Popular belief was that courts in the Third Circuit were more receptive to the controversial theory of deepening insolvency than were courts in certain other circuits. After all, in Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., the Third Circuit held that state courts in Pennsylvania would recognize an independent cause of action for deepening insolvency—a holding that many courts subsequently used as a basis for decisions recognizing that a deepening insolvency cause of action may be asserted against a variety of defendants, including, but not limited to, secured creditors.2 Sometimes popular belief is wrong. In an opinion issued on May 26, 2006, a panel of the Third Circuit Court of Appeals that included Judge Fuentes—the very judge that authored Lafferty—refused to extend deepening insolvency claims to actions based on negligence, stating that "[w]e know no reason to extend the scope of deepening insolvency beyond Lafferty's limited holding" that "only fraudulent conduct will suffice to support a deepening insolvency claim under Pennsylvania law."3 Instead, the Third Circuit held in CitX that (1) a plaintiff must prove fraud in order to recover on a cause of action for deepening insolvency; (2) deepening insolvency is not a viable damages theory if the underlying cause of action is professional negligence or malpractice; and (3) a deepening insolvency claim belongs to the estate, not to creditors (and thus cannot be asserted by a trustee stepping into the shoes of creditors pursuant to 11 U.S.C. §544). CitX has dealt quite a blow to the theory of deepening insolvency. Just a few days after the CitX opinion was handed down, the U.S. Bankruptcy Court for the Southern District of New York dismissed a deepening insolvency claim asserted under Delaware law in reliance on CitX's holding that Lafferty only applies to Pennsylvania law,4 and recently, the Delaware Chancery Court ruled that Delaware state courts do not recognize a cause of action based on deepening insolvency, which cited CitX as well.5 The Facts of CitX The facts of CitX are straightforward. CitX's only significant customer, Professional Resources Systems International, Inc. (PRSI), "was a fraudulent enterprise" and was shut down by the Florida Attorney General in January 2000.6 At the Florida Attorney General's request, a Florida state court froze all of PRSI's assets and appointed a receiver. The next day, PRSI's offices were closed and its computers, books and records were seized.7 At the time that PRSI's business was terminated, it owed CitX $2.4 million. CitX continued to show the PRSI receivable as an asset on its balance sheet long after PRSI was shut down. This permitted CitX to portray itself as balance-sheet solvent, whereas if it wrote off the receivable, CitX's balance sheet would have reflected liabilities in excess of its assets. CitX thereafter sold additional equity securities for more than $1 million. Within a year and a half, it lost all of the proceeds of the equity infusion.8 During that year and a half, CitX also incurred millions in additional debt that it could not repay.9 CitX then filed a chapter 11 bankruptcy that was later converted to a chapter 7 proceeding. The chapter 7 trustee sued CitX's accounting firm, Detweiler, Hershey & Associates, and Detweiler's engagement partner, Robert Schoen, for malpractice deepening insolvency, breach of fiduciary duty and negligent misrepresentation.10 The trustee alleged that CitX used the latest financial information prepared by Detweiler at the CitX February 2000 stockholder meeting to raise $1 million in new equity, and that Detweiler missed "red flags," including that it was inconceivable that CitX could recover on the $2.4 million receivable from PRSI after January 2000. The Third Circuit found that the allegations lacked sufficient basis, noting first that Detweiler was not engaged to conduct an audit of CitX, but solely to issue compilations.11 In addition, the Third Circuit pointed out there was a note that accompanied the latest financial statement, which stated that PRSI "[was] named as [a] defendant...and charged with certain security violations by the Attorney General's Office in Florida."12 The note concluded that "the company is not sure what impact, if any, these changes will have on its economic position."13 The financial statement also included the following notation: Management has elected to omit substantially all of the disclosures ordinarily included in the financial statements prepared on the income tax basis of accounting. If the omitted disclosures were included in the financial statements, they might influence the user's conclusions about the Company's assets, liabilities, equity, revenue, and expenses... Accordingly, these financial statements are not designed for those who are not informed about such matters.14 Third Circuit Finds that the Plaintiff Must Prove Fraud The Third Circuit first considered "whether deepening insolvency is a viable theory of damages for negligence.15 The court reviewed its holding in Lafferty and concluded that Lafferty "should not be interpreted to create a novel theory of damages (for deepening insolvency) for an independent cause of action like malpractice.16 The Third Circuit then addressed the issue