A Half-Baked Tort: Deepening Insolvency

Unfortunately, businesses fail despite the hard work and effort of everyone involved. A business failure can have lasting impacts upon the creditors of the business in addition to the owners. Some creditors of a failed business may experience significant losses. Other creditors, such as financial institutions, sometimes prevent significant loss through the efficient use of contracts, personal guaranties or security agreements. If, however, a creditor is not in a position to obtain these protections, they may find themselves fighting for an ever shrinking piece of the pie. In an environment where there is not enough to go around, a creditor facing serious losses may use aggressive tactics to create liability and increase their recovery by blaming others for the businesses failure.

Over the years, these aggressive tactics have developed in an attempt to create tort liability where it should not exist. Commonly, the liability finger is pointed at lenders, secured creditors or professional advisors thinking that these so called “deep-pockets” can foot the bill. If a novel theory of liability gains judicial acceptance, the theory can become an effective mechanism to obtain a better return for the creditor when it would not otherwise exist.

Recently, a new theory of tort liability is being asserted in the courts against lenders, secured creditors, and professional advisors. This vague and ill defined allegation of liability is labeled “deepening insolvency.” At its core, the theory of deepening insolvency is simple: the prolongation of a troubled business can by itself damage or harm the business’ creditor, and the theory allows the creditors to recover their damages from the owner or advisor who kept the business operating when it was insolvent. When the proper ingredients are present, the aggressive creditor may assert that a member or shareholder of the corporation, a lender under a workout agreement or a professional advisor is to blame for the increased losses of the creditor.

The theory of deepening insolvency is particularly troublesome. It can create a significant constraint on the actions of third-party lenders, corporate insiders, and advisors at a crucial time for the business. At a time of crises, quick and decisive actions are required to try and rehabilitate or minimize business losses. If prolongation of a troubled enterprise creates liability, there is no longer any incentive to save the business or minimize loss. Instead of advancing additional funds, lenders, or corporate insiders and advisors, should take steps to liquidate rather than rehabilitate or restructure a troubled business.

The concept of deepening insolvency has evolved over time through various court decisions. Some courts have determined that liability, if it exists, is not a separate claim in litigation, but is a way to show how a creditor was harmed when a claim already exists. For example, if fraud was committed, the theory of deepening insolvency can be used to show why the creditor’s damages are greater than it first appears. The distinction between a claim and an explanation of a creditor’s damages is important because identifying and proving a separate legal claim can be difficult for the creditor.

Other courts, however, have found that the half-baked tort theory of deepening insolvency can be its own claim and a way for a creditor to prove liability. For example, the Third Circuit Court of Appeals found liability exists under Pennsylvania law where a third-party insurance underwriter issued opinions that allegedly permitted two separate failing businesses to issue fraudulent debt securities. A number of additional courts in Delaware and surrounding states have subsequently evaluated and interpreted the Court’s opinion favorably as a separate claim for recovery.

The theory of deepening insolvency is not limited to the East Coast of the United States. It has already been discussed by the federal appeals court overseeing Oregon and Washington. The Ninth Circuit Court of Appeals, in an opinion addressing the activities of Arthur Andersen LLP, referenced the theory with approval when discussing the Third Circuit Court’s opinion. While the Ninth Circuit declined to discuss the theory in detail, the brief reference is a sign that the theory and allegations for liability are evolving. Given this positive reference, it is possible that a deepening insolvency claim could be filed in an Oregon or Washington case by an aggressive creditor seeking recovery due to a business failure.

As an evolving theory, it is unclear when liability exists and, if it does, what precisely creates liability. However, there are some signs you can pay close attention to that signal that a business is in trouble. For example, look for a business that is experiencing repeated losses and is financing those losses in unhealthy ways, where an entire industry or sector is in a downturn, for a business that is placing an emphasis on profit and neglecting the need for positive cash flow, for a business that is extending accounts payable over lengthening time periods or for situations where directors and officers have significant personal liability. When these signs exist, lenders, secured creditors, and professional advisors should carefully consider the implications of a decision to continue business operations in light of the theory of deepening insolvency.

Because the theory is not clearly defined, there is no easy answer on how to avoid liability when a warning sign appears. There are some logical steps that can and should be followed. Adequate insurance should be in place to address ongoing risks. Careful review and evaluation of financial information should occur and any publicly released financial information should be thoroughly examined before it is released. Above all, the business ought to extend every effort to document its business judgment throughout the rehabilitation process by documenting decisions in writing concerning any action designed to prolong the life of the business.

There are promising signs that courts will limit, or perhaps even eliminate, this new theory of liability. For example, the Third Circuit Court of Appeals recently limited the scope of the conduct for a claim for deepening insolvency to instances of fraud. Deepening insolvency is still rapidly evolving, has not been addressed in Oregon and Washington, and may remain a fertile ground for an aggressive creditor or bankruptcy trustee to obtain a significant recovery or, at the very least, leverage a better return on their behalf.

If you have questions about the issues discussed in this article, or related issues, please contact our office.