Back from a blogging R&R to take time to smell the roses, catch up on the ever-burgeoning e-precedent file, reflect on a year gone by since my mom’s passing, and–most significantly–get the house ready for Malthusian growth with a pair of twins due sometime next month (adding to the two young Jakubowski’s already here)! So please excuse my patchy blogging as of late, but as Livy first wrote, "better late than never…" (though, for the sake of completeness, I suppose I should add that Livy concluded, "but better never late").
Anyway, back to blogging, and thanks for reading.
As Bob Eisenbach, Francis Pileggi, and Scott Riddle were quick to observe, the Delaware Supreme Court just put the official kibosh on "deepening insolvency" as an independent cause of action. That is not the end of the story for bankruptcy litigators, however, since Vice-Chancellor Strine’s opinion in Trenwick America Litigation Trust v. Billet, 906 A.2d 168 (Del. Ch. 2006) (pdf), upon which the Delaware Supreme Court relied, doesn’t address whether deepening insolvency remains valid as a theory of damages.
As to the latter point, as I recapped here and here, last year the Third Circuit in Seitz v. Detweiler, Hershey & Assocs., P.C. (In re CitX, Inc.), 448 F.3d 672 (3d Cir. 2006) (pdf), held that–at least under Pennsylvania law–deepening insolvency "is not an independent form of corporate damage" and that its earlier decision in Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340 (3d Cir. 2001) (pdf), "should not be interpreted to create a novel theory of damages for an independent cause of action like malpractice … [or] for any other cause of action, such as fraud." In support of this proposition, the Third Circuit pointed to bankruptcy lawyer/novelist Sabin Willett’s oft-cited article, The Shallows of Deepening Insolvency, 60 Bus. Law. 549, 575 (2005), for the proposition that "[w]here an independent cause of action gives a firm a remedy for the increase in its liabilities, the decrease in fair asset value, or its lost profits, then the firm may recover, without reference to the incidental impact upon the solvency calculation."
Two recent opinions authored by the Seventh Circuit’s Judge Posner and the Southern District of New York’s Judge Lewis A. Kaplan, however, don’t adopt this per se rule (or at least, as regards Judge Kaplan, not in its entirety). In Fehribach v. Ernst & Young LLP, 2007 WL 2033734 (7th Cir. 7/17/07) (pdf), Judge Posner provides the following short discourse on the "controversial theory" of deepening insolvency as a theory of damages (including answering how shareholders might be "ineluctably" harmed by a company’s deepening insolvency):
The trustee’s damages claim thus is based on the theory of “deepening insolvency.” This controversial theory (see, e.g., In re Global Service Group, LLC, 316 B.R. 451, 456-59 (Bankr. S.D.N.Y. 2004), allows damages sometimes to be awarded to a bankrupt corporation that by delaying liquidation ran up additional debts that it would not have incurred had the plug been pulled sooner. As originally formulated, the theory was premised on the notion that borrowing after a company becomes insolvent would “ineluctably” hurt the shareholders. Schacht v. Brown, 711 F.2d 1343, 1350 (7th Cir. 1983). That was a puzzling suggestion because by hypothesis a company harmed by deepening insolvency was insolvent before the borrowing spree, so what had the shareholders to lose? But a corporation can be insolvent in the sense of being unable to pay its bills as they come due, Jeffrey M. Lipshaw, Law as Rationalization: Getting Beyond Reason to Business Ethics, 37 U. Toledo L.Rev. 959, 1016 (2006) (“equity” insolvency), yet be worth more liquidated than the sum of its liabilities and so be worth something to the shareholders; this was assumed to be a possibility in Schacht, 711 F.2d at 1348.
