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Questioning the deepening insolvency theory

by contributors Ken Herzinger, Orrick, and Alexander Aganin, Cornerstone Research | Published May 29, 2012 at 2:35 PM

A recent decision from the 3rd Circuit entitled Official Committee of Unsecured Creditors v. Baldwin (In re Lemington Home for the Aged) states that "deepening insolvency" is a cause of action under Pennsylvania law. The decision was followed by a flurry of legal commentary, including more than 20 articles by law firms. Though it is certainly not the first court to accept deepening insolvency as cause of action or a theory of damages, the 3rd Circuit's recent decision has renewed the debate over whether an insolvent corporation can be harmed by prolonging its life, often referred to as deepening insolvency by courts and academics alike.

Generally, there is an onslaught of litigation that follows the bankruptcy of any company. In addition to investor suits of various kinds, creditors often pursue claims in name of the corporation. In addition to transfer avoidance claims against various parties, the bankrupt entity can pursue claims against its former directors and officers, auditors or other "deep pocket" defendants alleging fraud, breach of fiduciary duty or some other type of wrongdoing. Interestingly, even though creditors typically stand to gain from any damages awards in resulting litigation, they can also pursue separate claims to recover their losses. This opens the possibility of "double-dipping" by plaintiffs, who can try to recover overlapping damages under both types of claims.

Based on the application of agency law principles, numerous courts have barred such claims based on a defense known as the in pari delicto defense. The reasoning is that if the entity participated in and benefited from the alleged wrongdoing, it should not be permitted to recover damages against its directors and officers or professionals that advised the company in connection with its own wrongdoing because that would be unjust.

In order to avoid this result, some courts have adopted the deepening insolvency theory to allow claims in the name of a bankrupt entity by its creditors. Generally, the theory is that the corporation was insolvent or in the "zone of insolvency" when the purported fraud, breaches or wrongdoing occurred, and but for the actions of the defendants, the corporation would not have continued to raise unserviceable debt and would have filed for bankruptcy more promptly, which would have avoided the unserviceable debt. In addition, California and Delaware both have laws that impose a duty on directors to refrain from making distributions to shareholders, and expand the directors' fiduciary duties to include a company's creditors, when the company is insolvent or on the verge of insolvency. Typically, the lawyers that file such cases retain damages experts, usually economists, who opine that the corporation was damaged because it lost opportunities to make optimal use of its assets under bankruptcy protection, to avoid further losses, to restructure debt or to liquidate the business. Over the years, the deepening insolvency theory has morphed from a theory of standing to a measurement of damages to an independent cause of action.

According to the U.S. Bankruptcy Code, 11 U.S.C. § 101(32), a company is insolvent when fair market value of its assets is less than the sum of its debts. Internal Revenue Service regulations define "fair market value" as the price at which the assets would change hands between a willing buyer and a willing seller, neither being under any compulsion to buy or to sell and both having reasonable knowledge of relevant facts.

Some courts have held that an insolvent company cannot be harmed by prolonging its life and have rejected deepening insolvency as a damages theory, noting that the company has already lost all the equity value that it had prior to the start of the damages period. Therefore, any alleged harm has been borne by creditors and may not be recoverable by the company itself. However, other courts disagree.

There are numerous flaws with the deepening insolvency theory, but the primary one is that it is not grounded in sound economic theory. Economists generally agree that the issuance of debt as such does not do damage to the company because when a company raises new debt, it generally acquires a new asset in the form of debt proceeds with fair market value equal to the new debt. This is true regardless of whether the entity is insolvent or in the zone of insolvency. Additional debt can increase the possible costs of financial distress, such as the direct legal and administrative expenses of preparing for or avoiding bankruptcy, but these are often de minimis in comparison to damages claimed in the deepening insolvency suits.

Some economists measure deepening insolvency damages as the widening of the gap between the fair market value of a company's assets and the sum of its debts from the time a hypothetical earlier bankruptcy filing to the time of the actual bankruptcy filing. However, this calculation, unless supplemented by further analysis, does not provide an intellectually sound answer. Fair market values of assets may decline for benign reasons due to industry developments, losses resulting from good-faith efforts by managers or asset sales at fair market value. Similarly, debts may increase because the company raises new debt to finance good investment opportunities.

As with any other damages theory, the deepening insolvency damages theory, to be legitimate, should isolate the effects of the alleged misconduct by comparing the value the bankrupt company would have received without the wrongdoing with the value it actually received. This comparison limits damages to those caused by the alleged wrongdoing and avoids charging the alleged wrongdoer with other losses. Such analysis requires an expert to create a model that depicts the path of corporate assets and debts in an alternative world. The model is different from the actual world in only one respect -- the alleged wrongdoing is replaced by alternative actions.

For example, an expert for an estate of a bankrupt company may claim that an auditor would have changed the course of the company's history had it alerted an audit committee of the board of directors about questionable financial reporting. Not surprisingly, courts often find that the assertion regarding the alternative path of corporate history is too speculative or that the auditor does not need to compensate a bankrupt estate for a portion of losses caused by the actions of a client company's management unrelated to financial reporting.

Assuming that the court permits the testimony and the damages expert can demonstrate that the course of corporate history would have been different, the expert can then compare the expected or realized paths of assets and debts in the actual and alternative worlds. Because the fair market value of assets equals the present value of their expected future cash flows, such a comparison, if done carefully, is equivalent to a lost profits analysis used to measure damages in many other contexts. Simplistic damages calculations based on the deepening insolvency comparisons often obfuscate important assumptions that become readily apparent in the lost profits framework. Therefore, deepening insolvency has questionable value as a separate theory of damages at best and can lead to large errors at worst.

The lesson to be learned from all of this is while the economic reasoning underlying the deepening insolvency theory is seriously flawed, some courts have still been willing to adopt it as a damages theory and even an independent cause of action, and the ensuing litigation can be lengthy and involve significant damages claims. Accordingly, a board of directors of a company that is insolvent or in the zone of insolvency should be mindful of the issues raised above when the company incurs additional debt or approves distributions to shareholders, and should consult its legal counsel and financial professionals to be fully informed when making such decisions.

Ken Herzinger, a partner in Orrick, Herrington & Sutcliffe LLP's San Francisco office, is a member of the securities litigation and regulatory enforcement group. Alexander Aganin is vice president of Cornerstone Research in Menlo Park, Calif.

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