of whether it would recognize a cause of action that Detweiler negligently deepened CitX's insolvency. While noting that certain cases hold or suggest that such a cause of action is viable,17 the court summarily rejected this position in three succinct sentences: We note that Lafferty holds only that fraudulent conduct will suffice to support a deepening-insolvency claim under Pennsylvania law... We know no reason to extend the scope of deepening insolvency beyond Lafferty's limited holding. To that end, we hold that a claim of negligence cannot sustain a deepening-insolvency cause of action.18 The Third Circuit was not required to elaborate on what elements must be proved to state a claim for deepening insolvency because it held that the trustee could prove no more than negligence, which was insufficient. However, the Third Circuit made clear that Lafferty required a showing of fraudulent conduct. The fact that the court cited with approval the Delaware Bankruptcy Court's recent decision in In re Oakwood Homes Corp.19 is also instructive. In Oakwood Homes, Judge Walsh interpreted the fraud requirement of Lafferty to mean that the plaintiff must prove all five of the typical elements of fraud under the applicable state's law. While noting that different courts state those five elements "in slightly different terms," Judge Walsh generally described them as follows: "a representation of material fact, falsity, scienter, reliance and injury."20 If, as these cases instruct, a plaintiff must prove all five elements of fraud and survive the pleading requirements of Rule 9(b)21 in order to prevail on a deepening-insolvency claim, the question must be raised: Does a cause of action for deepening insolvency have any continuing utility, or has it merely become an "add on" to fraud counts in complaints? Indeed, under this analysis it will be even more difficult to prevail on a deepening-insolvency cause of action than a fraud claim, because in addition to proving all five elements of fraud, presumably one would also have to prove, in the words of Lafferty, "an injury to the debtors' corporate property from the fraudulent expansion of corporate debt and prolongation of corporate life."22 Thus, it appears that a plaintiff asserting deepening insolvency as a cause of action must prove (1) fraud (with all five sub-parts noted above), (2) that the fraud caused the expansion of corporate debt and (3) that the fraud also caused the prolongation of the corporation's (pre-bankruptcy) life. Additionally, some cases suggest that a plaintiff must prove a pre-existing duty to the company.23 While this does not create an extra burden where the defendant is a fiduciary of the debtor, such as a director or officer, or as in CitX itself, the debtor's professionals, it does place an extra obstacle on claims against certain defendants, such as lenders.24 The logical conclusion would be that plaintiffs would prefer not to take on these additional hurdles; therefore deepening insolvency may not be included in complaints as an additional allegation (along with aiding/abetting breach of fiduciary duty, recharacterization, etc.) with the same frequency in which it had been seen in the past few years. Of course, this raises the specter of one of the criticisms often leveled at Lafferty in the first instance: It determined that Pennsylvania courts would recognize a claim for deepening insolvency solely on the basis that in Pennsylvania, "where there is an injury, the law provides a remedy."25 If one has to prove fraud—and then some—to prevail on a deepening-insolvency claim, it seems that the law already does provide a remedy for the harm deepening insolvency seeks to address: the law of fraud. Other courts have concluded that it is not their place to predict how a state court would rule on a novel theory of recovery.26 Lafferty Is Limited to Pennsylvania Law, at Most Perhaps recognizing this problem, the court in CitX took the occasion, even though the case before it, like Lafferty itself, required the application of Pennsylvania law, to state the following: "Although some courts in this circuit have extended Lafferty's reasoning to other states, see, e.g., Oakwood Homes [supra]...nothing we said in Lafferty compels any extension of the doctrine beyond Pennsylvania."27 The bankruptcy court in Oakwood Homes concluded earlier this year that even though Lafferty interpreted Pennsylvania law, and Oakwood Homes turned on Delaware, New York or North Carolina law, the bankruptcy court must follow Lafferty's reasoning because each of those states, like Pennsylvania, follow the common law principle that "where there is an injury, the law provides a remedy."28 The natural extension of this formulation would lead to the conclusion that deepening insolvency is the law of every state that acknowledges this principle. The Third Circuit disagreed with that formulation and appears to signal that the Third Circuit now would require a greater showing before concluding that other states would recognize a claim for deepening insolvency. One court has already interpreted CitX's analysis to mean that "the court must do its best to predict the ultimate decision of the Delaware courts as to whether a director can breach an independent duty by prolonging