Deepening Insolvency: A New Cause of Action Against Directors and Officers

In the once orderly world of business torts, a relatively new player, "Deepening Insolvency," has emerged. Extending beyond the established causes of action for breach of fiduciary duty to a corporation, Deepening Insolvency occurs when an officer, director or other party in control of a corporation inappropriately prolongs its life while increasing its debts and liabilities. Its development as a separate cause of action rests upon the assumption that the value of an insolvent company can be salvaged if the corporation is dissolved or turned around in a timely manner.

The essential elements of the cause of action are:

1. The prolongation of an insolvent corporation's life by hiding its true financial condition;
2. Causing the corporation to become more insolvent by incurring additional liabilities or the dissipation of assets;
3. So that the value that could have been realized if corporation's business activity had not been improperly prolonged is lost; and
4. The corporation suffers harm distinct from the harm suffered by its creditors.

The courts that have addressed disputes involving Deepening Insolvency disagree on the interpretation of key fundamentals of the elements.

In this respect, courts disagree as to whether the defendant must act with fraudulent intent.  Some courts hold that the defendant must have acted in bad faith or with fraudulent intent. Other courts accept the lesser standard of negligence. The standard of culpability can be a critical issue for workout specialists and banks. If the lesser standard of negligence applies, then the workout specialists should consider requiring the corporation to seek court supervision or approval in order to insulate all parties from future liability. 

Courts also disagree on whether Deepening Insolvency is a separate cause of action or a measure of damages for other causes of action such as breach of fiduciary duty. This theoretical divergence can cause confusion regarding a defendant's potential liability as well as the availability of defenses such as good faith and lack of damages.

Some courts limit standing to bring the cause of action. Technically, a defendant commits the tort of Deepening Insolvency against the company. Thus, only a representative of the company (such as a receiver, bankruptcy trustee or bankruptcy creditors' committee) can bring suit. Suits brought by trade creditors outside of a bankruptcy proceeding are often dismissed due to lack of standing.

Courts also vary in how to assess damages. Some courts measure the reduction in the company's value as a result of its financial distress, even if this means measuring a negative value with an even greater negative value. Other courts have used the amount of unpaid debt as the measure of damages. The problems inherent in both measures of damage could affect the existence of the cause of action. For instance, if a company is already insolvent and unable to pay its debts, does deeper insolvency actually inflict more damage?

While the courts continue to define the tort of Deepening Insolvency, the case law in this area can be used as a guide to avoiding liability while dealing with a troubled company. Directors, officers and others acting in a fiduciary capacity should:

1. Understand the business's solvency position by examining the balance sheet, cash flow and adequacy of capital on a regular basis;
2. Base decisions that could affect the business's solvency on sufficient information and after reasonable deliberation;
3. Memorialize in writing all decisions that increase a corporation's debt structure and include the backup data used to make the decision;
4. Resist financing losses with further debt;
5. Consider obtaining the consent or support of lenders or major creditors before implementing strategies that could put a major asset at risk or increase the company's debt structure;
6. Do not pay bonuses and other financial drains on the company during a financial crisis; and
7. Avoid conflicts of interest, self dealing, fraudulent conveyances, looting or dissipation of assets while encouraging creditors to extend more credit.

Lenders, auditors and trade creditors should:

1. Avoid active involvement in the company's operational decisions; and
2. Discover and disclose material transactions and lack of internal controls.

Insurance carriers must be cautious as well. Before extending directors and officers coverage, the carrier should inquire whether the managers are taking the appropriate measures to guard against Deepening Insolvency.

In conclusion, anyone in control of a troubled company with mounting debt should always seek advice from experienced counsel. Competent advice will help and will not only avoid possible liability but, whenever possible, will also help with turnaround or other debt relief measures.