The shallows of deepening insolvency

The shallows of deepening insolvency

The shallows of deepening insolvency



FALSTAFF What money is in my purse?

PAGE Seven groats and two pence.

FALSTAFF I can get no remedy against this consumption of the purse

Sir John didn’t realize that he had an action against his lender, but those were unenlightened times. Today he might have a remedy: “Growing acceptance of the deepening insolvency theory confirms its soundness,” wrote the U.S. Court of Appeals for the Third Circuit in 2001. (2) More and more Chapter Eleven trustees and estate representatives are filing suit against directors, officers, accountants, financial advisors, and others who, it is alleged, were involved in the wrongful “deepening” of a firm’s insolvency. Whether deepening insolvency is a cause of action or merely a damage theory remains a little murky, but the notion that a firm sustains harm when its insolvency deepens now goes unchallenged by all save heretics and cranks. (3) In 2003, a Delaware court moved the theory to its next step, ruling that a plaintiff stated a claim against a lender on the theory that the lender’s prepetition loan helped deepen the insolvency of a Chapter Eleven debtor. (4) Last year, in the In re Global Service Group, LLC decision, (5) a court dismissed a similar claim against a lender, (6) but a more recent decision concluded that “deepening insolvency” counts stated claims under Tennessee law. (7) Perhaps the time has come to take a closer look at deepening insolvency theory as an economic proposition.


The phrase “deepening insolvency” seems to have evolved from dictum in a 1983 decision of the U.S. Court of Appeals for the Seventh Circuit. (8) In Schacht v. Brown, (9) the liquidator of a failed insurance company made claims against corporate insiders and other defendants. He alleged that the carrier continued to write risky coverage after it had become insolvent, and that while in distress it generated cash by flogging off one of its few valuable assets, a plum portfolio. The defendant argued that the sale had provided corporate life support in the form of desperately-needed liquidity, and thus that the liquidator’s claim was barred “by the general rule prohibiting a corporation from suing for damages caused by the artificial prolongation of its life.” (10) The Seventh Circuit rejected this defense with a ringing phrase: “[T]he corporate body is ineluctably damaged by the deepening of its insolvency.” (11)

Doctrines are like life: complex organisms evolve from the most unremarkable amino acids. Within a generation of Schacht, federal courts were issuing pronouncements that “‘deepening insolvency’ constitutes a valid cause of action under Pennsylvania state law,” (12) and that Delaware recognizes a “tort of deepening insolvency.” (13) In re Exide Technologies, Inc., (14) a court let discovery proceed on a “deepening insolvency” claim against lenders who make loans to distressed buyers. (15) This is evolution at light speed. What was merely a failed defense in Schacht now walks on all fours and demands recognition by legal taxonomists as a fully-fledged cause of action.

As to the elements of this “cause of action,” Official Committee of Unsecured Creditors v. R.F. Lafferty & Co. and Exide were as delphic as the Restatement (Second) of Torts is silent. Was it enough to justify a damage award merely to utter the incantation, “deepening insolvency?” Perhaps the courts were ushering in a new Utopia, where Microsoft would be liable in tort to any failed software firm whose insolvency it had “deepened” by competing in the marketplace. Last year, Judge Bernstein’s Global Service Group decision injected much-needed sense into the discussion by ruling that “deepening insolvency” is not a cause of action at all. (16) A Chapter Seven trustee had brought “deepening insolvency” claims against corporate insiders and a lender for “allowing” an insolvent corporation to prolong its corporate existence, incur increased debt, and thereby reduce the recovery of unsecured creditors. The court dismissed, ruling that under New York law, “deepening insolvency” was simply a theory of damage, available only to a plaintiff who pleads an otherwise valid cause of action. (17) So Global Service Group seems sound as far as it goes. In long years of jurisprudence, statutes and the common law have evolved the duty of director to firm, of auditor to firm, of manager, lawyer, lender, underwriter, and competitor to firm. Unless all of this law is to be tossed out because the firm’s insolvency happened to be deepening at the time of the delict, surely “deepening insolvency,” if it is anything more than a charming dactyl, is no more than a theory of damage. (18)


Recent cases have seen “deepening insolvency” claims pursued against lenders with mixed success. No reported case has gone to judgment, but in Exide, the court denied a motion to dismiss, ruling that such a claim against a lender stated a valid cause of action. (19) Global Service Grow granted dismissal, holding that making a loan the bank “knew or should have known Global could never repay…. may be bad banking, but–isn’t a tort.” (20) The claims asserted against the lenders ran aground on the absence of duty. Neither case wrestled with the more interesting economic question: even if we assume the existence of a duty of lender to borrower broader than the contractual obligations of the loan documents, can a loan “deepen insolvency?” Does a loan worsen Falstaff’s plight, or does it only “linger and linger out” the consumption that was already there?


To understand what it is, as an economic proposition, to “deepen” insolvency, we should begin with what insolvency is. At least within the regime of Title 11, “insolvent” means a “financial condition such that the sum of such entity’s debts is greater than all of such entity’s property, at a fair valuation exclusive of [exempt property].” (21) The Third Circuit had this “balance-sheet insolvency” in mind in R.F. Lafferty. We might begin and end the economic analysis here, for “insolvency” is limited by definition to the balance-sheet brand. But to give ‘deepening insolvency’ theory its due, perhaps one should go further, and explore the two statutory equivalents that may authorize a court to avoid transfers. First, what we might call “cash-flow insolvency” exists where a company intends or believes that it will incur debts that would be beyond its ability to pay as those debts mature. (22) A company might fetch in a going-concern sale more than the amount of its liabilities, yet be so overwhelmed by competition that it does not expect to generate the cash to pay next-month’s payroll or the interest coupon due in June. This is close kin to “low-capital insolvency”–where a company engages in a business or transaction that its capital is simply too small to protect against the risk of future setbacks. (23)

Each of the latter two classes of insolvency is a function of expectations. Each turns on reasonable projections. If a company’s business model shows that in Years 2 and 3 it will generate too little cash to meet its projected fixed costs and interest payments, we may view it for present purposes as insolvent, even if in a going-concern sale today, all of today’s debt could be paid. The same may be said for the pro forma generated as part of a deal. If after acquiring Dunlop, Exide’s pro forma showed that it did not expect to be able to meet its obligations, it might be insolvent under the third test. (24)


How then would any of these forms of insolvency deepen? Balance-sheet insolvency presumably deepens as liabilities rise or the fair value of assets diminishes. Under the second and third classes, it is not so clear. Because the analysis is prospective to begin with, the financial setbacks of the future might be viewed as proving out the insolvency that always existed, not deepening it. But to analyze the theory we may say that if, as time goes on, updated projected operating statements show a growing disparity between projected obligations and cash available for payment, insolvency “deepens.”


Balance-Sheet Insolvency

It is simplest to begin with the first class of insolvency–the company whose liabilities exceed the fair valuation of its assets. For this purpose we posit Bottleco, a manufacturer of plastic bottles. It has annual earnings before interest, taxes, depreciation and amortization (“EBITDA”) of $10 million. All experts agree that plastic bottle manufacturers are valued at four times EBITDA. Bottleco has $50 million of debt. It is therefore balance-sheet insolvent. We will assume (unrealistically), that all of its debt is unsecured trade debt of equal priority. The holders of claims can expect that their claims are worth eighty percent of face value. Said another way, insolvency stands at $10 million, or twenty percent of the debt.

This insolvency might be deepened by reduction of fair asset value or increase in liabilities. Does the making of a loan cause either to occur? Suppose, for example, that the Bank of Last Resort makes a $10 million term loan. This fresh liability of $10 million brings Bottleco’s total debt to $60 million. But its assets also rise by $10 million of cash, and now stand at $50 million. Against their $60 million in debt, creditors would today recover $50 million–the $40 million enterprise value, and the $10 million of cash. That is eighty-three percent of their claims. On a sale today, the distribution to creditors actually looks better. Insolvency is “shallower,” not deeper–it is down to seventeen percent as a percentage of outstanding debt.

The hypothetical is a little artificial. We know that in the real world the Bank of Last Resort’s new loan will not be unsecured. Bottleco is in distress. The lender will demand security interests in everything. At the moment the loan closes, Bottleco will have two priorities of creditor: Bank, with an oversecured claim of $10 million, and trade creditors, with their $50 million in claims. Viewed as a snapshot when the loan is made, there is cash to pay Bank’s debt, leaving for trade the same $50 million of debt against a net $40 million of value. Bottleco’s insolvency stands unchanged. The calculation is the same at all levels of balance-sheet insolvency and at all levels of fresh secured debt. If the loan is $100 million, the result is the same. The fresh cash equals and cancels out the fresh debt, and the insolvency stands as it did before. In short, a new loan, however onerous or ill-advised, can never “deepen” balance-sheet insolvency.

