Corporate failures (at the risk of stating the obvious) usually result in the realization by creditors of the failed enterprise in less – often far less – than the par value of their claims. Unsurprisingly, this often leads to aggressive efforts to ascribe responsibility for the failure of the enterprise and to seek recovery from those deemed blameworthy (and deep-pocketed). Over the years, novel theories of liability have developed and been invoked against parties that were non-insiders of the corporate enterprise, such as lenders and professional advisors. When such theories are able to gain judicial acceptance, the threat of tort damages – particularly against third-party lenders – becomes an effective cudgel in an effort to upset contractual and statutory priorities, and transfer value to stakeholders whose place in the capital structure would otherwise leave them with little or no claim on corporate assets.
In the late 1980s and early 1990s, third-party lenders began facing attacks that went beyond attempts to avoid, or attacks on the validity, priority, enforceability or sufficiency of their claims. Instead, lenders were often confronted with causes of action brought under various theories of malfeasance (e.g., breach of an implied duty of good faith and fair dealing), which were generally referred to as “lender liability.” Borrowers (or trustees in bankruptcy) succeeded in a few cases in recovering significant tort damages resulting from a lender’s exercise of remedies. Although never defined as an independent cause of action, lender-liability litigation remained in vogue for several years. Eventually, however, such litigation came to be viewed as contrary to established commercial law and practice, and lender-liability claims were generally repudiated by courts.
More recently, bank lenders have been targeted by another vague theory of liability commonly known as “deepening insolvency.” Invoked against corporate insiders, and professional advisors as well in some cases, deepening insolvency at its core is a claim based on the idea that the prolongation of a troubled enterprise can in and of itself give rise to an actionable harm. As with lender liability, there is a distinct lack of judicial consensus on its fundamental nature – whether it is a theory of damages for a separate tort, or an independent cause of action (and if so, what the elements of the cause of action are). Nevertheless, this concept has managed to gain substantial traction in recent years. 1
Deepening insolvency is particularly pernicious because of the pall it casts over not only third-party lenders, but also corporate insiders and advisors, at a time when an enterprise is in distress and the decisions on the best means to save it (or at least to maximize asset values for all stakeholders) must often be made quickly and decisively. Taken to its logical conclusion, it suggests that a lender cannot extend new financing to (and that corporate insiders and advisors must take steps to liquidate, rather than rehabilitate or restructure) a troubled enterprise.
Courts, however, now appear to be recognizing the flaws and defects of deepening insolvency. Two recent decisions – In re CitX Corp. Inc., 448 F.3d 672 (3d Cir. 2006), and Trenwick America Litigation Trust v. Ernst & Young, et al., Delaware Chancery Court, C.A. No. 1571-N (Slip op. Aug. 10, 2006) – have severely weakened the stated rationales for deepening-insolvency claims. Together with another fairly recent opinion, In re Sharp International Corp., 403 F.3d 43 (2d Cir. 2005), which addresses the duties of a bank lender to other creditors of a failed enterprise, they go far in undermining efforts to utilize the threat of deepening-insolvency litigation as a weapon against lenders. Just as claims of lender liability eventually fell out of judicial favor, these decisions represent a significant step toward repudiation of the idea of imposing liability based solely on an increase in the indebtedness of an insolvent or near-insolvent corporate enterprise.
Background
Generally speaking, the concepts of deepening insolvency and lender liability both gained substantial notoriety from prominent circuit court decisions that applied existing case law doctrines in a novel fashion, suddenly and unexpectedly challenging established notions of whom could be deemed to be liable (and why) to a failed enterprise. A Sixth Circuit decision, KMC v. Irving Trust, 757 F.2d 752 (6th Cir. 1985), is viewed as one of the leading cases that gave rise to a wave of lender liability litigation against bank lenders. In KMC, the Sixth Circuit upheld a $7.5 million jury verdict against a bank lender for its failure to fund an $800,000 draw request under a $3.5 million line of credit where the jury found that, notwithstanding the express and unambiguous provisions of the loan documents on which the bank relied, the bank was constrained by an implied covenant of good faith and fair dealing.
KMC and its progeny placed an overhang on workouts and chapter 11 cases until the early 1990s, when a clear judicial trend emerged that implied covenants of good faith could not take precedence over express contractual provisions. See, e.g., National Westminster Bank, USA v. Ross, 1991 U.S. Dist Lexis 10586 (S.D.N.Y. 1991), aff’d sub nom., Yaeger v. National Westminster, 962 F.2d 1 (2d Cir. 1992). Other similarly vague theories of liability that arose during this period and that had been asserted against lenders also came to be rejected by courts. 2 Certainly by the middle of the decade, the invocation of lender liability as a threat to wring concessions from bank lenders had receded.
