Deepening Insolvency Secured Lenders and Bankruptcy Professionals Beware It Is Not Just for Officers and Directors Anymore

Deepening Insolvency Secured Lenders and Bankruptcy Professionals Beware It Is Not Just for Officers and Directors Anymore

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Editor's Note: Also see a related article in this issue by Paul Rubin.

With the increase in involuntary bankruptcy filings, as well as liquidations, corporate scandals and highly litigious bankruptcy cases, lawyers and advocates are becoming more and more creative in seeking remedies that may result in any recovery for the parties in the case.

When claims of deepening insolvency are first raised, the allegations are made against officers and directors on the theory that they may have breached their fiduciary duties by taking certain actions, such as borrowing additional funds or raising additional equity, which did nothing more than deepen the insolvency of the company and reduce the overall return to creditors.2 However, since the theory of deepening insolvency is not well defined or universally embraced by all courts, and with few written opinions concerning the topic, creativity in the use of the theory abounds. The theory has expanded beyond the realm of officers and directors and has been successfully raised against insolvency professionals, such as accountants,3 investment brokers4 and lawyers,5 with the allegations ranging from fraudulently concealing information that caused the deepening insolvency of the company to some newly created duty of care—specifically, that they knew, or should have known, that the business plans presented, upon which they based their advice, would not work, and accordingly they participated in the deepening of the insolvency of the company.

For example, a trustee in the Flagship Healthcare case filed a deepening insolvency claim against Flagship's officers and directors as well as its auditors PricewaterhouseCoopers (PWC), stating that the directors and officers should have seen the writing on the wall and known they were not going to pull a "rabbit out of the hat." The trustee argued that at some point it was an abuse of PWC's fiduciary obligation by not alerting creditors to the deepening insolvency.6 The trustee even suggested that PWC had an obligation to notify outside directors to stop the bleeding of the company's finances.7 Ultimately, the case settled for what one source says was about $3 million with PWC and with the officers and directors for an undisclosed amount.8


Of great concern to secured lenders...is a Delaware bankruptcy case in which the court suggested that secured lenders may also be liable for deepening the insolvency of a company based on their agreement to continue to lend...rather than pull the trigger on the loan.

Of great concern to secured lenders and chapter 11 professionals is a Delaware bankruptcy case in which the court suggested that secured lenders may also be liable for deepening the insolvency of a company based on their agreement to continue to lend and to further secure the obligation rather than pull the trigger on the loan.9

Given the lack of boundaries placed on deepening insolvency claims to date, the evolution of the theory should be something insolvency professionals watch closely. Also, given the exposure in the press concerning corporate scandals, it is hard to imagine that anyone would have great sympathy for claims lodged against third-party non-debtors (who just so happen to also have deep pockets) involved in any way with the deepening of the financial crisis of a debtor, whether it be intentional or unintentional.

A General Definition

Generally, the deepening insolvency theory of liability holds that there are times when a defendant's conduct, either fraudulently or even negligently, prolongs the life of a corporation, thereby increasing the corporation's debt and exposure to creditors.10 Moreover, when corporate managers, as well as third-party professionals including lawyers and accountants, either purposely or negligently help to hide information that shows a company was not solvent when certain actions, such as acquisitions or debt-raising, were undertaken, deepening insolvency can be alleged because the result is that the company's financial distress becomes more profound. Accordingly, those involved with fiduciary obligations, or newly created fiduciary duties of care, may be liable for the tort of deepening insolvency.11

For now, there seems to be three classes of possible defendants that need to be concerned about deepening insolvency actions: (1) directors and officers who may be liable concerning actions taken that could be construed to prolong the life of a corporation to the detriment of creditors, thereby deepening the insolvency of the corporation; (2) secured lenders concerned about the amount of control they exert in extending additional financing or in exchange for additional security while in the zone of insolvency; and (3) professionals who advise the corporation and whose actions could be construed as allowing the corporation to continue to the detriment of all creditors, thereby deepening the insolvency of the corporation. Further, failing to throw in the towel can open directors and their professionals to an entirely distinct basis for liability. Typically, these classes of actions divide into two distinct kinds of claims: (1) a mismanagement claim against the officers and directors or (2) a misrepresentation claim against both management and its professionals.12