Courts used to understand this. Before the birth of the “deepening insolvency” catch-phrase, the Ninth Circuit cogently analyzed the theory. (25) In 1970, Sunset International Petroleum Company filed a petition for reorganization under Chapter 10 of the Bankruptcy Act. The trustee sued directors, officers, and the company’s auditors. “The gist of Rochelle’s action was that the defendants, through mismanagement, misrepresentations, and breaches of duties owed to the corporation and to the investing public, grossly overstated the net worth of Sunset and concealed its deteriorating financial condition, causing substantial losses to Sunset, its creditors, and debenture purchasers and holders.” (26)

The Ninth Circuit held first that the trustee had no standing to maintain an action on the part of any person or entity other than his debtor corporation, and specifically that he could not bring actions on behalf of creditors. (27) Then it considered claims of the corporation. The trustee asserted that Sunset had been harmed by the fraudulent issuance of debentures that it was not capable of repaying. The Ninth Circuit nicely framed the “deepening insolvency” theory as applied to a lending case:

Each of the defendants asserts that Sunset cannot seek any relief

on this series of transactions because Sunset received the full

face amount of all debentures issued, from which it realized and

used more than $8 million. Rochelle admits that Sunset suffered

no loss on the issuance of its debentures. But, he argues,

Sunset was nevertheless a loser because the issuance of debentures

was part of a larger deceptive scheme by which the defendants

created a facade of corporate health when, in fact, Sunset’s

business was suffering from monetary pernicious anemia…. [T]he

defendants “ignored the disastrous cash flow demands of Sunset’s

real estate projects. Extensive funds obtained from Sunset’s

debentures and other lenders were expended to satisfy the negative

cash flows of various real estate projects, never to be

recouped…. Simply put, [defendants] purported to maintain a going

business when they should have acknowledged a business

failure….” (28)

The trustee’s admission that the company “suffered no loss” on the making of the loan (i.e., the issuance of the debentures) is almost quaint

Oh wise and upright judge! Falstaff is insolvent not because of how he borrows, but how he spends. (30) Despite how knowledgeable or complicit commercial lenders may be, it is corporate management, not lenders, who spend. Rochelle held therefore that no 10b-5 claim had been stated. (31) The court said,

Sunset could not successfully sue because it lost nothing in its

capacity as an investor on the issuance of its debentures. It

received full value for the securities

frittered away the funds on losing real estate ventures does not

mean that Sunset suffered a loss compensable under the federal

securities fraud laws. (32)

This logic would apply–we may even say apply ineluctably–in any lender case seeking deepening insolvency damages. In R.F. Lafferty, the committee alleged that fraud “wrongfully expanded the [D]ebtors’ debt out of all proportion of their ability to repay and ultimately forced the [D]ebtors to seek bankruptcy protection.” (33) But the expanded debt consisted of notes to bilked investors. The notes were issued on receipt of cash. The new obligations evidenced by the securities did not expand the debt “out of all proportion.” Quite the opposite, they expanded debt in precise proportion–dollar-for-dollar proportion–to the expansion of assets in the form of new cash contributed by the victims. Loans then do not deepen insolvency of the balance-sheet variety They may “linger and linger it out,” but they do not bring on consumption of the purse, even for a profligate like the fat knight. Yet the modern decisions are oblivious. Rochelle gathers dust in the cellar, while R.F. Lafferty and Exide are the popular vintages. (34)

Low-Capital Insolvency

What of the cousins? They involve the undertaking of obligations without sufficient capital, or the inability to meet one’s obligations as they come due. There is a good theoretical argument that a loan could never deepen “low-capital insolvency,” for a loan always adds capital. It is debt capital, to be sure, perhaps issued on improvident terms, but it is added capital nonetheless, and thus insolvency as a function of available capital cannot have deepened. A firm that boosts its capital account with loan proceeds may, through spending them unwisely, undermine its ability to repay, but if there is a deepening there, it must be of the third brand: the inability to pay debts as debts come due.

Cash-Flow Insolvency

Earlier this Article mentioned the threshold problem of the forward looking varieties of insolvency. If they are forms of insolvency at all, they refer to the expectation of the debtor at the outset, and yet we consider whether they can later “deepen.” To fit the theory to the lending context, we have to imagine that a company already unable to meet obligations as they came due borrowed money and thereby became even less able to meet its obligations. This seems strange: at a minimum, the loan proceeds must have helped with the most urgent, short-term obligations. At all events we have to show that a reasonable forecast of the future as of the date the loan closed would already show an inability to meet obligations. This will be a problem in the usual commercial case, where both the company and the lenders will have developed, as part of the loan approval process, a series of projections showing that the deal works. Typically, a distressed loan will be thought to alleviate a cash-flow problem. Thus, the firm (or its representative) will be faced with a steep evidentiary climb. In all likelihood its own contemporaneous loan analysis will contradict the notion that the loan worsened the firm’s projected cash flows. Worse, if the lender agreed, it likely based its view, at least in part, on the firm’s own representations or data.

This is only part of the plaintiff’s problem. If insolvency deepened after closing, it will be even clearer that it was the spending, not the borrowing, that actually deepened it, and it was management, not the lender, who spent. The failures demonstrated after closing inevitably will have been bound up in the board’s decisions after closing: the ventures pursued and not pursued, the products developed and the products discarded, the markets tended and those abandoned, in short, the uses to which loan proceeds were put. This should bring us around to the propositions in Global Service Group that (i) recovery for “deepening insolvency” can exist only where the law elsewhere affords a duty running from defendant to plaintiff, and (ii) a lender does not owe its borrower a duty to make it a good loan. (35)

The usual bromide is to the effect that a loan deepened a firm’s insolvency by causing or allowing it to operate longer than it prudently should have done. Suppose we cut our Bottleco example to fit. A year after the Bottleco loan is made, enterprise value has deteriorated. Now there are $50 million of unsecured claims and $10 million of senior secured claims, but the cash from Bank’s loan is gone and enterprise value has fallen to $20 million. $50 million of trade claims are chasing only $10 million in value, and insolvency from their perspective has increased to eighty percent. The question remains, did the loan cause this deterioration?

A commercial loan facility is an asset in the lower-case sense. It is a tool that a board may use or leave on the shelf, qualitatively no different than a willing vendor, a work force, an available production line, a warehouse full of sheet metal, or any of the other components of an operating enterprise. Management may elect–or decline–to put such tools to use: it may decide to hammer the metal into machines or sell it for scrap

Take Exide. In 1997, commercial lenders established a $650 million credit facility for Exide and its affiliates. Three years later, the lenders advanced a further $250 million to finance the acquisition of a competitor, GNB Dunlop. Exide soon tumbled into Chapter Eleven. The suit alleged that as part of the 2000 financing, the lenders improved the collateral footholds securing their 1997 loan, and increased their control over Exide itself. But borrowing the money did not harm Exide, spending it did. Although the lender surely knew how the loan proceeds would be spent, it was in the last analysis the directors who spent the money.

When insolvency deepens, one or both of two factors will be at play. First, micro- and macro-economies have changed. In the Bottleco example, a new competitor has appeared, petroleum-based plastics have doubled in cost, youth have renounced soft drinks, America has invaded another middle-eastern nation, interest rates have risen sharply, or something else has happened. The second factor is that in Bottleco, as in Exide, the company has spent the loan proceeds on something, and that something has not produced value. Whatever that something, whether extrusion machine or corporate acquisition, it represented the exercise of a fundamental business judgment at the core of the director’s duty: the decision whether to operate or liquidate. For the reasons discussed below, it is hard to see how the lender can ever be liable for that.

We should linger to observe that in deepening insolvency cases plaintiffs do say the strangest things. Consider this allegation by the plaintiffs in the Exide case: “[T]he [l]enders caused the Debtors to acquire GNB Dunlop so that they could obtain the control necessary to force the Debtors fraudulently to continue its business for nearly two years at eve>increasing levels of insolvency.” (36) Sharp commercial lenders spent a quarter billion dollars in order to obtain control of an insolvent company? It’s a shame no one told them that if they wanted control, they could have bought the equity. Because the plaintiff alleged deepening insolvency, we may assume insolvency to begin with, which means the equity would have cost the financiers at Credit Suisse First Boston something less than one dollar. Instead, plaintiff assures us, they thought it preferable to put up $250 million.

