Timing Is Everything: Liability of Directors and Officers Under the Deepening Insolvency Theory
Suppose you are a director of a struggling company that owns and operates a small business that has experienced significant losses over the past three years and is struggling to keep up with its creditors. You and the other directors, as well as management, consider filing for protection under the bankruptcy laws but believe that if the company can somehow continue to operate for another 12 months, it will break even and its prospects will be rosier.
Suppose you are a director of a struggling company that owns and operates a small business that has experienced significant losses over the past three years and is struggling to keep up with its creditors. You and the other directors, as well as management, consider filing for protection under the bankruptcy laws but believe that if the company can somehow continue to operate for another 12 months, it will break even and its prospects will be rosier. You and the rest of the board approve certain actions, including incurring additional debt secured by the last unencumbered assets of the company, that will allow the company to limp along for another 12 months. Unfortunately, a year later those actions have proved fruitless and the company is worth much less in terms of liquidation value than a year earlier. Did you create personal liability by prolonging the company’s agony, resulting in a reduced value to its creditors in a bankruptcy proceeding?
This illustration plainly demonstrates that not all things are worth saving, and that sometimes it is better to take immediate but painful action to prevent future loss. This is certainly the case in many corporate restructuring situations. While the shareholders, directors and officers typically struggle to save and keep their business alive even though the chance of survival of the business is slim, significant risk could ensue. Keeping a business alive when it is clearly beyond recovery may cause personal liability for the company’s directors, officers, professionals and even lenders under the so-called “deepening insolvency” theory. Under the deepening insolvency theory, a director or officer may be liable for prolonging a financially distressed corporation’s life and reducing its liquidation value. This article will briefly discuss the general duties of directors and officers and the deepening insolvency doctrine, and will provide certain suggestions for directors and officers of financially distressed corporations.
Directors’ and Officers’ Duties
Directors and officers owe duties of care and loyalty to the corporation and the corporation’s shareholders. The duty of care requires that directors and officers discharge their duties in good faith and in the best interest of the corporation. The duty of loyalty requires that directors and officers refrain from self-dealing, usurpation of corporate opportunities and receiving improper personal benefits. In general, the actions of directors and officers are protected under the business judgment rule, under which the courts will not second-guess actions taken, provided that the directors and officers acted on an informed basis, in good faith and in an honest belief that such actions would be in the best interest of the corporation.
Many courts have held that when a corporation becomes insolvent, directors’ and officers’ fiduciary duties are owed to the creditors, rather than to the corporation and the shareholders. However, when a corporation is in the “vicinity of insolvency,” the fiduciary duties of directors and officers are less clear. Many courts have extended the fiduciary duties of directors and officers to the creditors and other constituents of the corporation in addition to the corporation and its shareholders. The term “vicinity of insolvency” has not been clearly defined. The lack of a clear legal definition of “vicinity of insolvency” and the fact that directors and officers may owe fiduciary duties to multiple parties often leave the directors and officers in a quandary about when and to whom they should discharge their fiduciary duties.
Deepening Insolvency Theory
When corporations approach the “vicinity of insolvency,” directors and officers face the potential conflict between their fiduciary duties owed to the corporation and its shareholders in maximizing profit, and their fiduciary duties owed to the creditors in protecting and conserving corporate assets. Some of the most significant issues that arise when a corporation approaches the zone of insolvency include whether the corporation should declare bankruptcy, when the corporation should declare bankruptcy, and whether the directors’ and officers’ actions prevent or exacerbate the insolvency. Under the “deepening insolvency” theory, if the directors and officers expand corporate debt and prolong the life of a corporation, the directors and officers may be held liable because the continued operations of the corporation have the effect of increasing losses and deepening the corporation’s insolvency, thereby further reducing the value of the corporate assets and injuring the creditors. As one bankruptcy court put it,
“[T]he Debtor’s situation was not like an individual who sits in the rain all day and simply cannot get more wet. It is more akin to a boxer with one black eye who, despite being injured, might still persevere and win the fight. If that boxer (the debtor) winds up losing the fight and landing in the hospital (bankruptcy court), a doctor (judge) might find that it was the additional injuries (deepening insolvency) which put him there.”1
