Deepening Insolvency Secured Lenders and Bankruptcy Professionals Beware It Is Not Just for Officers and Directors Anymore

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Apr 2004

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Editor's Note:

Also see a related article in this issue by Paul Rubin.

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With the increase in involuntary bankruptcy filings, as well as liquidations, corporate scandals and highly litigious
bankruptcy cases, lawyers and advocates are becoming more and more creative in seeking remedies that may result
in any recovery for the parties in the case.

When claims of deepening insolvency are first raised, the allegations are made against officers and directors on the
theory that they may have breached their fiduciary duties by taking certain actions, such as borrowing additional
funds or raising additional equity, which did nothing more than deepen the insolvency of the company and reduce
the overall return to creditors.<a href="#2" name="2a">2</a> However, since the theory of deepening insolvency is not well defined or universally
embraced by all courts, and with few written opinions concerning the topic, creativity in the use of the theory
abounds. The theory has expanded beyond the realm of officers and directors and has been successfully raised
against insolvency professionals, such as accountants,<a href="#3" name="3a">3</a> investment brokers<a href="#4" name="4a">4</a> and lawyers,<a href="#5" name="5a">5</a> with the allegations
ranging from fraudulently concealing information that caused the deepening insolvency of the company to some
newly created duty of care—specifically, that they knew, or should have known, that the business plans presented,
upon which they based their advice, would not work, and accordingly they participated in the deepening of the
insolvency of the company.

For example, a trustee in the Flagship Healthcare case filed a deepening insolvency claim against Flagship's
officers and directors as well as its auditors PricewaterhouseCoopers (PWC), stating that the directors and officers
should have seen the writing on the wall and known they were not going to pull a "rabbit out of the hat." The
trustee argued that at some point it was an abuse of PWC's fiduciary obligation by not alerting creditors to the
deepening insolvency.<a href="#6" name="6a">6</a> The trustee even suggested that PWC had an obligation to notify outside directors to stop
the bleeding of the company's finances.<a href="#7" name="7a">7</a> Ultimately, the case settled for what one source says was about $3 million
with PWC and with the officers and directors for an undisclosed amount.<a href="#8" name="8a">8</a>

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Of great concern to secured lenders...is a Delaware bankruptcy case in which the court suggested that secured lenders may also be liable for deepening the insolvency of a company based on their agreement to continue to lend...rather than pull the trigger on the loan.

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Of great concern to secured lenders and chapter 11 professionals is a Delaware bankruptcy case in which the court
suggested that secured lenders may also be liable for deepening the insolvency of a company based on their
agreement to continue to lend and to further secure the obligation rather than pull the trigger on the loan.<a href="#9" name="9a">9</a>

Given the lack of boundaries placed on deepening insolvency claims to date, the evolution of the theory should be
something insolvency professionals watch closely. Also, given the exposure in the press concerning corporate
scandals, it is hard to imagine that anyone would have great sympathy for claims lodged against third-party
non-debtors (who just so happen to also have deep pockets) involved in any way with the deepening of the financial
crisis of a debtor, whether it be intentional or unintentional.

<h3>A General Definition</h3>

Generally, the deepening insolvency theory of liability holds that there are times when a defendant's conduct, either
fraudulently or even negligently, prolongs the life of a corporation, thereby increasing the corporation's debt and
exposure to creditors.<a href="#10" name="10a">10</a> Moreover, when corporate managers, as well as third-party professionals including lawyers
and accountants, either purposely or negligently help to hide information that shows a company was not solvent
when certain actions, such as acquisitions or debt-raising, were undertaken, deepening insolvency can be alleged
because the result is that the company's financial distress becomes more profound. Accordingly, those involved
with fiduciary obligations, or newly created fiduciary duties of care, may be liable for the tort of deepening
insolvency.<a href="#11" name="11a">11</a>

For now, there seems to be three classes of possible defendants that need to be concerned about deepening
insolvency actions: (1) directors and officers who may be liable concerning actions taken that could be construed to
prolong the life of a corporation to the detriment of creditors, thereby deepening the insolvency of the corporation;
(2) secured lenders concerned about the amount of control they exert in extending additional financing or in
exchange for additional security while in the zone of insolvency; and (3) professionals who advise the corporation
and whose actions could be construed as allowing the corporation to continue to the detriment of all creditors,
thereby deepening the insolvency of the corporation. Further, failing to throw in the towel can open directors and
their professionals to an entirely distinct basis for liability. Typically, these classes of actions divide into two
distinct kinds of claims: (1) a mismanagement claim against the officers and directors or (2) a misrepresentation
claim against both management and its professionals.<a href="#12" name="12a">12</a>