In short, whether we consider insolvency in its definitional, balance-sheet sense, or in its cash-flow or undercapitalization senses, extending credit does not deepen it. Depending on the terms of a loan, it may actually improve solvency from a balance-sheet or low-capital perspective. Solvency more likely will not change through borrowing, but certainly it will not change for the worse. Whether a firm’s solvency picture will deteriorate will turn, rather, on spending, and that concept is perhaps best framed by considering the two procedural roadblocks that receive the most ink in the reported cases.


In Pari Delicto

Significant procedural problems face all deepening insolvency claims brought on behalf of the firm (37) itself. One is in pari delicto: the equitable doctrine that a court should not assist a participant in a wrongful act to profit from it. Most analysis of deepening insolvency theory has assumed that harm to the firm is real, but wrestled with the procedural question whether plaintiff may claim relief. (38) This is because the suits generally are brought by a firm representative and allege some form of misconduct by the firm itself. It defrauded investors (many of the cases arise from Ponzi schemes), or it borrowed and spent negligently, as was alleged in Global Service Group, or it carried out a ruinous acquisition, as alleged in Exide. Others engaged in this activity–officers and directors, an accountant, say, or lender, but the debtor was a prime actor. Many courts acknowledge that deepening of insolvency harms a firm, but hesitate to say that the very firm (whose improvidence contributed to its own harm) may sue Ernst & Young or the First National Bank of Petaluma.

This was the holding of R.F. Lafferty. After hoisting the standard for deepening insolvency (even overruling the Supreme Court of Pennsylvania to announce the existence of a new tort under Pennsylvania law), the Third Circuit made clear that all of its musings about the doctrine were dicta. (39) Whether the doctrine was sound or not, the complaint had to be dismissed on the basis of in pari delicto. (40) Allegations of wrongdoing were made against corporate insiders, but because those insiders had controlled and dominated the corporations whose Chapter Eleven representatives brought the claims, the wrongdoing had to be imputed to the corporations themselves, and thus the claims were barred. (41) To the same effect was Sender v. Buchanan (In re Hedged-Investments Associates, Inc.), (42) where the Tenth Circuit ruled that the in pari delicto doctrine forbade the bankruptcy trustee of corporations that had engaged in Ponzi schemes to pursue, on behalf of creditors, claims against those who profited from the schemes. (43)

Traditionally, in pari delicto has been given broad scope in fraud claims. The knowledge and conduct of corporate officials acting within the scope of their duties generally is imputed to the corporation. (44) When the corporate official acted “entirely for his own or another’s purposes,” there was no imputation of his knowledge and conduct to the corporation, (45) but where the conduct was somewhere in the middle, as for example where a corporate official acted both for his personal and for corporate interests, the corporation remained liable. (46) Even where the actor engaged in outright fraud, and the corporation was nothing but a vehicle for that fraud, the conduct might be imputed. (47) Judge Posner has said that “a participant in a fraud cannot also be a victim entitled to recover damages, for he cannot have relied on the truth of the fraudulent representations.” (48) An additional policy issue arises where the claim is against a third party, such as an accountant or lender. As one court put it, “where a defendant’s only sin is its failure to prevent transgressions by the plaintiff, no benefit flows to the public from rewarding the transgressor.” (49)

Still, the trend seems to be to try to find a way around in pari delicto. In the Bloor v. Dansker (In re Investors Funding Corporation of New York Securities Litigation) case, (50) notwithstanding an in pari delicto defense, a court permitted a trustee under Chapter 10 of the Bankruptcy Act to pursue directors, officers, and auditors in connection with the insolvency of a securities firm. (51) The complaint alleged that three brothers used fraudulent misstatements to raise capital (both debt and equity) for Investors Funding Corporation of New York (“Investors Funding”). It alleged that Peat Marwick blessed financial statements that contained material misstatements. Peat Marwick defended on numerous grounds, among them that the bankruptcy trustee was barred on in pari delicto grounds. Because the brothers were the wrongdoers, it argued that their acts had to be imputed to Investors Funding. The court disagreed. (52) The brothers raised capital and then “misdirected” those funds into personal accounts. The court held these transactions were adverse to the corporate interest. (53)

The thrust of the complaint is that the [brothers] created the false

appearance of fiscal salubrity to conceal their past acts of

mismanagement, and to raise capital for their further plundering.

The complaint avers that this scheme was repeated through a number

of cycles, each time driving IFC further into deficit and toward

its ultimate financial ruin. (54)

The court also discerned harm to the corporation in “the artificial financial picture of IFC created by the [brothers] which prolonged IFC’s existence several years beyond its actual insolvency…. A corporation is not a biological entity for which it can be presumed that any act which extends its existence is beneficial to it.” (55)

The court therefore held it could not sustain Peat Marwick’s contention that the brothers’ knowledge had to be imputed to the corporation. The in pari delicto defense failed. (56)

In Allard v Arthur Andersen & Co., (57) the court observed that the doctrine would not be applied to underlying negligence claims, as it was trumped by the comparative negligence regime. (58) Other courts have declined to apply the in pari delicto defense where receivers, as opposed to bankruptcy trustees, are involved. (59) In Scholes v. Lehmann, (60) the Seventh Circuit observed that the appointment of a receiver removed the wrongdoer from the scene so that the in pari delicto doctrine “loses its sting,” (61) and other litigants have attempted to import this doctrine into the Chapter Eleven context. More recently in In re Personal and Business Insurance Agency, (62) the Third Circuit permitted a Chapter Seven trustee to bring fraudulent transfer claims on behalf of a debtor corporation that had defrauded the fraudulent transfer defendant on the theory that the trustee was an innocent person who ought not be stained with the corporation’s guilt. (63) In Smith ex tel. Estates of Boston Chicken, Inc. v. Arthur Andersen, L.L.P., (64) a district court held that in pari delicto would not shield an accounting firm from claims made by a plan trustee (i.e. a trustee appointed to pursue corporate litigation claims) based on the misfeasance of the company’s board in preparing financial statements. (65) The recent cases confuse the bona tides of the corporate successor with the relevant point: the malafides of the corporation that would profit from the successor’s suit. They forget the principle that a successor takes his predecessor as he finds him, warts and all. Whatever the merit of these decisions, there is little doubt that the doctrine of in pari delicto is now in retreat. R.F. Lafferty may be the rule, but Exide, Boston Chicken, and Personal and Business Insurance Agency show the trend.

The Business Judgment Rule

Where something less than fraud is alleged, corporate insiders in “deepening insolvency” theories may access the business judgment rule. In Global Service Group, the court dismissed corporate insiders’ claims for deepening insolvency that arose from their role in securing distressed financing for a distressed firm, and allowed the firm to continue operations. (66) The court held that absent allegations that the fiduciary acted in bad faith or with fraudulent intent, the complaint stated no claim, as it was well within the legitimate business judgment of corporate fiduciaries to continue corporate operations in a distressed situation. (67) This ruling may be of considerable significance in future cases involving New York law, for Allard left open the door to trustees by ruling that in pari delicto did not bar a suit for mere negligence. The business judgment rule should close it in most cases, although perhaps not on a motion to dismiss.


This Article began with the unremarkable proposition that “deepening insolvency,” unintelligible as a cause of action, is at best a theory of damage. It proceeded to mild provocation: that whatever else might deepen insolvency, a loan will not. The discussion now veers into outright heresy by asking whether “deepening insolvency,” as an economic proposition, is even a form of corporate damage at all.

We should begin by considering the constituencies who might claim an injury as a firm’s insolvency deepens. There are three.

Equity Holders

Shareholders are soon disposed of. Because we are exploring deepening insolvency, we posit that insolvency already exists at the time of the delia. And if a corporation is insolvent at the start of our analysis, then by definition the value held by equity was wiped out before the wrongdoing occurred. (68) Deepening the firm’s insolvency did not add insult to injury, it added insult to death. It should not surprise us that no reported decision allows relief to equity holders of a firm on the theory that someone deepened the firm’s insolvency. Still, we find the Seventh Circuit in a muddle on this. In its effort to explain how deepening insolvency (in the Schacht case, by fraudulently concealing the “true financial condition” of a firm) caused harm, it noted that “it would be crucial that the insolvency of the corporation be disclosed, so that shareholders may exercise their right to dissolve the corporation in order to cut their losses.” (69) Clearly this is wrong. You cannot cut what already you have lost, and at the point of insolvency the shareholders have already lost everything.

