LTV and Post-Petition Deepening Insolvency The Next Big Wave

Journal Issue

Feb 2006

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Feature

Citation

ABI Journal, Vol. XXV, No. 1, p. 1, February 2006

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Corporate Governance

Fraud

Practice and Procedure

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Few theories in recent years have generated more ink—whether in
the form
of pleadings, court decisions or academic debate—than
“deepening
insol-vency.” Some commentary has centered on whether deepening
insolvency
should be recognized as its own independent
tort,2
as a theory of damages3 or perhaps as no
harm to the
debtor at all.4 Until now, the complaints,
court opinions
and academic debate have all appeared to focus on the conduct of
directors,
officers, professionals, banks or other defendants before the debtor
filed a
chapter 11 bankruptcy case. After all, post-petition, the official
committee
of unsecured creditors investigates the debtor’s business and
plans, and
bankruptcy courts typically accord significant weight to the opinions
of the
committee. Moreover, any transaction out of the ordinary course of
business
must be approved by the bankruptcy court,5

and the
debtor is required to publicly file schedules, statements of financial
affairs
and monthly operating reports.6 These
requirements
and others are often referred to as the “fishbowl” of
bankruptcy.
Given creditors’ ability not only to peer through the fishbowl,
but to
appear and be heard on most motions filed by a
debtor,7
one would assume that a creditor’s right to complain about
insolvency
that deepened after a chapter 11 case was filed but before a
conversion to chapter
7 should be severely curtailed. 
 
Given this framework, a recent opinion in the LTV bankruptcy
case, which
permitted an official committee of administrative claimants (ACC) to
pursue
causes of action against directors and officers (D&Os) for
post-petition
as well as pre-petition deepening insolvency, and finding that such
causes of
action constitute “colorable claims,” is
noteworthy.8 This appears
to be the first written opinion recognizing a claim for post-petition
deepening
insolvency.9 It remains to be seen whether
other courts will agree with the
LTV court that a committee may have a “colorable
claim” for
post-petition deepening insolvency, and if so, what effects this might
have
on the conduct of D&Os, as well as two other constituencies that
often have
pre-petition deepening insolvency charges leveled against them:
professionals
and banks. This article provides some preliminary views on these
questions and
analyzes whether such claims should be recognized in the future.

The LTV Opinion 
 
LTV Steel Company Inc. and affiliates (LTV) filed chapter 11 cases on
Dec. 29,
2000. The complaint describes two sets of what appear to be entirely
separate
wrongs allegedly committed by the board, one of which occurred solely
pre-petition
and the other of which occurred more than nine months
post-petition.10 
 
The court summarized the key allegations of post-petition misconduct
as follows:
“In at least early September of 2001, at the latest, LTV
Corp.’s
directors and officers appear to have been aware that LTV Steel may
soon
be unable to pay its post-petition
debts;”11 nevertheless, the company
“continued to incur additional trade debt, which it either knew
or should
have known, it could not pay in
full.”12 Indeed, it might have
intentionally
stretched payments to trade creditors, having implemented an Immediate
Liquidation
Enhancement Program (ILEP). The ACC alleged that the ILEP caused the
company’s
trade payables to increase from $115 million in August 2001 to
somewhere between
$140-150 million between September and November 2001, despite
scaled-back operations.
The ILEP was first disclosed at a Dec. 5, 2001, hearing—less
than three
months after the program was implemented.

The court also noted, in less detail, certain allegations focusing on
the board’s
failure to monitor the company’s accounting, financial and
reporting systems,
as well as managment behavior, and to take corrective action and
approval of
retention plans and other transactions13
that, while the opinion does not specifically
state, appear to have been approved by the bankruptcy
court.14 
 
Procedural Posture 
 
The opinion granted the ACC’s motion for standing to sue
derivatively.
Under the Sixth Circuit’s applicable case law, such a motion
should be
granted if the committee makes a demand that is unjustifiably refused
and has
made “a prima facie demonstration that a colorable claim
exists
which, if successful, would benefit the
estate.”15 The “colorable
claim” analysis is “akin to that [analysis] made on a
motion to
dismiss.”16 Thus, from a precedential
standpoint, the LTV decision
should be read like an opinion on a motion to dismiss, rather than a
post-trial
opinion.

The Court’s Analysis 
 
The court acknowledged the defendants’ argument that no
independent cause
of action for deepening insolvency exists.17
However, it stated that a “growing
list of jurisdictions [have] recognized this
doctrine.”18 Noting that
the debtors were Delaware and New Jersey corporations, and that
Delaware and
New Jersey were in the Third Circuit, the court held that
Lafferty and
the Delaware Bankruptcy Court’s opinion in Exide
Technologies19
“arguably apply to the proposed
lawsuit.”20 The court did not analyze
whether Delaware or New Jersey laws are different than the
Pennsylvania law
applied in Lafferty or the law applied in Exide.