the life of a financially troubled or insolvent corporation, without violating any other duty."29 Indeed, the CitX panel (including the judge who wrote Lafferty) appeared to be signaling a willingness to reconsider Lafferty's primary holding that deepening insolvency is a cause of action under Pennsylvania law. The Third Circuit noted that Lafferty has "provoked much comment" and cited articles critical of the decision,30 but stated that "the issue was not before us."31 It also noted that the panel that decided CitX was not permitted to revisit the holding in Lafferty; only the entire Third Circuit, sitting en banc, may do so. Therefore, although the court's comments were not necessary to the outcome of the decision, they suggest a result in future cases. Deepening Insolvency Claims Are Estate Causes of Action The Third Circuit also "noted in passing" that because this cause of action seeks to recover injury to the corporation, it is property of the estate, which a trustee is only authorized to pursue under 11 U.S.C. §541. As such, it cannot be pursued on behalf of creditors pursuant to 11 U.S.C. §544, the section of the Code that permits a trustee to assert causes of action belonging to, inter alia, creditors.32 In doing so, CitX explicitly stated its agreement with a recent Delaware District Court decision, In re Student Fin. Corp.33 This is no mere technicality. The Student Finance court dismissed a deepening-insolvency complaint for failure to state a claim when the complaint only alleged that the defendant law firm, together with the debtor's CEO and sole shareholder, worked together to defraud the creditors. According to the Student Finance court, that allegation was insufficient because, as a §541 cause of action, the fraud must be on the debtor, not on its creditors, and working with the CEO to defraud others does not constitute fraud on the corporation itself. While the Third Circuit in CitX only noted this point "in passing," it appears that this theory could have provided another basis to grant summary judgment to the defendants. As the district court in CitX noted in a different context, "[t]o the extent that [the] defendants learned of PRSI's troubles, it was from CitX management. Therefore, the client was already aware of the PRSI 'red flag.'"34 In light of this finding, it is difficult to see how the client—the debtor—could have been defrauded by Detweiler's failure to disclose the collectibility of the PRSI receivable, and even if the court held that there was fraud, it seems that it could only have been fraud on the creditors—a cause of action that a trustee may lack standing to pursue. Indeed, it seems that there would be few cases where a plaintiff would be able to allege, much less prove, that someone other than an officer or director of the debtor defrauded the company itself—not its creditors—for the purpose of prolonging the company's life. Accordingly, the Third Circuit's guidance on this point in CitX could form the basis of the dismissal of many deepening insolvency counts in the future. Deepening Insolvency Is Not a Proper Measure of Damages for Professional Negligence or Malpractice Some courts that have not accepted deepening insolvency as an independent cause of action have acknowledged that it may be a viable theory of damages.35 The Third Circuit in CitX disagreed with those courts and held that deepening insolvency is not a valid theory of damages for the torts of professional negligence and malpractice. The court gave two reasons for this result. First, it stated that such a theory of damages is "novel" as it pertains to professional negligence and malpractice. The court ruled that the reasoning of Lafferty, which only discussed a cause of action for deepening insolvency, could not be read to create a new damages theory that otherwise would not have been recognized before Lafferty. Second, the court stated that Detweiler's actions "did nothing to 'deepen' CitX's insolvency. It did the opposite."36 Specifically, if it were true that its financial statements led to the $1 million equity infusion, the court observed that the equity infusion made CitX more solvent, not less, by $1 million. The later incurrence of debt after the equity infusion, according to the court, "was wrought by CitX's management, not Detweiler."37 The court opined that management could have used the $1 million equity investment "to turn the company around and transform it into a profitable business. They did not, and therein lies the harm to CitX."38 Thus, the Third Circuit's rejection of deepening insolvency as a measure of damages for professional negligence and malpractice claims appears to focus on the lack of injury caused by the defendant—i.e., the accounting firm should not be charged with management's misuse of the proceeds of the equity infusion. Of course, this does not rule out deepening insolvency as a measure of damages on other types of claims. For example, if the defendants in CitX were directors or officers rather than the debtor's accounting firm, the court might have been more receptive to deepening insolvency as a theory of damages because those defendants' actions caused the harm. Thus, the court merely stated that "we do not mean to imply that deepening insolvency