Failure to disclose insolvency harms a purchaser of equity securities, of course, but no new tools are needed to harvest this garden-variety 10b-5 fruit. Had the misstatement not occurred, the plaintiff says she would not have bought. Because the issuer is insolvent, the equity she bought is worthless. Her purchase price measures her damages. No excursus into whether the issuer’s insolvency “deepened” is necessary

The Discrete Claims of Creditors

What of creditors? Where a firm is insolvent, creditors are injured, not dead

In the event, the reported decisions involve deepening insolvency theories pursued by someone other than discrete creditors–someone like a Chapter Eleven trustee (Allard), an insurance liquidator (Schacht), a creditor’s committee (R.F. Lafferty), or a Chapter Seven trustee (Global Service Group). Creditors are not the corporation itself. In Caplin v. Marine Midland Grace Trust Co. (71) the Supreme Court long ago held that a bankruptcy trustee is not a proper standard-bearer for individual creditors. (72) There the trustee sought to bring on behalf of bondholders claims against the sole owner of a corporation and partner in several partnerships, based on actions defrauding investors. The Court upheld dismissal of these claims. Although Caplin was decided under the Bankruptcy Act, no one doubts that its holding thrives under the Code. (73) Congress intended that the trustee stand in the shoes of the debtor and “take no greater rights than the debtor himself had.” (74)

The rule makes practical sense. As to creditors, things are always messy. Some may be harmed as insolvency increases, but others may be paid out, sell product, be insiders who also hold equity, or obtain some other benefit. Some may have had old claims paid by newer financing. (75) Different creditors will have had different degrees of knowledge of, and perhaps participation in the alleged wrongdoing. Investing the trustee with power to bring claims for creditors creates confusion when creditors bring claims for themselves. (76) Thus, although a discrete creditor might have standing to pursue a deepening insolvency theory, we can understand that representatives of bankruptcy estates should not be granted a general brief to pursue them on behalf of creditors. The issue can be confusing where claims are pursued by creditors’ committees, as occurred in R.F. Lafferty, but it must be remembered that when bringing suit as estate representatives, creditors’ committees act only as estate representatives. (77) They too are not empowered to pursue rights on behalf of discrete creditors. (78)

Claims of the Corporation

The last constituency is the corporation itself. A corporation is a legal person, capable of making contracts, contracting debts, and commencing Chapter Eleven proceedings. Legal persons enjoy benefits and sustain harm. So we may consider whether an insolvent corporation is itself harmed if it becomes more insolvent. Although recent deepening insolvency decisions peg the injured party as the corporation, (79) the question has met little analysis, If Enron is already insolvent, does the deepening of that insolvency harm Enron?

Twenty-one years ago, the Seventh Circuit announced that “the corporate body is ineluctably damaged by the deepening of its insolvency.” (80) “Ineluctably” is one of those magisterial adverbs–useful for ipse dixits where analysis is wanting. As recently as last year, it appears that Judge Bernstein accepted the notion that where there is an underlying cause of action, “deepening insolvency” may indeed constitute a measure of corporate damage (81) To test the proposition whether there is harm here, whether indeed there is a theory of corporate damage, one must look beyond adverbs to the nouns and verbs of economics. The slate is remarkably clean.


Like R.F. Lafferty, Schacht arose from the kind of fraud that often ensues when a financial debtor becomes insolvent. To improve its apparent liability-to-surplus ratio (a regulatory necessity for staying in business), an insurance company sold off a profitable division and continued to write high-risk policies. Later it was declared insolvent and a liquidator appointed. He brought RICO claims against officers, directors, and the company’s outside auditors. In the Seventh Circuit, defendants argued that “since [the Insurance Liquidator] admits that Reserve’s officers and directors instigated the illegal conduct here, [Liquidator], standing in the shoes of Reserve, is estopped.” (82) They asserted that in those shoes the Liquidator could “never sue to recover damages alleged to have resulted from the artificial prolongation of an insolvent corporation’s life.” (83) The Seventh Circuit acknowledged that older authorities supported this view, but upbraided them for a “seriously flawed assumption[–]that [prolonging] life beyond insolvency is automatically to be considered a benefit to the corporation’s interests.” (84) Apart from its Olympian pronouncement on “ineluctable” harm to the corporate body, the court offered no explanation other than the incorrect notion that shareholders are harmed.

R.F. Lafferty, perhaps the leading decision today, identifies four harms to the corporation. First, it says that “the [fraudulent and concealed] incurrence of debt can force an insolvent corporation into bankruptcy, thus inflicting legal and administrative costs on the corporation….[and creating] operational limitations which hurt a corporation’s ability to run its business in a profitable manner.” (85) Next, “deepening insolvency can undermine a corporation’s relationships with its customers, suppliers and employees. The very threat of bankruptcy, brought about through fraudulent debt, can shake the confidence of parties dealing with the corporation.” (86) Third, “prolonging an insolvent corporation’s life through bad debt may simply cause the dissipation of corporate assets.” (87) Last, the court reprises the Schacht rationale that nondisclosure harms shareholders who lose “their right to dissolve the corporation in order to cut their losses.” (88)

We have already disposed of the obvious fallacies of the last argument. It appears to be a makeweight, for although the Third Circuit quotes Schacht, it does not linger over it.

The first serious argument is that deepening insolvency forces a company into bankruptcy, imposing upon it legal and administrative cost and hampering its operations. It will be the plaintiff’s burden, then, to show that insolvency itself was not enough: the debtor would have avoided Chapter Eleven had its insolvency not gotten worse. This will be a challenge. How will the insolvent debtor show that it would not have filed for Chapter Eleven protection anyway? The facts of R.F. Lafferty illustrate this difficulty The debtor was an equipment lessor. Equipment lessors depend on financial spreads. They borrow money at six percent, use the funds to purchase equipment, and lease out the equipment at seven. When they reach a point where lease payment streams do not cover borrowing costs, they can no longer borrow. When this happens they cannot write new leases. At that point they may wind down their portfolios, but otherwise they are out of business. In R.F. Lafferty, when the principal debtor Walnut could no longer borrow legitimately, its principals incorporated ELCOA, a new subsidiary, in order to raise money fraudulently Investors were duped into believing that ELCOA had collateral. As to Walnut, the opinion says that it “was experiencing financial difficulties … [and] as a result … could not raise sufficient capital.” (89) Thus, Walnut was out of business. It appears that either a Walnut bankruptcy or a Walnut liquidation was inevitable anyway, without the fraud. If a Chapter Eleven case was inevitable–if, as appears, the fraud occurred precisely because Chapter Eleven was inevitable–then this first explanation of harm fails. The harm was going to be felt anyway.

Even if plaintiff can convince a court that it was the deepening, not the original insolvency that forced it into Chapter Eleven, one views with skepticism the proposition that outside of Chapter Eleven the company would have fared better. In that wilderness there is no automatic stay to protect an insolvent firm, no statutory framework with which to force compromise among feuding constituencies. A firm’s assets will be subject to piecemeal attack by creditors. Within Chapter Eleven’s stockade there is protection, there may even be enforced financing through use of cash collateral, or debtor in possession (“DIP”) financing, with its calming effect on creditors. Where we posit a firm insolvent to begin with, would the cost (both legal and administrative) of defending collection suits and attachments be less than the cost of Chapter Eleven professionals? This will be plaintiff’s burden to demonstrate.

R.F. Lafferty’s second explanation of how “deepening insolvency” harms the corporation itself is that “the very threat of bankruptcy” shakes the confidence of vendors, suppliers, and others whose confidence is necessary to the company’s ongoing operational health. (90) This has things precisely backwards. Because we posit a company already insolvent, relationships with customers, suppliers, and employees are already strained. There is already a threat of bankruptcy. The essence of the deepening insolvency complaint is that the defendant “wrongfully” prolonged life, or, worse, participated in a scheme to cover up the debtor’s true financial condition during the period when insolvency deepened. (91) In effect, the factual claim is that the defendant acted to wrongfully improve the debtor’s reputation, whether through lies outright, as in R.F. Lafferty, or through distressed borrowing, as in Exide and Global Service Group. This is particularly true in the lending case. A new loan provides cash, and some hope that bankruptcy will be avoided. In other words, to the extent a distressed loan has an impact on relationships with stakeholders, it would appear to improve them.

