November 21, 2013 Articles

Deepening Insolvency as a Method for Calculation of Damages

The possibility of recovering damages from deep pockets makes treading through these murky waters worthwhile

by Viraj Deshmukh and Radha Gordon

The phrase "deepening insolvency" is all the rage. However, its meaning is not self-evident, and the concept has been used variously to support an independent cause of action or merely as a way to measure damages. Generally, deepening insolvency refers to the "injury to the Debtor's 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, 347 (3d Cir. 2001). Beyond that fundamental concept, courts grapple with the question of precisely what role the notion of deepening insolvency should play.

One line of cases recognizes deepening insolvency as a separate cause of action under state law. Id. at 344; see also In re Exide Techs., Inc., 299 B.R. 732 (Bankr. D. Del. 2003). Another line rejects that approach and observes deepening insolvency as a theory of damages when the plaintiff successfully pleads state-law claims such as breach of fiduciary duties, aiding and abetting breach, fraud, and malpractice. See, e.g., Official Comm. of Unsecured Creditors of Hydrogen L.L.C. v. Blomen (In re Hydrogen L.L.C.), 431 B.R. 337, 357–58 (Bankr. S.D.N.Y. 2010). Yet a third line of cases has rejected the validity of deepening insolvency, both as a theory of damages and as a cause of action, viewing it as redundant to claims for breach of fiduciary duty, fraud, fraudulent conveyance, and breach of contract. Trenwick Am. Litig. Trust v. Ernst & Young, L.L.P., 906 A.2d 168, 174 (Del. Ch. 2006) ("Put simply, 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."), aff'd, 931 A.2d 438 (Del. 2007); see also Drabkin v. L & L Constr. Assocs. Inc., 168 B.R. 1, 6 (Bankr. D.D.C. 1993). Nevertheless, the distinction between deepening insolvency as an independent claim and deepening insolvency as a theory of damages may be trivial. The only advantage that the circumstance of deepening insolvency provides beyond those already conferred by claims such as fraud or breach of fiduciary duty lies in its use as a theory of damages. David Gordon, "The Expansion of Deepening Insolvency Standing," 22 Emory Bankr. Dev. J. 221, 231 (2005).

Under a deepening insolvency claim, similar to an assertion of breach of fiduciary duty, a plaintiff may sue directors and officers of the debtor. In addition, professionals such as accountants, auditors, financial advisors, and attorneys may be liable for aiding and abetting breach of fiduciary duty or malpractice. The potential to sue such defendants with deep pockets makes the theory of deepening insolvency attractive to a plaintiff. However, the focus in this article is on courts that recognize deepening insolvency as a theory of damages. We begin with a brief background on the measurement of damages under a theory of deepening insolvency. Next, we describe three approaches used by courts in measuring damages: loss in value, increased liabilities, and looting of assets. Finally, we address criticism leveled against these approaches.

Background: Damages for Deepening Insolvency
Plaintiffs often plead breach of fiduciary duty and other state-law claims alongside deepening insolvency where directors have acted to the detriment of the debtor corporation. A plaintiff seeking to recover under a deepening insolvency theory must demonstrate that by prolonging the corporation's life and increasing its debts, the defendant's actions resulted in a cognizable injury. In re Unsecured Creditors of Hydrogen L.L.C., 431 B.R. 337, 358 (Bankr. S.D.N.Y. 2010) ("A plaintiff seeking to recover under a deepening insolvency theory therefore must demonstrate that in prolonging the relevant corporation's life and increasing its debts, the defendants' actions gave rise to a separate cause of action."); see also In re Global Serv. Grp. LLC, 316 B.R. 451, 455–56 (Bankr. S.D.N.Y. 2004) (defendant directors operated while insolvent, incurred debt that it could not repay, and reduced potential recovery for creditors); R.F. Lafferty & Co., 267 F.3d at 352.

Insolvency provides a baseline for calculating damages under deepening insolvency. The Bankruptcy Code defines insolvency as the "financial condition such that the sum of such entity's debts is greater than all their assets, at a fair valuation" with some exclusions. 11 U.S.C. § 101(32) (2010). As it applies to damages in deepening insolvency, the question is whether the value of assets relative to the amount of debts was made worse as a result of alleged wrongful conduct. Wrongful conduct can exacerbate insolvency in three ways: by making the debtor incur additional debt, through a decline in asset value, or a combination of the two. Even if the debtor was insolvent before the alleged conduct, the additional debt incurred thereafter, as a result of a defendant's actions, may provide a recoverable measure of damages. Tabas v. Greenleaf Ventures Inc. (In re Flagship Healthcare, Inc.), 269 B.R. 721, 728 (Bankr. S.D. Fla. 2001). But see In re Parmalat Sec. Litig.,501 F. Supp. 2d 560, 574 (S.D.N.Y. 2007)(holding that the mere act of incurring debt by an already insolvent debtor does not deepen its insolvency).

