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Rancorous bankruptcies stretch from Hawaii to San Francisco to Manhattan. In Honolulu, Boeing Co.’s leasing arm is charging bankrupt Hawaiian Airlines Inc. management with fraudulent conveyance and self-dealing. Bankrupt PG&E Corp. is fighting with California regulators. In a downtown New York courtroom, MCI creditors have railed against its parent, bankrupt WorldCom Inc., and have called for a trustee to look after the unit’s interests. As the pot of money gets ever smaller and the creditor constituencies grow even larger in today’s bankruptcies, no legal argument or ploy is off-limits. Novel approaches mark how asbestos-related debtors are now defending themselves against claimants. Fraudulent conveyance motions have become increasingly common tools for creditors. So why hasn’t anyone really seized upon the use of the “deepening insolvency” theory to press their claims against debtors and their management? The deepening insolvency theory of liability holds that there are times when corporate managers, as well as third-party professionals, either purposefully or negligently help to hide information that show a company was insolvent when certain actions, such as acquisitions or debt-raising, are undertaken. The result is that the company’s financial distress becomes only more profound. “It’s a very interesting theory and a testament to the creativity of lawyers for expanding the scope of creditors’ remedies,” says Michael Reynolds, a bankruptcy attorney and commercial litigator with Phoenix-based Snell & Wilmer. “But I don’t know if it will ultimately find widespread acceptance in courts. Most courts, at least at the trial court level and bankruptcy court level, tend to want to follow statutes. They tend to not to want to invent or be perceived as inventing new claims.” Most recently, a deepening insolvency case was settled last year involving privately held Flagship Healthcare Inc., an acquisitive home healthcare company that filed for Chapter 7 liquidation in January 2000 in the U.S. Bankruptcy Court for the Southern District of Florida in Miami. Flagship regularly grossed $100 million year, had thousands of employees, and about 10,000 patients. Yet the bankruptcy process revealed that while Flagship did many acquisitions, it didn’t do much of the integration. As a result, its receivables were substantially overstated. The company’s Chapter 7 trustee, Joel Tabas of Tabas, Freedman & Soloff in Miami, says the company went on a buying binge so it could increase its gross amount of receivables to better position itself for a public offering. The plan was designed to “induce banks to keep lending money and to sucker creditors into extending them credit,” Tabas says. Tabas filed deepening insolvency claims against Flagship’s directors and officers, and against its auditing firm, PricewaterhouseCoopers. “Our argument was that, at some point in time, the directors and officers should have seen the writing on wall, and should have known they weren’t going to pull a rabbit out of the hat,” Tabas explains. “We argued that it was an abuse of their fiduciary obligation of not alerting creditors” to the deepening insolvency. Craig Rasile, Flagship’s counsel at Holland & Knight in Miami, takes issue with Tabas’ allegation of fraud. “The directors and officers did have a business plan when I got involved with the company. It just wasn’t implemented as well as it should have been,” Rasile counters. “Whether that borders on fraud and is actionable, I don’t know.” He adds that there was no criminal or regulatory investigation of the company by any agency, such as the Securities and Exchange Commission or the FBI. And PwC? “They should have raised the red flag sooner,” Tabas says. “They should have notified certain outside directors or someone to stop the bleeding.” Tabas settled the case against PwC for what one source says was about $3 million, though Tabas didn’t confirm that and filings involving the matter have been sealed. He also settled with Flagship’s directors and officers for an undisclosed amount, though the judge in the case dismissed many of Flagship’s executives from it early on. Tabas admits the deepening insolvency theory is a difficult sell. “It’s hard to say at what point in time someone had the fiduciary obligation to say ‘Stop,’” he says. “But I think it’s a valid theory.” It’s also still a new one, unlike most of the federal bankruptcy code, much of which can be traced back to 18th century English jurisprudence. To that end, the theory has its limits. It isn’t particularly well-defined. Not all court circuits have embraced it. And there are very few judges’ opinions on the matter. Of further concern for Reynolds is what could result if the theory finds widespread application. He fears it could become part of a common cycle in bankruptcy; when creditors can’t squeeze blood out of one party they look for another. In other words, they go looking for someone who is solvent to whom they can attach liability. “I don’t think it’s necessarily unjust for creditors to pursue remedies such as this,” Reynolds says. “On the other hand, this could be just one step on a slippery slope of creditors trying to hold everyone liable for every conceivable wrong and thereby creating a much more litigious process than we already have for resolving debtor-creditor issues.” Craig Millet, a bankruptcy partner with Los Angeles-based Gibson, Dunn & Crutcher, also warns about the implications of deepening insolvency claims. “It’s a legitimate area of inquiry, but it can be dangerous,” he says. “It could allow creditors to go on a witch hunt, in which any business decision that doesn’t work out can be liable.” Still, Rasile says deepening insolvency cases are still rare for a good reason. “It’s kind of esoteric because it’s somewhat difficult to prove,” he says. “Directors and officers typically try to do the best they can to maximize shareholder value