The deepening insolvency theory was originally recognized as a theory of damages. Recently, an increasing number of courts have recognized it as a separate cause of action–the tort of deepening insolvency. In Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., the Court of Appeals for the Third Circuit held that the Pennsylvania Supreme Court could recognize the tort of deepening insolvency as “an injury to the Debtor’s corporate property from the fraudulent expansion of corporate debt and prolongation of corporate life.”2 The case involved claims that certain third-party professionals fraudulently induced two lease-financing corporations involved in a Ponzi scheme to issue fraudulent debt certificates, which resulted in deepening their insolvency and forcing them into bankruptcy.3 The court articulated three rationales for the recognition of deepening insolvency as a separate cause of action. It noted first that the theory was essentially sound because fraudulent and concealed incurrence of debt can damage the value of corporate property by forcing an insolvent corporation into bankruptcy, which inflicts legal and administrative costs on the corporation, creating operational limitations that impair the corporation’s ability to operate profitably, shaking the confidence of other parties who have dealings with the corporation, undermining the corporation’s relationship with its employees, customers and suppliers, and dissipating the corporate assets. The court stated that “[t]hese harms can be averted, and the value within an insolvent corporation salvaged, if the corporation is dissolved in a timely manner, rather than kept afloat with spurious debt.”4 The court then stated that the soundness of the deepening insolvency cause of action was confirmed by the growing acceptance of the theory, including the acceptance by several federal courts and state courts. Finally, the court noted that the remedial theme in Pennsylvania jurisprudence requires that where deepening insolvency causes injury to the corporate assets, the law must provide a remedy by recognizing deepening insolvency as a cause of action.
Applying the Third Circuit’s analysis, the United States Bankruptcy Court for the District of Delaware concluded that the Delaware Supreme Court could recognize deepening insolvency as a cause of action under Delaware law.5 In the case of In re Exide Technologies, Inc., the official committee of unsecured creditors of the corporation sued the corporation’s pre-petition secured lenders, claiming that the secured lenders contributed to and were liable for the deepening insolvency and the ultimate bankruptcy of the corporation by extending credit to the corporation in exchange for additional collateral when the corporation had little or no hope of recovery, and causing the corporation to acquire another corporation so that the secured lenders could obtain control necessary to cause the corporation to remain in business for close to two years at increasing levels of insolvency.6 Applying the same analysis as in the Lafferty case, the Exide court found that the deepening insolvency theory was sound, judicially accepted and conformed to the policy of the Delaware courts of providing a remedy for an injury. Not all courts have recognized the theory as a separate cause of action, however.
Elements of the Deepening Insolvency Theory
Neither the Lafferty court, the Exide court nor any other court that has recognized the deepening insolvency cause of action has articulated the elements or legal standards for a claim. In general, the deepening insolvency cause of action is based on two types of claims: a mismanagement claim against directors and officers, and a misrepresentation claim against both the management and its professionals, such as its accountants.7 The mismanagement claims against directors and officers are often based on the theory that the directors and officers have breached their fiduciary duties by taking certain actions to extend artificially the life of the corporation, such as the incurrence of additional debt, which results in increased insolvency and the diminution and dissipation of the corporation’s assets and value.8 These claims typically do not involve fraud or other malfeasance. The misrepresentation claims against management and professionals generally involve the artificial or fraudulent prolongation of an insolvent corporation’s life, misrepresentation or omission of the corporation’s financial condition, and increased level of insolvency of the corporation caused by the prolongation and incurrence of additional debt. Some cases refer to fraud or negligence, such as the Lafferty case and the Exide case. However, no court has addressed the issue of whether fraud or negligence is a required element of the deepening insolvency cause of action. Therefore, even though some courts have accepted the theory as a separate cause of action, the elements of the cause of action are far from clear or uniform among the different states and federal circuits.
Damages Under the Deepening Insolvency Theory
Similarly, the measure of damages under a deepening insolvency claim is not yet clear. As enumerated by the Lafferty court, damages under a deepening insolvency claim may include, among other things, legal and administrative costs caused by bankruptcy; impaired and lost ability of the corporation to operate profitably due to certain operational limitations that may be imposed on the corporation; lost profit and value due to the loss of confidence of other parties who have dealings with the corporation; impairment of the corporation’s relationship with its employees, customers and suppliers; and dissipation of the corporate assets. The court, however, did not specify how the damages for these items should be measured.