Not all courts have recognized the validity of a deepening insolvency action.<a href="#13" name="13a">13</a> However, many have. The Third
Circuit began the hunt for deepening insolvency when it analyzed a deepening insolvency claim in a case brought by
a creditors' committee. The Lafferty case<a href="#14" name="14a">14</a> involved the bankruptcy of two lease-financing corporations that
allegedly operated as a Ponzi scheme. To operate the scheme, an individual aided by others allegedly caused the
corporation to issue fraudulent debt certificates, which were then sold to the individual investors. The corporation
was unable to pay investors and filed for bankruptcy. The committee, on behalf of the estate, brought two claims in
district court alleging that third parties had fraudulently induced the corporations to issue the debt securities, thereby
deepening their insolvency and forcing them into bankruptcy. The district court held that it could not rule on the
possibility of a cognizable injury. On appeal, the Third Circuit had to determine whether deepening insolvency was
cognizable under Pennsylvania law.<a href="#15" name="15a">15</a> The appeals court held that three factors would persuade the Pennsylvania
Supreme Court to recognize deepening insolvency as giving rise to a cognizable injury under the proper
circumstances.<a href="#16" name="16a">16</a> These factors were the (1) soundness of the theory, (2) growing acceptance of the theory among
courts and (3) the remedial theme in Pennsylvania law (when there is an injury).<a href="#17" name="17a">17</a> The court stated that the theory
of deepening insolvency, particularly in the bankruptcy context, was sound.<a href="#18" name="18a">18</a> Furthermore, the court stated that the
growing acceptance of the deepening insolvency theory confirms its soundness.<a href="#19" name="19a">19</a> The court then cited numerous
cases in which deepening insolvency was found to give rise to a cognizable injury. Finally, the court determined
that one of the most venerable principles in Pennsylvania jurisprudence, and in most common law jurisdictions, for
that matter, is that where there is an injury, the law provides a remedy.<a href="#20" name="20a">20</a>

<h3>Exide and Secured Lenders</h3>

In Exide, the U.S. Bankruptcy Court suggested that if a secured lender, through its continued extension of credit,
exerted such control over a failing borrower as to allow the borrower to continue to operate despite its continuing
decline in value, the lender could face liability to the borrower's unsecured creditors for the tort of deepening
insolvency.<a href="#21" name="21a">21</a> Essentially, a claim against a lender for deepening insolvency is grounded in the theory that the
lender, by (1) extending credit in exchange for additional security (or other enhancement) to a financially troubled
borrower where there is little or no hope of financial recovery and (2) causing the borrower to remain in business for
the lender's benefit, is extracting value from the borrower at the expense of its unsecured creditors—that is, the
unsecured creditors might have been repaid a higher percentage of their claims had the borrower not been "propped
up" with additional secured financing, and may assert that the borrower's deepening insolvency caused them
financial harm.<a href="#22" name="22a">22</a> Accordingly, the Exide decision seems to imply that lenders, in trying to decide whether they
should extend additional credit and how much security they can safely take without exerting too much control over
a corporation, may expose themselves to additional liability in trying to further the reorganization efforts of the
debtor.

It is also important to take notice that, in Exide, the committee sued Credit Suisse First Boston individually and as
administrative agent, joint lead arranger, sole book manager and class representative for a syndicate of banks and
other institutions identified in the lawsuit as "pre-petition banks." Salomon Smith Barney was also sued as the
syndication agent, joint lead arranger and class representative for the pre-petition banks.<a href="#23" name="23a">23</a> The number and extent of
the secured-lender defendants demonstrates the creativity used and the expansive nature of the tort of deepening
insolvency.

<h3>Other Recent Cases</h3>

In addition to the Lafferty and Exide decisions,<a href="#24" name="24a">24</a> several other courts have recently issued opinions dealing with
the area of deepening insolvency. A recent district court in Maine recognized the ability to consider damages under a
deepening insolvency claim.<a href="#25" name="25a">25</a> The court cited in a footnote the case of Schacht v. Brown,<a href="#26" name="26a">26</a> which concluded that
the corporate body is ineluctably damaged by the deepening of its insolvency through increased exposure to creditor
liability. In another case in New York, the court ruled that the fraud that was alleged resulted in damage to the
firm's reputation and led to the firm's deepening insolvency.<a href="#27" name="27a">27</a>

Just a few months ago, the U.S. Bankruptcy Court for the Eastern District of Pennsylvania recognized the ability to
make a claim based on the tort of deepening insolvency and that it was not barred by either the economic loss
doctrine or the gist of the action doctrines.<a href="#28" name="28a">28</a>

