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Deepening Insolvency Plaintiff vs. Defendant

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The financial expert in bankruptcy matters is frequently asked to calculate compensatory damages resulting from the actions of another party. While there are numerous approaches to calculating damages, they generally measure the loss in value to the damaged party.

Traditionally, damages reflect the decline in the value of equity caused by the harm. In the typical case, the firm is solvent both before and after the bad acts occur. In other cases, the company becomes insolvent as a result of the bad acts. While these latter cases are less frequent, the damage is calculated similarly: the difference in equity value to the wronged party. Yet in still other situations, the company is already insolvent at the time of the bad acts. Since the company was insolvent at the time of the bad acts, a relevant question is: What is the damage? The market value of the equity, it can be argued, was already zero prior to the bad acts. As such, one might conclude that there are no damages to an already insolvent company. This article discusses the methodology of damage measurement in this situation. Namely, what are the damages to a company whose insolvency "deepens" as a result of being wronged by another party? This concept of deepening insolvency has received increasing attention in bankruptcy court, yet relatively little attention in the financial literature.

Consider the following three companies:
Company A:
Pre-damage Value = $1 million
Post-damage Value = $0 million
Company B:
Pre-damage Value = $1 million
Post-damage Value = -$20 million
Company C:
Pre-damage Value = -$1 million
Post-damage Value = -$20 million

Prior to being damaged, the equity values of companies A and B are both $1 million. The equity value of company C prior to the damage is -$1 million. As a result of being damaged, companies A, B and C are respectively valued at $0, -$20 million and -$20 million. The value of the damage in the case of company A is simply the difference between the pre-damage value of $1 million and the post-damage value of $0, for a damage of $1 million. The case of company B is somewhat more complex. The plaintiff in this case might argue that the damage is similarly calculated as the difference between the pre-damage value of $1 million and post-damage value of -$20 million, equaling $21 million. The defendant's response might be that once the equity value falls below $0, the equity-holders, having limited liability, can "put" the assets of the company back to the debt-holders. As such, the equity-holders are not damaged for the decline in value from $0 to -$20 million. They are damaged only $1 million for the fall in value from $1 million to $0.

On the other hand, the plaintiff may argue that the defendant should be responsible for the full amount, including the cost of returning the company to solvency so the company can continue to exist as a going concern. In other words, the defendant must pay as damage the entire $21 million. Under this scenario, the $21 million is composed of $1 million in damage from the reduction in equity value of the company from $1 million to $0, as well as the $20 million from the return of the company's equity value from -$20 million to $0.

A second argument by the plaintiff justifying the $21 million in damages might well be that this is the amount needed to compensate the unsecured debt-holders, as is often the case in a fraudulent transfer claim. For example, suppose that the unsecured debt is $20 million. The plaintiff would hold that the defendant is responsible for $21 million, which is for both the amount needed to satisfy the obligations of the unsecured debt-holders (i.e., $20 million) as well as for the damage causing the company's value to fall from $1 million to $0 (i.e., $1 million). Thus, the plaintiff would argue that the decline in equity value from $0 to -$20 million is associated with tangible cost, namely the amount needed to repay the creditors.

Now consider the case of company C. This is the case of deepening insolvency. While the plaintiff will likely argue that the damage is $19 million, the defendant will claim that there are no damages due to the fact that the equity-holders of an insolvent company cannot be further harmed. However, the plaintiff will likely contend that the defendant's arguments are flawed for several reasons.

First, note that companies B and C are virtually identical. The difference between the two companies is merely $2 million in starting equity value. The post-damage equity value for both is identical: -$20 million. The plaintiff may argue that it is not reasonable that in one situation the maximum damages are $21 million, while in the other the maximum damages are $0. There is no economic rationale to have such a discontinuity in the damage calculation.

Second, the plaintiff may argue that just because company C had a negative equity starting position does not necessarily mean that a rational buyer would be unwilling to pay a positive amount for company C's equity. This argument is based on the theory of option pricing. A call option whose underlying stock price trades below the strike price still will frequently trade at a positive value (i.e., this is an out-of-the money option). Similarly, a company whose equity is slightly below zero has value in the marketplace to a buyer who thinks the value will increase and the firm will become solvent. Thus, while the calculated market value of equity is negative, a buyer may be willing to invest in the supposedly "insolvent company." The true value of a company prior to the damage, according to the plaintiff, would therefore be positive, not negative. The plaintiff might argue that the damage is the amount necessary to bring the company back to its pre-damage value, namely $19 million (i.e., the difference between -$1 million and -$20 million). The resolution of such a valuation debate depends on the specific circumstances, which will obviously vary from case to case.

Third, the plaintiff in the case of company C may argue that the harm has affected more than merely the company's shareholders, but that the damage has affected the entire corporation, including non-investor stakeholders such as suppliers, distributors, employees and tax authorities. The nature of the deepening insolvency affects each of the stakeholders and, in turn, the corporation.

Fourth, the defendants in bankruptcy cases are frequently accountants who have performed audits of the company. Consider a situation in which a flawed audit determines company C's equity value as $3 million, rather than its true value of -$1 million. In this case, the plaintiff might contend that if it were not for one or more flawed audits, the firm would never have reached the point of significant insolvency. In other words, the poorly executed audit enabled the company to continue receiving goods and services. If the audit had been performed properly, company C would have noticed that its initial value was -$1 million, rather than the reported $3 million. If the auditors had properly performed their duties, they could have insured that further harm to the corporation would have been prevented. To the extent that layoffs ensued and the firm's reputation deteriorated, the plaintiffs would argue that the accountants are responsible for the entire fall in value, from -$1 million to -$20 million. Moreover, in these situations, there are frequently red-flag warning signals that the plaintiff would contend should have been recognizable to the accountants. Examples include accounts receivable growing more rapidly than sales, or collateralized debt exceeding available collateral.

Indeed, courts have determined that deepening insolvency is a distinct harm to the firm. For example, in a recent Ponzi case, Breeden v. Sphere Drake Insurance PLC, No. 96-61376, slip op., (Bankr. N.D.N.Y. Dec. 28, 1999), the court ruled that the fraud resulted in damage to the firm's reputation and led to the firm's deepening insolvency.


Footnotes

1 The authors are professors at Boston University's School of Management and Managing Directors of The Michel/Shaked Group, a firm providing expert witness services nationwide. Return to article


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Wednesday, May 1, 2002

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