David E. Gordon, the Expansion of Deepening Insolvency Standing: Beyond Trustees and Creditors' Committees

• Publication year: 2011

THE EXPANSION OF DEEPENING INSOLVENCY STANDING: BEYOND TRUSTEES AND CREDITORS' COMMITTEES

INTRODUCTION

Deepening insolvency has been defined by the Third Circuit as "an injury to the Debtors' corporate property from the fraudulent expansion of corporate debt and prolongation of corporate life."¹A defendant becomes liable for this tortious injury by causing an insolvent corporation to incur further debt rather than dissolve or file for bankruptcy.²

Deepening insolvency occurs in a variety of circumstances. Although there is no all-encompassing fact pattern that would include every imaginable type of deepening insolvency claim, a simple hypothetical example is useful to illustrate the nature of deepening insolvency. Assume a corporation becomes insolvent. Assume further the officers and directors of this corporation take affirmative steps to conceal that insolvency from the corporation's shareholders and creditors-for example, by conspiring with an accounting firm to misrepresent corporate finances. Rather than declare bankruptcy, the officers and directors continue to operate the corporation beyond the point of insolvency. Creditors, misled by false representations of solvency, are induced into making further loans to the insolvent corporation, unknowingly risking their assets while further deepening corporate insolvency. In this way, the officers and directors, as well as the accounting firm, have deepened the insolvency of the corporation to the detriment of the unsecured creditors and the corporate entity itself. This is an example of the emerging tort of deepening insolvency.³

This is also fraud. In the continuing debate over whether to accept the tort of deepening insolvency as an independent cause of action at state law, the Bankruptcy Court for the Southern District of New York recently posed a pertinent question: what does deepening insolvency do that other causes of action cannot do?⁴As this Comment will demonstrate, the answer is that deepening insolvency piggybacks⁵on other causes of action and, in so doing, allows the plaintiff to utilize a theory of damages that is economically devastating to the deepening insolvency defendant, creating an immense pressure on the defendant to settle litigation.

Most jurisdictions have yet to decide a case involving deepening insolvency. Scholarly articles on deepening insolvency focus primarily on two issues: (1) who can be a deepening insolvency defendant⁶and (2) what kind of damages can be awarded.⁷An area that remains largely unexplored, and a primary contribution of this Comment, is the issue of standing in deepening insolvency cases. Much of the literature about deepening insolvency has centered on the question of whom deepening insolvency can be asserted against.⁸This Comment will explore the opposite question: who can assert deepening insolvency? In answering this question, this Comment analyzes the standing of deepening insolvency plaintiffs and concludes a shareholder ought to have standing to bring a claim for deepening insolvency in a shareholder's derivative action.

Following this Introduction, Part I of this Comment traces the historical roots of deepening insolvency in its evolution from a theory of damages to a cause of action.⁹It will examine the most notable cases recognizing deepening insolvency to date as well as cases from jurisdictions that have rejected the theory.¹⁰Part I concludes with a discussion of the merits of using deepening insolvency as a cause of action in addition to claims for fraud or breach of fiduciary duty including a brief summary of who can be a deepening insolvency defendant.¹¹Part II discusses damages for deepening insolvency and highlights problems in calculating damages under the theory.¹²Part III explores issues of standing in deepening insolvency and looks toward the possibility of future deepening insolvency claims in shareholder's derivative suits.¹³The Conclusion discusses the rationale behind the use of deepening insolvency and advocates extending its application into shareholder's derivative suits.¹⁴

I. DEEPENING INSOLVENCY AS A THEORY OF RECOVERY FOR BANKRUPTCY

CREDITORS AND TRUSTEES

A. The Historical Development of Deepening Insolvency

Deepening insolvency is a relatively new theory. It began as a theory of damages and only recently grew into an independent cause of action.¹⁵In

1983, the Seventh Circuit recognized deepening insolvency as a theory of damages in Schacht v. Brown.¹⁶In Schacht, the plaintiff alleged that by keeping Reserve Insurance Company in business beyond the point of insolvency and incurring additional liabilities, the defendant directors and officers of the debtor corporation caused Reserve's policyholders, creditors, and the company itself damages in excess of $100 million.¹⁷Although the plaintiff sought damages under the civil damages apparatus of the Federal Racketeer Influenced Corrupt Organizations ("RICO") statute,¹⁸the Seventh Circuit implicitly approved deepening insolvency as the applicable theory of