Not all courts have recognized the validity of a deepening insolvency action.13 However, many have. The Third Circuit began the hunt for deepening insolvency when it analyzed a deepening insolvency claim in a case brought by a creditors' committee. The Lafferty case14 involved the bankruptcy of two lease-financing corporations that allegedly operated as a Ponzi scheme. To operate the scheme, an individual aided by others allegedly caused the corporation to issue fraudulent debt certificates, which were then sold to the individual investors. The corporation was unable to pay investors and filed for bankruptcy. The committee, on behalf of the estate, brought two claims in district court alleging that third parties had fraudulently induced the corporations to issue the debt securities, thereby deepening their insolvency and forcing them into bankruptcy. The district court held that it could not rule on the possibility of a cognizable injury. On appeal, the Third Circuit had to determine whether deepening insolvency was cognizable under Pennsylvania law.15 The appeals court held that three factors would persuade the Pennsylvania Supreme Court to recognize deepening insolvency as giving rise to a cognizable injury under the proper circumstances.16 These factors were the (1) soundness of the theory, (2) growing acceptance of the theory among courts and (3) the remedial theme in Pennsylvania law (when there is an injury).17 The court stated that the theory of deepening insolvency, particularly in the bankruptcy context, was sound.18 Furthermore, the court stated that the growing acceptance of the deepening insolvency theory confirms its soundness.19 The court then cited numerous cases in which deepening insolvency was found to give rise to a cognizable injury. Finally, the court determined that one of the most venerable principles in Pennsylvania jurisprudence, and in most common law jurisdictions, for that matter, is that where there is an injury, the law provides a remedy.20

Exide and Secured Lenders

In Exide, the U.S. Bankruptcy Court suggested that if a secured lender, through its continued extension of credit, exerted such control over a failing borrower as to allow the borrower to continue to operate despite its continuing decline in value, the lender could face liability to the borrower's unsecured creditors for the tort of deepening insolvency.21 Essentially, a claim against a lender for deepening insolvency is grounded in the theory that the lender, by (1) extending credit in exchange for additional security (or other enhancement) to a financially troubled borrower where there is little or no hope of financial recovery and (2) causing the borrower to remain in business for the lender's benefit, is extracting value from the borrower at the expense of its unsecured creditors—that is, the unsecured creditors might have been repaid a higher percentage of their claims had the borrower not been "propped up" with additional secured financing, and may assert that the borrower's deepening insolvency caused them financial harm.22 Accordingly, the Exide decision seems to imply that lenders, in trying to decide whether they should extend additional credit and how much security they can safely take without exerting too much control over a corporation, may expose themselves to additional liability in trying to further the reorganization efforts of the debtor.

It is also important to take notice that, in Exide, the committee sued Credit Suisse First Boston individually and as administrative agent, joint lead arranger, sole book manager and class representative for a syndicate of banks and other institutions identified in the lawsuit as "pre-petition banks." Salomon Smith Barney was also sued as the syndication agent, joint lead arranger and class representative for the pre-petition banks.23 The number and extent of the secured-lender defendants demonstrates the creativity used and the expansive nature of the tort of deepening insolvency.

Other Recent Cases

In addition to the Lafferty and Exide decisions,24 several other courts have recently issued opinions dealing with the area of deepening insolvency. A recent district court in Maine recognized the ability to consider damages under a deepening insolvency claim.25 The court cited in a footnote the case of Schacht v. Brown,26 which concluded that the corporate body is ineluctably damaged by the deepening of its insolvency through increased exposure to creditor liability. In another case in New York, the court ruled that the fraud that was alleged resulted in damage to the firm's reputation and led to the firm's deepening insolvency.27

Just a few months ago, the U.S. Bankruptcy Court for the Eastern District of Pennsylvania recognized the ability to make a claim based on the tort of deepening insolvency and that it was not barred by either the economic loss doctrine or the gist of the action doctrines.28

Is Deepening Insolvency Really New?

One commentator suggests that the theory of deepening insolvency just repackages concepts already familiar to reorganization attorneys. Since the crux of the deepening-insolvency theory is that, subject to applicable defenses, officers and directors of an insolvent entity should not fraudulently or negligently extend the life of a business if it results in a continued worsening of the business to the detriment of creditors and interest-holders in that the theory expands liability from where it stands at present, it is conceivable that directors and officers faced with a prospect of deepening-insolvency litigation may opt for bankruptcy court supervision under chapter 11 rather than run the risk of being second-guessed on their business judgment.29 The commentator believes that the deepening-insolvency theory is really more of a general factual backdrop than something entirely new.30

Yet another commentator has stated that "current corporate and bankruptcy laws give directors no incentive to timely place a firm in bankruptcy and fail to sanction directors who place a DOA firm in a chapter 11 reorganization proceeding."31 This commentator goes on to suggest that such incentives or punitive consequences are necessary to ensure that a company is timely placed into liquidation or a bankruptcy proceeding.32

The whole concept is very troubling, to say the least, because it lacks clear definition and limitation, is not uniformly applied and seems to be slowly expanding to impose (or at least allege) a duty of care on professionals and secured lenders to protect companies from themselves.

What Protections Are There?

