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Deepening Insolvency: A New Headache for Lenders
Lending & Restructuring Alert
December 2003
Authors: Paul A. Rubin

A recent decision by a Delaware bankruptcy court suggests that courts may recognize a claim by a borrower's creditors against its lenders for "deepening insolvency." Lenders should take heed of this development, since it appears that this still-evolving claim may now be asserted against a lender that acquires significant control over a borrower and then forces the borrower to "fraudulently continue in business" at increasing levels of insolvency, thereby causing creditors to lose value that could have been realized had the borrower dissolved in a timely manner.

The Facts as Alleged by the Creditors

In 1997, two lenders led a syndicate of more than 80 banks that established a $650 million credit facility for the lead borrower and many of its subsidiaries. In 2000, the lending group made an additional loan of $250 million to finance the borrowers' acquisition of a competitor. In exchange, the lending group obtained significant additional collateral and guarantees from the borrowers. The lenders allegedly initiated the acquisition, and provided investment banking services and the financing for the transaction, when the borrowers were already insolvent and market conditions were continuing to decline. The borrowers' financial condition deteriorated rapidly after the acquisition, to the point of affording the lenders de facto control.

In October 2001, at the direction of the lending syndicate, the lead borrower replaced its CFO with a principal from a restructuring advisory firm. Over the next few months, the parties negotiated and executed amendments to their loan agreement. Under these amendments, the lending group obtained liens on the assets and capital stock of all foreign subsidiaries of the lead borrower, and additional collateral and guarantees from the lead borrower and some of its subsidiaries. While these amendments were being negotiated, the borrowing group suffered massive losses, and became more insolvent. The lenders caused the borrowers' bankruptcy filings to be delayed in an effort to prevent the new liens they obtained from being voidable as preferences in bankruptcy.

The Creditors Committee formed in the borrowing groups' bankruptcy asserted a variety of claims against the lenders, including fraudulent conveyance (actual fraud), equitable subordination, and deepening insolvency. The Committee alleged that: (i) the lenders caused the debtors to make the acquisition so they could obtain control and to force the debtors fraudulently to continue their business for nearly two years at ever-increasing levels of insolvency; and (ii) the lenders' conduct caused the debtors to suffer massive losses and become more deeply insolvent, costing creditors substantial value.

The Delaware Court Tread Into New Legal Waters

The lenders moved to dismiss the complaint, arguing that no claim for "deepening insolvency" is recognized under Delaware law. In considering the motion, the Delaware court accepted as true the factual allegations in the Committee's complaint. The court noted that there is no Delaware Supreme Court decision addressing whether such a claim should be recognized under Delaware law. But the court observed that the Third Circuit Court of Appeals--which has jurisdiction over cases emanating from Delaware bankruptcy and district courts--had opined that a claim for deepening insolvency should be recognized under Pennsylvania law, even though no Pennsylvania court had ruled on the question.

The Third Circuit found that the theory for liability under a deepening insolvency theory is sound, is enjoying growing acceptance among courts, and furthers the theme that the law should provide a remedy for injury. Accordingly, the Delaware bankruptcy judge concluded that the Delaware Supreme Court would also recognize a claim for deepening insolvency where there has been damage to corporate property.

Analysis

In the past, some courts have recognized claims against officers, directors and corporate parents for allowing the corporation to continue its business beyond the point of insolvency while at the same time draining the corporation of assets or divesting it of profitable business as part of a  scheme to defraud. In its opinion discussed above, the Third Circuit ruled that an independent underwriter might be liable for assisting the borrowers in issuing fraudulent debt that kept the companies afloat, thereby deepening their insolvency.

Significantly, this decision from the Delaware Court extends application of the deepening insolvency theory to lenders. While the Court did not specify the precise elements of the claim, the following factors appear to be essential: (i) the lender obtains the ability to dictate the borrower's corporate policy and disposition of assets; (ii) the lender exercises that power to force the borrower to fraudulently continue its business at increasing levels of insolvency; and (iii) the lender's conduct causes the borrower to suffer losses and become more deeply insolvent, causing other creditors to lose substantial value that could have been realized if the borrower's business activity not been prolonged.

Nevertheless, important questions remain unanswered. May a lender be held liable for deepening insolvency where there are allegations of only constructive fraud and/or inequitable conduct, but not actual fraud? A lender should not be punished for assisting a distressed borrower's turnaround effort in good faith. One would hope that, if instead of shutting down an insolvent borrower, a lender permits and carefully supervises a transaction that prolongs the borrower's life, improves the lender's secured position, but fails to reverse the borrower's losses, the lender would not be found liable for deepening insolvency, even though creditors may have recovered more if the unsuccessful transaction had not been attempted. Whether liability for deepening insolvency may be imposed under such circumstances remains to be seen.

Herrick, Feinstein's Bankruptcy and Corporate Restructuring group will continue to monitor this critical development to keep our clients/friends abreast of any changes in law or policy that affect lenders.

For more information on this or issues of concern to lenders, please contact Paul Rubin at prubin@herrick.com or (212) 592-1448.

Copyright ©2003 Herrick, Feinstein LLP. Lender's 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.