Id. damages by noting "the corporate body is ineluctably damaged by the deepening of its insolvency, through increased exposure to creditor liability."¹⁹

In 1989, New York recognized deepening insolvency as a theory of damages while inching slightly closer to recognizing deepening insolvency as an independent cause of action.²⁰In Corcoran v. Frank B. Hall & Co., the Supreme Court of New York, Appellate Division, rejected the defendant directors and shareholders' motion to dismiss a case brought by the Superintendent of Insurance for the State of New York.²¹The Superintendent alleged that the defendants operated the Union Indemnity Insurance Company of New York as a "loss leader" for the benefit of their own business.²²This operation resulted in the rapid insolvency of Union; the Superintendent alleged the defendants concealed this fact.²³The Superintendent sought $140 million in damages, an amount equal to the full extent of Union's insolvency.²⁴While the Superintendent couched his complaint in terms of violations of New York insurance law and breaches of fiduciary duty, the court noted "failure to disclose the insolvency of an insurance company is an injury to that corporation for which the Superintendent may institute an action."²⁵

B. From a Theory of Damages to an Independent Cause of Action

Beginning with a 2001 decision from the Third Circuit Court of Appeals in

Official Committee of Unsecured Creditors v. R.F. Lafferty & Co.,²⁶courts began to recognize deepening insolvency as an independent cause of action. Following the Third Circuit's recognition of deepening insolvency as an independent cause of action under Pennsylvania law in Lafferty, in 2003 the Bankruptcy Court for the District of Delaware in In re Exide Technologies,

Inc.²⁷recognized the tort of deepening insolvency under Delaware law. These decisions have paved the way for a growing judicial acceptance of deepening insolvency as an independent cause of action.

In Lafferty, the Third Circuit recognized deepening insolvency as an independent tort.²⁸The insolvent corporations in Lafferty were two lease financing corporations allegedly operating as a Ponzi scheme.²⁹The plaintiffs, the unsecured creditors' committee, brought claims in the District Court on behalf of the two corporations against the management of both corporations and third parties allegedly involved in the Ponzi scheme for fraudulently deepening the insolvency of the corporations.³⁰Because the committee was suing on behalf of the corporations and managers of the corporations accused of participating in the wrongdoing were also the sole shareholders of both corporations, the district court held the doctrine of in pari delicto prevented the committee from asserting this claim.³¹On appeal, the court of appeals upheld the district court's dismissal of the committee's claims on the grounds of in pari delicto,³²but further concluded "'deepening insolvency' constitutes a valid cause of action under Pennsylvania state law and that the committee therefore has standing to bring this action."³³

The Third Circuit accepted deepening insolvency because it "believe[d] that the soundness of the theory, its growing acceptance among courts, and the remedial theme in Pennsylvania law would persuade the Pennsylvania Supreme Court to recognize 'deepening insolvency' as giving rise to a cognizable injury in the proper circumstances."³⁴Although the committee's complaint in Lafferty was dismissed on what some have referred to as the "pointless technicality" of in pari delicto,³⁵Lafferty is nonetheless a seminal deepening insolvency case because the Third Circuit explicitly recognized (1) deepening insolvency is an independent cause of action and (2) a creditors' committee's standing to bring an action for deepening insolvency.³⁶

Two years after the Third Circuit first recognized the existence of a cause of action for deepening insolvency in Lafferty, the Bankruptcy Court for the District of Delaware followed suit.³⁷In Exide, the creditors' committee asserted a deepening insolvency claim against a syndicate of secured lenders that essentially exercised complete control over Exide Technologies.³⁸The lenders used this control to prevent Exide from filing for bankruptcy while granting themselves security interests in Exide's valuable assets, thus causing

Exide to operate for almost two years at "ever-increasing levels of insolvency."³⁹This activity resulted in substantial losses to the plaintiffs- Exide's other creditors.⁴⁰

The lenders moved to dismiss the claims of the creditors' committee on grounds that Delaware law does not recognize deepening insolvency as a cause of action.⁴¹Citing the Third Circuit Court of Appeals' decision in Lafferty, the court denied the lenders' motion to dismiss.⁴²The court stated the first two factors used by the Third Circuit in its analysis of deepening insolvency in Lafferty were met: (1) the soundness of the theory and (2) the growing acceptance of the...