1. Officers and Directors. Several areas are still developing with respect to the deepening of insolvency cause of action, such as just what exactly is the standard of care for officers and directors. Some courts have applied the business judgment rule to the actions of officers and directors, where others have used a best-interest-of-creditors test. However, the one thing that seems to be clear is that in the "zone of insolvency," an increased standard of care may be imposed upon officers and directors.

With respect to officers and directors, much harm and potential exposure can be avoided if officers and directors make reasonable decisions concerning the future viability of company. Specifically, officers and directors should not take on excessive debt with the very slim chance of producing a recovery for creditors and additional recovery for creditors vis-à-vis the current situation of the company. Accordingly, officers and directors should be realistic in their assessment as to the timely filing of a chapter 11 liquidation or reorganization proceeding.

2. Secured Lenders. The Exide case is still not totally resolved. A detailed analysis of the claims against the pre-petition banks was never entered into because a proposed settlement as part of the reorganization plan was presented to the bankruptcy court. Settlement of the claims was not approved due to the objection of an "overwhelming" majority of unsecured creditors affected by the settlement.33 Additionally, confirmation of the plan was denied and is currently set for a hearing on the amended reorganization plan on March 15, 2004. However, the suggestion from the opinion in August 2003 and the discussion at the confirmation hearing in December 2003 concerning the proposed settlement of the deepening insolvency claim makes it clear that secured lenders may be liable under the tort of deepening insolvency for lending a company additional funds and securing the alleged risky loan, rather than pulling the trigger to exercise its rights and/or force the company into a bankruptcy proceeding and possibly make the same loan in a DIP facility.34

The court's discussion of the proposed settlement at the confirmation hearing is particularly troubling because it essentially assumes the availability of the tort of deepening insolvency against lenders.35 In fact, the court determined it could not approve the settlement, even though the issues were complex and likely to be expensive to litigate, because the proposed $8.5 million settlement was below "the lowest range of reasonableness."36 To be sure, there are many problems and many open issues concerning a deepening-insolvency claim against secured lenders. Further, the liability can be huge—as demonstrated by the court's determination that $8.5 million in damages was below the lowest range of reasonableness given the facts in the case. Accordingly, it is difficult to recommend actions that provide protection other than that it is wise not to exert any control over the borrower during the lending relationship (as in all lender liability-prone situations), including further extensions of credit and the negotiation of workout agreements. Additionally, the secured lender may have greater exposure if it seeks to make the loan in order to improve its position on the backs of the trade. Overall, these seem like very unclear answers for very unclear questions and areas of exposure.

3. Insolvency Professionals. There are also many areas of concern in considering whether to extend the deepening-insolvency theory to impose a duty of care on professionals who advise officers and directors and others with fiduciary duties. It has not yet been defined and fleshed out as to what exactly this newly created duty of care is and on what basis such a duty to unsecured creditors exists. Further, if, as the trustee in the Flagship case suggests, professionals have a duty to notify someone outside the board, who exactly are the person/persons they are required to notify? Exactly at what point in time does the duty arrive, or is there a period of time that would be the reasonable period in which to make the decision to notify the undefined persons? Moreover, how does an attorney get past the issue of attorney-client privilege in notifying others of his client's financial condition or business strategy? These and many other questions remain open, which makes it difficult to determine how professionals can protect themselves from such claims. However, for now, a suggestion would be that the professionals who advise the officers and directors in such a capacity should be realistic in their assessments and reasonable in the "creative" remedies used to address the issues.

4. Damages and Defenses. Two other areas that are unclear and are still developing in this area are the pari delicto defense and how to measure damages for the tort of deepening insolvency. In the Lafferty case, the court discusses the pari delicto defense and denied recovery by finding that the company and its principals were inseparable and equally guilty of wrongdoing. It can easily be seen how this defense could be asserted in situations where fraud and misrepresentation is alleged against the officers and directors where it is based on the fraud and misrepresentation of the officers and directors.37

In assessing how to measure damages in deepening insolvency claims, much has been written on the difficulty of computing damages, and a complete discussion merits a separate article.38 However, one thing is clear: Potential liability can be enormous.39

Conclusion

Overall, deepening insolvency is an area that requires close watch by all chapter 11 professionals as well as the secured-lending community. The most troubling aspect is that the tort is not clearly defined or uniformly applied, and accordingly, that makes it very difficult to determine how to avoid liability. It may be the latest claim that creditors' committees, trustees and others throw out against officers and directors, secured lenders and professionals in the hope of settlements to avoid litigation. Ultimately, if secured creditors become conservative about working with borrowers to reorganize a company over fear of a deepening insolvency claim, it may result in more chapter 11 filings to provide the protections of a DIP facility. Or it may force the pendulum back the other way, where new claims arise against secured lenders that harken back to the days of old concerning lenders' alleged bad faith and unwillingness to work with borrowers to reorganize their businesses.