<h3>Is Deepening Insolvency Really New?</h3>

One commentator suggests that the theory of deepening insolvency just repackages concepts already familiar to
reorganization attorneys. Since the crux of the deepening-insolvency theory is that, subject to applicable defenses,
officers and directors of an insolvent entity should not fraudulently or negligently extend the life of a business if it
results in a continued worsening of the business to the detriment of creditors and interest-holders in that the theory
expands liability from where it stands at present, it is conceivable that directors and officers faced with a prospect of
deepening-insolvency litigation may opt for bankruptcy court supervision under chapter 11 rather than run the risk
of being second-guessed on their business judgment.<a href="#29" name="29a">29</a> The commentator believes that the deepening-insolvency
theory is really more of a general factual backdrop than something entirely new.<a href="#30" name="30a">30</a>

Yet another commentator has stated that "current corporate and bankruptcy laws give directors no incentive to timely
place a firm in bankruptcy and fail to sanction directors who place a DOA firm in a chapter 11 reorganization
proceeding."<a href="#31" name="31a">31</a> This commentator goes on to suggest that such incentives or punitive consequences are necessary to
ensure that a company is timely placed into liquidation or a bankruptcy proceeding.<a href="#32" name="32a">32</a>

The whole concept is very troubling, to say the least, because it lacks clear definition and limitation, is not
uniformly applied and seems to be slowly expanding to impose (or at least allege) a duty of care on professionals
and secured lenders to protect companies from themselves.

<h3>What Protections Are There?</h3>

1. Officers and Directors. Several areas are still developing with respect to the deepening of insolvency cause of
action, such as just what exactly is the standard of care for officers and directors. Some courts have applied the
business judgment rule to the actions of officers and directors, where others have used a best-interest-of-creditors
test. However, the one thing that seems to be clear is that in the "zone of insolvency," an increased standard of care
may be imposed upon officers and directors.

With respect to officers and directors, much harm and potential exposure can be avoided if officers and directors
make reasonable decisions concerning the future viability of company. Specifically, officers and directors should not
take on excessive debt with the very slim chance of producing a recovery for creditors and additional recovery for
creditors vis-à-vis the current situation of the company. Accordingly, officers and directors should be realistic in
their assessment as to the timely filing of a chapter 11 liquidation or reorganization proceeding.

2. Secured Lenders. The Exide case is still not totally resolved. A detailed analysis of the claims against the
pre-petition banks was never entered into because a proposed settlement as part of the reorganization plan was
presented to the bankruptcy court. Settlement of the claims was not approved due to the objection of an
"overwhelming" majority of unsecured creditors affected by the settlement.<a href="#33" name="33a">33</a> Additionally, confirmation of the plan
was denied and is currently set for a hearing on the amended reorganization plan on March 15, 2004. However, the
suggestion from the opinion in August 2003 and the discussion at the confirmation hearing in December 2003
concerning the proposed settlement of the deepening insolvency claim makes it clear that secured lenders may be
liable under the tort of deepening insolvency for lending a company additional funds and securing the alleged risky
loan, rather than pulling the trigger to exercise its rights and/or force the company into a bankruptcy proceeding and
possibly make the same loan in a DIP facility.<a href="#34" name="34a">34</a>

The court's discussion of the proposed settlement at the confirmation hearing is particularly troubling because it
essentially assumes the availability of the tort of deepening insolvency against lenders.<a href="#35" name="35a">35</a> In fact, the court
determined it could not approve the settlement, even though the issues were complex and likely to be expensive to
litigate, because the proposed $8.5 million settlement was below "the lowest range of reasonableness."<a href="#36" name="36a">36</a> To be
sure, there are many problems and many open issues concerning a deepening-insolvency claim against secured
lenders. Further, the liability can be huge—as demonstrated by the court's determination that $8.5 million in
damages was below the lowest range of reasonableness given the facts in the case. Accordingly, it is difficult to
recommend actions that provide protection other than that it is wise not to exert any control over the borrower
during the lending relationship (as in all lender liability-prone situations), including further extensions of credit and
the negotiation of workout agreements. Additionally, the secured lender may have greater exposure if it seeks to
make the loan in order to improve its position on the backs of the trade. Overall, these seem like very unclear
answers for very unclear questions and areas of exposure.

