Getting in Deep: Bankruptcy Theory could Pose Problems for Executives
By: Phil C. Appenzeller, Jr. (Co-author) and Ross H. Parker (Co-author)
Texas Lawyer
October 3, 2005
In the movie "The Princess Bride," the hero, Westley, is tortured until near death. In an attempt to heal him, a wizard examines Westley and announces that he is only "mostly dead."
Like Westley, many companies teeter on the brink of death but retain hope for survival. In legal vernacular, these companies are in the zone of insolvency. When a company slides deeper into this zone, officers' and directors' potential liability rises. Disgruntled shareholders, trustees and creditors' committees use the theory of deepening insolvency to hold corporate management and third-party professionals responsible for a company's demise.
So what is deepening insolvency? The theory derives from the notion that, when executives or other professionals artificially extend a corporation's life past its insolvent state, they exacerbate the company's injuries. The recent spotlight on corporate malfeasance has expanded the theory's use.
Generally, a corporation's officers and directors owe duties to the company and its shareholders, not to its creditors. When a company becomes insolvent, however, the law obligates officers and directors to refrain from actions detrimental to the company's creditors. Under the deepening insolvency i theory, creditors can hold officers and directors liable for damages they suffer as a result of the directors' and officers' breaches of fiduciary duties. Liability can also extend to third parties, such as professionals or accountants, who aid and abet breaches of the officers' and directors' fiduciary duties.
Courts generally look for four things when a creditor or shareholder makes a deepening insolvency claim:
- Fraudulent or wrongful prolongation of an insolvent corporation's life by hiding its true financial condition
- Increasing the corporation's insolvency by incurring additional liabilities or dissipating its assets
- Loss of value that creditors could have realized if the executives or professionals had not improperly prolonged the corporation's business
- Harm to the corporation distinct from that suffered by its creditors.
Mercy Killing
Courts reject the notion that prolonging a corporation's life is always in its best interest. For example, if the motivation for prolonging the corporation’s life is to obfuscate officers’ and directors’ bad acts, then the added life support is not in the corporation’s best interest. Judges often accept the theory of deepening insolvency in such instances.
In In Re: Exide Technologies, et al., (2003) decided by the U.S. Bankruptcy Court in Delaware, a lender had extended credit to a financially troubled borrower in exchange for additional security; the credit extension, according to the opinion, enabled the borrower to remain in business, essentially for the lender’s benefit. The court found that the lender was extracting value from the borrower at the expense of the borrower’s unsecured creditors; the unsecured creditors might have been repaid at a higher percentage had the borrower not been propped up with additional secured financing. The court allowed the creditors’ committee to maintain its claim against the lender for deepening the insolvency of the company.
The U.S. Bankruptcy Court for the Southern District of New York attempted to standardize deepening insolvency claims and, unlike the court in Exide, also provided support for defendants that find themselves targets of these claims.
The trustee in In Re: Global Service Group (2004) asserted claims against the company’s lender for deepening insolvency, alleging that the bank knew or should have known the company was insolvent, the New York bankruptcy court wrote. Because the lender knew or should have known about the debtorfinances, the trustee argued that it also should have known the company would be unable to service its debts.
Although the case focused on the lender’s liability for making loans while the borrower was insolvent, the judge also addressed the liability of the insolvent corporation’s officers and directors. Finding fault with the premise that managers of an insolvent company have an absolute duty to liquidate, the court took issue with the plaintiff’s assumption that anyone who aids or abets a manager’s alleged wrongdoing is liable. The court reasoned that, when a company is insolvent, its officers and directors are obligated to exercise their business judgment to maximize the corporation’s value.
The court noted that Chapter 11 bankruptcy is based on the notion that a business is worth more alive than dead. The court held that an officer or director of an insolvent company will not face liability based on a negligent – but made in good faith – decision to operate the business and maximize its value. To rebut the presumption, a plaintiff must show bad faith, fraudulent intent or self-dealing.
Even though there is a split among bankruptcy courts regarding how to apply the theory of deepening insolvency, executives should consider their potential liability assuming the theory applies before becoming involved with a financially troubled company.
If an executive does decide to work for a company that’s in the zone of insolvency, there are ways to avoid becoming a defendant. In addition to the general admonition to refrain from self-dealing, choose competent advisers, always use your best business judgment and make no decision haphazardly, the following rules are particularly important for execs at companies sliding deeper into debt.
- As a general rule, do not sell corporate assets to insiders.
- Do not reject valid purchase offers if the offers are in the best interests of the company’s shareholders
and creditors. - Do not be afraid to declare bankruptcy if that is in the best interest of the company and its creditors.
- If execs decide that declaring bankruptcy is in the best interest of the company and its creditors, they
should examine venue alternatives before filing. Jurisdictions vary in their approach to deepening
insolvency theories.
While the theory of deepening insolvency can pose a risk for executives, some common-sense steps can help minimize their risk.