“Growing Acceptance” of Deepening Insolvency
The concept of deepening insolvency first crossed onto the radar of most restructuring professionals and commentators with the handing down of the Third Circuit opinion in Official Committee of Unsecured Creditors v. R.H. Lafferty & Co. Inc., 267 F.3d 340 (3d Cir. 2001). In Lafferty, the Third Circuit considered, among other things, the charge that a non-insider, a third-party underwriter, could be liable to the bankruptcy estates of two failed corporate enterprises for issuing professional opinions that allegedly permitted the debtor’s management to issue fraudulent debt securities that “deepen[ed] their insolvency and forc[ed] them into bankruptcy.” Id. at 344. With no applicable state law precedent on which to rely, the Third Circuit hypothesized that the Pennsylvania Supreme Court would recognize the significant damage to a corporate entity that could result from the “fraudulent and concealed incurrence of debt,” id. at 349, including the costs of a bankruptcy proceeding, the harm to its business and dissipation of corporate assets. According to the court, “these harms 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.” Id. at 350. Although affirming a ruling to dismiss on the grounds of in pari delicto, the court expressly upheld the notion of deepening insolvency as an independent cause of action under applicable (Pennsylvania) state law.
Among other reasons for upholding the claimed cause of action, the Third Circuit noted the “growing acceptance” of “the deepening insolvency theory.” Id. at 350. The court cited earlier cases such as Schacht v. Brown, 711 F.2d 1343 (7th Cir. 1983), and Allard v. Arthur Anderson & Co., 924 F.Supp. 488 (S.D.N.Y. 1996), but failed to note a crucial distinction: Those cases had not viewed deepening insolvency as an independent cause of action. Instead, the concept of deepening insolvency had been recognized as a theory of damages resulting from a separate tort or as a basis for invoking the adverse-interest exception to an in pari delicto defense. Moreover, even as the court determined that under Pennsylvania law, “where there is injury, the law provides a remedy,” it never identified what the elements of an independent cause of action for deepening insolvency actually might be.
Not long after Lafferty, in In re Exide Technologies Inc., 299 B.R. 752 (Bankr. D. Del. 2003), an official committee brought claims on behalf of the bankruptcy estate, this time against the debtors’ pre-petition bank lenders. Among the causes of action pleaded was a claim for deepening insolvency, based on the lenders’ alleged control of the debtors. The committee claimed that the lenders directed the debtors to increase their indebtedness to the lenders by $250 million so as to permit the lenders to obtain additional collateral and guarantees for their existing loans of $650 million. This, it was alleged, “force[d] the debtors fraudulently to continue its business for nearly two years at ever-increasing levels of insolvency.” Exide, 299 B.R. at 750-51.
The lenders argued, among other things, that deepening insolvency was not recognized under Delaware law, and that the lenders had no duty to Exide or its creditors. The court only addressed the first issue. Following Lafferty, the Delaware bankruptcy court held that deepening insolvency would be recognized as an independent cause of action under Delaware law and denied the bank’s motion to dismiss. The court noted Lafferty’s determination that “the growing acceptance of the deepening insolvency theory confirms its soundness.” Id. at 751-52 (citing Lafferty, 267 F.3d at 350). The court concluded that “[t]he tort of deepening insolvency has been pled sufficiently,” id. at 752, but offered no more guidance than Lafferty did as to the specific elements of the cause of action were.
A Theory of Damages, or a Separate Cause of Action?
In the wake of Lafferty and Exide, there was a clear question as to whether deepening insolvency was a theory of damages in support of a separate cause of action, or an independent cause of action (and if so, the elements of such a cause of action).
In In re Global Service Group LLC, 316 B.R. 451 (Bankr. S.D.N.Y. 2004), a chapter 7 trustee commenced an action accusing the debtor’s lending bank of extending loans that it “knew or should have known that the debtor would be unable to repay,” thus prolonging its corporate existence and increasing its debt. Id. at 455. The bankruptcy court in Global Services identified the inconsistency created by Lafferty (and followed in Exide) arising from using cases that viewed deepening insolvency as a theory of damages in order to support recognition as an independent cause of action. See Global Services, 316 B.R. at 457 (“What began as a justification for recognizing the ‘adverse interest’ exception [to an in pari delicto defense] . . . morphed into a theory of recovery”).
