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Update on Deepening Insolvency
Lending & Restructuring Alert
August 2006
Authors: Paul A. Rubin

What is Deepening Insolvency? In a prior issue, we commented on the warm reception some courts had afforded a new cause of action known as "deepening insolvency," even though it is difficult to grasp precisely what that theory entails. Since then, a growing number of creditors' committees and bankruptcy trustees jumped on the bandwagon and attempted to assert deepening insolvency claims against a wide variety of "deep pocket" defendants, including lenders, underwriters, accountants, and directors and officers of troubled companies.

Five years ago, a panel of judges from the Third Circuit Court of Appeals issued the first decision explicitly recognizing deepening insolvency--which it described as an injury to a debtor's corporate property from the fraudulent expansion of corporate debt and prolongation of corporate life--as a separate cause of action (under Pennsylvania law).

What's New? A clear trend is emerging in favor of limiting, and even rejecting, claims based on deepening insolvency. This is refreshing news for lenders and other participants in workouts, who should not be deterred from embarking on restructuring efforts because of the risk that they could be hit with novel claims, the elements and basis of which have not been uniformly defined.

Three recent cases illustrate this trend:

The Third Circuit Retrenches

A few months ago, five years after the Third Circuit Court of Appeals recognized deepening insolvency as a separate cause of action (see above), a different panel of judges from this court published a new decision that takes a skeptical view of the concept. This second group of judges lacked the power to overrule the decision of the first, but they did go out of their way to limit the impact of the prior decision.

Specifically, the second panel held that nothing stated in the first decision compels any extension of the deepening insolvency doctrine beyond what was stated in that case. Accordingly, it ruled that deepening insolvency may not be used as a theory to prove that a plaintiff suffered damages in order to support another cause of action, such as fraud. The court also held that fraudulent conduct, not mere negligence, must be alleged and proved to sustain a deepening insolvency claim. Further, the court clarified that a claim of deepening insolvency must involve injury to the corporation and not simply injury to its creditors.

The New York Bankruptcy Court Finds the Claim to Be Duplicative

Two months ago, a bankruptcy judge sitting in Manhattan granted a motion to dismiss a claim of deepening insolvency asserted by a creditors committee against former directors of a debtor. The court was asked to predict whether Delaware law would recognize a claim against directors of a financially troubled company for deepening insolvency for prolonging its life even though the directors did not violate their duties of care or loyalty to the company. The court rejected the claim, stating that there is no reason why directors of an insolvent company may not conserve cash and increase a company's debt level. To hold otherwise, it observed, would prevent the directors from attempting to work out the corporation's problems.

Consistent with rulings of other courts, this New York bankruptcy judge also held that a claim for deepening insolvency should be dismissed where it is duplicative of other claims already pled in the complaint, such as claims of fraud and breach of fiduciary duty.

The Delaware Chancery Court Finally Weighs In

Contrary to predictions by several judges outside of Delaware, and even some Delaware bankruptcy judges, that Delaware law would recognize a cause of action for deepening insolvency, a Delaware state court judge ruled that, under Delaware law, deepening insolvency "is no more of a cause of action when a firm is insolvent than a cause of action for 'shallowing profitability' would be when a firm is solvent."

Moreover, an insolvent corporation's directors are protected by the business judgment rule. They do not have an obligation to liquidate the company if it is unable to pay its bills, and may, with diligence and good faith, pursue a business strategy that they believe will increase the company's value, even if that would involve the incurrence of additional debt.

Conclusion: The Delaware judge's remarks regarding his decision can sum up the trend as a whole: "a growing body of federal jurisprudence . . . has recognized that those federal courts that became infatuated with the [deepening insolvency] concept did not look closely enough at the object of their ardor."

For further information regarding these or other lending issues, you may contact Paul Rubin (212-592-1448 or prubin@herrick.com).

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Herrick's Bankruptcy, Business Reorganization and Creditors' Rights Practice Group represents a broad range of clients having varied interests in the bankruptcy, workout and reorganization arenas. From Fortune 500 corporations to small public and private companies, our clients include all of the major players in the bankruptcy process: debtors, creditors' committees, secured and unsecured creditors, trustees, financial institutions, investment banks, asset-based lenders, insurance companies, pension funds, purchasers of assets, landlords, claims traders, equipment lessors and licensors.  

Copyright © 2006 Herrick, Feinstein LLP. The Lending and Restructuring Alert is published by Herrick, Feinstein LLP for information purposes only. Nothing contained herein is intended to serve as legal advice or counsel or as an opinion of the firm.