The End of Deepening Insolvency?
By: Douglas E. Deutsch
Chadbourne & Parke LLP; New York
Over the last 10 years or so, courts have frequently recognized a deepening insolvency cause of action brought against pre-bankruptcy petition officers and directors, lawyers, accountants, bankers and other professionals. Based on the premise that a corporation "is not a biological entity for which it can be presumed that any act which extends its existence is beneficial to it," see In re Global Service Group LLC, 316 B.R. 451, 457 (Bankr. S.D.N.Y. 2004) (citing Bloor v. Dansker (In re Investors Funding Corp. of New York Sec. Litig.), 523 F.Supp. 533 (S.D.N.Y. 1980)), the essence of the action is that the debtor corporation's life has been improperly prolonged beyond insolvency, resulting in damages caused by increased debt.
As the phrase "deepening insolvency" is not contained in the Bankruptcy Code and does not arise from other federal law, a federal court that seeks to consider whether this relatively new theory (it appears to trace back about 20 years) is an actionable tort does so by predicting how its respective state court would likely rule. Federal courts, including the Third Circuit in the leading deepening insolvency case of Official Committee of Unsecured Creditors v. R.F. Lafferty & Co.,267 F.3d 340 (3d Cir. 2001), have frequently referenced the adage "where there is an injury, the law provides a remedy" when making this determination. See id. at 357. The result, unsurprisingly, is almost always recognition of the new cause of action. The expansion of the deepening insolvency's application, however, may have finally reached its outer boundary.
In Seitz v. Detweiler, Hershey and Associates (In re CitX Corp.), -- F.3d --, 2006 WL 1453117 (3d Cir. 2006), an opinion released last month, the influential Third Circuit was faced with a corporation formed by an individual who, from formation, pillaged investor money for his benefit. The corporation, an Internet company of sorts, quickly linked up with another internet entity. The result, with the help of a phenomenon called the Internet Bubble, was that the corporation was able to sell additional equity in itself. Within a year, however, the Florida attorney general shut down the corporation's fraudulent business partner. At the time, the corporation was owed $2.4 million by its business partner. Despite the business partner's shutdown, the corporation continued to show its business partner's obligation as an asset on its balance sheet, theoretically keeping the corporation in the black. As a result, the corporation showed a positive balance sheet and was able to sell additional securities for over $1 million. It burned through that remaining equity money in the next year and a half. The corporation then filed for bankruptcy.
The chapter 7 trustee sued the corporation's accountant on the grounds that the accountant missed many "red flags" when he prepared the corporation's financial statements. Although the trustee brought a number of causes of action, all were dismissed by the district court. However, two of the dismissals (the malpractice action and the deepening-insolvency action) were subsequently appealed to the Third Circuit.
On appeal, the Third Circuit first addressed the malpractice action. See id. at *3 - *6. As an element of a malpractice claim is actual damages, the trustee had asserted that the accountant had harmed the corporation by, among other things, deepening the insolvency of that entity and expanding its debt "by virtue of its compilation statements prepared and relied on by third parties." In short order, the Third Circuit found that its earlier decision in Lafferty was in the context of a deepening insolvency cause of action and ruled that the decision should not be interpreted to create a novel theory of damages as an element in a malpractice cause of action. Accordingly, the dismissal of that cause of action was affirmed. See In re CitX Corp. at *6.
The Third Circuit then turned to the deepening insolvency cause of action. See id. at *6 - *7. The Third Circuit noted that the Lafferty decision had merely determined -- in the absence of Pennsylvania higher court decisions, by predicting how Pennsylvania's highest court would rule -- that a Pennsylvania court would recognize a deepening insolvency where there is fraudulent conduct. According to the Third Circuit, the facts in Lafferty were different than those facts faced in CitX Corp. Here, the court recognized that the trustee had alleged that the accountant had acted negligently, not fraudulently. As such, the Third Circuit knew of "no reason to extend the scope of deepening insolvency beyond Lafferty's limited holding" and upheld the dismissal of that cause of action. See In re CitX Corp. at *6.
As the remedial reasoning set forth in Lafferty should seemingly support the extension of deepening insolvency to the facts of CitX Corp., the Third Circuit's opinion is not fully consistent with precedent. The Third Circuit provides some insights for its conclusion in footnote 11 of the CitX opinion. There, the opinion acknowledges that the "deepening insolvency" tort recognized in Lafferty has been subject to criticism by commentators and courts. However, the panel of three judges writing the CitX Corp. opinion explained that their hands were somewhat tied. Stated the court, "we cannot revisit the correctness of that interpretation of Pennsylvania law" even if a party had challenged Lafferty. See In re CitX at n.11. The court noted that this was because overruling the prior Lafferty decision required an en banc ruling. Id. Finally, the court opined that the Lafferty decisions should not be read to require a lower court to extend that doctrine beyond Pennsylvania. Id. While not a fully satisfactory outcome, this appears to be the best result the CitX Corp. panel was capable of providing.
The panel that wrote the CitX Corp. opinion clearly sought to restrict the application of what they seem to have perceived as bad governing law, but recognized that their options were limited. The panel was somewhat critical of Lafferty, albeit in a veiled manner, and sought to limit the effect of that holding to very specific and limited situations. The Third Circuit panel seemed concerned about cases like OHC Liquidation Trust v. Credit Suisse First Boston (In re Oakwood Homes Corp.), 340 B.R. 510 (Bankr. D.Del. 2006), a case cited in footnote 11, which recognized "the mounting pile of authority rejecting a [deepening insolvency] cause of action," yet felt bound by Lafferty to recognize the deepening insolvency tort in Delaware, New York and North Carolina. See In re Oakwood Homes at 531-32. The three judges may also have been influenced by a number of recent decisions, including the Northern District of Texas Bankruptcy Court decision in Official Committee of Unsecured Creditors v. Rural Telephone Finance Coop. (In re VarTec Telecom, Inc.), 335 B.R. 631 (Bankr. N.D. Tex. 2005). That opinion painstakingly reviewed and criticized the legal doctrine of deepening insolvency and determined that the applicable state court (Texas) would not adopt deepening insolvency as an independent tort because it would duplicate an existing tort. See In re VarTec at 644.
So what does CitX Corp. teach us? Plaintiffs should be aware that invoking the doctrine of deepening insolvency, as has so often been done in the past, may lead to a debate as to the underlying viability of that cause of action. Meanwhile, lenders and professionals who might be defendants in such an action should take some comfort from the decision, as it appears that courts will now carefully scrutinize a deepening insolvency cause of action.