation into bankruptcy, thus inflicting legal and administrative costs on the corporation."16
Making a catchy phrase into a workable measure of damages hasn't been as easy as it might seem. Some of the measures courts have discussed are clearly off-base, such as "increased debt load." Consider a company with no cash and $100,000 in debt that borrows another $100,000. The borrowing is solvency-neutral: When the loan proceeds are received, the company will have $100,000 in cash and $200,000 in debt and the degree of insolvency ($100,000) is unchanged, although the amount of debt has increased. There has been no economic injury. Of course, injury occurs if the loan proceeds are then looted, but the injury comes from the looting, not the borrowing. Measuring damage by debt load makes no sense.
The Third Circuit posits that the threat of bankruptcy due to deepening insolvency "can shake the confidence of parties dealing with the corporation...thereby damaging the corporation's assets...."17 How to measure such damage is not discussed, but no matter—the proposition is a non sequitur. The Third Circuit's view is that "deepening insolvency" demands "fraudulent" prolongation of corporate life through concealment of true financial condition,18 and if that is the case, no one's confidence will be shaken because no one will know that bankruptcy beckons.
The costs of bankruptcy are a questionable damage measure as well. "Deepening insolvency" presumes a troubled corporation even before wrongdoing "prolongs its life beyond insolvency." It would be a stretch to say, much less find evidence to prove, that a corporation in or on the verge of insolvency can always be shut down without bankruptcy, or that a badly insolvent company can be terminated only through that process. Moreover, chapter 11 cases, in which there is hope of rehabilitating a debtor that is not "DOA," are often more costly than the chapter 7 cases that dispose of the hopelessly insolvent. Deepening insolvency thus may lessen the costs of burial once wrongdoing is exposed; those costs do not measure loss incurred by creditors due to prolonging the corporation's existence.
What measure makes sense? Where the insolvent corporation (or its representative) asserts a claim, "dissipation of assets" is the logical measure of damage. Where an insider loots, the corporation should recover the value of the looted assets. Where directors bet the remaining assets on a high-risk strategy in violation of fiduciary duties, the amount of the bet should be recoverable. The looted or squandered assets have been removed from the corporation, thus increasing its insolvency.
If a creditor is a direct victim of the fraud that prolonged a corporation's life and thus is a proper plaintiff, the measure of damages would be different. Each creditor cannot sue for the deepening of the hole in the corporation's balance sheet that was dug during the wrongdoing.19 To be sure, the creditor body as a whole suffers whatever deepened insolvency is visited upon the corporation, but individual creditors feel that loss as measured against the amount of their credit extensions.
A defrauded creditor's economic damage is the shortfall between the dollars it contributed and the pennies ultimately distributed on those dollars by the debtor or its bankruptcy estate (plus interest). If a creditor extended terms before looting or insolvency began, it would have been fully repaid but for the wrongdoing that later occurred. If credit was extended while the looting or insolvency was fraudulently concealed, the creditor will say it was damaged because it would not have extended credit had it known that which was wrongfully concealed. In either case, its damage is its shortfall.
Neither the corporation's damage measure (dissipated assets) nor the creditor's measure (out-of-pocket loss) is novel. These have long been the damage measures in fiduciary breach and fraud suits.20 Neither measure necessarily equals the amount by which a corporation's insolvency increased during a period of wrongdoing. For example, not all assets acquired by fraudulent declarations of solvency may have been looted. Some money may have been spent on legitimate business operations that kept up appearances (but lost money) while insiders looted other funds. That money will not be recovered by a fiduciary breach suit.21 Nor will every creditor be able to prove a fraud claim. Some creditors will have extended credit in hopes that a company on the ropes could be kept in business, or because they did not check the borrower's credit, or for a myriad of other reasons that are not attributable to misconduct. The sum of creditors' recoveries is therefore unlikely to total the corporation's increased insolvency. There is no reason to think that adding the recoveries of defrauded creditors and the corporate representative will hit this number, either.
The damage measures that make economic sense are the ones employed in traditional attacks on the chicanery of directors, officers and their confederates. "Deepening insolvency"—a corporation's further losses during a period of wrongdoing—is not such a measure, nor are traditional recoveries likely to equal that amount. "Deepening insolvency" is no more a good damage measure than it is a good cause of action.
