Few theories in recent years have generated more ink—whether in the form of pleadings, court decisions or academic debate—than “deepening insol-vency.” Some commentary has centered on whether deepening insolvency should be recognized as its own independent tort,² as a theory of damages³ or perhaps as no harm to the debtor at all.⁴ Until now, the complaints, court opinions and academic debate have all appeared to focus on the conduct of directors, officers, professionals, banks or other defendants before the debtor filed a chapter 11 bankruptcy case. After all, post-petition, the official committee of unsecured creditors investigates the debtor’s business and plans, and bankruptcy courts typically accord significant weight to the opinions of the committee. Moreover, any transaction out of the ordinary course of business must be approved by the bankruptcy court,⁵ and the debtor is required to publicly file schedules, statements of financial affairs and monthly operating reports.⁶ These requirements and others are often referred to as the “fishbowl” of bankruptcy. Given creditors’ ability not only to peer through the fishbowl, but to appear and be heard on most motions filed by a debtor,⁷ one would assume that a creditor’s right to complain about insolvency that deepened after a chapter 11 case was filed but before a conversion to chapter 7 should be severely curtailed.

Given this framework, a recent opinion in the LTV bankruptcy case, which permitted an official committee of administrative claimants (ACC) to pursue causes of action against directors and officers (D&Os) for post-petition as well as pre-petition deepening insolvency, and finding that such causes of action constitute “colorable claims,” is noteworthy.⁸ This appears to be the first written opinion recognizing a claim for post-petition deepening insolvency.⁹ It remains to be seen whether other courts will agree with the LTV court that a committee may have a “colorable claim” for post-petition deepening insolvency, and if so, what effects this might have on the conduct of D&Os, as well as two other constituencies that often have pre-petition deepening insolvency charges leveled against them: professionals and banks. This article provides some preliminary views on these questions and analyzes whether such claims should be recognized in the future.

The LTV Opinion

LTV Steel Company Inc. and affiliates (LTV) filed chapter 11 cases on Dec. 29, 2000. The complaint describes two sets of what appear to be entirely separate wrongs allegedly committed by the board, one of which occurred solely pre-petition and the other of which occurred more than nine months post-petition.¹⁰

The court summarized the key allegations of post-petition misconduct as follows: “In at least early September of 2001, at the latest, LTV Corp.’s directors and officers appear to have been aware that LTV Steel may soon be unable to pay its post-petition debts;”¹¹ nevertheless, the company “continued to incur additional trade debt, which it either knew or should have known, it could not pay in full.”¹² Indeed, it might have intentionally stretched payments to trade creditors, having implemented an Immediate Liquidation Enhancement Program (ILEP). The ACC alleged that the ILEP caused the company’s trade payables to increase from $115 million in August 2001 to somewhere between $140-150 million between September and November 2001, despite scaled-back operations. The ILEP was first disclosed at a Dec. 5, 2001, hearing—less than three months after the program was implemented.

The court also noted, in less detail, certain allegations focusing on the board’s failure to monitor the company’s accounting, financial and reporting systems, as well as managment behavior, and to take corrective action and approval of retention plans and other transactions¹³ that, while the opinion does not specifically state, appear to have been approved by the bankruptcy court.¹⁴

Procedural Posture

The opinion granted the ACC’s motion for standing to sue derivatively. Under the Sixth Circuit’s applicable case law, such a motion should be granted if the committee makes a demand that is unjustifiably refused and has made “a prima facie demonstration that a colorable claim exists which, if successful, would benefit the estate.”¹⁵ The “colorable claim” analysis is “akin to that [analysis] made on a motion to dismiss.”¹⁶ Thus, from a precedential standpoint, the LTV decision should be read like an opinion on a motion to dismiss, rather than a post-trial opinion.

The Court’s Analysis

The court acknowledged the defendants’ argument that no independent cause of action for deepening insolvency exists.¹⁷ However, it stated that a “growing list of jurisdictions [have] recognized this doctrine.”¹⁸ Noting that the debtors were Delaware and New Jersey corporations, and that Delaware and New Jersey were in the Third Circuit, the court held that Lafferty and the Delaware Bankruptcy Court’s opinion in Exide Technologies¹⁹ “arguably apply to the proposed lawsuit.”²⁰ The court did not analyze whether Delaware or New Jersey laws are different than the Pennsylvania law applied in Lafferty or the law applied in Exide.