and make sure creditors are paid in the ordinary course of business. I think such cases are filed for leverage purposes or settlement value rather than to provide a windfall for creditors.” In addition, if a company is already insolvent, what do creditors pursuing a deepening insolvency claim think they’ll get in terms of damages? “That’s still the question mark,” says Luis Salazar, an attorney at Greenberg Traurig, who has written extensively on the issue. “I don’t know if the damages portion [of the theory] has been tested, or ever will be. If a company’s value starts at 0 and it goes to [a deficit of] $5 million, for example, how are damages determined”? Arthur Andersen made that argument when defending itself against the Chapter 7 trustee for DeLorean Motor Co., who sued the auditing firm for contributing to the automaker’s deepening insolvency. DeLorean filed for Chapter 7 liquidation in 1984 under a cloud of suspicious accounting. The trustee, Dave W. Allard, argued that Andersen helped prolong an insolvent company’s life through the fraudulent expansion of corporate debt. At trial, Allard argued that DeLorean’s value diminished by tens of millions of dollars during the period preceding its bankruptcy. He said certain transactions occurred that the auditors should have discovered, exposed in their audit and reported to DeLorean’s board of directors. One particularly controversial transaction involved a $17.5 million payment that was divided between one of the company’s directors and two others through a series of complex, international transactions. “Our argument was, there’s a big difference between owing a $1 and owing in the millions,” Allard recalls. After stints in federal court and New York state court, the issue took 15 years to conclude. Andersen finally agreed to a reported $27 million settlement in 1999 after a jury found that it was liable for as much as $111.2 million — $46.2 million in damages and possibly up to $65 million in interest — to DeLorean’s investors and creditors, according to press reports at the time. The jury decided that Andersen committed negligence and breach of contract in audits of the defunct auto company in 1978 and 1979. “During all of those years in federal court, Andersen attacked all of the trustee’s theories for damages, and the only one remaining was deepening insolvency,” Allard says. “That was the one rock-solid theory of damages that couldn’t be disposed of.” Nonetheless, the matter was extremely novel. “At the time, we couldn’t find a case where the matter had been tried prior to our trial,” says Allard, co-founder of Detroit law firm Allard & Fish. Aside from the DeLorean case, the federal appeals courts in the 3rd and the 11th Circuits have had more recent experience with the theory. Consider the case of Walnut Equipment Leasing Co. Inc., and its wholly owned subsidiary, Equipment Leasing Corp. of America, and a debt underwriting by R.F. Lafferty & Co. Both Walnut and ELC, which are lease financing companies, were allegedly operated as Ponzi schemes. To operate the schemes, William Shapiro, Walnut’s president, and others allegedly caused the corporations to issue fraudulent debt certificates. When the companies lost any reasonable prospect of repaying the outstanding debt, they filed for bankruptcy. The unsecured creditors’ committee of both companies brought claims to the U.S. District Court for the Eastern District of Pennsylvania, alleging third parties had fraudulently induced the companies to issue the debt securities. The district court ruled the committee lacked standing to assert its claims. The committee then appealed that ruling to the 3rd U.S. Circuit Court of Appeals. The appeals court then dismissed the committee’s claims and affirmed the District Court’s ruling. Yet in its October 2001 opinion, the court delved into whether deepening insolvency is a valid theory that gives rise to a cognizable injury. Even when a corporation is insolvent, its corporate property may have value, and the fraudulent and concealed incurrence of debt can damage that value in several ways, the court said. “The very threat of bankruptcy, brought about through fraudulent debt, can shake the confidence of parties dealing with the corporation, calling into question its ability to perform, thereby damaging the corporation’s assets, the value of which often depends on the performance of other parties,” the court said. “These 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.” The court ruled that the unsecureds can’t recover damages because the committee basically represented the company and its principals in the case, making the committee inseparable from its advisers and equally guilty of wrongdoing. Stuart L. Melnick, a New York attorney who represented Lafferty, says he thought the charge was frivolous. “We deemed the entire complaint without merit,” he says. “The [committee's] attorneys were seeking to generate fees instead of seeking legitimate relief.” Yet the 3rd Circuit panel’s written opinion will likely give hope to future users of the theory. “We believe deepening insolvency is generally a valid theory for federal law claims,” the 3rd Circuit said. The seeds for use of the theory have certainly been planted. Liquidations are widespread nowadays. So are involuntary bankruptcy filings, which provide a good launching point for deepening insolvency actions. ( Flagship started as an involuntary bankruptcy case). And with the plethora of corporate sandals and contentious bankruptcy cases, the time may be ripe for more deepening insolvency cases to pop up. “I think public sentiment is likely to favor the expansion of remedies along this line,” Reynolds says. “Nobody is going to have sympathy for third-party nondebtors who are in any way involved in deepening the financial crisis of debtors, whether it be intentional or unintentional.” Copyright �2003 TDD, LLC. All rights reserved.

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