There is no universal agreement about who may complain of deepening insolvency, whether using a cause of action by that name or some other. Directors and officers owe their fiduciary duties to the corporation. If violation of those duties is the wrong that makes a "deepening insolvency" actionable, the corporation is a proper plaintiff. "Whether a firm is solvent or insolvent, it—and not a constituency such as its stockholders or its creditors—owns the claim that a director has, by failing to exercise sufficient care, mismanaged the firm and caused a diminution to its economic value."22 This is not to say that the corporation is the only proper plaintiff. Stockholders, as the residual owners of a solvent firm, may bring derivative claims against management, and on the same principle creditors of an insolvent firm (its residual owners) may complain derivatively of directors' breaches of their fiduciary duties.23 A bankruptcy trustee, or a creditors' committee if there is no trustee, likewise can complain about management misconduct on behalf of the corporate debtor's estate.24
This matrix is straightforward enough when the only defendants are officers and directors. But they may not have deep enough pockets or sufficient insurance to make happy everyone who has lost money. The unhappy therefore may also try to pursue solvent third parties that have played some role. Standing issues now become more complicated.
The third parties will have contractual duties to their counterparties, but the plaintiff may not be among those to whom these duties are owed. In a famous case, an indenture trustee was contractually bound to make sure the debtor's assets always were at least double its liabilities. It raised no alarm when it became aware that was no longer true, and the debenture-holders suffered losses because the debtor slipped into insolvency before its problems came to light. The debtor's bankruptcy trustee sued the indenture trustee, but that was wrong: Its duties were owed directly to the indenture holders, and the bankruptcy trustee could not speak for them.25
Sometimes the plaintiff must be a representative of the corporation's estate because the duties are owed to the corporation rather than to its creditors.26 A bankruptcy trustee or unsecured creditors' committee acting on the estate's behalf is the usual nominee. Any such plaintiff may encounter the in pari delicto defense, among other obstacles. The nub of this problem is that management was usually running whatever nefarious racket the defendants are charged with assisting, and the corporation often benefited from it, at least for awhile. For example, falsified revenue reports by management and a botched audit may allow a company to borrow additional funds on the strength of a fraudulent balance sheet, and the corporation arguably benefits from the cash infusion. The defendant auditors will argue that the plaintiff stands in the shoes of the corporation and cannot recover because it is equally guilty of misconduct.
Standing tangles are difficult, and this particular one has been resolved in different ways by different courts. The Third Circuit barred an action by a creditors' committee against underwriters that enabled the corporate debtor to sell debt securities to fund a Ponzi scheme, citing in pari delicto.27 The Second Circuit has elevated the in pari delicto defense to a standing rule.28 The Seventh Circuit held that any in pari delicto problem disappears when the wrongdoers are displaced, e.g., by an equity receiver.29
"Deepening insolvency" started as a branch of these standing wars. In pari delicto will not impute management's wrongdoing to the corporation if the misconduct conferred no benefit on the corporation. The argument is that the corporation did not benefit from the cash raised in a fraudulent borrowing, or from the prolongation of corporate existence enabled thereby, because it suffered deepening insolvency as a result. Several courts have accepted this argument or something like it, and found that in pari delicto is no bar when the only ones to benefit were wrongdoing insiders who looted corporate assets.30
Whether or not deepening insolvency makes sense as a curative for standing problems,31 it does not operate sensibly as a cause of action to right the underlying wrong or as a measure of damages. However, it remains a catchy phrase, and those are hard even for courts to resist. "Deepening insolvency" should not develop further—but it might.
