Deepening Insolvency: The Third Circuit Steps Back from the Breach

At my alma mater's faculty blog, my friend and former classmate, Professor Bob Rasmussen, writes about a business's "Prime Directive"; that is, "first hire the right person as CEO, [then] ensure that the CEO is shown the door at the appropriate time."  Bob concludes his post by noting that "law can influence the discussion. Doctrines such as lender liability, equitable subordination, and the tort of deepening insolvency, if pushed too far, can make lenders hestitate, thus prolonging the tenure of managers that need to go."

Speaking of "pushing too far," consider the highly controversial case of Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340 (3d Cir. 2001) (pdf), in which the Third Circuit -- "predicting Pennsylvania law" -- declared that deepening insolvency is a separate and independent tort in Pennsylvania and that the resultant "injury" from this tort is "to [a debtor's] corporate property from the fraudulent expansion of corporate debt and prolongation of corporate life."   

In Seitz v. Detweiler, Hershey & Assocs., P.C. (In re CitX, Inc.), 2006 WL 1453117 (3d Cir. 5/26/06) (pdf), the Third Circuit pushed back in a follow up to its much-maligned opinion in Lafferty.  In CitX, the Third Circuit commented on the controversy spawned by Lafferty, stating (at footnote 11):

Though Lafferty and the economic tort it interpreted Pennsylvania law as approving for fraudulent conduct have provoked much comment, see, e.g., William Bates III, Deepening Insolvency: Into the Void, Am. Bankr.Inst. J., Mar. 2005, at 1; J.B. Heaton, Deepening Insolvency, 30 J. Corp. L. 465 (2005); Willett, [The Shallows of Deepening Insolvency, 60 Bus. Law. 549, 552-57 (2005)], that issue is not before us. Even if it were, we cannot revisit the correctness of that interpretation of Pennsylvania law. See In re Merck & Co. Sec. Litig., 432 F.3d 261, 274 (3d Cir. 2005) (noting that only the Court en banc can overrule a precedential decision). Although some courts in this Circuit have extended Lafferty' s reasoning to other states, nothing we said in Lafferty compels any extension of the doctrine beyond Pennsylvania.  (Citations omitted.)

Two questions were addressed by the Third Circuit in CitX.  First, does negligence alone suffice to establish liability for deepening insolvency?  The Third Circuit answered this question with a resounding "no!," stating:

In addressing this question, we note that Lafferty holds only that fraudulent conduct will suffice to support a deepening-insolvency claim under Pennsylvania law. See id. at 347 (defining the injury as a “fraudulent expansion of corporate debt and prolongation of corporate life”); id. at 349 (referring to the “fraudulent and concealed incurrence of debt”); (citations to lower court cases within circuit omitted).  We know no reason to extend the scope of deepening insolvency beyond Lafferty' s limited holding. To that end, we hold that a claim of negligence cannot sustain a deepening-insolvency cause of action.

That's bombshell #1. 

The second question addressed by the Third Circuit in CitX was "whether deepening insolvency is a viable theory of damages for negligence (as opposed to whether it is a viable cause of action [as discussed above])."  In this regard, the opinion's author -- Judge Thomas L. Ambro -- noted that the Lafferty opinion itself was responsible for some of the confusion regarding whether deepening insolvency is a "type of injury," a "theory of injury," and/or an "independent cause of action."  Writing for a unanimous panel that included Judge Julio M. Fuentes and Judge Joseph E. Irenas (sitting by designation), Judge Ambro stated:

Although we did describe deepening insolvency as a “type of injury,” and a “theory of injury,” we never held that it was a valid theory of damages for an independent cause of action.  Those statements in Lafferty were in the context of a deepening-insolvency cause of action.  They should not be interpreted to create a novel theory of damages for an independent cause of action like malpractice.  [FN 8:  By this we do not mean to imply that deepening insolvency would be a valid theory of damages for any other cause of action, such as fraud, and Lafferty did not so hold.]  (Emphasis added.)