Actual harm can be measured under several methodologies and may include legal and administrative costs. Cost of distress is the preferred method because wrongfully incurred unpayable debt may inflict financial distress on a corporation, including the administrative costs of bankruptcy. J.B. Heaton, "Deepening Insolvency," 30 J. Corp. L. 465, 482 (2005). Cost of distress is appropriate because it is consistent with the traditional understanding of corporate injury. Id. at 500. Cases following this view have awarded damages for the administrative costs involved in bankruptcy. See, e.g., OHC Liquidation Trust v. Credit Suisse First Boston (In re Oakwood Homes Corp.), 340 B.R. 510, 532 (Bankr. D. Del. 2006) (noting that debtor suffered two distinct harms: the cost of bankruptcy and the costs of not filing the bankruptcy soon enough).

Below we discuss three approaches used in measuring damages under deepening insolvency.

Loss in value. The first approach calculates damages with reference to the reduction of a company's value. There is a multitude of methods for calculating value, including the book value approach of subtracting liabilities from assets, the discounted cash flow method, and the enterprise value method. Debtors' counsel may use any of these methods or a combination to determine the company's value, depending on the facts and circumstances of the case.

The loss-in-value approach permits recovery of the diminution in value of the company between the date it became insolvent and the date it filed for bankruptcy, and this calculation can include the legal and administrative expenses attributed to a delayed filing of bankruptcy or the bankruptcy proceeding itself. See, e.g., Bookland of Me. v. Baker, Newman & Noyes LLC, 271 F. Supp. 2d 324, 326 (D. Me. 2002). Bookland has been viewed by some commentators as setting a ceiling for damages. Gordon, supra, at 329 (citing Bookland, 271 F. Supp. 2d at 331). The broadest time frame for which alleged harm can be considered for damages in deepening insolvency is the time between the defendant's wrongful conduct and the time the bankruptcy petition is filed. Id. Courts will find liability on proof of financial hardships resulting from the increased insolvency. Tabas, 269 B.R. at 728 (where an acquisition resulted in increased debt and significantly contributed to debtor's financial death). Even if the debtor may have been insolvent before the alleged misconduct, the additional debt incurred as a result of the defendant's actions may provide recoverable damages. Id.

Increased liabilities. An increase in liabilities of the debtor is another method of measuring damages. Courtshave held that "an increase in liabilities is a harm to the company and the law provides a remedy when a plaintiff proves a negligence cause of action." Thabault v. Chait, 541 F.3d 512, 520 (3d Cir. 2008). Following Thabault, a district courtnoted that deepening insolvency can be measured by the "harm it encompasses" including increased liabilities. Collins & Aikman Corp. v. Stockman, 2009 U.S. Dist. LEXIS 93806, at *10 (D. Del. Sept. 30, 2009) (holding that pleading for damages under a deepening insolvency theory was sufficient).

The increased-liabilities approach views damages more conservatively than the loss-in-value approach. The former permits a dollar-for-dollar recovery for the increase in liabilities, whereas the loss-in-value approach also considers the multiplier effect of newly incurred debt on the value of the enterprise. In Freeman v. BDO Seidman, L.L.P., the court denied the defendant's summary judgment motion and concluded that the plaintiff could recover the amount of new debt incurred because of fraudulent auditing practices used by the defendants. Freeman v. BDO Seidman, L.L.P. (In re E.S. Bankest, L.C.), 2010 Bankr. LEXIS 1288 (Bankr. S.D. Fla. 2010); see also Allard v. Arthur Andersen & Co. (U.S.A.),924 F. Supp. 488, 494 (S.D.N.Y. 1996) (holding that the defendantwas "not entitled to summary judgment as to whatever portion of the claim for relief represents damages flowing from indebtedness to trade creditors."); Tabas, 269 B.R. at 728–29 (holding that additional debt incurred because of defendant's negligence may provide a measure of damages).