3. Insolvency Professionals. There are also many areas of concern in considering whether to extend the
deepening-insolvency theory to impose a duty of care on professionals who advise officers and directors and others
with fiduciary duties. It has not yet been defined and fleshed out as to what exactly this newly created duty of care
is and on what basis such a duty to unsecured creditors exists. Further, if, as the trustee in the Flagship case
suggests, professionals have a duty to notify someone outside the board, who exactly are the person/persons they are
required to notify? Exactly at what point in time does the duty arrive, or is there a period of time that would be the
reasonable period in which to make the decision to notify the undefined persons? Moreover, how does an attorney
get past the issue of attorney-client privilege in notifying others of his client's financial condition or business
strategy? These and many other questions remain open, which makes it difficult to determine how professionals can
protect themselves from such claims. However, for now, a suggestion would be that the professionals who advise
the officers and directors in such a capacity should be realistic in their assessments and reasonable in the "creative"
remedies used to address the issues.

4. Damages and Defenses. Two other areas that are unclear and are still developing in this area are the pari delicto
defense and how to measure damages for the tort of deepening insolvency. In the Lafferty case, the court discusses
the pari delicto defense and denied recovery by finding that the company and its principals were inseparable and
equally guilty of wrongdoing. It can easily be seen how this defense could be asserted in situations where fraud and
misrepresentation is alleged against the officers and directors where it is based on the fraud and misrepresentation of
the officers and directors.<a href="#37" name="37a">37</a>

In assessing how to measure damages in deepening insolvency claims, much has been written on the difficulty of
computing damages, and a complete discussion merits a separate article.<a href="#38" name="38a">38</a> However, one thing is clear: Potential
liability can be enormous.<a href="#39" name="39a">39</a>

<h3>Conclusion</h3>

Overall, deepening insolvency is an area that requires close watch by all chapter 11 professionals as well as the
secured-lending community. The most troubling aspect is that the tort is not clearly defined or uniformly applied,
and accordingly, that makes it very difficult to determine how to avoid liability. It may be the latest claim that
creditors' committees, trustees and others throw out against officers and directors, secured lenders and professionals
in the hope of settlements to avoid litigation. Ultimately, if secured creditors become conservative about working
with borrowers to reorganize a company over fear of a deepening insolvency claim, it may result in more chapter 11
filings to provide the protections of a DIP facility. Or it may force the pendulum back the other way, where new
claims arise against secured lenders that harken back to the days of old concerning lenders' alleged bad faith and
unwillingness to work with borrowers to reorganize their businesses.

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<h3>Footnotes</h3>

<a name="1">1</a> Board Certified in Business Bankruptcy Law by the American Board of Certification. <a href="#1a">Return to article</a>

<a name="2">2</a> See, e.g., Smith v. Arthur Anderson, 175 F.Supp. 2d 1180 (D. Ariz. 2001). <a href="#2a">Return to article</a>

<a name="3">3</a> See, e.g., Allard v. Arthur Anderson & Co (USA), 924 F.Supp. 488 (S.D.N.Y. 1996); In re Walnut Leasing Co. Inc., 1999 WL 729267 (E.D. Pa. 1999); In re Jack Greenburg Inc.,

240 B.R. 486 (Bankr. E.D. Pa. 1999). <a href="#3a">Return to article</a>

<a name="4">4</a> See, e.g., In re Walnut Leasing Co. Inc., 1999 WL 729, 267 (E.D. Pa. 1999); In re Exide Tech. Inc., 299 B.R. 732 (Bankr. D. Del. 2003). <a href="#4a">Return to article</a>

<a name="5">5</a> See, e.g., In RDM Sports Group Inc., 277 B.R. 415 (Bankr. N.D. Ga. 2002). <a href="#5a">Return to article</a>

<a name="6">6</a> See In re Flagship Healthcare Inc., 269 B.R. 721 (Bankr. S.D. Fla. 2001). <a href="#6a">Return to article</a>

<a name="7">7</a> See Murray, Shannon, "Digging Deeper," The Deal, May 28, 2003. <a href="#7a">Return to article</a>

<a name="8">8</a> See, generally, Murray, Shannon, "Digging Deeper," The Deal, May 28, 2003; Flagship, 269 B.R. at 721. <a href="#8a">Return to article</a>

<a name="9">9</a> In re Exide Tech. Inc., 299 B.R. 732 (Bankr. D. Del. 2003). <a href="#9a">Return to article</a>

<a name="10">10</a> MacKuse, "Deepening Insolvency," 74 PABAQ 42 Jan. 2003. <a href="#10a">Return to article</a>

<a name="11">11</a> See Murray, Shannon, "Digging Deeper," The Deal, May 2003. <a href="#11a">Return to article</a>