Although the first two theories of harm are unsound, it is worth noting that each depends on the proposition that the debtor is harmed by bankruptcy: either the reality of bankruptcy, or its appearance. According to R.F. Lafferty, it is harmed in the first case, because bankruptcy costs money and hampers operations, and in the second because the threat of bankruptcy does. (92) So the reader is a little jolted by the somersault in the decision’s third explanation of harm, when the court tells us that a company that is harmed because it does not file for bankruptcy soon enough. The third justification is that the corporation is damaged when its liquidation is delayed. In a liquidation, assets will be sold and the proceeds distributed to creditors. Indeed there can be harm in that narrow range of cases where liquidation is inevitable, but it is harm to the beneficiaries of that liquidation–the creditors. The corporation is no more one of them than the deceased is a beneficiary at the reading of his own will. If asset liquidation is the inevitable best case, the corporation is defunct. Delay does not hinder its ability to purchase raw material, operate its factories, sell widgets, collect receivables, make payroll, or sponsor the Mite A hockey team. All of those attributes of corporate life are gone, and once again we are adding insult only to death. So the third rationale, like the first two, does not explain how the firm qua firm sustains any harm through the deepening if its own insolvency. (93)

In In re Flagship Healthcare, (94) a district judge deferred, as most recent courts have done, to R.F. Lafferty and Schacht, and held that a Chapter Seven trustee’s deepening insolvency complaint articulated a harm specific to the corporation itself. (95) Still, the court must have been troubled, for it sparred with the metaphysical question in a charming footnote:

To utilize judicial/artistic license, the Debtor’s situation was

not like an individual who sits in the rain all day and simply

cannot get more wet. It is more akin to a boxer with one black eye

who, despite being injured, might still persevere and win the

fight. If that boxer (the debtor) winds up losing the fight and

landing in the hospital (bankruptcy court), a doctor (judge)

might find that it was the additional injuries (deepening

insolvency) which put him there. (96)

The court is on to a good metaphor here, but it is a metaphor with a counterpunch. At the outset, the boxer with one black eye is not yet in the hospital. His future is uncertain. Shall he throw in the towel or persevere? There is a purse for the winner of this bout, and none for the loser. If we think of the boxer as a moneymaking enterprise, then he has everything to lose by quitting, and nothing to lose by persevering. He may lose the fight later. That will result in the same loss of income he will certainly sustain if he bows out now. He may yet win (it rather sounds like the judge hopes he will), but he cannot win–that is, cannot succeed as a moneymaking enterprise–unless he carries on. Persevering, in other words, is a good thing. As Judge Bernstein put it, “[t]he fiduciaries of an insolvent business might well conclude that the company should continue to operate in order to maximize its ‘long-term wealth creating capacity,’ or more generally, its enterprise value.” (97) Suppose the boxer, refreshed with a cup of water and advice from his corner about the champ’s weakening jab, resolves to go another round or two. (The firm, refreshed with an emergency loan and some financial advice about a new market focus, carries on.) But the champ’s left was not so weak as hoped: it blackens our boxer’s other eye, and he falls. By falling, the boxer has lost no more of the purse than he would have lost by throwing in the towel earlier. He may have suffered greater injury, but he is no more defunct as a moneymaker. The injury will be a problem for his creditors, but it will have no different impact on our boxer as purse-winner than his exit in an earlier round would have done.


Although the writer knows of no decision testing the theory, a litigant might try to fit a “filed too late” theory to an operating, rather than a liquidating, firm. Instead of delaying a liquidation, so the theory would go, the dilatory filing might lead to a reorganized company of diminished value. By operating outside of bankruptcy protection, the debtor lost value, and the plan of reorganization it later confirmed brought less to creditors than an earlier-filed and earlier-confirmed case would have done. In the lending context, the debtor’s theory may be that a distressed loan prevented it from making the earlier and more prudent Chapter Eleven filing it otherwise would have made.

At the outset, a plaintiff pursuing this theory will have stood R.F. Lafferty’s leading justification on its head. Once a poison of “legal and administrative costs on the corporation … [and] operational limitations which hurt a corporation’s ability to run its business in a profitable manner,” (98) bankruptcy would now be a medicine not administered soon enough. The key point remains that the imagined harm was suffered by the discrete creditors who received a diminished dividend, and not by the debtor itself. The debtor, if it emerged from Chapter Eleven, did so with a plan that by operation of law must have been deemed feasible. (99) Thus, the company was able to carry on its business.

The plaintiff will face insuperable evidentiary problems. In the “filed too late” reorganization case, we have, first, a board that could have, and did not commence a Chapter Eleven when the plaintiff, with hindsight, says the time was right. It is difficult to imagine a corporate decision more fundamental than whether or not to file a Chapter Eleven proceeding. Even in a jurisdiction prone to relax or misunderstand in pari delicto, this would be a hard case to shift liability to a lender. Next, particularly in the distressed-lending scenario, the firm almost certainly had a liquidity problem, that led to the now-challenged loan. Choosing bankruptcy instead wouldn’t have helped that problem. If it had not received the defendant’s loan and instead had filed, the debtor-who-should-have-filed-sooner would have needed cash from somewhere–presumably a debtor-in-possession loan. (100) The plaintiff would have to prove not only that operating in bankruptcy would have been more profitable, but that borrowing would have been cheaper. He will have reached an entirely fanciful domain.

There is also a considerable policy problem. There are many consensual, out-of-court workouts. Most borrowers think them preferable to Chapter Eleven cases. The press release announcing an accord between an airline and its bondholders has heretofore been viewed as good news. What advice will corporate counsel give their clients after the first board is held liable for authorizing a workout instead of filing a Chapter Eleven case?


We begin to see that discerning the corporation’s peculiar harm in the so-called deepening of its own insolvency is more problematic than the cases–or the metaphors–suggest. A few examples will illustrate.

Suppose that Blackacre, a commercial property, is the sole material asset of Blackacre LLC. When Blackacre was bought in 2000, experts appraised its value at $25 million and a bank loaned $20 million toward the purchase. Interest is paid currently and the principal is due in a lump sum in 2010. Alas, the commercial real estate market softened, and experts would agree that Blackacre’s market value in 2003 fell to $19 million. A year later the market value was at $18 million. (101) Throughout the period Blackacre remained fully leased, and Blackacre LLC faithfully met its obligations. Did the “deepening” of Blackacre LLC’s insolvency in 2003 injure the LLC itself?

The fluctuation in property value has not had much effect on the LLC’s existence or operations. The entity found tenants, it leased the space, it paid the building manager, and each January it provided new uniforms for the doorman. Real estate values might recover or they might get worse. These fluctuations have impact on the holders of debt, and dramatic impact on the holders of equity, but if they represent harm to Blackacre LLC as a distinct legal person, it is not a harm easily measured.

Or suppose a substandard appraiser’s opinion, written in 2002, showed heaps of equity for the members. Thereafter the market deteriorated even further, the lender foreclosed, and equity and unsecured creditors lost everything. Has the appraiser injured the LLC? We can see that the delay in foreclosure may have harmed the lender. We can even see that some trade creditors may have been hurt. But how did the delay–or the appraisal–harm the LLC? It didn’t lose “business” or liquidity Perversely, the LLC as a discrete entity may have benefited. The false news of asset value was balm alike to vendors, who offered relaxed terms, and tenants, who signed long-term leases.

Or imagine a third case. Blackacre LLC is out of business. The doors are shut. The tenants have left. An appraisal shows that the building would fetch only $10 million in a sale. During the ensuing year cracks appear in the pavement: value slips by another million. Has the LLC been hurt? It hardly seems so. The LLC is no more out-of-business than it was before. Only the bank’s expectancy seems to have been further eroded.