The court also quoted with approval portions of the Lafferty
opinion’s
rationale for recognizing a tort of deepening insolvency: Incurring
debt can
force a company into bankruptcy, which adds to administrative costs
and undermines
relationships with customers, suppliers and
employees.21 
 
While the court noted, in multiple sections of its opinion, the
defendants’
objection to applying a deepening-insolvency analysis to post-petition
conduct,
its analysis of this argument is brief. The court correctly held that
a committee
may be granted standing to pursue post-petition as well as
pre-petition causes
of action and that post-petition causes of action may, in certain
circumstances,
be deemed core proceedings.22 However,
acknowledging that the ACC may be an
appropriate party to pursue such a claim if it exists seems to have
little to
do with the issue of whether, from a substantive standpoint, such a
cause of
action does, or should, exist.

Considerations: Post-Petition Deepening Insolvency 
 
This article does not attempt to enter into the debate as to whether
pre-petition
deepening insolvency should be recognized as an independent tort, a
damages
theory or neither. Rather, this section explores some of the problems
with the
LTV court’s analysis, even assuming arguendo that
pre-petition
deepening insolvency constitutes an independent tort. 
 
The most obvious concern is that certain of the conduct complained
of—for
example, employee retention and other transactions—appears to
have been
approved by the bankruptcy court in prior proceedings. If a
transaction has
been approved by a bankruptcy court, it is difficult to conceive of
any basis
for imposing liability for that transaction’s later failure,
short of
an allegation that the debtor intentionally submitted fraudulent
information
to the court in an effort to obtain court approval. Indeed, even an
allegation
that the information disclosed to the court was wrong or incomplete,
standing
alone (i.e., without an allegation of fraud or intent to
deceive) ought
to be insufficient. After all, any party in interest can take
discovery in opposing
a motion to approve a transaction23 and can
cross-examine any witness who testifies
in support of the motion. Of course, such discovery and
cross-examination may,
in part, focus on the accuracy of the debtor’s representations
to the
court in support of approval.

Permitting a post-hoc challenge to court-approved transactions through
a deepening-insolvency
claim is problematic for several reasons. First, it would
significantly undermine
the confidence that parties would have in the finality of bankruptcy
court orders,
which could impede the reorganization process. Second, such challenges
might
well run afoul of the doctrines of res judicata and collateral
estoppel.
Bankruptcy courts only may approve the use or sale of property out of
the ordinary
course of the debtor’s business if such use or sale has a
“sound
business purpose,”24 and typically the
order approving the transaction
will state that the transaction is in the best interests of the
debtor’s
estate. Once a court has made such findings, the room for it to hold,
in retrospect,
that the transaction actually was harmful to the estate and deepened
the debtor’s
insolvency appears to be minimal at best. Third, because all creditors
have
the ability to object to a motion to approve a transaction, the time
to voice
any concerns ought to be before the court approves the transaction,
not afterwards
when parties have relied on the sale order and when hindsight is
20/20.25 
 
The concerns with recognizing post-petition deepening insolvency
claims are
not limited to claims that center on transactions approved by the
bankruptcy
court. A debtor’s financial affairs are not a secret. At the
very beginning
of a bankruptcy case, a debtor must complete detailed schedules as
well as statements
of financial affairs, both of which are made publicly
available.26 Thereafter,
it completes and publicly files monthly operating reports for the
duration of
the stay in chapter 11, which provide further monthly financial
information.
In this era of electronic dockets, ease of access to such disclosures
is significant.
Moreover, chapter 11 provides multiple opportunities to probe such
disclosures.
An official committee of unsecured creditors, which operates as a
fiduciary
for all unsecured creditors, is charged with, inter alia,
“investigat[ing]
the acts, conduct, assets, liabilities and financial condition of the
debtor,
the operation of the debtor’s business and the desirability of
the continuance
of such business...”27 These
investigations are typically aided by sophisticated
counsel and financial advisors hired by the committee and paid by the
bankruptcy
estate. Moreover, any individual creditor may question the debtor at
the meeting
of creditors28 or may take discovery of the
debtor concerning “the acts,
conduct or property or...the liabilities and financial condition of
the debtor...”29
With these tools at hand, it is difficult to conceive why
post-petition deepening
insolvency claims should be permitted to survive unless they allege
that the
debtor fraudulently misrepresented its financial condition in court
filings.

Additionally, recognizing a tort for post-petition deepening
insolvency would
represent a fundamental shift in who bears the risk of a failed
reorganization—from
creditors to directors and officers, or perhaps their lawyers and
debtor-in-possession
lenders. That risk is real. History proves beyond cavil that not all
reorganizations
are successful. One might reasonably ask whether directors will have
any tolerance
for the risk of being sued for a failed reorganization when it would
be easier
for them to resign at the moment of bankruptcy (or sooner), or to
advocate more
risk-adverse strategies like immediate liquidation. If we want skilled
directors
to attempt to reorganize companies, recognizing this new cause of
action will
not help. 
 