would be a valid theory of damages for any other cause of action, such as fraud, and Lafferty did not so hold."39 Post-CitX Opinions In the Verestar case,40 handed down a few days after CitX, the U.S. Bankruptcy Court for the Southern District of New York predicted that Delaware state courts would not permit recovery against directors on an independent tort of deepening insolvency where the debtor had a permissible corporate charter provision, pursuant to 8 Del. C. §102(b)(7), generally exculpating directors from monetary damages other than for claims of bad faith or breach of the duty of loyalty. The court reasoned that a typical deepening-insolvency claim asserts that the debtor was harmed by the defendants' action or inaction, which results in "the corporation...remain[ing] in business and incur[ring] 'unnecessary' debt."41 According to the Verestar court, that "charge must relate to a breach of the duty of care," and therefore is exculpated by such a charter provision.42 This opinion potentially is at odds with CitX because if deepening insolvency requires proof of fraud, it is difficult to conceive of fraudulent conduct that relates more to the duty of care than to bad faith or the duty of loyalty—conduct that cannot be exculpated under §102(b)(7). Nevertheless, it demonstrates potential additional hurdles in pleading and proving deepening insolvency as a cause of action against directors. Most recently, a Delaware Chancery Court addressed these issues directly under Delaware law in Trenwick.43 In Trenwick, the court laid to rest any notion that Delaware state courts would recognize deepening insolvency as an independent cause of action. In the court's words, "the concept of deepening insolvency has been discussed at length in federal jurisprudence, perhaps because the term has the kind of stentorious academic ring that tends to dull the mind to the concept's ultimate emptiness."44 The court then engaged in a thorough examination of state and federal law in an attempt to identify any basis for a claim based on deepening insolvency. First, Judge Strine stated that Delaware law does not obligate the board of a company to cease the operations of the company and liquidate it when the company becomes insolvent, thus there is no basic duty under Delaware law to underpin such a claim. Judge Strine then looked to federal law and found it consistent with Delaware law, noting that federal bankruptcy law expresses a shared societal philosophy that an insolvent corporation may benefit by operating in a chapter 11 proceeding.45 Finally, Judge Strine noted that Delaware law permits a board of a corporation, acting in good faith and acting after appropriate due diligence, to pursue a business strategy that it believes will increase the corporation's value, including incurring additional debt, without guaranteeing the success of the strategy.46 In his view, such actions are protected by the business-judgment rule, and any other conclusion would be contrary to accepted legal standards. In sum, the court concluded that a cause of action for deepening insolvency cannot be supported under Delaware law any more than such law would recognize a cause of action for "shallowing profitability."47 The court then reviewed the various published opinions in which courts have addressed the issue of deepening insolvency as a cause of action. The court concurred with what is described as "a growing body of federal jurisprudence, which has recognized that those federal courts that became infatuated with the concept did not look closely enough at the object of their ardor."48 As to those courts that had embraced it, the court remarked that such cases do not explain "the rationale for concluding that deepening insolvency should be recognized as a cause of action or how such recognition would be consistent with traditional concepts of fiduciary responsibility," citing CitX as a recent case that was appropriately skeptical of the notion.49 The Future of Deepening Insolvency—Practical Pointers It appears clear that CitX and Verestar have made a future claim of deepening insolvency more difficult, if not impossible, to plead and maintain, and simultaneously they have decreased its utility by making it redundant of a fraud claim. Whether this will deter plaintiffs from pleading and attempting to prove deepening insolvency in the future remains to be seen. Additionally, the CitX court's admonition that Lafferty only sets forth the Third Circuit's prediction of the law in Pennsylvania, and Trenwick's holding that Delaware would not recognize the cause of action, may provide the final blows to the viability of the theory of recovery. Until this uncertainty is resolved, recent case law developments do provide a few suggestions from a practice perspective: 1. Before bringing a deepening insolvency claim in the future, do not simply add it as a separate cause of action in your "kitchen sink" complaint. Decide which state's law may apply, and check the case law of that state or states to ascertain the specific requirements which must be plead to allege fraud under Rule 7009. Further, in analyzing future prospects for recovery and counseling clients, be mindful of the expense and difficulty in successfully litigating a complaint based on fraud. 