Murphy & King – atLaw Article – Good Money After Bad? Deepening Insolvency

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Good Money After Bad? Deepening Insolvency—An Update

Natalie B. Sawyer

617-226-3466

Associate

Areas of Concentration

Bankruptcy and Financial Restructuring

Office

Boston

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The legal concept of “deepening insolvency” has long been a volatile one.

As defined by the Third Circuit Court of Appeals, deepening insolvency is “an injury to the Debtors’ corporate property from the fraudulent expansion of corporate debt and prolongation of corporate life.” Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340 (3rd Cir. 2001). For example, a faltering company (and its lender) may be faced with a choice of shutting the company’s doors or borrowing more in an effort to turn the company around. When that turnaround effort fails, and less is ultimately available for unsecured creditors, blame may be cast on the basis that “value [could have been] salvaged, if the corporation [was] dissolved in a timely manner, rather than kept afloat with spurious debt.” Id.

The scope of defendants who have found themselves defending against a deepening insolvency claim is wide, including officers, directors, lenders, parent corporations, professionals, and customers. For creditors seeking alternate sources of recovery, a claim based on deepening insolvency seems a just result. For those involved in the company’s transactions, however, the concept of deepening insolvency seems like a no-win position— giving creditors the opportunity to be “Monday morning quarterbacks” and fix blame for innocent efforts to rejuvenate.

In the years since Lafferty, however, the popularity of the deepening insolvency theory has waned, and a review of the most recent cases indicates that no resurgence is on the horizon. Critics have questioned not only the scope of circumstances to which deepening insolvency should be applied, but the basic rationale of the theory. See, e.g., In re SI Restructuring, Inc., 532 F.3d 355 (5th Cir. 2008). For example, why, such critics ask, should lenders be held accountable for making a loan, when the real problem is the unwise spending of the loan’s proceeds? See, e.g., In re Propex Inc., 2009 WL 562595 (Bankr. E.D. Tenn.). The Delaware Supreme Court, reprimanding a prior bankruptcy court which dared to predict that Delaware would recognize deepening insolvency, surmised that deepening insolvency’s prior success was only “because the term has the kind of stenorious academic ring that tends to dull the mind to the concept’s ultimate emptiness.” Trenwick America Litigation Trust v. Billet, 931 A.2d 438 (Del. 2007).

Some critics have rejected the notion of deepening insolvency not because they quibble with the rationale, but because they find deepening insolvency redundant to existing causes of action. See, e.g., In re VarTec Telecom, Inc., 335 B.R. 631 (Bankr. N.D. Tex. 2005). This distinction is instructive. It is a reminder that, even in jurisdictions that reject the notion of deepening insolvency, the underlying basis for the claim may simply be repackaged and prosecuted under more traditional legal theories. For example, a lender who lends to an insolvent borrower may still face claims of equitable subordination, fraudulent transfer and fraud.

Yet other critics are willing to accept the notion of deepening insolvency, but only as a theory of damages, not as an independent cause of action. Such critics say that, while deepening insolvency may be raised as a means of demonstrating the harm suffered by a company, a separate tort is required to establish liability. See, e.g., In re Felt Mfg. Co., Inc., 371 B.R. 589 (Bankr. D. N.H. 2007); In re Adelphia Communication Corp., 2006 WL 687153 (Bankr. S.D. N.Y.).

While the trend continues toward rejection of the deepening insolvency concept—potential defendants should remain aware that deepening insolvency has yet to be expressly denounced in all jurisdictions, and that, even if it were, potential liability remains in the form of other, established causes of action.

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