Now consider an operating company. Imagine that Bottleco’s owners purchased the company with Bank’s financing in 1999. Those were heady days when growth seemed certain. Bank provided a $40 million revolving credit facility and a $10 million term loan. But the company’s fortunes soon waned and the loans fell into covenant default. On a balance-sheet basis, Bottleco is now insolvent. Still, it is capable of limping along with receivables and inventory sufficient to support the $20 million of outstanding revolving debt. Does it harm Bottleco to limp along? Its alternative is to liquidate, and there is no benefit to the corporation, as distinguished from its creditors, in liquidation. Often Bank will continue to revolve loans to Bottleco through covenant waivers and loan amendments. Suppose it lends but Bottleco takes another turn for the worse–is Bank now liable for “deepening the insolvency” of Bottleco? Once again it is the creditors of Bottleco who have suffered a diminished expectancy, but Bottleco itself has not sustained a harm that it would not have sustained anyway, had it earlier ceased operations. This fact pattern is similar to that involved in In re Del-Met Corp. (102)

We know from experience that the scenario outlined above is common, and further, that participants in similar scenarios act from self-interest. Bank will lend only if it perceives that its collateral and debt position will benefit from lending–that translates loosely to a perception that the loan helps Bottleco, whose assets would yield less to Bank as creditor if liquidated than if operated as a going concern. Bottleco believes that as long as it keeps manufacturing and selling, there is hope that markets will turn, that there may be a going-concern sale, that the company may reposition itself for another day. Thus, there is advantage to Bottleco in continuing to operate. Extending deepening insolvency liability to lenders would chill a common form of lending well-regulated through the exercise by borrower and lender of self-interest. Both Bottleco and the creditor with the highest financial interest in its success contradict, by their acts, the Seventh Circuit’s pronouncement in Schacht that “prolonging life” is not necessarily good. More recently, the Seventh Circuit itself has acknowledged, in its In re Lifschultz Fast Freight decision, (103) that lending into insolvency is not per se wrongful, and indeed constitutes a kind of social good. (104)

Suppose that Bottleco simply cannot sell bottles for a sum greater than its cost of manufacture. Every dollar spent on operating costs is a dollar that cannot fully be recovered. Every day spent operating the factory is a day when the equipment depreciates. Now suppose that Bank loans $10 million. The proceeds are used to pay salaries to insiders and to operate the extrusion machines. As time passes, the assets become less valuable. A year later the loan proceeds are gone


As we explore whether deepening insolvency injures the firm, as opposed to its creditors, we may pause to ask why we are focused on insolvency. Solvency and insolvency are part of the same continuum. They describe quadrants of a graph on either side of a midpoint where liabilities equal the fair value of assets. Imagine such a graph, whose left endpoint represents the solvency of Microsoft (assets dwarf liabilities), and whose right endpoint represents the insolvency of Enron (liabilities dwarf assets). The midpoint of the line is the tipping point where liabilities are precisely equal to fair value of assets. Deepening insolvency cases involve firms that start somewhere to the right of the midpoint, and move farther to the right. Limiting ourselves to the right-hand quadrant makes sense when we consider the discrete harm to creditors, for so long as the firm is solvent, creditors will be paid in full, even if solvency is reduced. But from the firm’s point of view, rather than that of discrete creditors, there is no obvious reason why one diminution in solvency is unlike another, even if one begins in solvent, and the other in insolvent territory. If rightward movement along the continuum constitutes the harm, why wouldn’t any equal rightward movement be as actionable as any other?

Suppose a firm has $100 in liabilities and $50 of asset value. Asset values diminish to $25. We may say that insolvency has “deepened” to the tune of $25. Now suppose the firm started with $115 of assets, and during the relevant period values diminished to $90. As far as the initial period is concerned, there was no deepening insolvency, as the firm went from solvent to insolvent. What if we take the case further, imagining a debtor that went from solvent to less solvent–from $150 in asset value to $125

In the second case, a creditor’s expectation was injured only by $10, and in the third case, it was not injured at all. The endpoint in the second case leaves $90 to pay claims, and in the third, there is always more than the $100 that creditors are owed. But we’ve already conceded that we are not considering the discrete harm to creditors. We are asking, rather, what the harm to the corporation is. And in each case the corporation lost the same amount of net asset value, and presumably the same amount of liquidity.

If injury to solvency made sense as a theory of corporate damage, we might expect to find that any injury along the solvency/insolvency continuum would be actionable. And that is not the case–or at any rate not the case yet. As of yet there are no reported decisions sustaining damages of “diminishing solvency.” This is instructive, and suggests that there is, similarly, no doctrinal soundness in recognizing a theory of corporate damage for “deepening insolvency.”

True, experience teaches that reduced solvency may be associated with a kind of harm to an operating business. Most economists would identify an association between solvency and liquidity, and agree that loss of liquidity represents injury to the business enterprise. As insolvency deepens, a firm’s access to capital sometimes diminishes. Equity investors may pass. Vendors may not give terms. Without cash, needed repairs, investments, and inventory purchases might not be made. The firm’s charter says that it was organized for the purpose of carrying on business, and now its business operations may have been rendered more difficult. (105) Further, corporate injury does appear more likely in the center of the graph, and less likely at the extremes. If Microsoft loses $1 million in asset value, it will sustain $1 million of movement along the scale, but likely no injury at all to access to capital markets, liquidity, productivity, or market share. At the right-hand endpoint (imagine a no-asset debtor in Chapter Seven), a new $1 million allowed claim doesn’t add any more pain to the firm: it was already defunct. Near the midpoint it does appear that an operating business is likely to be suffering injury as its solvency diminishes.

But injury to solvency is an incident to the harm, not the harm itself. If the debtor lost asset value through defendant’s conversion of property, the law measures damage

Two propositions emerge. First, none of the “deepening insolvency” rationales adequately describes an actual harm sustained by the corporation, as distinguished from its creditors. Second, compensable injuries may have the indirect effect of deepening insolvency, but this indirect impact adds nothing to a direct impact (loss in asset value, increase in liabilities, or lost profits) that itself will be compensable–or not–under familiar common and statutory law remedies.


If the reader has persevered to this point, she may feel a little like the bruised boxer. The ring gets smaller and smaller. The harms we can identify aren’t corporate harms, or if they are, they were self-inflicted. Distressed lending is a good, not a bad. We reach another heretical question. Was the old wine enough–did it provide all the remedies any injured party needs?


Common law fraud is flexible in application, catholic in reach. Where a lender owing a duty lies about something material, or, having a duty to speak, remains silent in a deceptive way, and where a victim reasonably relies and suffers damage, that victim should have a remedy for her damage. But the cases make clear that lenders have fiduciary duties to their borrowers in only the rarest cases. (106) And it is hardly plausible, in most commercial contexts anyway, to say both that a lender lied to its borrower about the borrower’s own ability to repay a loan, and that the borrower was justified in relying on that lie. The borrower generally knows more about its business than the lender, and a borrower’s “reliance” in this context would have to be viewed with the deepest skepticism. We can imagine extreme cases where a borrower is so overwhelmed by its lender as to rely on it, but, happily the law has already provided a remedy.


Here we find another field well occupied by existing doctrine, whose dimensions need no “deepening insolvency” to mark them. Where we assume Bank dominated and controlled the board, and caused it to act in some inequitable way, the law–indeed the statute–has long afforded remedies in equitable subordination. (107) In the leading case of Benjamin v. Diamond (In re Mobile Steel Co.), (108) the Fifth Circuit’s oft-cited (albeit opaque) test is that claims of a creditor may be subordinated to other claims if (i) the claimant engaged in inequitable behavior, (ii) the misconduct resulted in injury to creditors or conferred on the actor an unfair advantage, and (iii) equitable subordination is not inconsistent with the provisions of the Bankruptcy Act. (109) The court vouchsafed less Delphic guidance in 1994, observing that equitable subordination is generally confined to three paradigms: “([i]) when a fiduciary of the debtor misuses his position to the disadvantage of other creditors, ([ii]) when a third party controls the debtor to the disadvantage of other creditors, [or] ([iii]) when a third party actually defrauds other creditors.” (110) Elucidation of the general section 510(c) power is beyond the scope of this Article, but two observations may be made. First, the doctrine focuses on injury to creditors, not the firm, and provides a vehicle for reshuffling the priorities among creditors where one creditor has abused its position to the detriment of others. (111) Second, it needs no solvency analysis. An outsider such as a lender may, if it overreaches, be subordinated to the interests of other creditors. (112) The target creditor may be a fiduciary that has abused its trust, or an outsider that has abused its power, but in each case, the harm is between creditor and creditor. The courts need not consider whether the insolvency of the debtor has deepened.

In this doctrinal field there is much guidance. For example, the relationship of lending and the zone of insolvency is treated in Paulman v. Gateway Venture Partners III, L.P. (In re Filtercorp), (113) where the Ninth Circuit held that the fact that the debtor was insolvent at the time it entered into a loan was not, standing alone, sufficient to require subordination of the lender’s claim. (114) In its Lifschultz Fast Freight decision, (115) the Seventh Circuit held that undercapitalization alone, without evidence of fraud, was not a sufficient basis equitably to subordinate an insider loan. (116) The decision contains a thoughtful examination of lending in the distressed environment, and concludes that there is no sin in lending into insolvency. (117) The problem lies rather in “trickery,” by which the court meant fraud and its close kin–the abuse of insider knowledge or position in a manner that deceives outsiders. (118) That kind of misconduct causes harm and may be actionable, but no deepening insolvency is necessary to make it so. (119)


A case can be made that where loans are concerned, fraudulent transfer law provides all the remedy a wronged party needs. (120) Whatever its dimensions, the field should not be expanded through deepening insolvency theory. First, fraudulent transfer law applies by definition to a situation of “deepening” insolvency, for the challenged conduct must have occurred during or at the outset of the debtor’s insolvency. (121) The statute also describes wrongful conduct with more precision than the current “deepening insolvency” literature. On the closing of the loan, did the borrower expect to be unable to meet its obligations as they came due? Was it undertaking a new venture for which it lacked a sufficient capital? If so, we have a potentially-avoidable transfer, and we are down to one issue: was the credit extended by the lender of a value to the debtor reasonably equivalent to the obligations undertaken?