This latter holding -- bombshell #2 -- surely caused shock waves in law offices across the land, as it appears to put the kibosh on theories of damages that are premised on notions of "deepening insolvency."  In CitX,  the debtor's former accountants were sued by the debtor's chapter 7 trustee for malpractice.  The debtor, an internet high-flyer in the late 1990's, was involved in a Ponzi scheme with one of its partners and used the financial statements compiled by its accountants to dupe its investors into investing in the company.  The accounting firm committed malpractice, the trustee charged, because "it missed many 'red flags' at CitX ... including that CitX's “bookkeeper” was actually [the CEO]'s girlfriend, and a high school dropout; CitX was bouncing checks; it was insolvent (i.e., without the PRSI receivable [attributable to the Ponzi scheme], it had virtually no income); PRSI had been shut down; and yet CitX was selling stock to the public."

In affirming the lower court's summary judgment ruling dismissing the malpractice action, the Court held that no legally cognizable "harm" could be attributed to the accounting firm because "[t]he deepening of a firm's insolvency is not an independent form of corporate damage."  The Court reasoned as follows:

[W]e note that Seitz did not provide sufficient evidence to allow a reasonable jury to find harm. Assuming for the sake of argument that Detweiler's financial statements allowed CitX to raise over $1,000,000, that did nothing to “deepen” CitX's insolvency. It did the opposite.  Cf. Sabin Willett, The Shallows of Deepening Insolvency, 60 Bus. Law. 549, 552-57 (2005) (discussing loans). Before the equity infusion, CitX was $2,000,000 in the red (using round numbers for ease of discussion). With the added $1,000,000 investment, it was thereby insolvent only $1,000,000. Insolvency decreased rather than deepened. Any later increase in insolvency ( i.e., the several million dollars of debt incurred after the $1,000,000 investment) was wrought by CitX's management, not by Detweiler.

The crux, then, is the claim that the $1,000,000 equity investment allowed CitX to exist long enough for its management to incur millions more in debt. But that looks at the issue through hindsight bias. As noted, the equity investment was hardly harmful to CitX. Its management surely misused the opportunity created by that investment; that was unfortunate. But they 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 CitX. In any event, “[t]he deepening of a firm's insolvency is not an independent form of corporate damage. Where 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.” Id. at 575.  (Emphasis added.)

The Court also agreed that "there is nothing in the record to support a finding that anyone extended credit to CitX in reliance on the financial statements compiled by [the accounting firm], [the trustee] cannot establish that [the accounting firm] caused any harm to CitX."

Clearly, there are many nuances left unresolved by the opinion.  For example, would the result change if the $1 million advanced as equity in CitX had been advanced as debt instead?   The last quoted sentence above suggests that the result would be different, though a trustee would be hard-pressed to justify why it would have standing to bring an action based on claims that appear specific to the creditor who relied on the faulty financial statements.  The case also leaves us wondering whether the result would change if the financial statements had been audited instead of merely compiled?

For those who still want more, you'll find a couple of my prior posts on "deepening insolvency" here, here, and here.  Other cases recognizing deepening insolvency as a "damages" theory that you may want to review are Schacht v. Brown, 711 F.2d 1343 (7th Cir. 1983) (Wood, Jr., J.), Allard v. Arthur Andersen & Co. (USA), 924 F. Supp. 488 (S.D.N.Y. 1996) (Mukasey, J.), and Kittay v. Atlantic Bank of N.Y. (In re Global Serv. Group LLC), 316 B.R. 451 (Bankr. S.D.N.Y. 2004) (Bernstein, J.).

Thanks for reading.

© Steve Jakubowski 2006

Written By:Mark T On June 15, 2006 8:45 AM

This is a brilliant decision by a brilliant judge. Finally a judge has the common sense to state that helping companies raise money does not damage the company, even if they are insolvent and even if they raise the money improperly. The investors may be damaged by such conduct and can pursue whatever claims they may have, but the company certainly is not.