The court, while strongly suggesting that it would not support the view of deepening insolvency as an independent cause of action, stated that it was unnecessary to make the distinction, because either way, “one seeking to recover for ‘deepening insolvency’ must show that the defendant prolonged the company’s life in breach of a separate duty, or committed an actionable tort [e.g., fraud] that contributed to the continued operation of a corporation and increased its debt.” Id. at 458 (emphasis added).
The Global Services court’s analysis unquestionably slowed the burgeoning trend of deepening insolvency.3 However, the decision earlier this year in In re Oakwood Homes Corp., 340 B.R. 510 (Bankr. D. Del. 2006), demonstrated that the doctrine retained potential vitality, particularly in the District of Delaware. The Delaware Bankruptcy Court in Oakwood Homes considered a motion to dismiss an action for deepening insolvency brought by a post-confirmation liquidation trust against a bank that, together with its affiliates, acted not only as lender to the debtor, but also as financial advisor and underwriter.
Following up on Global Service’s analysis of deepening insolvency, the court noted that there was no judicial consensus on whether it even existed as a basis for imposing liability, whether it served as a theory of damages or constituted an independent tort and, if the latter, the elements of such a cause of action. The court cogently observed both that the theory of deepening insolvency was “one of rapid evolution,” id. at 536, and that “state courts will have the final word.” Id. at 537. Viewing itself as bound by the holding of Lafferty, however, the court held that “deepening insolvency” would be recognized as a cause of action by the courts of New York, Delaware and North Carolina (the potentially applicable state laws to the complaint brought against the bank).
What Duty Does a Third-Party Lender Owe to Other Creditors?
The Second Circuit decision in Sharp International does not address the issue of deepening insolvency. Nevertheless, it deals with an ancillary issue that is important in shaping the contours of the doctrine and its application against a third-party lender. If, as argued by the lenders in Exide and noted by the court in Global Services, a claim of deepening insolvency against a third-party lender requires that there be a breach of a specific duty owed, Sharp International plainly shows the limits of such duty. Specifically, Sharp International considers the steps that a lender may take to protect its interests and exercise remedies set forth in arm’s length loan documents without subjecting itself to liability to the borrower or its creditors.
In Sharp International, a lender, State Street Bank and Trust, suspected fraud on the part of corporate insiders and took steps in accordance with its loan documents to protect itself. The bank kept silent about its suspicions, and indeed stood by as the borrower arranged new financing to pay off the existing loan. After the insiders’ conduct became known and the borrower filed for bankruptcy, it brought an action against the bank for allegedly “aiding and abetting” the insiders’ misconduct.
The Second Circuit affirmed the order to dismiss. The borrower did not contend that State Street owed a fiduciary duty. The issue, therefore, was whether the bank in some way committed an affirmative act in support of the insiders’ misconduct. The court expressly found that the bank’s inaction did not rise to such a level. “State Street had no affirmative duty under New York law to inform Sharp, Sharp’s existing creditors or Sharp’s prospective creditors of the [insiders’] fraud.” Id. at 52, fn. 2. Although the bank remained silent (even avoiding creditor inquiries), the court noted: “The nub of the complaint is that State Street knew that there would likely be victims of fraud, and arranged not to be among them . . . Sharp fails to identify any duty on State Street’s part to precipitate its own loss in order to protect lenders that were less diligent.” Id. 52-53.
Rapid Evolution and the Final Word?
In CitX, the Third Circuit revisited the issue of deepening insolvency. A chapter 7 trustee sued the debtor’s accountant, alleging, among other things, that the accountant’s malpractice in preparing the debtor’s financial statements, which were used to attract investors into an illegal Ponzi scheme, led to the debtor’s deepening insolvency.
In its opinion, the court appeared mindful of the fallout from Lafferty. It first confronted directly the question of whether deepening insolvency comprised a theory of damages or a distinct cause of action. On the malpractice claim, the trustee asserted that the damages resulting from the accountant’s negligence was the wrongful expansion of the debt of the enterprise. The Third Circuit was quick to strike this down as a theory of damages that could support a separate cause of action, noting that its earlier opinion in Lafferty held that deepening insolvency was a cause of action in and of itself, and that Lafferty could not be read “to create a novel theory of damages for an independent cause of action like malpractice.” CitX, 448 F.3d at 677.