Although the measure of damages is not clear, it is obvious that directors and officers are subject to greater risks of liability and damages, because the deepening insolvency theory provides a new and separate cause of action for which liability and damages may be assessed, in addition to the traditional causes of actions such as breach of fiduciary duty, misrepresentation and fraud. As the courts have not articulated any limits to the deepening insolvency cause of action, the liability under this theory is uncertain.
Protections Available to Directors and Officers
As indicated above, directors and officers generally owe fiduciary duties to the corporation and its shareholders. However, when the corporation becomes insolvent, fiduciary duties are also owed to the creditors. The standard of care of directors and officers is not clear in deepening insolvency situations. Some courts have applied the business judgment rule to actions of directors and officers in such situations, while other courts have determined that the best interest of creditors controls. The Delaware Chancery Court held that the business judgment rule applies even when the law recognizes that directors’ and officers’ duties include the interest of the creditors.9 The business judgment rule creates the presumption that the actions of directors and officers are made in good faith and in the best interest of the corporation. The business judgment rule, therefore, offers directors and officers some protection from the risk of liability under the deepening insolvency theory. The rule, however, cannot completely shield directors and officers from liability, especially since directors and officers may be subject to a different standard in the zone of insolvency.
What Should be Done When the Business Faces Insolvency
As the number of courts that recognize the deepening insolvency theory as a separate cause of action increases, directors and officers may be exposed to significant risks of liability if they fail to evaluate realistically the financial situation and the chance of survival and recovery of the corporation. Because the courts have yet to articulate any legal limits or measure of damages under this theory, the possibility of significant personal liability of directors and officers, as well as professionals and lenders, clearly exists. What should directors and officers do when the corporation faces insolvency?
First, directors and officers should make a realistic and practical evaluation of the future viability of the corporation. They should consider that not every business merits continuation and that continuation could result in personal liability for the directors and officers under the deepening insolvency theory. This is not to say that whenever a corporation approaches insolvency, directors and officers should file bankruptcy prematurely to avoid personal liability. The necessity and timing of the filing of bankruptcy or reorganization should form a significant part of the assessment and evaluation by the directors and officers.
Directors and officers should be cautious in taking on additional or excessive debt if the chance of recovery for the corporation is slim. Similarly, directors and officers should be wary of granting additional security to secured lenders to extend the life of the corporation when the corporation is in the vicinity of insolvency. Directors and officers should be mindful that they may owe fiduciary duties to creditors as well as the corporation and its shareholders.
Directors and officers should also understand and monitor the corporation’s financial condition closely as the corporation approaches the vicinity of insolvency. In this regard, the directors and officers should apply realistic market values and be on guard for accounting irregularities.
Directors and officers should ensure that the articles of incorporation or bylaws of the corporation provide for indemnification for their official actions. Adequate liability insurance for directors and officers should be maintained by the corporation.
Most importantly, directors and officers should act in accordance with the requirements of the business judgment rule, including making informed decisions by seeking advice from financial and legal advisors in evaluating the corporation’s financial situation and prospects of recovery and determining the best course of action for the corporation. Directors and officers must be mindful that their exposure to personal liability tends to increase at this point in a corporation’s existence. Additionally, since the courts have not articulated any limits to a deepening insolvency claim, the potential liability for directors and officers is still uncertain. Experienced financial and legal advisors should be consulted to assist in realistically evaluating the corporation’s condition, the risks associated with any proposed actions, the best course of action for the corporation to take, and the avoidance of liability for directors and officers. In that regard, directors and officers should consider whether in this process advisors other than the corporation’s regular advisors should be consulted with respect to the personal liability of the directors and officers.
- In re Flagship Healthcare, 269 B.R. 721, 728 n. 4 (S.D. Fla. 2001). ↩
- Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340, 347-50 (3d Cir. 2001). ↩
- Id. at 343. ↩
- Id. at 350. ↩
- In re Exide Technologies, Inc., 299 B.R. 732 (Bankr. D. Del. 2003). ↩
- Id at 736. ↩
- Jo Ann J. Brighton, Deepening Insolvency: Secured Lenders and Bankruptcy Professionals Beware: It is Not Just for Officers and Directors Anymore, AM. BANKR. INST. J., Apr. 23, 2004, at 34. ↩
- Id. ↩
- Angelo, Gordon & Co. L.P. v. Allied Riser Communications Corp., 805 A.2d 221, 229 (Del. Ch. 2002). ↩