CHAPTER 9 Standing issues in Pursuing Deepening insolvency Claims

• Jurisdiction: United States

CHAPTER 9: Standing issues in Pursuing Deepening insolvency Claims

1. Generally

A threshold question in the pursuit of deepening insolvency claims is whether the plaintiff is the proper party to assert those claims. The Supreme Court held in Caplin v. Marine Midland Grace Trust Co. of New York that a bankruptcy trustee has standing to represent only the interests of the debtor corporation and does not have standing to pursue claims for damages against a third party on behalf of one creditor or a group of creditors.⁴²⁴ Generally speaking, the law regarding a receiver's standing similarly limits that standing to the pursuit of claims against third parties to the extent that the claim is one belonging to the debtor entity as opposed to the individual investors.⁴²⁵

Trustees, receivers and other successors-in-interest to the debtor corporation allege on the one hand that the corporate debtor has been harmed, thereby conferring standing on them. Individual creditors, on the other hand, contend that a claim for damages based on increased liabilities that the debtor is unable to pay is really a claim of the creditors. The manner in which courts draw the line between harm to the corporate entity versus harm to the individual creditor varies and often turns on the particular facts of a case.⁴²⁶ For example, many courts find that deepening insolvency is an injury to the corpo-ration⁴²⁷ and thus would not grant standing upon individual creditors.

However, other courts find that the harm runs to the creditors. "The fact that [the debtor] could not repay its 'loans' ... upon incurring $1.4 billion in new LBO debt ... is a harm not to [the debtor] but to [the debtor's] creditors, to whom the assets were owed."⁴²⁸

2. A Trustee's Standing to Pursue a Deepening Insolvency Claim

A. As Representative of Creditors

Despite the divergent views taken on standing based on the analysis of the actual harm suffered, courts have generally found that a trustee should not be denied standing simply because he is a representative of the creditors who are going to ultimately receive any recovery. The court in Gordon v. Basroon⁴²⁹ recognized the bankruptcy trustee's standing to bring a deepening insolvency action, writing:

[I]t is important to note a fallacy in the argument that the claims asserted "really" belong to the investors/creditors. This argument often comes from the mistaken notion that the creditors are the ones who will receive the money anyway, so why not let them pursue the wrongdoers themselves and do away with the trustee. This argument misunderstands the nature of bankruptcy and the role of the trustee in bankruptcy. Bankruptcy is a collective debt collection device. Indeed, the trustee's job is to investigate the debtor's financial affairs, liquidate assets, pursue the debtor's causes of action, and acquire assets through the trustee's avoiding powers in order to make a distribution to creditors. "The concept of a trustee in bankruptcy is that of a creditor representative whose single effort will replace that of multiple and often wasteful and competitive efforts of individual creditors." 1 Daniel R. Cowans et al., Cowans Bankruptcy Law and Practice § 2.7, at 72 (1986 ed.). To find that the trustee has no standing to pursue causes of action belonging to the debtor because the recovery would only benefit the creditors is an absurd argument, given the fact that the trustee's goal is to make a distribution to creditors.⁴³⁰

The court in Schnelling v. Thomas (In re AgriBioTech Inc.) echoed the sentiment of the Gordon court, noting:⁴³¹

Whether damages to the creditors is a proper measure of damages to the debtor is a separate question from whether the Trustee has standing to assert claims that allege the defendant harmed the debtor.... In deciding whether the injury was to the corporation or its creditors, the Court believes that "best practices" would call for the Court to examine to whom any allegedly breached duty was owed; what was the injury underlying the claims; who suffered the injury; who would gain from the recovery, or lose out if the recovery were awarded to a different successful plaintiff; and, to the extent different from any of the foregoing, whether any creditor of the debtor could assert the claim (directly or derivatively on behalf of the corporation), or just those creditors suffering a particularized injury.⁴³²

Alternatively, if corporate harm cannot be established, some courts have found that an additional method for a trustee to obtain standing is by obtaining an assignment of creditors' claims. For example, the Fourth Circuit has found that if a trustee takes an unconditional assignment of claims from creditors, the trustee obtains standing to assert claims directly on behalf of the estate.⁴³³ In Bogdan,⁴³⁴ the court distinguished the Supreme Court's decision in Caplin,⁴³⁵ finding that the trustee in Bogdan was not asserting claims on behalf of the creditors as in the case of Caplin, but that the unconditional assignments constituted property of the estate, thus conferring standing upon the trustee.⁴³⁶ Another court noted, "Caplin does not apply to the activities of a liquidating trust created by a plan of reorganization (or, for that matter, an ex-debtor operating under a confirmed plan), and [] the post-liquidation trustee had standing to pursue the investors' assigned claims against the bank."⁴³⁷

B. Courts that Recognize that a Trustee Does Have Standing

Trustees have used the theory of deepening insolvency specifically to establish standing as proof of damages to the debtor entity. The Third Circuit's decision in Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co. aptly described the theory, holding that "prolonging an insolvent corporation's life through bad debt may ... cause the dissipation of corporate assets. Th[is] harm can be averted, and the value within an insolvent corporation salvaged, if the corporation is dissolved in a timely manner, rather than kept afloat with spurious debt."⁴³⁸

In Smith v. Arthur Andersen LLP, the Ninth Circuit likewise found that the trustee had standing to pursue claims for breach of contract and duties against attorneys, auditors and investment bankers who allegedly concealed the financial condition of the debtor, thereby causing the debtor to waste additional assets on a failing business.⁴³⁹ The court found that "allegedly wrongful expenditure of corporate assets qualifies as an injury to the firm which is sufficient to confer standing upon the Trustee."⁴⁴⁰ Additionally, "[w]hether damages to the creditors is the proper measure of damages to the debtor is a separate question from whether the Trustee has standing to assert claims that allege the defendant harmed the debtor."⁴⁴¹ The standing inquiry therefore is limited to whether the trustee has sufficiently alleged standing, and not how to measure the damages themselves.

Courts have additionally recognized that bankruptcy trustees may use deepening insolvency as a theory of damages. Examples include:

• In re Latin Inv. Corp. (finding that trustee had standing to bring action on behalf of debtor where debtor was injured by defendants and damages would include "damages inflicted in perpetuating the debtor's existence past the point of insolvency in order to loot").⁴⁴²
• In re Flagship Healthcare (finding that trustee's allegations of negligence by financial advisor on which debtor relied in its acquisition strategy and that caused debtor's financial position to weaken were sufficient to support a claim for damages incurred by debtor under the deepening insolvency theory and therefore conferred standing on the trustee. "As applied to the instant case, even if the Debtor may have been insolvent before the Greenleaf Valuation, the additional debt incurred thereafter, and allegedly as a result of the Defendants' negligence, may provide a measure of damages recoverable by the Trustee").⁴⁴³
• Tug Liquidation LLC v. Atwood (In re Buildnet Inc.) ("Corporate waste and deepening insolvency are claims designed for the protection of creditors and shareholders in general because they are derivative of an injury to the corporation, and are not the result of a direct injury sustained by a single creditor.").⁴⁴⁴
• In re Student Finance Corp. (finding that trustee had standing to bring deepening insolvency claim against attorneys where wrongful conduct harmed debtor through wrongful expansion of corporate debt and prolongation of corporate life beyond insolvency, but claim was not stated where alleged injury was to creditors rather than to debtor).⁴⁴⁵
• Miller v. Dutil (In re Total Containment Inc.) ("The Third Circuit has held that the tort of deepening insolvency is one belonging

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