Provided that the loan proceeds go to the obligor, the answer generally will be yes. A dollar of new obligation is balanced by a dollar of new loan credit–either cash, or a letter of credit that induces a needed shipment, or some other similar value. (122) Situations can be imagined where there is no equivalence. The loan costs might be usurious or unreasonable, for example. If Bottleco pays a $1 million cash fee in order to secure a $1 million line of revolving credit, we might say there is no equivalence. But the point is this: if there is equivalence–if a loan is not avoidable as a fraudulent transfer, then it is hard to explain why it should ever be vulnerable to a deepening insolvency challenge. if debtor indeed received reasonably-equivalent value, why should it be able to unwind the transaction, or bring suit on it later?


The heresies of this Article are now hammered to the church door. Ineluctability notwithstanding, one sounds deepening insolvency theory and finds only shallows. Apart from the narrow circumstance where an inevitable Chapter-Seven-style liquidation is delayed, the “doctrine” makes little sense as law and none as economics, and even in that rare scenario one can identify no injury to the already defunct firm, as distinct from its creditors.

At least as to lenders in reorganization contexts, the proposition that “deepening insolvency” is harmful is self-contradictory, Most actual workout practice is built on the assumption that aiding the wounded is a good, and delaying Chapter Eleven is generally preferable from the point of view of the debtor to filing it. (123) Thus we have forbearance agreements, covenant waivers, loan amendments, priming loans, preference defenses based on contemporaneous exchanges, payments in the ordinary course, and extension of new value, all of which are intended to encourage continued dealings with a distressed business. (124) Even within Chapter Eleven we have prepackaged plans and first-day DIP loans. The inevitable effect of the deepening insolvency doctrine would be to throw all of this useful economic activity into confusion.

Perhaps a reformation is coming. If so, we may number among its theses the following:

1. There is no valid “cause of action” for deepening insolvency.

2. Loans do not deepen insolvency. Although improvident use of firm assets (including credit but not limited to credit) may cause harm, the borrower is responsible for the uses to which credit is put.

3. The 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.

4. The law of fraud, equitable subordination, and fraudulent transfer occupy the field in cases where lending to insolvent borrowers is challenged. Where those legal regimes provide no remedy, “deepening insolvency” should afford none.

(1.) WILLLAM SHAKESPEARE, HENRY IV: PART TWO, act 1, sc. 2, at 22 (David Bevington, ed., Bantam Books 1988).

(2.) See Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340, 350 (3d Cir. 2001).

(3.) For decisions acknowledging that “deepening insolvency” injures a firm, see, e.g., R.F. Lafferty, 267 E3d 340

(4.) Exide Techs., 299 B.R. at 752.

(5.) 316 B.R. 451 (Bankr. S.D.N.Y. 2004).

(6.) Id. at 466.

(7.) In re Del-Met Corp., No. 01-13208-KML-3-7, 01-13209-KML-3-7, 2005 WL 546679, at *23-*26 (Bankr. M.D. Tenn. Mar. 4, 2005).

(8.) Schacht, 711 F.2d at 1350. According to a LEXIS search of “deepening insolvency,” the federal reports from 1940 until the Schacht decision in 1983 are innocent of this phrase.

(9.) 711 F.2d 1343.

(10.) Id. at 1350.

(11.) Id.

(12.) Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., 267 E3d 340, 344 (3d Cir. 2001) (emphasis added).

(13.) In re Exide Techs., Inc., 299 B.R. 732, 752 (Bankr. D. Del. 2003) (emphasis added)

(14.) 299 B.R. 732 (Bankr. D. Del. 2003).

(15.) Id. at 752.

(16.) Global Serv. Group, 316 B.R. at 461.

(17.) Id. at 459-60.

(18.) For discussion of whether “deepening insolvency” is even a charming dactyl, see infra notes 68-105 and accompanying text.

(19.) Exide Techs., 299 B.R. at 752.

(20.) Global Serv. Group, 316 B.R. at 459.

(21.) 11 U.S.C. [section] 101(32)(A)(ii)

(22.) See 11 U.S.C. [section] 548(a)(1)(B)(ii)(III) (2000).

(23.) See id.[section] 548(a)(1)(B)(ii)(II). Although the balance-sheet test is the only definitional “insolvency,” each of the three measures operates in an equivalent manner. When coupled with an exchange for less than reasonably equivalent value during the avoidance period, it gives rise to a right in the debtor or trustee to avoid a transfer as a constructively-fraudulent transfer. Accordingly, this Article treats each as an equivalent form of insolvency

(24.) For a thoughtful analysis of undercapitalization and the dangers of hindsight, see In re Lifschultz Fast Freight, 132 F.3d 339 (7th Cir. 1997) (holding that undercapitalization, without more, is insufficient ground equitably to subordinate insider loan).

(25.) Rochelle v. Marine Midland Grace Trust Co., 535 F.2d 523 (9th Cir. 1976).

(26.) Id. at 526.

(27.) See Caplin v. Marine Midland Grace Trust Co., 406 U.S. 416, 434 (1972)

(28.) Rochelle, 535 F.2d at 528-29 (emphasis added).

(29.) Id. at 529.

(30.) PETO Item a capon 2s. 2d.

Item sauce 4d.

Item sack two gallons 5s. 8d.

Item anchovies and sack after supper 2s. 6d.

Item bread ob.

PRINCE O monstrous! But one halfpennyworth of bread to this

intolerable deal of sack!

WILLIAM SHAKESPEARE, HENRY IV: PART ONE, act 2, sc. 4, at 95 (P. H. Davison ed., Penguin Books 1981).

(31.) Rochelle, 535 F.2d at 529.

(32.) Id.

(33.) 267 F.3d 340, 345 (3d Cir. 2001).

(34.) Old wine is good, but the modern decisions decline to drink. R.F. Lafferty discerned a Pennsylvania “deepening insolvency” cause of action, despite the fact that the highest court in the commonwealth had squarely rejected the notion that a corporation is harmed by fraudulent puffing of its financial condition. In Patterson v. Franklin, 35 A. 205 (Pa. 1896), the assignee of an insolvent corporation sued the incorporators, alleging that their false representations had allowed the corporation to contract debt. The court affirmed dismissal, noting that “[t]he fraud was perpetrated for [the corporation’s] benefit. It was a gainer, not a loser because of it. It was given a considerable credit by the statement to which, as it is alleged, it had no claim whatever.” Id. at 206. 35. In re Global Serv. Group, LLC, 316 B.R. 451,462 (Bankr. S.D.N.Y 2004).

(36.) In re Exide Techs., Inc., 299 B.R. 732, 750-51 (Bankr. D. Del. 2003).

(37.) The firm might be a corporation, partnership, or any other business enterprise.

(38.) See, e.g., R.F. Lafferty, 267 F.3d at 354.

(39.) Id. at 352.

(40.) Id. at 360.

(41.) Id. at 359-60.

(42.) 84 F.3d 1281 (10th Cir. 1996)

(43.) The Exide court did not explain how the case could survive the in pari delicto defense. At a minimum, the board was jointly responsible for the Dunlop acquisition, and surely that acquisition was within the scope of its corporate powers. Under the R.F. Lafferty rule, the corporation’s representative (in this case a creditors’ committee) should have been barred from pursuing the action.

(44.) Allard v. Arthur Anderson & Co., 924 E Supp. 488, 495 (S.D.N.Y. 1996) (quoting Upjohn Co. v. N.H. Ins. Co., 476 N.W. 2d 392, 401 (Mich. 1991)).

(45.) Id. (citing to Center v. Hampton Affiliates, 488 N.E.2d 828, 830 (N.Y. 1985))

(46.) Allard, 924 F. Supp. at 495

(47.) official Comm. of Unsecured Creditors v R.F. Lafferty & Co., 267 F.3D 340, 359 (3d Cir. 2001)

(48.) Cenco, Inc. v. Seidman & Seidman, 686 F.2d 449, 454 (7th Cir. 1982).