2. In defending a claim of deepening insolvency, raise issues of the validity of the claim as a separate cause of action in the state in which the complaint is brought. Also question whether it is duplicative of a cause of action that already exists under state law (i.e., breach of fiduciary duty, aiding/abetting breach of fiduciary duty, fraud, etc.) or whether an independent fiduciary duty is necessary. 3. Where your client is a professional or a lender, question the validity of deepening insolvency as a measure of damages for the particular cause of action which has been pleaded. 4. Explore the possibility of filing a motion to dismiss a separate count of deepening insolvency if the pleading requirements of Rule 7009 have not been met, or there is a good-faith basis to assert that applicable state law would not recognize it. Footnotes 1 267 F.3d 340 (3d Cir. 2001); see, also, OHC Liquidation Trust v. Credit Suisse First Boston (In re Oakwood Homes Corp.), 340 B.R. 510 (Bankr. D. Del. 2006) (holding that Delaware, New York and North Carolina would recognize the cause of action). 2 See, e.g., In re Exide Tech. Inc., 299 B.R. 732 (Bankr. D. Del. 2003) (opening the door for the possibility of a deepening-insolvency claim against secured lenders); Bondi v. Bank of America Corp. (In re Parmalat Sec. Litig.), 383 F.Supp.2d 587 (S.D.N.Y. 2005) (citing Lafferty in support of a position that deepening insolvency is a separate cause of action). Other courts, discussed later, have subsequently disagreed with Lafferty and found that deepening insolvency is merely a theory of damages for the breach of some independent tort. 3 Seitz v. Detweiler, Hershey and Assoc. P.C. (In re CitX Corp.), 448 F.3d 672, 681 (3d Cir. 2006) (the "Third Circuit Opinion"). 4 In re Verestar Inc., 343 B.R. 444 (Bankr. S.D.N.Y. 2006). 5 Trenwick America Litigation Trust v. Ernst & Young L.L.P., 2006 WL 2333201 (Del. Ch. Aug. 10, 2006) (unpublished). 6 Third Circuit Opinion at 674. 7 In re CitX Corp., 2005 WL 1388963 (E.D. Pa. June 7, 2005) (the "District Court Opinion"), aff'd by the Third Circuit Opinion. 8 Third Circuit Opinion at 674-676. 9 Id. 10 The bankruptcy court dismissed the fiduciary duty claim and the district court granted summary judgment in favor of Detweiler on the negligent-misrepresentation claim. Id. at 675. The district court later granted Detweiler summary judgment on the malpractice and deepening-insolvency claims. Id. The trustee appealed only the summary judgment as to malpractice and deepening insolvency. Id. 11 As the district court explained, "the primary difference between a compilation and an audit is the degree and amount of responsibility undertaken by the accountant. In an audited engagement, the accountant assumes responsibility for the accuracy of the figures, in effect warranting the reliability of the report which he prepares. By contrast, in an unaudited engagement, the accountant does not warrant and is not responsible for the ultimate accuracy of the report if the figures supplied by the client are erroneous." District Court Opinion at *4 (internal quotation omitted and citations omitted). 12 Third Circuit Opinion at 675-76. The district court noted that the charge actually was fraud, not a securities violation, but that this would make little difference to a reader of the financial statements. District Court Opinion at *6 n.3 13 Third Circuit Opinion at *2. 14 Id. at 676, n. 5. 15 Id. at 677. 16 Id. 17 See id. (citing Smith v. Arthur Andersen LLP, 421 F.3d 989, 995 (9th Cir. 2005); In re Parmalat, 383 F.Supp. at 601, and Gouiran Holdings Inc. v. DeSantis, Prinzi, Springer, Keifer & Shall (In re Gouiran Holdings Inc.), 165 B.R. 104, 107 (E.D.N.Y. 1994)). 18 Id. at 681 (internal citations omitted). 19 340 B.R. 510 (Bankr. D. Del. 2006). 20 Id. at 534. 21 Fed. R. Civ. P. 9(b) contains the pleading requirements for fraud and is incorporated into the Bankruptcy Rules at Fed. R. Bankr. P. 7009. 22 Lafferty, 267 F.3d at 347. 23 See, e.g., Global Serv. Group, 316 B.R. at 458 (and cases cited therein). 24 See, e.g., Oakwood Homes, 340 B.R. at 530 ("simply lending to an insolvent corporation, without more, cannot possibly be a tort"). 25 Lafferty, 267 F.3d at 351. 26 See, e.g., In re VarTec Telecom Inc., 335 B.R. 631, 644 (Bankr. N.D. Tex. 2005). 27 Third Circuit Opinion at 680 n.11. 28 Oakwood Homes, 340 B.R. at 530-31 (citing Lafferty, 267 F.3d 2d at 351 and collected cases). 29 In re Verestar Inc., 343 B.R. at 476. 30 Third Circuit Opinion at 680 n.11 (citing Bates, William III, "Deepening Insolvency: Into the Void," Am. Bankr. Inst. J., Mar. 2005, at 1; Heaton, J.B., "Deepening Insolvency," 30 J. Corp. L. 465 (2005); Willet, Sabin, "The Shallows of Deepening Insolvency," 60 Bus. Law. 549 (2005)). 31 Id. 32 Id. at 676 n.6. 33 335 B.R. 539, 548-49 (D. Del. 2005). 34 District Court Opinion at *6. 35 See, e.g., Global Serv. Group, 316 B.R. at 458 (collecting cases); VarTec Telecom, 335 B.R. at 644. 36 Third Circuit Opinion at 677. 37 Id. 38 Id. at 678. 39 Third Circuit Opinion at 677 n.8. 40 343 B.R. 444 (Bankr. S.D.N. Y. 2006). 41 Id. 42 Id. 43 2006 WL 232201 (Del. Chan. 2006). 44 Id. at *28. 45 Id. (citations omitted). 46 Id. at *29 (citations omitted). 47 Id. 48 Id. at 29. 49 Id.