• The Latest on Deepening Insolvency
  • July 21, 2008 | Authors: Ezra H. Cohen; Vivieon E. Kelley
  • Law Firm: Troutman Sanders LLP - Atlanta Office
  • Some commentators have suggested that a recent decision by the Delaware bankruptcy court is contrary to other recent cases that prevent the trustee of a bankruptcy corporation from recovering damages for deepening insolvency that occurs after liquidation is inevitable. See Miller v. McCown De Leeuw & Co. (In re The Brown Schools), 386 B.R. 37 (Bankr. D. Del. April 24, 2008) (Walrath, B.J). However a careful reading of that opinion, as well as a review of the pleadings in the case, dispels that suggestion.

    The doctrine of deepening insolvency has been airily described as a “controversial theory” that “allows damages sometimes to be awarded to a bankruptcy corporation that by delaying liquidation ran up additional debts that it would not have incurred had the plug been pulled sooner.”  Fehribach v. Ernst & Young LLP, 493 F.3d. 905, 908 (7th Cir. 2007).  Until recently, there was substantial doubt to whether deepening insolvency is a tort or, alternatively, whether it is a theory of damages.  See Sabin Willett, “The Shallows of Deepening Insolvency”, 60 Bus. Law. 549 (2005). 

    It is now widely accepted that deepening insolvency is not an independent cause of action but rather, if anything, a theory of damages that may apply to an established cause of action, such as for breach of a duty owed to a corporation.  See e.g., Seitz v. Detweiler, Hershey & Assocs., P.C. (In re CitX Corp.), 448 F.3d 672 (3rd Cir 2006); Trenwick America Litigation Trust v. Ernst & Young, L.L.P., 906 A.2d 168 (Del. Ch. 2006), aff’d Trenwick America Litigation Trust v. Billett, Case No. 495,2006, 2007 Del. Lexis 357 (Del. 2007).  Courts are now considering how to quantify damages from a deepening of insolvency caused by an established tort. 

    After CitX, significant cases have rejected the proposition that the recoverable damages are simply the amount (often huge) by which the insolvency is deepened.  Rather, courts have held that the deepening of insolvency is not an injury for which the corporation can recover if the deepening occurs after liquidation is inevitable.  See In re Parmalat Securities Litigation, 501 F. Supp.2d 560, at 574-75 (S.D.N.Y. 2007); Alberts v. Tuft (In re Greater Southeast Community Hospital Corp.) 353 B.R. 324, 335 (Bankr. D.C. 2006). 

    In Miller, the Delaware bankruptcy court adjudicated defendants’ motion to dismiss a case seeking, among other things, damages for the deepening insolvency that occurred after liquidation was inevitable.  The bankruptcy trustee for the debtor corporation alleged that in order to profit at the expense of the debtor corporation and its creditors, defendants breached their fiduciary duty by wrongfully prolonged the corporation’s existence past the point when the corporation should have filed bankruptcy and been liquidated.  See Miller, 386 B.R. 37 at 45.   Based on the court’s denial of a motion to dismiss the counts so alleging, some commentators are suggesting that the decision may be read as holding that the deepening insolvency is a proper measure of damages even if the deepening occurs after liquidation is inevitable.  However, the reason for the denial appears to be that the complaint makes out a claim for looting or waste, in breach of fiduciary duties. 

    Miller is like many cases alleging deepening insolvency.  These cases are brought by a debtor corporation’s surrogate, such as a bankruptcy trustee.  The defendants are often the corporation’s directors, who are alleged to have breached fiduciary duties to the corporation, and the corporation’s lawyers, accountants, lenders, and controlling shareholders, who are alleged to have aided and abetted the breach of fiduciary duty or otherwise breached a duty to the corporation.  The breach of duty is alleged to have resulted in an improper, artificial prolongation of the corporation’s faulty business model, during which prolongation the corporation’s insolvency is deepened by virtue of the corporation’s continuing losses.  The bankruptcy trustee generally seeks to recover as damages the amount by which the corporation’s insolvency increased during this period of artificial prolongation. 

    Parmalat and Alberts hold that a bankruptcy trustee cannot recover the amount by which the corporation’s liabilities increased or its assets decreased by virtue of artificially prolonging the corporation’s unprofitable business operations, where the artificial prolongation begins after the point where liquidation is inevitable.  In each of these cases, the court concluded that, since the corporation was bound to be liquidated, the corporation’s creditors, rather than the corporation, suffered the injury of such a deepening of insolvency.  The corporation’s inability to recover in such cases is characterized as a “lack of standing” to recoup losses suffered by creditors.  See Parmalat, 501 F. Supp.2d at 574-75; Alberts, 353 B.R. at 335.

    This is not to say that a debtor corporation’s insolvency is a defense to looting, waste or other loss of assets proximately caused by a breach of a duty to the corporation.  Parmalat specifically reaffirms that the bankruptcy trustee may recover the value of looted or wasted assets, regardless of whether the looting or wasting occurred when the corporation was solvent or insolvent.  See, e.g., Parmalat, 501 F. Supp.2d at 578.  This reflects established law apart from any consideration of the concept of deepening insolvency. 

    Both Parmalat and Alberts recognize that the bankruptcy trustee can recover damages if the deepening of insolvency occurs after the corporation is insolvent but when the company can reorganize around a profitable business.  See also Fehribach, 493 F.3d at 908-9.  In that circumstance, the damages will not be measured simply by the amount by which the debtor corporation’s insolvency was deepened.  Rather the debtor corporation must fairly precisely quantify the impact of the increased debt on the debtors’ business operations.

    In Miller, the bankruptcy trustee sued the debtor corporation’s major stockholder as well as the corporation’s directors and lawyers.  The bankruptcy trustee alleged that during the period when the corporation’s business operations were wrongfully prolonged, the corporation’s indebtedness increased about $22 million and assets in at least that amount were looted or wasted. 

    The bankruptcy court’s denial of the motion to dismiss does not appear to be based on the proposition that the amount of the increase in insolvency was, or could be, an appropriate measure of damages.  Rather, the denial appears based on the sufficiency of the claims of looting or waste. Indeed, elsewhere in its opinion, the bankruptcy court cited both Parmalat and Alberts with approval and gave no indication that it would hold contrary to them with respect to their holding that a corporation’s trustee in bankruptcy lacks standing to recover for an increase in insolvency after liquidation was inevitable.