Footnotes

1 Board Certified in Business Bankruptcy Law by the American Board of Certification. Return to article

2 See, e.g., Smith v. Arthur Anderson, 175 F.Supp. 2d 1180 (D. Ariz. 2001). Return to article

3 See, e.g., Allard v. Arthur Anderson & Co (USA), 924 F.Supp. 488 (S.D.N.Y. 1996); In re Walnut Leasing Co. Inc., 1999 WL 729267 (E.D. Pa. 1999); In re Jack Greenburg Inc., 240 B.R. 486 (Bankr. E.D. Pa. 1999). Return to article

4 See, e.g., In re Walnut Leasing Co. Inc., 1999 WL 729, 267 (E.D. Pa. 1999); In re Exide Tech. Inc., 299 B.R. 732 (Bankr. D. Del. 2003). Return to article

5 See, e.g., In RDM Sports Group Inc., 277 B.R. 415 (Bankr. N.D. Ga. 2002). Return to article

6 See In re Flagship Healthcare Inc., 269 B.R. 721 (Bankr. S.D. Fla. 2001). Return to article

7 See Murray, Shannon, "Digging Deeper," The Deal, May 28, 2003. Return to article

8 See, generally, Murray, Shannon, "Digging Deeper," The Deal, May 28, 2003; Flagship, 269 B.R. at 721. Return to article

9 In re Exide Tech. Inc., 299 B.R. 732 (Bankr. D. Del. 2003). Return to article

10 MacKuse, "Deepening Insolvency," 74 PABAQ 42 Jan. 2003. Return to article

11 See Murray, Shannon, "Digging Deeper," The Deal, May 2003. Return to article

12 Miller and Salazar, "Failing to Act after Signs of Trouble," NYLJ 11, 229. Return to article

13 See, e.g., Exide Technology Inc., 299 B.R. 732 (Bankr. D. Del. 2003) (court determined that even though the Delaware bankruptcy court had not ruled with respect to the existence of deepening insolvency claims, it was able to predict how the Delaware Supreme Court would rule on the claim if such claim was presented to it and determined that the Delaware courts would recognize a deepening insolvency action.). Return to article

14 Off'l. Comm. of Unsecured Creditors v. RF Lafferty and Co., 267 F.3d at 340 (3d. Cir. 2003). Return to article

15 Id. Return to article

16 Lafferty, 267 F.3d at 352. Return to article

17 Id. Return to article

18 Id. at 349-50. Return to article

19 Id. at 350. Return to article

20 Id. at 351. See, also generally, In re Exide Technologies Inc., 299 B.R. 732, 752 (Bankr. D. Del. 2003). Return to article

21 299 B.R. 732 (Bankr. D. Del. 2003). Return to article

22 See Dimassa Jr., "Deepening Insolvency Concerns Secured Lenders," Bankruptcy Legal Intelligencer, Vol. 229, No. 67 at page 5. Return to article

23 See Exide, 303 B.R. 48, 54 n.9 (Bankr. D. Del. 2003). Return to article

24 299 B.R. 732 (Bankr. D. Del. 2003); 303 B.R. 48 (Bankr. D. Del. 2003). Return to article

25 Bookland of Maine v. Baker, Newman and Noyes LLC, 271 F.2d 324 (D. Maine 2003). Return to article

26 711 F.2d 1343, 1350 (7th Cir. 1983). Return to article

27 Breeden v. Fear Drake Insurance PLC., No. 96-61376, Slip Op (Bankr. N.D.N.Y. Dec. 28, 1999). Return to article

28 In re Computer Personalities Sys. Inc., 2003 WL 22844863 (Bankr. E.D. Pa. Nov. 18, 2003). Return to article

29 See Wallander, "What's New Is Old Again: Deepening Insolvency Repackages Familiar Concepts," Texas Lawyer, Vol. 19 No. 37, Nov. 17, 2003. Return to article

30 Id. Return to article

31 Dickerson, "A Behavioral Approach to Analyzing Corporate Failures," 38 W.F.L.R. 1 (Spring 2003). Return to article

32 Id. Return to article

33 In re Exide Tech., et al., 303 B.R. 48 (Bankr. D. Del. 2003). Return to article

34 Id. See, also, Exide, 299 B.R. at 732. Return to article

35 See, generally, 303 B.R. at 65-70. Return to article

36 303 B.R. at 70. Return to article

37 Id. Return to article

38 See, e.g., Michel & Shaked, "Deepening Insolvency: Plaintiff vs. Defendant," ABI Journal, 2002; Mackuse, "Damages for Deepening Insolvency: A Defendant's Nightmare," 74 PABAQ 42 (January 2003). Return to article

39 Mackuse, "Damages for Deepening Insolvency: A Defendant's Nightmare," 74 PABAQ 42 January 2003. Return to article

Journal Date: 
Thursday, April 1, 2004