CHAPTER 5 Deepening insolvency as a Theory of Damages

• Jurisdiction: United States

CHAPTER 5: Deepening insolvency as a Theory of Damages

1. Generally

Where a party has committed an independent, legally cognizable tort, that party may be liable to the extent that the misconduct led to the deepened insolvency of the debtor.¹³³ Courts accepting deepening insolvency as a theory of damages hold that deepening insolvency cannot stand as an independent claim. If the independent claim on which deepening insolvency damages are sought is dismissed, then so too must that claim for damages.¹³⁴

The practical nature of a deepening insolvency theory of damages has been summarized as follows:

Whether courts term it "deepening insolvency" or describe in detail the gamut of destruction that the term is meant to embrace, the bottom line is the same. Harm is harm. Where there is harm, the law provides a remedy.... [T]he artificial prolongation of an insolvent corporation's life can harm a corporation.¹³⁵

2. substantive Claims in Which Deepening insolvency Damages May Apply

Deepening insolvency may be used as a measure of damages in a variety of tort claims. It has been used in connection with claims for:

• breach of fiduciary duty¹³⁶
• aiding and abetting fraud¹³⁷
• aiding and abetting breach of fiduciary duty¹³⁸
• negligence¹³⁹
• malpractice¹⁴⁰

3. Lafferty Methodology to Measure Damages under Deepening insolvency Theory

Plaintiffs are drawn to a deepening insolvency theory of damages by the potential for significant damage awards. The damages that may be available under a deepening insolvency theory will vary by jurisdiction because state law governs the underlying claim brought by the plaintiff. Courts have attempted to articulate standards for computing damages on a deepening insolvency claim, varying widely in their approaches and results.

In the seminal case of R.F. Lafferty & Co., the Third Circuit introduced four competing concepts of damage calculations in its discussion of value.¹⁴¹ The court based its deepening insolvency decision on the concept that even insolvent corporations have value. First, the Lafferty court explained that when an insolvent corporation assumes additional debt, it might incur further legal and administrative costs.¹⁴² Second, damage might occur when an insolvent corporation takes on additional debt, as this may "undermine a corporation's relationships with its customers, suppliers, and employees."¹⁴³ Third, "The very threat of bankruptcy, brought about through fraudulent debt, can shake the confidence of parties dealing with the corporation, calling into question its ability to perform, thereby damaging the corporation's assets, the value of which often depends on the performance of other parties."¹⁴⁴ Finally, and more directly, the Lafferty court noted that "prolonging an insolvent corporation's life through bad debt may simply cause the dissipation of corporate assets."¹⁴⁵

On the other hand, deepening insolvency defendants have argued that damages are too speculative to grant. Additionally, deepening insolvency defendants have argued that if the corporation is insolvent at the time of the injury, then no damage could occur to the corporation by deepening its insolvency.¹⁴⁶ However, other courts refute this argument, holding:

[D]amages need not be proved with mathematical certainty, but only with reasonable certainty, and evidence of damages may consist of probabilities and inferences.... Where the amount of damage can be fairly estimated from the evidence, the recovery will be sustained even though such amount cannot be determined with entire accuracy. It is only required that the proof afford a reasonable basis from which the fact-finder can calculate the plaintiff's loss.¹⁴⁷

In some instances, plaintiffs allege that, but for the wrongful conduct of the defendant, insolvency proceedings would have been avoided altogether. In other instances, plaintiffs assert that the delay in the insolvency proceedings caused the damages. Courts have used a variety of approaches, discussed infra, in trying to measure damages under a deepening insolvency theory as to whether bankruptcy could have been avoided altogether or was artificially delayed.

4. Definition of insolvency as Baseline Measurement

Insolvency is defined in the Bankruptcy Code as a "financial condition such that the sum of such entity's debts is greater than all of such entity's property, at a fair valuation, exclusive of [exempt property.]"¹⁴⁸ In other words, two factors are relevant in the analysis of insolvency: property and debts. In evaluating whether a company's already insolvent position has "deepened," the question is whether the value of the property relative to the amount of the debts was made worse as a result of the alleged wrongful conduct. This could happen by a decline in the value of the property or an increase in the debts, or a combination of both.

