Academic journal article Stanford Journal of Law, Business & Finance

A Critique of "Deepening Insolvency," a New Bankruptcy Tort Theory

Academic journal article Stanford Journal of Law, Business & Finance

A Critique of "Deepening Insolvency," a New Bankruptcy Tort Theory

Article excerpt

Introduction

In several recent decisions the theory of so-called "deepening insolvency" has been brought as an independent tort cause of action against directors, lenders, and outside advisors. The plaintiffs, generally bankruptcy trustees, allege that defendants improperly kept afloat an insolvent business by taking new loans, enabling continued waste of corporate assets to the detriment of the creditor class.

This Note argues that the "deepening insolvency" cause of action is fundamentally flawed, as it attempts to use expand common law principles without statutory direction, to impose a new tort obligation over existing contractual relationships between sophisticated parties. Further, acceptance of the "deepening insolvency" theory conflicts with existing law, increases inefficiency, restricts the freedom of sophisticated parties to contract, and has adverse policy implications.

This Note first examines the history of "deepening insolvency" from its murky origins to its amoebic growth into both a tort cause-of-action and a theory of damages. It then evaluates and critiques the various forms that "deepening insolvency" has taken.

Background

In an era when Ken Lay and Jeffery Skilling are household names, the theory of "deepening insolvency" presents an attractive story for a jury: a floundering business was run deep into the ground and somebody should be held responsible for the resulting losses to shareholders and creditors. The theory allows plaintiffs' attorneys to march a parade of deep pocketed wrongdoers before the jury, from shamed directors who failed to shut down the company sooner, to lenders who kept the company alive long enough for management to continue to plunder corporate coffers. The existence of wrongdoing seems obvious given the wreckage of a collapsed firm; how else could so much money be lost? In such a situation the jury is likely to attempt to set things right by taking money from deep-pocketed defendants and putting it into pockets left empty by the corporate collapse. The benefits of imposing liability are direct and immediate: someone is punished and someone else may be made right. The costs of imposing liability are distant and indirect (even if much larger in scale): lending costs increase, qualified directors avoid service, or a company is forced into bankruptcy instead of negotiating a consensual workout.

Of course, the mere attractiveness of a common-law theory to a jury is not a sufficient justification for its existence. Each new tort theory must be analyzed to determine if it advances the basic goals of tort law, and further examined for the policy implications that will result from its implementation. A proposed common-law tort theory must be rejected if it is inconsistent with the goals of the tort system, creates negative policy implications, or clashes with other values recognized in the common-law system.1

I. History of Deepening Insolvency

It is generally agreed that the idea of deepening insolvency emerged from dicta in In re Investor Funding Corporation of New York Securities Litigation (Bloor v. Dansker) regarding an in pari delicto affirmative defense.2 The complaint alleged that the principal officers of Investor Funding Corporation had fraudulently misappropriated company funds for personal gain, and then covered their tracks by seeking ever-larger loans based on fraudulent financial statements. Eventually the scheme collapsed, leaving creditors empty-handed. In bankruptcy, the creditors sought additional sources of recovery by going after the corporation's still-solvent auditors.

The Chapter 10 bankruptcy trustee for the then-defunct corporation sued auditors Peat Marwick for certifying the allegedly false financial statements. The plaintiffs alleged that but-for Peat Marwick's failure to investigate the financial condition of the company, the lenders would have ceased lending and cut their losses significantly. …

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