It should also be noted that no matter what one thinks of the
reasoning of Lafferty
in the pre-petition context, Lafferty offers no support for
recognizing
a tort of post-petition deepening insolvency. For example,
Lafferty’s
observation that deepening insolvency could cause a company to file
for bankruptcy,
thereby causing it to incur increased administrative costs, makes
little sense
if the alleged wrong did not occur until after the company filed for
bankruptcy.
Nor does the argument that suppliers and customers will not react well
to a
bankruptcy filing work if you posit that the company was already in
chapter
11 when the insolvency deepened. The most one could say, in either
case, is
that perhaps the case should have been converted to chapter 7 faster.
But any
creditor can move to convert a case to chapter 7 at any
time.30 With the monitoring
tools described above and in the absence of fraud,
conversion—not a tort—is
the appropriate remedy.

Case-Specific Problems with the Post-Petition Deepening-Insolvency
Theory 
 
Even if a cause of action for deepening insolvency might exist under
certain
circumstances, the facts of LTV appear to be particularly
ill-suited
for such a theory. The court’s opinion focuses on the fact that
due to
the ILEP, trade payables increased by $25-$35 million, or 18-23
percent, over
a very short time. But this increase in “debt” was not a
new layer
of financing thrust upon existing creditors, but rather the
debtor’s continued
purchase of goods, services and supplies in the ordinary course of its
business
while stretching the pay cycle. Absent an argument that the debtor did
not receive
reasonably equivalent value in exchange for the goods, services and
supplies,
it is hard to understand how the debtor (as opposed to individual
trade creditors)
was harmed by paying later rather than sooner. 
Indeed, it is questionable whether this type of claim is even a
derivative claim
at all. Presumably, most if not all administrative trade vendors
provided their
goods or services to LTV pursuant to a contract or purchase order that
specified
the credit terms of the transaction. Thus, each trade creditor could
pursue,
if appropriate, its own direct cause of action for breach of contract,
or some
well-defined body of case law such as fraud or misrepresentation if
the creditor
argues that it was tricked into contracting in the first place. Of
course, the
result of each such case might well be different, depending on what
the individual
contracts provided and what was stated to each trade creditor. This
tends to
show that treating the LTV ACC’s claims as derivative
claims might
not have been appropriate.

Moreover, it does not seem that the debtor is harmed by stretching
payments
for goods and services it actually received. Arguing that the debtor
should
not have incurred the debt amounts to an argument either that the
debtor should
have switched to C.O.D. purchases so that no debt ever
exists—which obviously
makes little business sense—or that it should not have made the
purchases
in the first place. But unless the debtor has received less than
reasonably
equivalent value in the exchange and cannot sell the goods for a
profit, how
has the debtor been harmed by such an exchange? Moreover, not making
such purchases
means being unable to operate a business as a going concern, which
amounts to
an argument that the moment that a chapter 11 debtor has to start
stretching
its payments to its vendors, it must scale back purchases or cease
operating.
If that theory is adopted, it would be akin to setting a new standard
requiring
conversion to chapter 7 under those circumstances. The statutory
standard for
conversion is quite different: If a debtor or anyone else objects, the
court
may only grant a creditor’s motion to convert a case from
chapter 11 to
chapter 7 if the creditor demonstrates “cause” and if
there is no
reasonable probability of timely confirming a reorganization plan or
liquidation.31 
 
Additionally, a committee of administrative expense claim creditors is
an anomalous
class to pursue deepening insolvency claims that center on stretching
administrative
claim trade vendors. Typically, deepening-insolvency claims are
pursued on account
of holders of “older” debt claims who argue that newer
debt should
have never been incurred. In contrast, one would posit that a
significant percentage
of the LTV ACC’s constituency were the very trade vendors
who were
stretched, because older post-petition claims, before the adoption of
the ILEP
strategy, were not stretched and presumably paid reasonably promptly.
Thus,
allowing the ACC to sue is akin to a company that has existing bond
debt but
no bank debt being sued for deepening insolvency when it took out a
bank loan—not
by the bondholders, but by the banks. 
 
