Sara E. Apel, in Too Deep: Why the Federal Courts Should Not Recognize Deepening Insolvency as a Cause of Action

• Publication year: 2011

COMMENTS

IN TOO DEEP: WHY THE FEDERAL COURTS SHOULD NOT RECOGNIZE DEEPENING INSOLVENCY AS A CAUSE OF ACTION

INTRODUCTION

In the past decade, the theory of "deepening insolvency" has generated intense legal and academic debate over its meaning, scope, and contentious existence.¹The controversy surrounding deepening insolvency inheres in its amorphous nature and expansive scope. Bankruptcy scholars have struggled to pinpoint the legal foundation or theoretical basis for the emergence of deepening insolvency.²While there is no precise definition of the term, courts and commentators typically refer to deepening insolvency as "an injury to the [debtor's] corporate property from the fraudulent expansion of corporate debt and prolongation of corporate life."³Deepening insolvency is technically a creature of state law; however, the theory has originated and developed almost exclusively in federal courts.⁴

At its most basic level, deepening insolvency occurs when a corporation takes on additional debts past the point of insolvency.⁵The concept of deepening insolvency has been used in two ways: as a theory of damages and as an independent cause of action.⁶Deepening insolvency began as a theory of damages that attaches to an independent tort and measures the injury caused to an insolvent corporation from increased debt.⁷As a theory of damages, deepening insolvency enables a plaintiff to claim an injury beyond the equity drained from a corporation, such as the injury sustained from severed relationships with suppliers or distributors.⁸When offered as an independent cause of action, deepening insolvency holds a defendant liable for conduct that, in attempting to sustain an insolvent corporation's life, causes the company to incur additional debt.⁹However, courts recognizing the deepening insolvency theory have failed to state the essential elements of the cause of action or, for that matter, a method of calculating the injury sustained from deepening insolvency. As a result, judicial recognition of deepening insolvency has caused a myriad of substantive and jurisdictional problems.

Federal court recognition of deepening insolvency created widespread fear that courts were dramatically altering state corporate law governing the fiduciary duties owed to a corporation.¹⁰Whether deepening insolvency constitutes a valid theory of corporate damage or an independent tort depends upon the underlying state law. Each state develops its own internal affairs doctrine that articulates the fiduciary duties and responsibilities that officers, directors, and shareholders of a corporation owe to each other and third parties.¹¹By focusing on the actions taken by a corporation upon becoming insolvent, deepening insolvency is inextricably linked to questions of how a business and its stakeholders should act and what fiduciary duties are owed to whom when the company is at or near the point of insolvency. In fact, the cause of action ties the hands of corporations entering the zone of insolvency by holding corporate officers or third party professionals liable for debts incurred while trying to turn the company around.

Moreover, the sporadic recognition of deepening insolvency has resulted in a split amongst the courts over whether deepening insolvency constitutes a viable theory in the first place. In some instances, this split has occurred between the federal court and the state court of a given jurisdiction. As a result, a state law claim could be brought in a federal court when it could not be brought in that jurisdiction's state court. This disparity raises serious questions as to the propriety of federal courts predicting a cause of action for deepening insolvency with no state statutory or common law supporting it. This Comment argues that deepening insolvency provides an example of when federal courts should utilize the abstention provisions of the Bankruptcy Code to decline to exercise jurisdiction over complex and unique issues of state law.

This Comment dissects the ongoing debate over deepening insolvency in five parts. Part I explains the origins of deepening insolvency as a theory of corporate injury. It traces the development of deepening insolvency as a theory of damages that attaches to a separate tort. Part I concludes with an analysis of the case law and criticisms rejecting the deepening insolvency model of damages. Part II introduces deepening insolvency as an independent cause of action. Then, Part III discusses the current state of the law regarding deepening insolvency. Part IV explores the jurisdictional confusion resulting from the conflicting treatment of deepening insolvency by federal and state courts. Part V discusses the application of the abstention clauses of the Bankruptcy Code to deepening insolvency cases. Part V also argues that federal courts faced with deepening insolvency claims should utilize the abstention provisions to either remand the deepening insolvency claim to state court or stay the proceeding in federal court until the highest state court rules on the viability of deepening insolvency. Finally, where available, state certification procedures should be utilized to minimize delays in the abstention process and quickly resolve the proceeding before the court.