The theory could also be invoked in a case in which management in cahoots with an auditor or other outsider concealed the corporation’s perilous state which if disclosed earlier would have enabled the corporation to survive in reorganized form. Sabin Willet, The Shallows of Deepening Insolvency, 60 Bus. Law. 549, 565-66 (2005). However, as explained in Trenwick America Litigation Trust v. Ernst & Young, L.L.P., 906 A.2d 168, 204 (Del. Ch. 2006), the theory makes no sense when invoked to create a substantive duty of prompt liquidation that would punish corporate management for trying in the exercise of its business judgment to stave off a declaration of bankruptcy, even if there were no indication of fraud, breach of fiduciary duty, or other conventional wrongdoing. Nor would it do to fix liability on a third party for lending or otherwise investing in a firm and as a result keeping it going, when “management … misused the opportunity created by that investment…. [T]hey [management] could have instead used that opportunity to turn the company around and transform it into a profitable business. They did not, and therein lies the harm to [the company].” In re Citx Corp., 448 F.3d 672, 678 (3d Cir. 2006).
Notably, according to Judge Posner, the trustee’s claim fails "on the facts" (and not as a matter of law). Winnowing the trustee’s theory to its essence, Judge Posner states:
The argument has to be that had Ernst & Young included the going-concern qualification in its audit report of October 1995, Bank One would have acted sooner, precipitating an earlier liquidation.
Judge Posner, however, refuses to tag Ernst & Young with deepening insolvency damages for the period between the time of its "clean" audit report and the bank’s subsequent pulling the plug on the business, finding that the debtor’s officer (whose knowledge is imputed to the corporation) "knew everything she had to know in order to determine whether the company had been injured by Ernst & Young’s failure to have included a going-concern qualification in the audit report…, yet it didn’t deflect her from trying to avert liquidation." In essence, according to Judge Posner, the case failed because there was no proximate cause between the auditor’s alleged wrongdoing and the alleged injury (i.e., the alleged "deepening insolvency".)
What’s the final precedential impact of Judge Posner’s opinion on the law? Maybe none, as it all may be dictum, even under Judge Posner’s definition of it, given the concurrence by Judge Ilana Rovner, who simply wrote: "I agree that this action is barred by the statute of limitations, and would limit the decision to that issue alone."
Those interested in gaining insights into Judge Posner’s views on the scope of an auditor’s responsibilities in connection with the issuance of a going-concern opinion are well-advised to listen to his pointed questions (and his demand for pointed answers) in the 40 minute oral argument in the case. Here are a couple of notable Posnerian pragmatisms, drawn from his trenchant exchanges with counsel for the trustee, regarding the scope of an auditor’s responsibilities under SAS 59 (which requires the auditor to consider whether "certain conditions or events that, when considered in the aggregate, indicate there could be substantial doubt about the entity’s ability to continue as a going concern for a reasonable period of time") (see also, the discussion of SAS 59’s requirements in the opinion at pp.8-9):
- "The auditor’s responsibility … so far as the company is concerned … is to make sure the [numbers] are accurate…. You don’t need an auditor to tell you your market is collapsing…. The auditors are not supposed to have business insight. They’re counters. They’re not supposed to make predictions about how your markets are doing. They’re supposed to reconcile your books and indicate you’re not a going concern because your debt is too high and so on…. And what is this boxed food business anyway? Auditors are not supposed to know trends in the boxed food business." (12:15-13:15)
- "Do you think the auditor is supposed to know about market power?… An auditor is not an economic consultant who goes out and figures out what the market trends in an industry are!…" (17:43-18:07)
Finally, to round out the analysis, there’s Judge Kaplan’s recent analysis of deepening insolvency as a theory of damage in In re Parmalat Securities Litigation, 2007 WL 2263893 (S.D.N.Y. 8/8/07) (pdf). Relying heavily on Sabin Willet’s deepeningly influential article, Judge Kaplan makes a distinction–notably, one that Judge Posner did not make–between delaying the inevitable (i.e., delaying liquidation) and delaying a save opportunity (i.e., delaying reorganization). According to Judge Kaplan, as a matter of law, deepening insolvency damages cannot arise in a "delayed liquidation," but they’re at least theoretically possible in a "delayed reorganization" (though in such instance, "[p]lainitffs [must] supply factual allegations sufficient to raise a right to relief above the speculative level [to survive a motion to dismiss]"). (Op. at pp. 24-33.)
So, while the death knell tolls for "deepening insolvency" as an independent cause of action, confusion continues to reign over whether damages for "deepening insolvency" exist, and if so, under what circumstances.
© Steve Jakubowski 2007