The court also quoted with approval portions of the Lafferty opinion’s rationale for recognizing a tort of deepening insolvency: Incurring debt can force a company into bankruptcy, which adds to administrative costs and undermines relationships with customers, suppliers and employees.²¹

While the court noted, in multiple sections of its opinion, the defendants’ objection to applying a deepening-insolvency analysis to post-petition conduct, its analysis of this argument is brief. The court correctly held that a committee may be granted standing to pursue post-petition as well as pre-petition causes of action and that post-petition causes of action may, in certain circumstances, be deemed core proceedings.²² However, acknowledging that the ACC may be an appropriate party to pursue such a claim if it exists seems to have little to do with the issue of whether, from a substantive standpoint, such a cause of action does, or should, exist.

Considerations: Post-Petition Deepening Insolvency

This article does not attempt to enter into the debate as to whether pre-petition deepening insolvency should be recognized as an independent tort, a damages theory or neither. Rather, this section explores some of the problems with the LTV court’s analysis, even assuming arguendo that pre-petition deepening insolvency constitutes an independent tort.

The most obvious concern is that certain of the conduct complained of—for example, employee retention and other transactions—appears to have been approved by the bankruptcy court in prior proceedings. If a transaction has been approved by a bankruptcy court, it is difficult to conceive of any basis for imposing liability for that transaction’s later failure, short of an allegation that the debtor intentionally submitted fraudulent information to the court in an effort to obtain court approval. Indeed, even an allegation that the information disclosed to the court was wrong or incomplete, standing alone (i.e., without an allegation of fraud or intent to deceive) ought to be insufficient. After all, any party in interest can take discovery in opposing a motion to approve a transaction²³ and can cross-examine any witness who testifies in support of the motion. Of course, such discovery and cross-examination may, in part, focus on the accuracy of the debtor’s representations to the court in support of approval.

Permitting a post-hoc challenge to court-approved transactions through a deepening-insolvency claim is problematic for several reasons. First, it would significantly undermine the confidence that parties would have in the finality of bankruptcy court orders, which could impede the reorganization process. Second, such challenges might well run afoul of the doctrines of res judicata and collateral estoppel. Bankruptcy courts only may approve the use or sale of property out of the ordinary course of the debtor’s business if such use or sale has a “sound business purpose,”²⁴ and typically the order approving the transaction will state that the transaction is in the best interests of the debtor’s estate. Once a court has made such findings, the room for it to hold, in retrospect, that the transaction actually was harmful to the estate and deepened the debtor’s insolvency appears to be minimal at best. Third, because all creditors have the ability to object to a motion to approve a transaction, the time to voice any concerns ought to be before the court approves the transaction, not afterwards when parties have relied on the sale order and when hindsight is 20/20.²⁵

The concerns with recognizing post-petition deepening insolvency claims are not limited to claims that center on transactions approved by the bankruptcy court. A debtor’s financial affairs are not a secret. At the very beginning of a bankruptcy case, a debtor must complete detailed schedules as well as statements of financial affairs, both of which are made publicly available.²⁶ Thereafter, it completes and publicly files monthly operating reports for the duration of the stay in chapter 11, which provide further monthly financial information. In this era of electronic dockets, ease of access to such disclosures is significant. Moreover, chapter 11 provides multiple opportunities to probe such disclosures. An official committee of unsecured creditors, which operates as a fiduciary for all unsecured creditors, is charged with, inter alia, “investigat[ing] the acts, conduct, assets, liabilities and financial condition of the debtor, the operation of the debtor’s business and the desirability of the continuance of such business...”²⁷ These investigations are typically aided by sophisticated counsel and financial advisors hired by the committee and paid by the bankruptcy estate. Moreover, any individual creditor may question the debtor at the meeting of creditors²⁸ or may take discovery of the debtor concerning “the acts, conduct or property or...the liabilities and financial condition of the debtor...”²⁹ With these tools at hand, it is difficult to conceive why post-petition deepening insolvency claims should be permitted to survive unless they allege that the debtor fraudulently misrepresented its financial condition in court filings.