I. THE ORIGINS OF DEEPENING INSOLVENCY: A THEORY OF CORPORATE

INJURY

In the early 1980s, deepening insolvency emerged as a theory of damages in the Seventh Circuit. The theory of deepening insolvency provided an expansive measure of the damage accrued by a corporation continuing to operate at a loss past the point of insolvency. This section analyzes the origins of deepening insolvency and its contested evolution as a theory of corporate injury.

A. The Development of Deepening Insolvency as a Theory of Damages

Deepening insolvency first arose as a theory of corporate damage that provided a means of measuring the injury sustained by an insolvent corporation from independent tortious conduct. In this context, deepening insolvency attaches to a separate tort and provides an expansive means of measuring the harm accrued by extending the life of a corporation. For example, a plaintiff may be wronged by the conduct of another party, perhaps through fraud or a breach of a fiduciary duty, that results in a decline in the value of a corporation.¹²In the typical case, the injury sustained by the debtor corporation will be measured by the decline in the company's equity value.¹³

This calculation is based upon the belief that a corporation is comprised of its equity and once the equity is drained from a corporation, the equity holders may not be injured. Conversely, under a deepening insolvency theory of damages, a plaintiff may argue "that the damage is the amount necessary to bring the company back to its pre-damage value."¹⁴The measure of damages under a deepening insolvency theory extends beyond a calculation of the equity lost and may include damages sustained by "the entire corporation, including non-investor stakeholders such as suppliers, distributors, employees and tax authorities."¹⁵

The theory of deepening insolvency originated in the Seventh Circuit. In Schacht v. Brown,¹⁶the Seventh Circuit critiqued the assumption that measures taken to prolong the life of a corporation through additional loans necessarily benefit the corporation.¹⁷In Schacht, the State Director of Insurance ("Director") sued the officers and directors of an insurance company ("Reserve") under the Racketeer Influenced and Corrupt Organizations ("RICO") Act.¹⁸The Director alleged that the defendants' fraudulently maintained the company while insolvent and caused it to accrue additional debts resulting in over $100,000,000 in damages.¹⁹

The Schacht court rejected the defendants' claim that "a corporation may never sue to recover damages alleged to have resulted from the artificial prolongation of an insolvent corporation's life" and held that "the corporate body is ineluctably damaged by the deepening of its insolvency, through increased exposure to creditor liability."²⁰According to the court, the fraudulent extension of the corporation's life prevented the shareholders from liquidating the company early on and enabled the corporation to accrue substantially more debt while its most lucrative assets were plundered from it.²¹In affirming the concept of deepening insolvency as a viable theory of damages, the court stated that "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."²²

By focusing on the need to deter corporate mismanagement as a justification for attaching damages measured by the extent of the corporation's insolvency, the theory of deepening insolvency became linked to state law causes of action. Indeed, state corporate law already creates a cause of action for a breach of fiduciary duty or corporate mismanagement.²³These causes of action hold officers and directors liable for plundering corporate resources in order to maintain the illusion of solvency. The theory of deepening insolvency piggybacks onto these state law tort claims and challenges the assumption that preserving the corporation's life at all costs is necessarily beneficial.²⁴

Awarding damages measured by the deterioration of corporate assets and the concurrent rise of corporate debt arguably deters the officers and directors of a corporation from engaging in business strategies that benefit the persons behind the corporation rather than the corporation itself.²⁵

The court's recognition that the prolonging of the corporation's life did not benefit the corporation and instead benefited the officers and directors engaging in fraud was, in essence, a justification for protecting the corporation independent of the actions of its officers and...