Deepening Insolvency is Liability Trap for the Unwary: Searching for a Scapegoat

By: Phil C. Appenzeller, Jr. (Co-author) and Ross H. Parker (Co-author)
The Journal of Corporate Renewal
July 2005

Little Leaguers often seem to have excuses if they underperform on the baseball diamond. Someone missed a throw. The wind caught the ball. An umpire made a bad call. Unfortunately, the corporate world is sometimes no different.

Creditors’ committees and trustees often call on turnaround professionals to analyze a company’s demise and help identify those responsible. If the post-mortem is carried out diligently, no one escapes examination. Officers, directors, accountants, lawyers, and banks all have potential exposure. The arsenal of weapons typically employed in this attack include theories of liability premised on self-dealing, fraud, misappropriation, gross negligence, breaches of fiduciary duties of care and loyalty, and related business tort claims.

Creative lawyers, with the help of accommodating courts, also have developed a new weapon — deepening insolvency. The theory holds liable those who prolong the life of an already insolvent corporation and thus increase the insolvency or dissipation of assets to the detriment of the company, its shareholders, and its creditors. The theory is premised on the idea that the wrongful prolongation of the life of a business diminishes the value of an insolvent company and thereby decreases the value that could have gone to its creditors or shareholders.

This article provides a glimpse of the applicability and use of this theory. Because the theory is in its infancy, relatively speaking, it is evolving and being defined by the courts. Even though jurisdictions differ on its availability and applicability, those who deal with troubled companies should make no mistake — the theory can be a liability trap for corporate officers, directors, and third parties who advise them.

Good Intentions
The following scenario provides a glimpse into how theories on deepening insolvency can be used. A failing professional-services company has hired a new CEO. The executive believes that with proper marketing, the company’s services will realize resurgence in demand. Before the CEO came aboard, the company, in accordance with its roll-up business model, aggressively acquired several smaller, similarly situated companies. Unfortunately, the by-product of the company’s aggressive acquisition plan was a problem in its cash flow. The new CEO calls the company’s CFO to discuss a strategy for improving cash flow so that the business can succeed.

The CFO explains that the company has two potential funding sources. First, it has a $5 million credit line that is linked to the company’s receivables and work in process (WIP). Currently, the company uses only half of that credit line, and the new CEO determines that there are enough receivables and WIP to maximize it. The CFO expresses concern about the age or the receivables and candidly says that aggressive accounting methods were used to estimate the WIP. He assures the CEO, however, that its outside auditors assessed the company’s financials and that their reports were provided to the lenders.

The second source of financing is available through an investment bank that maintains an equity position in the company. The bank is interested in loaning several million dollars in exchange for a future conversion of the notes to preferred equity.

The CEO weighs the company’s options. Because its liabilities exceed its assets, the executive could recommend that the business declare bankruptcy. The second alternative is based on the CEO’s belief that the company can be turned around. However, to do so, it needs new funding. The CEO decides to go with a combination of both financing options. The company increases its draw on the credit line and obtains financing from the investment bank.

One year later, the company is bleeding cash at an alarming rate. The CFO indicates that the problem is two-fold. First, the receivables are worse than he thought: he had been too optimistic. Some of the company’s clients were teetering on bankruptcy or already had shut down. Second, he grossly overestimated WIP. Current cash levels are insufficient to meet near-term overhead obligations. Moreover, the company will be unable to service its debt obligations on a go-forward basis. The CEO realizes that the company must declare bankruptcy and recommends this action to the board of directors.

Within a few months after declaring bankruptcy, the CEO is sued, along with other members of the management team, the auditors, and the investment bank. The lawsuit claims that the CEO breached his fiduciary duties to the company by deepening its insolvency and that the other defendants aided and abetted him in causing the company’s demise. Would it have been better if the CEO had just killed off the company 12 months earlier? Under the deepening insolvency theory, the answer is, perhaps.

In this scenario, who is at fault? Is the CEO who takes a gamble on the company by increasing its debt to blame? Is it the accountants, who should have caught the inflated accounting practices? Or were the lenders negligent because they loaned a faltering company more money, allowing it to sink further into the red? Recent case law suggests that all three groups are potentially liable.

Caution Required
A plaintiff’s attorney may look to the following facts to determine if a viable deepening insolvency claim exists:

• How was the decision to take on more debt made? Did the officers and directors use advisors? Did they exercise sound business judgment?
• What were the company’s accounting practices? Was the company taking aggressive positions on booking revenue and expenses? Were outside auditors used?
• Did self-dealing or fraudulent transfers occur while the company was insolvent or in the zone of insolvency?
• Were loans made in exchange for preferred liens or equity interests? Can the value for the exchanged consideration be challenged as unequal?
• Were any assets transferred or sold to insiders for inadequate consideration?
• What efforts were made to sell the company, its assets, or lines or business that would have maximized at return to investors or creditors?
• How much time was spent considering bankruptcy? Were professionals consulted?

Turnaround professionals who manage or advise companies that are insolvent or teetering on insolvency should proceed with caution. They should make sure that the decisions they make are in the best interests of the company, its creditors, and its shareholders. While closing the doors of a troubled company may be the most difficult decision for professionals to make, that may be a better option than artificially keeping the business alive and exposing themselves to liability.