Additionally, recognizing a tort for post-petition deepening insolvency would represent a fundamental shift in who bears the risk of a failed reorganization—from creditors to directors and officers, or perhaps their lawyers and debtor-in-possession lenders. That risk is real. History proves beyond cavil that not all reorganizations are successful. One might reasonably ask whether directors will have any tolerance for the risk of being sued for a failed reorganization when it would be easier for them to resign at the moment of bankruptcy (or sooner), or to advocate more risk-adverse strategies like immediate liquidation. If we want skilled directors to attempt to reorganize companies, recognizing this new cause of action will not help.

It should also be noted that no matter what one thinks of the reasoning of Lafferty in the pre-petition context, Lafferty offers no support for recognizing a tort of post-petition deepening insolvency. For example, Lafferty’s observation that deepening insolvency could cause a company to file for bankruptcy, thereby causing it to incur increased administrative costs, makes little sense if the alleged wrong did not occur until after the company filed for bankruptcy. Nor does the argument that suppliers and customers will not react well to a bankruptcy filing work if you posit that the company was already in chapter 11 when the insolvency deepened. The most one could say, in either case, is that perhaps the case should have been converted to chapter 7 faster. But any creditor can move to convert a case to chapter 7 at any time.³⁰ With the monitoring tools described above and in the absence of fraud, conversion—not a tort—is the appropriate remedy.

Case-Specific Problems with the Post-Petition Deepening-Insolvency Theory

Even if a cause of action for deepening insolvency might exist under certain circumstances, the facts of LTV appear to be particularly ill-suited for such a theory. The court’s opinion focuses on the fact that due to the ILEP, trade payables increased by $25-$35 million, or 18-23 percent, over a very short time. But this increase in “debt” was not a new layer of financing thrust upon existing creditors, but rather the debtor’s continued purchase of goods, services and supplies in the ordinary course of its business while stretching the pay cycle. Absent an argument that the debtor did not receive reasonably equivalent value in exchange for the goods, services and supplies, it is hard to understand how the debtor (as opposed to individual trade creditors) was harmed by paying later rather than sooner.
Indeed, it is questionable whether this type of claim is even a derivative claim at all. Presumably, most if not all administrative trade vendors provided their goods or services to LTV pursuant to a contract or purchase order that specified the credit terms of the transaction. Thus, each trade creditor could pursue, if appropriate, its own direct cause of action for breach of contract, or some well-defined body of case law such as fraud or misrepresentation if the creditor argues that it was tricked into contracting in the first place. Of course, the result of each such case might well be different, depending on what the individual contracts provided and what was stated to each trade creditor. This tends to show that treating the LTV ACC’s claims as derivative claims might not have been appropriate.

Moreover, it does not seem that the debtor is harmed by stretching payments for goods and services it actually received. Arguing that the debtor should not have incurred the debt amounts to an argument either that the debtor should have switched to C.O.D. purchases so that no debt ever exists—which obviously makes little business sense—or that it should not have made the purchases in the first place. But unless the debtor has received less than reasonably equivalent value in the exchange and cannot sell the goods for a profit, how has the debtor been harmed by such an exchange? Moreover, not making such purchases means being unable to operate a business as a going concern, which amounts to an argument that the moment that a chapter 11 debtor has to start stretching its payments to its vendors, it must scale back purchases or cease operating. If that theory is adopted, it would be akin to setting a new standard requiring conversion to chapter 7 under those circumstances. The statutory standard for conversion is quite different: If a debtor or anyone else objects, the court may only grant a creditor’s motion to convert a case from chapter 11 to chapter 7 if the creditor demonstrates “cause” and if there is no reasonable probability of timely confirming a reorganization plan or liquidation.³¹

Additionally, a committee of administrative expense claim creditors is an anomalous class to pursue deepening insolvency claims that center on stretching administrative claim trade vendors. Typically, deepening-insolvency claims are pursued on account of holders of “older” debt claims who argue that newer debt should have never been incurred. In contrast, one would posit that a significant percentage of the LTV ACC’s constituency were the very trade vendors who were stretched, because older post-petition claims, before the adoption of the ILEP strategy, were not stretched and presumably paid reasonably promptly. Thus, allowing the ACC to sue is akin to a company that has existing bond debt but no bank debt being sued for deepening insolvency when it took out a bank loan—not by the bondholders, but by the banks.