Considering next the separate cause of action for deepening insolvency, the court considered whether, in the absence of fraud, negligence alone could constitute a basis for liability. While declining to overrule Lafferty (noting that a prior precedential decision could only be overruled by an en banc panel), the court made clear its intent to read that case as narrowly as possible, and expressly held that only a claim of fraudulent conduct “will suffice to support a deepening-insolvency claim under Pennsylvania law.” CitX, 448 F.3d at 681.
The decision in Trenwick came down in the Chancery Court of the State of Delaware only a few months later. The Trenwick case was commenced by a liquidation trust following the chapter 11 case of an insurance holding company against the directors of both the debtor and its corporate parent. The opinion in Trenwick contains a thorough analysis of a number of complex issues arising from the intersection of Delaware corporate law and bankruptcy. Among other things, the court considered issues of standing, the nature of the fiduciary duties owed by corporate directors, the relationship between a corporate parent and its wholly-owned subsidiary, and the distinctions between damages to a corporate enterprise and to the residual claimants of the enterprise. The crux of the opinion, however, is the court’s explication of a cause of action based on the prolonging of the corporate enterprise and a resulting increase in its liabilities.
In unusually blunt language, the court rejected the notion of deepening insolvency as a basis for liability. “The concept of deepening insolvency has been discussed at length in federal jurisprudence, perhaps because the term has the kind of stentorious academic ring that tends to dull the mind to the concept’s ultimate emptiness.” Slip op. at 62. The court noted that there existed no duty or obligation on the part of directors of an insolvent enterprise to cease operations and liquidate the corporate assets,4 and that corporate directors, even of an insolvent enterprise, “may, in the appropriate exercise of their business judgment, take action that might, if it does not pan out, result in the firm being painted in a deeper hue of red.” Slip op. at 6.
The court in Trenwick makes the essential point that corporate directors and other insiders are not guarantors. The risk of failure is inherent in any enterprise. The entire purpose of the corporate structure is to provide a means to encourage investors, the directors who represent them and the officers who implement a chosen corporate strategy to take good-faith risks in order to seek to maximize returns. Simply increasing the liabilities of a corporate enterprise, without some distinct accompanying malfeasance, does not support a cause of action. The court notes that there are numerous existing causes of action, such as abrogation of the duties of care and loyalty, fraud, fraudulent conveyance and breach of contract, to protect against improper behavior by the directors of an insolvent corporate enterprise.5
Conclusion
CitX, Trenwick and Sharp should combine to consign the threat of deepening insolvency against a third-party lender to the same repudiated status as lender liability. These decisions go a long way in providing the necessary framework for separating genuine malfeasance and actionable behavior from empty legalisms.
CitX and Trenwick provide that, in the absence of fraud or similar bad actions, tort liability should not arise from efforts to extend the life of a corporate enterprise, even if it results in an increase in the indebtedness of the enterprise. The Trenwick opinion, in particular, systematically dismantles the argument that, in the absence of some distinct malfeasance, the prolongation of a corporation’s existence and a concomitant increase in its aggregate indebtedness can support an assertion of liability against corporate insiders or noninsider third parties of the corporate enterprise. Sharp provides further protection specifically for third-party lenders, holding that such a lender, confronted with a failing borrower, may take appropriate actions consistent with its loan documents to maximize its chances of being repaid.
1 As asserted against a third-party lender, deepening insolvency could perhaps be viewed as the mirror image of lender liability - the latter usually stemmed from a lender’s determination to cease lending and exercise remedies, whereas deepening insolvency derives from a decision to continue funding to a troubled enterprise.
2 Compare Farah Manufacturing Corp. v. State National Bank, 678 S.W.2d 661 (Tex. 1984) (liability upheld against bank for tort of interference with corporate governance), with Ed Wolf v. National City Bank, 1997 Ohio App. Lexis 237 (1997) (refusing to recognize such a cause of action).
3 Granting the bank’s motion to dismiss, the court succinctly summed up the inherent deficiency in the theory that lending to an insolvent entity, in and of itself, could be actionable: “This may be bad banking, but it isn’t a tort.” Id. at 459.
4 The court favorably citing an observation in Global Services that the underlying notion of chapter 11 itself is “the accepted notion that a business is worth more to everyone alive than dead.” Slip op. at 63, fn. 103.
5 “The contours of these causes of action have been carefully shaped by generations of experience, in order to balance the societal interests in protecting investors and creditors against exploitation by directors and in providing directors with sufficient insulation so that they can seek to create wealth through the good-faith pursuit of business strategies that involve a risk failure.” Slip op. at 64.