Finally, two other anomalies of applying this new theory under the
facts of
LTV should be noted. First, it appears from the court’s
opinion
that the debtor disclosed the existence of the ILEP within three
months of its
implementation. Thus, the period of nondisclosure, even if disclosure
were necessary,
was not overly long. Moreover, presumably the debtor was filing
monthly operating
reports for all of these periods, so the fact that administrative
liability
was increasing should have been available even sooner. This raises the
question
of just how fast a debtor must disclose plans of this sort. Second,
LTV had
an active chief restructuring officer (CRO). Thus, this was not a case
of an
insider board trying to retrench itself without oversight. Given the
prominence
of an independent CRO in setting strategy for the DIP, it would appear
that
permitting a deepening-insolvency claim would significantly impede on
the protections
of Delaware’s business-judgment rule, which protects business
decisions
made in good faith and on an informed
basis.32

The Future of the Theory 
 
It is not clear whether other courts will follow LTV and permit
claims
of post-petition deepening insolvency to go forward. If they do, it is
likely
that a significant percentage of failed chapter 11 cases will see
litigation
of this sort. This in turn could make directors much more risk-adverse
and could
cause them to liquidate companies sooner and discourage directors from
attempting
more difficult reorganizations under chapter 11. Moreover, it is
likely that
debtor’s counsel and DIP lenders would become codefendants in
future suits,
just as lawyers and banks are frequent defendants in pre-petition
deepening
insolvency cases. None of these are welcome consequences.
<blockquote>
<blockquote>  </blockquote>
</blockquote>

<hr>

<h3>Footnotes</h3>
1 The analysis and conclusions set forth in this article are those of
the author
and not necessarily of Richards, Layton & Finger, PA or its clients.
 
2 See, e.g., Official Committee of Unsecured Creditors of R.F.
Lafferty &
Co. Inc., 267 F.3d 340, 350 (3d Cir. 2001) (applying
Pennsylvania law).
 
3 See, e.g., In re Global Service Corp. LLC, 316 B.R. 451
(Bankr.
S.D.N.Y. 2004).

4 See, e.g.,Willet, Sabin “The Shallows of Deepening
Insolvency,”
60 The Business Lawyer, No. 2 (Feb. 2005). 
5 11 U.S.C. §363. 
6 Fed. R. Bankr. P. 107. 
7 11 U.S.C. §1109(a).

8 In re LTV Steel Co. Inc., ___ B.R. ___, 2005 WL 2573515
(Bankr.
N.D. Ohio Sept. 2, 2005). 
9 Id. at * 26 (noting that one director argued they
“no court
has ever recognized a claim for deepening insolvency based upon actions
occurring
after the commencement of a bankruptcy”). 
10 Because this article focuses on post-petition deepening insolvency,
the alleged
pre-petition wrongs and the court’s analysis of such claims is
omitted
here. 
11 Id. at *2 (emphasis supplied). 
12 Id.

13 Id. at *17. 
14 Id. at *26 (noting that one defendant objected that the
ACC’s
“complaint is based upon post-petition conduct that was approved
by the
bankruptcy court and/or could have been attacked by any creditor in
these transparent
bankruptcy proceedings”). 
15 Id. at *4 (citing, inter alia, In re Gibson
Group, 66 F.
3d 1436, 1446 (6th Cir. 1995)).

16 Id. (collecting cases). 
17 Id. at *20. 
18 Id. (citing Lafferty, 267 F.3d at 488-89).

19 Official Committee of Unsecured Creditors v. Credit Suisse First
Boston
(In re Exide Technologies Inc.), 299 B.R. 732 (Bankr. D. Del
2003).
 
20 LTV, 2005 WL 2573515 at *21. 
21 Id. at 20 (quoting Lafferty, 267 F.3d at ___).

22 Id. at 27. 
23 See Fed. R. Bankr. P. 9014. 
24 See, e.g., Myers v. Martin (In re Martin), 91 F.3d 389,
395 (3d
Cir. 1996) (citing Fulton State Bank v. Schipper (In re
Schipper),
933 F.2d 513, 515 (7th Cir. 1991)); Stephens Indus. Inc. v.
McClung, 789
F.2d 386, 390 (6th Cir. 1986); Comm. of Equity Sec. Holders v. Lionel
Corp.

(In re Lionel Corp.), 722 F.2d 1063, 1070 (2d Cir. 1983); In
re Del.
& Hudson Ry. Co., 124 B.R. 169, 176 (D. Del. 1991). 
25 These problems, of course, are in addition to any conceptual
problems with
recognizing an independent tort for deepening insolvency at any time,
whether
pre-petition or post-petition. 
26 Fed. R. Bankr. P. 1007. 
27 11 U.S.C. §1103(c)(3).

28 11 U.S.C. §341. 
29 Fed. R. Bankr. P. 2004(b). 
30 11 U.S.C. §1112(b). 
31 11 U.S.C. §112(b)(1)-(2). 
32 See Aronson v. Lewis, 473 A.2d 805, 812 (Del. 1984).

Journal Authors

Russell C. Silberglied

Journal Date

Wednesday, February 1, 2006 - 12:00

Bankruptcy Rule

2006

none