Finally, two other anomalies of applying this new theory under the facts of LTV should be noted. First, it appears from the court’s opinion that the debtor disclosed the existence of the ILEP within three months of its implementation. Thus, the period of nondisclosure, even if disclosure were necessary, was not overly long. Moreover, presumably the debtor was filing monthly operating reports for all of these periods, so the fact that administrative liability was increasing should have been available even sooner. This raises the question of just how fast a debtor must disclose plans of this sort. Second, LTV had an active chief restructuring officer (CRO). Thus, this was not a case of an insider board trying to retrench itself without oversight. Given the prominence of an independent CRO in setting strategy for the DIP, it would appear that permitting a deepening-insolvency claim would significantly impede on the protections of Delaware’s business-judgment rule, which protects business decisions made in good faith and on an informed basis.³²

The Future of the Theory

It is not clear whether other courts will follow LTV and permit claims of post-petition deepening insolvency to go forward. If they do, it is likely that a significant percentage of failed chapter 11 cases will see litigation of this sort. This in turn could make directors much more risk-adverse and could cause them to liquidate companies sooner and discourage directors from attempting more difficult reorganizations under chapter 11. Moreover, it is likely that debtor’s counsel and DIP lenders would become codefendants in future suits, just as lawyers and banks are frequent defendants in pre-petition deepening insolvency cases. None of these are welcome consequences.

 

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Footnotes

1 The analysis and conclusions set forth in this article are those of the author and not necessarily of Richards, Layton & Finger, PA or its clients.
2 See, e.g., Official Committee of Unsecured Creditors of R.F. Lafferty & Co. Inc., 267 F.3d 340, 350 (3d Cir. 2001) (applying Pennsylvania law).
3 See, e.g., In re Global Service Corp. LLC, 316 B.R. 451 (Bankr. S.D.N.Y. 2004).
4 See, e.g.,Willet, Sabin “The Shallows of Deepening Insolvency,” 60 The Business Lawyer, No. 2 (Feb. 2005).
5 11 U.S.C. §363.
6 Fed. R. Bankr. P. 107.
7 11 U.S.C. §1109(a).
8 In re LTV Steel Co. Inc., ___ B.R. ___, 2005 WL 2573515 (Bankr. N.D. Ohio Sept. 2, 2005).
9 Id. at * 26 (noting that one director argued they “no court has ever recognized a claim for deepening insolvency based upon actions occurring after the commencement of a bankruptcy”).
10 Because this article focuses on post-petition deepening insolvency, the alleged pre-petition wrongs and the court’s analysis of such claims is omitted here.
11 Id. at *2 (emphasis supplied).
12 Id.
13 Id. at *17.
14 Id. at *26 (noting that one defendant objected that the ACC’s “complaint is based upon post-petition conduct that was approved by the bankruptcy court and/or could have been attacked by any creditor in these transparent bankruptcy proceedings”).
15 Id. at *4 (citing, inter alia, In re Gibson Group, 66 F. 3d 1436, 1446 (6th Cir. 1995)).
16 Id. (collecting cases).
17 Id. at *20.
18 Id. (citing Lafferty, 267 F.3d at 488-89).
19 Official Committee of Unsecured Creditors v. Credit Suisse First Boston (In re Exide Technologies Inc.), 299 B.R. 732 (Bankr. D. Del 2003).
20 LTV, 2005 WL 2573515 at *21.
21 Id. at 20 (quoting Lafferty, 267 F.3d at ___).
22 Id. at 27.
23 See Fed. R. Bankr. P. 9014.
24 See, e.g., Myers v. Martin (In re Martin), 91 F.3d 389, 395 (3d Cir. 1996) (citing Fulton State Bank v. Schipper (In re Schipper), 933 F.2d 513, 515 (7th Cir. 1991)); Stephens Indus. Inc. v. McClung, 789 F.2d 386, 390 (6th Cir. 1986); Comm. of Equity Sec. Holders v. Lionel Corp. (In re Lionel Corp.), 722 F.2d 1063, 1070 (2d Cir. 1983); In re Del. & Hudson Ry. Co., 124 B.R. 169, 176 (D. Del. 1991).
25 These problems, of course, are in addition to any conceptual problems with recognizing an independent tort for deepening insolvency at any time, whether pre-petition or post-petition.
26 Fed. R. Bankr. P. 1007.
27 11 U.S.C. §1103(c)(3).
28 11 U.S.C. §341.
29 Fed. R. Bankr. P. 2004(b).
30 11 U.S.C. §1112(b).
31 11 U.S.C. §112(b)(1)-(2).
32 See Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984).