Courts have employed different methods for evaluating swings in both the property and debts of a debtor in attempting to define deepening insolvency damages. While some courts use a general "loss in value" approach,¹⁴⁹ others look primarily at the proximately caused debts and costs associated with an insolvency proceeding.¹⁵⁰ Yet other courts focus on the loss of property due to looting of corporate assets by management.¹⁵¹ A discussion of the different approaches follows.

5. Loss in Value Approach

In the case where the plaintiff contends that the debtor could have avoided insolvency proceedings altogether but for the wrongful conduct of the defendant, a "loss in value" calculation may be used. Some courts have found that damages based on deepening insolvency can be calculated by a "loss in value," which "can occur in a reduction of a company's value from a positive value to a lower positive value; from a positive value to a negative value; or from a negative value to a greater negative value. The measurement of value is determined by subtracting liabilities from assets."¹⁵²

This method of calculation permits recovery of the diminution in value of the company between the date it became insolvent and the date it ultimately filed for bankruptcy. The court in Bookland of Maine v. Baker, Newman & Noyes LLC permitted the jury to consider both the legal and administrative expenses incurred in the bankruptcy proceedings, along with "any loss in the value of [the] company up until [filing for bankruptcy] that ... was caused by [defendant's] act or failure to act."¹⁵³

Such a calculation of damages could hold defendants liable for the entire diminution in value of the company, whether or not the defendant is solely responsible for the loss:

In the world of corporate workouts, turnaround managers and the possibility for a quick change in an economic tide, it is not uncommon for a corporation to revitalize itself and work out financial problems no matter how dire they appear. The financial hardships which possibly resulted from the increased insolvency were not necessarily forthcoming, and if it can be proven that they were a result of the increased insolvency, liability may be found.¹⁵⁴

Some have criticized the loss-in-value measurement of damages. One commentator noted:

[I]njury to solvency is an incident to the harm, not the harm itself. If the [corporation] lost asset value through [the] defendant's conversion of property, the law measures damage; if through breach of contract, commission of tort, breach of fiduciary duty, or fraudulent transfer, the law already measures damage. The damages may include the insult to asset values ... or the accumulation of a liability.... Depending on the underlying law, the damage may or may not also include lost profits.... Solvency analysis will be incidental to all of these damage analyses. It may so happen that the diminished asset value, new liability, or lost profits that measures the damage also measures precisely the deepening of the firm's insolvency. The point is that insolvency analysis adds nothing to the measure of damages the law already allows.¹⁵⁵

Moreover, a loss in value of the debtor corporation because of a delayed bankruptcy filing might not necessarily lead to a finding of damages based on deepening insolvency. In Shandler v. DLJ Merchant Banking Inc. , the court found that "the complaint never articulates a rational basis for inferring that [the defendant], which the complaint alleges held large amounts of senior debt and was acting for the senior lenders, intentionally kept [the company] out of bankruptcy knowing that would result in a diminishment of [the company's] value for the purpose of allowing [the defendant] to reap illicit gains for itself," adding:¹⁵⁶

In a situation like this one, to sustain this theory would require the pleading of a scenario whereby it was plausible that: i) [the defendant] knew that failing to file for bankruptcy would lower the value of [the company]; and ii) irrespective of [the defendant's substantial equity and senior debt position, [the defendant] could reap enough gains through fees and debt sales to make it worthwhile to take action reducing [the company]'s value and therefore its ability to satisfy debt claims, including its ability to pay back the additional $15 million [the defendant] put at risk in 2001 to keep [the company] operating. After the point in time when [the creditor trustee] alleges that [the defendant] should have caused [the company] to file for bankruptcy, [the creditor trustee] does not allege that [the defendant] received any material amount of fees from [the company], much less enough to approach the level of the additional $15 million it was putting at risk. Nor does [the creditor trustee] allege facts suggesting that [the defendant] had a rational incentive to keep [the company] out of bankruptcy knowing that would lower its value because [the defendant] could reap more from its senior debt positions that way through market sales of that debt than if [the company] had actually declared bankruptcy.
Although [the creditor trustee] alleges that [the

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