Some courts reject the increased-liabilities approach as an accurate reflection of damages. This stems from the understanding that liabilities are balance sheet neutral, so incurring a liability does not deepen insolvency because it results in a proportional increase in the debtor's assets. For example, one court noted that increased liabilities might be an accurate measure of damages if calculating injury to creditors. Alberts v. Tuft (In re Greater Se. Cmty. Hosp. Corp.), 353 B.R. 324, 338 (Bankr. D.D.C. 2006). However, this approach will not yield accurate results for the purpose of calculating injury to the debtor. The court thus held that a better approach would be to quantify the detrimental impact of the defendant's actions on the debtor's business operations. Id. at 338, n.12.

Plaintiffs thus need to quantify the costs of bankruptcy for the debtor and the costs incurred from failing to operate in a profitable manner. Alternatively, it would suffice for the plaintiff to quantify the lost value in assets. Id.; see also In re Parmalat Sec. Litig., 501 F. Supp. 2d at 574 (holding that "a company's insolvency is not deepened simply by the incurrence of new debt where the company suffers no loss on the loan transaction"); Grede v. McGladrey & Pullen LLP, 421 B.R. 879, 887 n.7 (N.D. Ill. 2008) (holding that "the concept of deepening insolvency . . . [,] as a measure of damages, is inapplicable when liabilities are incurred for fair value"); Official Comm. of Unsecured Creditors of Propex Inc. v. BNP Paribas (In re Propex Inc.), 415 B.R. 321, 327 (Bankr. E.D. Tenn. 2009) (holding that "loans do not of themselves deepen insolvency: they are balance sheet neutral because the incoming loan proceeds balance the new repayment obligation").

Looting of assets. The looting-of-assets approach is the third method of measuring damages in deepening insolvency. This approach holds that "[a]ny harm done to the corporation is not done by the extension of credit itself but by any subsequent looting or embezzlement." Kirschner v. Grant Thornton L.L.P, 2009 U.S. Dist. LEXIS 32581, at *30 (S.D.N.Y. 2009). This approach applies to instances in which the debtor has increased liabilities while the defendants have depleted the entity's assets through illicit transfers or other wrongful actions.

To measure damages under this approach, courts will examine changes in a company's net equity as a result of amounts embezzled by insiders.Gordon v. Basroon (In re Plaza Mortg. & Fin. Corp.), 187 B.R. 37, 44 (Bankr. N.D. Ga. 1995) (adopting a net equity change analysis based partially on moneys improperly used by inside director). In effect, the court measured damages by outgoing money rather than incoming money.  

A damages calculation should include damages from the looting itself, as well as damages inflicted by perpetuating the debtor's existence past the point of insolvency in order to loot. Drabkin, 168 B.R. at 5. Damages should account for efforts to aid looters and losses for intangibles like reputation and goodwill, as even these are legally cognizable. In re Bennett Funding Grp., 1997 Bankr. Lexis 2366 (Bankr. N.D.N.Y. 1997) (debtor operated a Ponzi scheme and successfully pled damages for intangibles). The challenge for plaintiffs is articulating not only that the defendant knew that failing to file bankruptcy would lower a company's value but also that the defendant anticipated reaping gain during the time of delay. Tabas, 269 B.R. at 728.

One court has formulated three necessary elements of looting assets where deepening insolvency is pled as a theory of damages: (1) the borrowed sums do not benefit the debtor because they were transferred to principals without consideration, (2) the wrongful acts enabled the principals to deplete assets, and (3) the debtor saw a diminution in its value as an enterprise, not just artificial prolongation of an insolvent existence. Silverman v. KPMG L.L.P. (In re Allou Distribs., Inc.), 395 B.R. 246, 271 (Bankr. E.D.N.Y. 2008).

Under a deepening insolvency theory of damages, plaintiffs may allege damages suffered by the debtor in the form of loss in value, increased liabilities, or looted assets. Measuring damages under any of the three approaches poses significant challenges to counsel. Apart from the problems noted above, counsel must prove proximate and actual causation and respond to a challenge to liability on these grounds. Further, using insolvency as a baseline for the calculation of damages will generally require the measurement of debts and property under the fair valuation standard. Regardless of these challenges, the theory of deepening insolvency empowers plaintiffs to sue for substantial damages. The possibility of recovering these damages from deep pockets may well make treading through the murky waters of deepening insolvency worth the effort.

Keywords: litigation, commercial, business, deepening insolvency, theory of damages, loss in value, increased liabilities, looting of assets

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