Watch Out Directors and Officers: Third Circuit Keeps "Deepening Insolvency" Action Alive
November 30, 2011
Deepening insolvency is a controversial cause of action that can create a rich recovery or harsh penalty. Essentially, where applicable, a cause of action for deepening insolvency can be brought by a corporation, directly or derivatively, against its directors and officers for increasing an insolvent corporation's debt and/or decreasing the value of its assets by prolonging its corporate life. Deepening insolvency has come under attack in some jurisdictions, including Delaware, by the venerable Delaware Chancery Court, which has all but said that deepening insolvency is dead. However, the Third Circuit Court of Appeals has recently held that deepening insolvency is alive and well, at least under Pennsylvania law.
In 2007, the Delaware Supreme Court adopted a Delaware Chancery Court opinion finding that deepening insolvency is not a viable cause of action under Delaware law. However, in 2008, the United States Bankruptcy Court for the District of Delaware found that deepening insolvency may apply to the determination of damages even thought there is no independent cause of action for it under Delaware law. Now, in 2011, the United States Court of Appeals for the Third Circuit has firmly held in Lemington Home for the Aged v. Baldwin (3d Cir. Sept. 21, 2011), that a cause of action for deepening insolvency is viable under Pennsylvania law, if the directors and officers had fraudulently expanded the corporation's debt and prolonged its corporate life.
Since a successfully prosecuted claim for deepening insolvency can be a rich source of recovery for creditors’ committees, bankruptcy trustees and others, private equity firms, directors and officers need to be acutely aware of their actions when the corporation is nearing insolvency; failure to do so can lead to harsh results. While the trend is to limit the applicability of the theory of deepening insolvency, there remain certain jurisdictions where the theory remains alive and well. Regardless of whether a party is on the prosecution or defense side of a cause of action for deepening insolvency, it will usually require an intensive factual investigation with a sophisticated legal analysis that will vary, perhaps significantly, depending upon the jurisdiction in which the cause of action is asserted.