5 See 11 U.S.C. §§706(a) (debtor may convert involuntary liquidation case to reorganization case as a matter of right) and 1112(b) (court may convert or dismiss reorganization case where continuing losses and absence of reasonable likelihood of rehabilitation). Return to article
6 Merely by way of example, UAL Corp., U.S. Airways Group Inc. and WorldCom Inc. spent or are spending substantial portions of their stays in bankruptcy court with continuing operating losses. See "US Airways Group Inc.: Loss Widens to $236 Million Amid a Surge in Fuel Costs," Wall St. J., Feb. 1, 2005, at A10; Carey, Susan, "UAL Posts Wider Loss; JetBlue's Profit Tumbles," Wall St. J., Jan. 28, 2005, at A3; "WorldCom Loss Is $194 Million," N.Y. Times, Dec. 16, 2003, at C11. Return to article
7 See, e.g., Cede & Co. v. Technicolor Inc., 634 A.2d 345, 361 (Del. 1993); Smith v. Van Gorkum, 488 A.2d 858 (Del 1985); Rev. Model Bus. Corp. Act §8:30(a) (1985). When directors are not self-interested and have adequately informed themselves, their conduct enjoys the protection of the business-judgment rule: a presumption that they have acted properly. See, e.g., Smith, 488 A.2d at 872. Return to article
8 See Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340 (3d Cir. 2001); Official Committee of Unsecured Creditors v. Credit Suisse First Boston (In re Exide Technologies Inc.), 299 B.R. 732 (Bankr. D. Del. 2003). Return to article
9 Schacht v. Brown, 711 F.2d 1343, 1350 (7th Cir. 1983); see Corporate Aviation Concepts Inc. v. Multi-Service Aviation Corp., 2004 U.S. Dist. LEXIS 17154, at *12-14 (E.D. Pa. Aug. 25, 2004). Return to article
10 Production Resources Group L.L.C. v. NCT Group Inc., 2004 Del. Ch. LEXIS 174, at *50 & n.60 (Nov. 17, 2004); see In re Logue Mechanical Contracting. Corp., 106 B.R. 436, 439-42 (Bankr. W.D. Pa. 1989). Return to article
11 Cf. Credit Lyonnais Bank Nederland N.V. v. Pathe Communications Corp., 1991 WL 277613, at *34 n.55 (Del. Ch. Dec. 30, 1991). Credit Lyonnais is often cited for its dictum that directors owe fiduciary duties to the "corporate enterprise," including creditors, when a company approaches but has not yet reached insolvency. Whether or not that is true, compare Production Resources Group, 2004 Del. Ch. LEXIS at *46-49; it is settled that directors owe duties to creditors once insolvency occurs and as it deepens, and the management gamble discussed by Credit Lyonnais would breach such duties whenever they arise. Return to article
12 See Global Serv. Group, 316 B.R. at 458. In addition to cases discussed there, see In re Investors Funding Corp. of N.Y. Sec. Litig., 523 F. Supp. 533, 539 (S.D.N.Y. 1980); McHale v. Huff (In re Huff), 109 B.R. 506 (Bankr. S.D. Fla. 1989) (looting; fraudulent concealment). Return to article
14 Florida Dept. of Ins. v. Chase Bank of Texas N.A., 274 F.2d 924, 935 (5th Cir. 2001); see In re Flagship Healthcare Inc., 269 B.R. 721 (Bankr. S.D. Fla. 2001); cf. Bookland of Maine v. Baker, Newman & Noyes, 271 F. Supp. 2d 324, 327 n.3 (D. Me. 2003). Return to article
21 Directors have the benefit of the business-judgment rule even when their corporations are insolvent and are no more the guarantors of the success of legitimate business activities then than in a healthier financial environment. See, e.g., Official Committee of Unsecured Creditors of RSL Primecall Inc. v. Beckoff, 2003 Bankr. LEXIS 1635 (Bankr. S.D.N.Y. Dec. 11, 2003). Return to article
23 "The fact that the corporation has become insolvent does not turn [fiduciary duty] claims into direct creditor claims, it simply provides creditors with standing to assert those claims." Id. at *8. According to this court, that is so even though "[w]hen a firm has reached the point of insolvency, it is settled that under Delaware law, the firm's directors are said to owe fiduciary duties to the company's creditors." Id. at *50. Return to article
28 See Shearson Lehman Hutton Inc. v. Wagoner, 944 F.2d 114, 120 (2d Cir. 1991), holding that a bankruptcy trustee could not sue a brokerage house because "[a] claim against a third party for defrauding a corporation with the cooperation of management accrues to creditors, not to the guilty corporation." Return to article
30 See, e.g., FDIC v. Nathan, 804 F. Supp. 888, 894 (S.D. Tex. 1992); Drabkin v. L&L Construction Assocs. Inc., 168 B.R. 1, 5 (Bankr. D.C. 1993); Investors Funding Corp., 523 F. Supp. at 541. Return to article
31 See, generally, e.g., Alam, Tanvir, "Fraudulent Advisors Exploit Confusion in the Bankruptcy Code: How In Pari Delicto Has Been Perverted to Prevent Recovery for Innocent Creditors," 77 Am. Bankr. L.J. 305 (2003); Goldman, Irve J., "Whose Cause of Action Is It, Anyway?," ABI Journal, March 2004 at 1. Return to article