<a name="12">12</a> Miller and Salazar, "Failing to Act after Signs of Trouble," NYLJ 11, 229. <a href="#12a">Return to article</a>

<a name="13">13</a> See, e.g., Exide Technology Inc., 299 B.R. 732 (Bankr. D. Del. 2003) (court determined that even though the Delaware bankruptcy court had not ruled with respect to the
existence of deepening insolvency claims, it was able to predict how the Delaware Supreme Court would rule on the claim if such claim was presented to it and determined that
the Delaware courts would recognize a deepening insolvency action.). <a href="#13a">Return to article</a>

<a name="14">14</a> Off'l. Comm. of Unsecured Creditors v. RF Lafferty and Co., 267 F.3d at 340 (3d. Cir. 2003). <a href="#14a">Return to article</a>

<a name="15">15</a> Id. <a href="#15a">Return to article</a>

<a name="16">16</a> Lafferty, 267 F.3d at 352. <a href="#16a">Return to article</a>

<a name="17">17</a> Id. <a href="#17a">Return to article</a>

<a name="18">18</a> Id. at 349-50. <a href="#18a">Return to article</a>

<a name="19">19</a> Id. at 350. <a href="#19a">Return to article</a>

<a name="20">20</a> Id. at 351. See, also generally, In re Exide Technologies Inc., 299 B.R. 732, 752 (Bankr. D. Del. 2003). <a href="#20a">Return to article</a>

<a name="21">21</a> 299 B.R. 732 (Bankr. D. Del. 2003). <a href="#21a">Return to article</a>

<a name="22">22</a> See Dimassa Jr., "Deepening Insolvency Concerns Secured Lenders," Bankruptcy Legal Intelligencer, Vol. 229, No. 67 at page 5. <a href="#22a">Return to article</a>

<a name="23">23</a> See Exide, 303 B.R. 48, 54 n.9 (Bankr. D. Del. 2003). <a href="#23a">Return to article</a>

<a name="24">24</a> 299 B.R. 732 (Bankr. D. Del. 2003); 303 B.R. 48 (Bankr. D. Del. 2003). <a href="#24a">Return to article</a>

<a name="25">25</a> Bookland of Maine v. Baker, Newman and Noyes LLC, 271 F.2d 324 (D. Maine 2003). <a href="#25a">Return to article</a>

<a name="26">26</a> 711 F.2d 1343, 1350 (7th Cir. 1983). <a href="#26a">Return to article</a>

<a name="27">27</a> Breeden v. Fear Drake Insurance PLC., No. 96-61376, Slip Op (Bankr. N.D.N.Y. Dec. 28, 1999). <a href="#27a">Return to article</a>

<a name="28">28</a> In re Computer Personalities Sys. Inc., 2003 WL 22844863 (Bankr. E.D. Pa. Nov. 18, 2003). <a href="#28a">Return to article</a>

<a name="29">29</a> See Wallander, "What's New Is Old Again: Deepening Insolvency Repackages Familiar Concepts," Texas Lawyer, Vol. 19 No. 37, Nov. 17, 2003. <a href="#29a">Return to article</a>

<a name="30">30</a> Id. <a href="#30a">Return to article</a>

<a name="31">31</a> Dickerson, "A Behavioral Approach to Analyzing Corporate Failures," 38 W.F.L.R. 1 (Spring 2003). <a href="#31a">Return to article</a>

<a name="32">32</a> Id. <a href="#32a">Return to article</a>

<a name="33">33</a> In re Exide Tech., et al., 303 B.R. 48 (Bankr. D. Del. 2003). <a href="#33a">Return to article</a>

<a name="34">34</a> Id. See, also, Exide, 299 B.R. at 732. <a href="#34a">Return to article</a>

<a name="35">35</a> See, generally, 303 B.R. at 65-70. <a href="#35a">Return to article</a>

<a name="36">36</a> 303 B.R. at 70. <a href="#36a">Return to article</a>

<a name="37">37</a> Id. <a href="#37a">Return to article</a>

<a name="38">38</a> See, e.g., Michel & Shaked, "Deepening Insolvency: Plaintiff vs. Defendant," ABI Journal, 2002; Mackuse, "Damages for Deepening Insolvency: A Defendant's Nightmare," 74
PABAQ 42 (January 2003). <a href="#38a">Return to article</a>

<a name="39">39</a> Mackuse, "Damages for Deepening Insolvency: A Defendant's Nightmare," 74 PABAQ 42 January 2003. <a href="#39a">Return to article</a>

Journal Authors

Jo Ann J. Brighton

Journal Date

Thursday, April 1, 2004 - 12:00

Bankruptcy Rule

2004