Thank you for sharing!

Your article was successfully shared with the contacts you provided.
With much of the fallout from the major securities scandals of the past decade now waning, public attention to corporate fraud seems to have declined. The U.S. Supreme Court itself recently refused to revisit the issue in the WorldCom case, and the reformulation of securities regulations over the past few years has helped to tighten market oversight and allay public concerns. However, where one leak is plugged, another has sprung. The massive securities frauds of the 1990s have given way to a new form of corporate fraud that targets a different class of victims: corporate creditors. As the nation looks back with relief at the receding wave of the past, it has largely failed to notice the next big one on the horizon in the form of post-insolvency fraud. The Delaware Chancery Court recently released a stunning indictment of the so-called theory of “deepening insolvency,” stating that “Delaware law does not recognize this catchy term as a cause of action, because catchy though the term may be, it does not express a coherent concept.” Trenwick American Litigation Fund v. Ernst & Young LLP, 906 A.2d 168 (New Castle Co., Del., Ch. 2006). In the context of the Trenwick case, this pronouncement was not altogether unwarranted. Unfortunately, it appears that what set off the chancery court in this case was not a true claim for deepening insolvency � in fact, insolvency was not even satisfactorily alleged in the complaint. What was alleged appears to be nothing more than a set of conclusory allegations of the sort that are unquestionably protected by the well-established business judgment rule, a fact that the court amply recognized: “What Delaware law does not do is to impose retroactive fiduciary obligations on directors simply because their chosen business strategy did not pan out.” Based on such remarkably deficient pleadings, the chancery court’s vitriolic response is better understood; however, by attaching a plainly empty assertion of “deepening insolvency” onto the tail end of these allegations, the Trenwick complaint did the true concept a massive disservice. The logic behind the theory As a conceptual matter, the theory recognizes that there exist different levels of insolvency and that the progression of a corporation from barely insolvent to irretrievably insolvent can have devastating effects on corporate stakeholders. This is not a revolutionary principle; nor is the proposition that those parties that are damaged by the purposeful and fraudulent deepening of a corporation’s insolvency should be compensated for their full financial loss. As first recognized in Schacht v. Brown, 711 F.2d 1343, 1350 (7th Cir. 1983), “the corporate body is ineluctably damaged by the deepening of its insolvency, through increased exposure to creditor liability.” While many point to existing economic mechanisms to price-adjust for this risk, the statistically unlikely aspect of fraud precludes their effectiveness. With debt a staple of the current American business diet, companies are no longer afraid to assume increasingly complex and highly leveraged financial positions as part of their overall growth strategy. In a market in which staggered-maturity debt is common and firms are not bound by the expiry of a single debt load, the traditional discipline imposed by debt no longer holds much power. Firms now juggle various loan structures, often replacing expiring capital with new debt to remain operational despite book insolvency. All the while, it is the existing unsecured creditors that bear the cost of the new loans. As such, corporate management and equity holders have incentive to sustain the corporation as long as possible, “a gamble paid for by the extant early creditors” when these efforts fail. Barry E. Adler, “Accelerated Resolution of Financial Distress,” 76 Wash. U. L.Q. 1169, 1172 (1998). Meanwhile, two significant doctrinal problems often block post-insolvency creditors from gaining recompense for corporate malfeasance: the requirement of standing and the in pari delicto defense. In pari delicto evolved from traditional principles of agency to prevent a party that shares responsibility for wrongdoing from collecting against a co-conspirator for the result of their joint actions. However, when applied to fraud in a post-insolvency context, the defense often bars trustees from pursuing claims in a way that similarly situated investors in derivative actions are not. Simultaneously, when creditor committees attempt to evade this roadblock by asserting claims on their own behalf, they are often precluded by technical issues of standing and lack of privity. In the end, even successful actions untainted by these problems remain largely incapable of recapturing the total sum of dissipated assets resulting from deepened insolvency, thereby limiting adequate recovery. Contrary to popular belief, deepening insolvency theory does not declare open season on corporate-turnaround professionals. Nor does it circumvent existing bankruptcy norms; on the contrary, concealing insolvency is what precludes creditors from exercising the oversight powers specifically granted them by the Bankruptcy Code and by many loan covenants to prevent this harm. Deepening insolvency responds to the inability of creditors to bring successful actions against management and outside professionals in cases in which the measure of damages resulting from a fraud exceeds easily identifiable misappropriated funds. Recent misapplications of the theory notwithstanding, using this concept to justify damages spanning the total value of dissipated post-insolvency corporate assets may provide much needed protection to a class of creditors that are in a similar position today to that of the victimized shareholders of the post-Enron fury of the 1990s � and herein lies its value. Maaren Choksi, a recent graduate of Stanford Law School, will be an associate in the New York office of Quinn Emanuel Urquhart Oliver & Hedges in the fall.

This content has been archived. It is available through our partners, LexisNexis® and Bloomberg Law.

To view this content, please continue to their sites.

Not a Lexis Advance® Subscriber?
Subscribe Now

Not a Bloomberg Law Subscriber?
Subscribe Now

Why am I seeing this?

LexisNexis® and Bloomberg Law are third party online distributors of the broad collection of current and archived versions of ALM's legal news publications. LexisNexis® and Bloomberg Law customers are able to access and use ALM's content, including content from the National Law Journal, The American Lawyer, Legaltech News, The New York Law Journal, and Corporate Counsel, as well as other sources of legal information.

For questions call 1-877-256-2472 or contact us at [email protected]

Reprints & Licensing
Mentioned in a Law.com story?

License our industry-leading legal content to extend your thought leadership and build your brand.


ALM Legal Publication Newsletters

Sign Up Today and Never Miss Another Story.

As part of your digital membership, you can sign up for an unlimited number of a wide range of complimentary newsletters. Visit your My Account page to make your selections. Get the timely legal news and critical analysis you cannot afford to miss. Tailored just for you. In your inbox. Every day.

Copyright © 2021 ALM Media Properties, LLC. All Rights Reserved.