Digging the Hole Deeper

What Happens When a Business is In Over Its Head and Who is to Blame?

When firms approach bankruptcy, a definition of what constitutes “deepening insolvency” becomes critical in establishing the legitimacy of litigation concerning damages, breach of fiduciary duty, and more. Michael J. Molder explains context, consequences, and case law on the matter.

Desperate times call for desperate measures—bold, innovative moves.

When these strategies work, management is hailed as heroes. When they don’t ….

Courts across the country have been wrestling with the application of “deepening insolvency.” The concept arises in a variety of contexts ranging from a measure of damages for a breach of a long-estab­lished legal duty to an independent cause of action. While an action for deepening insolvency, to the extent it exists, would, as those for breach of fiduciary duty, be grounded in state law, the issue arises most commonly in bankruptcy proceedings. As a result, much of the case law addressing the issue is found in federal court decisions de­termining the likely application of state law. 

The term “deepening insolvency” has been traced to Bloor v. Dansker (In re Investors Funding Corp. of New York Sec. Litig.), 523 F. Supp. 533 (S.D.N.Y. 1980). In Bloor, the bankruptcy trustee of Investors Fund­ing Corporation of New York (“IFC”) alleged that the Danskers, IFC’s controlling shareholders, manipulated the company’s financial state­ments to report artificial profits and conceal actual losses. “On the basis of this false image of financial health, the Danskers were alleg­edly able to obtain for IFC huge quantities of funds from creditors, debenture holders, stockholders, and other sources, monies purport­edly utilized in perpetuating and concealing ‘the Fraud.’”[1] Named as a defendant in the litigation, IFC’s auditor moved for judgment on the pleadings and summary judgment, based, in­ter alia, on the theory that as agents of the corporation, the Dan­skers’ knowledge should be imputed to IFC, and thereby the plaintiff asserting claims on behalf of the corporate debtor. In response to plaintiff’s argument for application of the “adverse interest” excep­tion to imputation,[2] the auditor argued that the Danskers’ conduct “benefitted IFC by enabling it to continue operations.” [3] The court dismissed this argument, holding:

 “… even to the extent one focuses upon the artificial financial picture of IFC created by the Danskers which prolonged IFC’s existence sev­eral years beyond its actual insolvency, [the auditor’s] position is not persuasive. A corporation is not a biological entity for which it can be presumed that any act which extends its existence is beneficial to it. The complaint plainly alleges that, as a result of the Danskers’ prac­tices, IFC’s financial situation was caused to deteriorate even further after 1971. Accepting the allegations of the complaint as true, it is manifest that the prolonged artificial solvency of IFC benefited only the Danskers and their confederates, not IFC.”[4]

As the court noted in Kittay v. Atl. Bank (In re Global Serv. Group LLC), 316 B.R. 451, 457 (Bankr. S.D.N.Y. 2004), “[w]hat began as a justifica­tion for recognizing the ‘adverse interest’ exception soon morphed into a theory of recovery.” Analyzing the issue in the context of Illinois law, the Seventh Circuit took the Investors Funding analysis a step fur­ther. If artificially prolonging the life of a corporation is not a benefit, then it must be an injury. For the Seventh Circuit, the notion that fraudulently prolonging the life of a corporation beyond insolvency:

“collides with common sense, for the corporate body is ineluctably damaged by the deepening of its insolvency, through increased expo­sure to creditor liability. Indeed, in most cases, it would be crucial that the insolvency of the corporation be disclosed, so that shareholders may exercise their right to dissolve the corporation in order to cut their losses. Thus, acceptance of a rule which would bar a corporation from recovering damages due to the hiding of information concerning its insolvency would create perverse incentives for wrong-doing officers and directors to conceal the true financial condition of the corpora­tion from the corporate body as long as possible.”[5]

 In Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340 (3d Cir., 2001), the Third Circuit took the concept a step further in ruling on an issue of undecided Pennsylvania law. R. F. Lafferty & Co. (“Lafferty”) was the “qualified independent underwriter” for deben­tures, which were issued by two leasing companies and sold through a brokerage firm affiliated with the leasing companies. As alleged in the complaint, the leasing companies operated as a Ponzi scheme and Lafferty’s fairness opinions on the debentures’ terms were essen­tial to registering the securities with the U.S. Securities and Exchange Commission. Lafferty challenged plaintiff’s claims against it, but the Third Circuit found, “…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.”[6] 

The Third Circuit’s ruling in Lafferty was hardly the last word on this issue. In Collins & Aikman Corp. v. Stockman  (2009 U.S. Dist. LEXIS 43472 (D.Del.) May 20, 2009), the issue arose in the context of claims for violation of the federal securities laws. In that case, plaintiff, a liti­gation trust which was the successor to liquidated debtors, sued the company’s former officers, directors, and significant shareholders, as well as its former auditor. The claims arose from an allegedly fraudu­lent scheme through which the company issued $415 million in de­bentures at a time when it was insolvent and, had accurate financial information been available, would never have been able to sell the notes. Defendants moved to dismiss the complaint, arguing that the company benefited from the alleged fraud because it used the pro­ceeds from the sale of the debentures to pay off short-term liabili­ties and delayed ultimate repayment of the debt by six years. Citing Trenwick America Litig. Trust v. Ernst & Young, LLP, 906 A.2d 168 (Del.Ch. 2006), the Stockman court acknowledged that “[u]nder Delaware law, deepening insolvency is not viable as a stand-alone claim.” The theory, however, was applicable in establishing that plaintiff had sus­tained an “injury,” which was a requisite element of its claims under the federal securities laws. Citing cases from a variety of jurisdictions, the court accepted plaintiff’s argument that the sale of the deben­tures “unnaturally prolonged the Company’s life and made its ulti­mate bankruptcy more painful, and more expensive, than it other­wise would have been.”[7]

These examples of acceptance of deepening insolvency logic, however, may have led to over-reaching. In Anderson Gustafsson Advokatbyra, KB v. eSCRUB Systems, Inc. (2011 U.S. Dist. LEXIS 15688 (E.D.Va.) February 15, 2011), the court granted defendants’ motion to dismiss as it related to deepening insolvency issues. The case arose from the failure to pay fees for legal services which plaintiff had provided to defendants. Plaintiff included a breach of fiduciary duty claim, arguing that the individual defendants’ wrongful conduct resulted in “‘increasing the amount of unpaid debts of [the corporation], further weakening its financial position.’”[8] The court analyzed the claim under both Delaware and Virginia law, concluding that neither would recognize an independent claim for deepening insolvency. Further, the court concluded that while both jurisdictions provide for creditors to pursue claims against officers and directors of insolvent corporations, such claims rested in self-dealing. Absent some personal benefit, the court would not permit the breach of fiduciary duty, alleging damages arising from deepening insolvency, to proceed.

As these cases demonstrate, deepening insolvency is a fluid concept which courts are beginning to recognize as a viable concern. The is­sue arises in a wide variety of cases across a spectrum ranging from legitimate business judgment to fraudulent manipulation. Courts are still working to define when a strategy crosses the line to breach a legal duty.

This article was originally published in the Volume 2, 2012 issue of the National Litigation Consultants’ Review.

Michael J. Molder, J.D., CPA/CFF, CVA, CFE, is a senior manager in the Philadelphia, PA, office of Marcum LLP. He can be reached at 484.270.2500 or via e-mail at Michael.molder@marcumllp.com.