CHAPTER 4 The Tort Claim for Deepening insolvency
| Jurisdiction | United States |
CHAPTER 4: The Tort Claim for Deepening insolvency
1. Elements of a Deepening insolvency Claim
Whether deepening insolvency is recognized as an independent claim for relief or a theory of damages is a question of state law.93 For those courts that are willing to consider deepening insolvency as an independent tort,94 they have generally established the following elements of the cause of action: (1) the existence of an insolvent company; (2) fraud and/or negligent conduct; (3) the fraudulent or negligent conduct causes the expansion of corporate debt through the incurrence of additional liabilities or dissipation of assets; (4) prolongation of the life of the corporation; and (5) harm to the company that is distinct from harm to individual creditors.95
A. Split of Authority on Culpability Element
Courts are split on whether fraudulent activity is a necessary element of a deepening insolvency claim or whether negligence will suffice. While some courts hold that fraudulent conduct is required for a finding of damages based on deepening insolvency, others have found deepening insolvency to be based on the lower threshold of negligent behavior.
A number of courts have determined that a finding of negligence is sufficient and that the defendant need not have engaged in actual fraudulent behavior to be found liable under the theory of deepening insolvency. In Smith v. Arthur Andersen, the Ninth Circuit recognized deepening insolvency damage to a corporation based on allegations that the defendants "misrepresent[ed] (not necessarily intentionally) the firm's financial condition to its outside director and investors."96
However, in the context of deepening insolvency as a claim for relief, as opposed to a theory of damages, the Greater Southeast court noted, "If deepening insolvency were treated as a separate cause of action rather than as a theory of harm, it would make sense to require a higher threshold of scienter than mere negligence lest the tort expose directors and third parties to a standard of care that they otherwise would never have owed in the first place."97
Other courts have refused to extend the scope of deepening insolvency liability to negligent acts. For example, the Third Circuit has held that "a claim of negligence cannot sustain a deepening insolvency cause of action."98 Such courts require a finding of fraud in order to find liability based on deepening insolvency.99
B. Harm to the Entity
Another element of a claim for deepening insolvency is that some form of harm occurred.100 Generally speaking, harm to the corporation allegedly occurs when the corporation incurs additional liabilities beyond those that render the corporation insolvent. These damages become apparent when the corporation enters an insolvency proceeding when it otherwise could have avoided doing so, or alternatively, where the corporation should have gone into an insolvency proceeding sooner to avoid making the corporation even more insolvent.
In a fraudulent scheme, however, some courts have considered whether any harm could in fact occur if the company was never legitimate in the first place. For example, Ponzi schemes are fraudulent from their inception. Some courts have found that where a debtor is created and operated as a Ponzi scheme from its start, any alleged harm is entirely illusory, and therefore and the damage element cannot be satisfied.101
The Feltman102 court noted:
As the corporations were essentially only conduits for stolen money, any injury to the debtors in this case must be substantially coterminous with the injury to the defrauded creditors. Everything Gherman stole from the debtor corporations, the debtors had stolen from the creditors. Thus, any alleged injury to the debtors is as illusory as was their corporate identity.103
Defendants have also argued that if a corporation was insolvent before a Ponzi scheme had even begun, then the corporation cannot demonstrate damages.104 The court in In re Le-Nature 's Inc. held that "[s]tated another way, since [the debtor] was insolvent before the Ponzi scheme started, [their] shareholders were entitled to zero; thus, even if the Ponzi scheme increased [their] liabilities and debts, the shareholders were in no worse position because of the Ponzi scheme."105 However, the Le-Nature 's court declined to dismiss the complaint on the basis that the insolvency predated the Ponzi scheme, noting that "the bankruptcy occurred post-Ponzi scheme, post-insolvency, and was foisted on Le-Nature's involuntarily by its creditors."106 Accordingly, some courts find that in such circumstances, a deepening insolvency claim for relief will likely not stand since a plaintiff will be unable to demonstrate harm to the corporation.
C. Causation of Damages
Some courts have dismissed deepening insolvency claims for a failure to demonstrate causation of damages.107 In Marion v. TDI, the receiver sued the defendants under a deepening insolvency theory, alleging that their cash infusion into a Ponzi scheme led the debtor to take on additional liability to the investors. The court found that the causal link was missing between the defendants' actions and the harm that the debtor allegedly suffered.108 "The problem in this kind of scenario is one of proximate causation. Between the initial act (the injecting of money into the business) and the end result (the expansion of the company's debt relative to where it was prior to the cash infusion) stand the intervening acts of the company's management (i.e., what it chose to do with the money)."109
The Third Circuit similarly was unable to find causation in In re CitX Corp.110 and In re Parmalat Securities Litigation.111 In CitX, the court concluded that the defendant accounting firm had not caused the harm to the corporation:112
[CitX argues] that the $1,000,000 equity investment allowed CitX to exist long enough for its management to incur millions more in debt. But that looks at the issue through hindsight bias.... [T]he equity investment was hardly harmful to CitX. Its management ... misused the opportunity created by that investment ... and therein lies the harm to CitX.113
In Thabault v. Chait, the Third Circuit supplemented the proximate-cause analysis from CitX and stated:
To the extent that the extra capital, which decreased CitX's insolvency, extended the corporation's life and allowed management to incur more debt, the ultimate harm was caused by mismanagement, not the auditor. In this case, on the other hand, the jury found that the negligent audit proximately caused an increase in liabilities through the writing of more insurance policies. The audit in the present case had an immediate negative consequence, as contrasted with the immediate positive consequence following the audit in CitX.114
The court thus reasoned that proximate causation was established because but for the auditor's negligence in writing additional insurance policies, the company's insolvency would not have deepened.115
The court in In re Parmalat Securities Litigation echoed the Third Circuit's rationale, explaining:
[A] company's insolvency is not deepened simply by the incurrence of new debt where the company suffers no loss on the loan transaction. The insolvency is deepened when, for example, the proceeds of the loan are squandered or assets otherwise are looted. It is at that point that the gap between liabilities and assets widens and the ability to service outstanding debt is impaired.116
The court elaborated on the difficulties of establishing causation of damages in the deepening insolvency...
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