(49.) Miller v. N.Y. Produce Exch., 550 F.2d 762, 768 (2d Cir. 1977), cert. denied, 434 U.S. 823 (1977).

(50.) 523 F. Supp. 533 (S.D.N.Y. 1980).

(51.) Id. at 545.

(52.) Id. at 541.

(53.) Id.

(54.) Id.

(55.) Id.

(56.) Id.

(57.) 924 F. Supp. 488 (S.D.N.Y. 1996).

(58.) Id. at 495.

(59.) FDIC v. O’Melveny & Myers, 61 F.3D 17, 19 (9th Cir. 1995)

(61.) Id. at 754. Surely that much must be wrong. Legal persons should not be able to shed legal disabilities merely by changing representatives. See Bank of Marin v. Eng., 385 U.S. 99, 101 (1966). If a corporation equitably cannot be heard to complain of a “wrong” in which it was a knowing participant, then why should an estate representative whose charge is to represent that corporation?

(62.) 334 F.3D 239 (3d Cir. 2003).

(63.) Id. at 241.

(64.) 175 F. Supp. 2d 1180 (D. Ariz. 2001).

(65.) Id. at 1199

(66.) 316 B.R. 451, 465-66 (Bankr. S.D.N.Y. 2004).

(67.) Id. at 465.

(68.) “One of the [most] painful facts of bankruptcy is that the interests of shareholders become subordinated to the interests of creditors.” Commodity Futures Trading Comm’n v. Weintraub, 471 U.S. 343, 355 (1985).

(69.) Schacht v. Brown, 711 F.2d 1343, 1350 (7th Cir. 1983), cert. denied, 464 U.S. 1002 (1983).

(70.) See Bergeson v. Life Ins. Corp. of Am., 265 F.2d 227, 233 (10th Cir. 1959) (holding that a stockholder derivative suit could not maintain claims based on insiders’ fraudulent misstatements, which permitted insurer to operate, as “the result was not a legal injury to the corporation. If stock purchasers, policyholders or creditors were injured … the remedy lies in appropriate actions by them.”).

(71.) 406 U.S. 416 (1972).

(72.) Id. at 434.

(73.) See Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340, 349 (3d Cir. 2001). See also Fla. Dep’t of Ins. v Chase Bank of Tex. Nat’l Ass’n., 274 F.3d 924, 932 (5th Cir. 2001) (holding that the liquidator of failed insurance company lacks standing to pursue claims of policy holders)

(74.) Bankruptcy Reform Act of 1978, H.R. REP. No. 95-595, at 368 (1978), reprinted in 1978 U.S.C.C.A.N. 5963, 6323.

(75.) See Feltman, 122 B.R. at 474-75.

(76.) See Caplin, 406 U.S. at 431-32.

(77.) See La. World Exposition v. Fed. Ins. Co., 858 F.2d 233, 247 (5th Cir. 1988)

(78.) The rule would apply equally in lender cases. A bankruptcy trustee lacks standing to assert against a lender that discrete creditors suffered damage when that lender caused or participated in the deepening of its borrower’s insolvency.

(79.) “[A] corporation can suffer an injury unto itself, and any claim it asserts to recover for that injury is independent and separate from the claims of shareholders, creditors, and others.” Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3D 340, 348 (3d Cir. 2001)

(80.) Schacht v Brown, 711 F.2d 1343, 1350 (7th Cir. 1983), cert. denied, 464 U.S. 1002 (1983). The court’s use of the “corporate body” rather than the “corporation” perhaps betrays a discomfiture with the question as to who exactly is harmed.

(81.) “[O]ne seeking to recover for ‘deepening insolvency’ must show that the defendant prolonged the company’s life in breach of a separate duty, or committed an actionable tort that contributed to the continued operation of a corporation and its increased debt.” In re Global Serv. Group, LLC, 316 B.R. 451, 458 (Bankr. S.D.N.Y. 2004) (emphasis added). So, too, in In re Del-Met Corp., did the court uncritically accept the notion that “deepening insolvency” constitutes a corporate harm. In re Del-Met Corp., No. 01-13208-KML-3-7, 01-13209-KML-3-7, 2005 WL 546679, at *25-*26 (Bankr. M.D. Tenn. Mar. 4, 2005).

(82.) Schacht, 711 F.2d at 1346.

(83.) Id. at 1350.

(84.) Id.

(85.) Official Comm. of Unsecured Creditors v R.F. Lafferty & Co., 267 F.3d 340, 349-50 (3d Cir. 2001). The adjective, “fraudulent” (and its cousin, the adverb “fraudulently”), is deployed regularly in the deepening insolvency cases, as it is here. But where is the fraud? What is the misrepresentation or omission? The harm is corporate, we are told–what then is the corporation’s reliance? And if there is really “fraud,” why do we need “deepening insolvency” to discern a cause of action?

(86.) Id. at 350.

(87.) Id.

(88.) Id.

(89.) Id. at 344.

(90.) Id. at 350.

(91.) See, e.g., id. at 345

(92.) R.F. Lafferty, 267 F.3d at 350.

(93.) The theory of delayed liquidation cannot apply where the debtor reorganizes because, in confirming a plan, the court has found that the return to creditors is at least as good as liquidation. See 11 U.S.C. [section] 1129(a)(11) (2000)

(94.) 269 B.R. 721 (Bankr. S.D. Fla. 2001).

(95.) Id. at 728.

(96.) Id. at 728 n.4.

(97.) In re Global Serv. Group, LLC, 316 BR. 451, 460 (Bankr. S.D.N.Y. 2004).

(98.) Official Comm. of Unsecured Creditors v R.F. Lafferty & Co., 267 F.3d 340, 350 (3d Cir. 2001).

(99.) See 11 U.S.C. [section] 1129(a)(11) (2000).

(100.) See Fla. Dept. of Ins. ,a Chase Bank of Tex., 274 F.3d 924, 935-36 (5th Cir. 2001) (rejecting “deepening insolvency” theory as cause of action to be pursued by liquidator of failed insurance company against bank that certified value of carrier’s trust

(101.) Discounted cash flow analysis is often a key valuation metric for commercial real estate. Even where leases perform at a constant rate, significant movement in interest rates may lead to significant changes in property value.

(102.) No. 01-13208-KML-3-7, 01-13209-KML-3-7, 2005 WL 546679 (Bankr. M.D. Tenn. Mar. 4, 2005).

(103.) 132 F.3d 339 (7th Cir. 1997).

(104.) See id. at 349.

(105.) See In re Flagship Healthcare, Inc., 269 B.R. 721,728 (Bankr. S.D. Fla. 2001).

(106.) See, e.g., McCormack v. Citibank, NA., 100 F.3d 532, 540-41 (8th Cir. 1996)

(107.) 11 U.S.C. [section] 510(c) (2000).

(108.) 563 F.2d 692 (5th Cir. 1977).

(109.) Id. at 700.

(110.) U.S. Abatement Corp. v. Mobil Exploration & Producing U.S., Inc. (In re U.S. Abatement Corp.), 39 F.3d 556, 561 (5th Cir. 1994).

(111.) For example, Del-Met Corp., with its allegations that key customers/creditors controlled finances, operations, and managers, seems like a case where, if a wrong were proved, equitable subordination would provide the remedy In re Del-Met Corp., No. 0l-13208-KML-3-7, 01-13209-KML-3-7, 2005 WL 546679, at *26 (Bankr. M.D. Tenn. Mar. 4, 2005).

(112.) See Smith v. Assocs. Commercial Corp. (In re Clark Pipe & Supply Co.), 893 F.2d 693, 699 (5th Cir. 1990).

(113.) 163 F.3d 570 (9th Cir. 1998).

(114.) Id. at 583.

(115.) 132 F.3d 339 (7th Cir. 1997).

(116.) Id. at 349.

(117.) Id. at 346.

(118.) Id.

(119.) Id.

(120.) One question left unanswered by Schacht is why there was not a perfectly adequate remedy for many of the perceived wrongs through a garden-variety fraudulent transfer action against the recipient of the insurance portfolio.

(121.) See 11 U.5.C. [section] 548(a)(1)(B)(ii)(1) (2000).

(122.) The Third Circuit has ruled, however, that the answer is not automatically yes. See Mellon Bank, N.A. v. Official Comm. of Unsecured Creditors of R.M.L., Inc. (In re R.M.L., Inc.), 92 F.3d 139, 153-54 (3d Cir. 1996)

(123.) See In re Global Serv. Group, LLC, 316 B.R. 451, 459 (Bankr. S.D.N.Y. 2004).

(124.) See 11 U.S.C. [section] 547(c)(1), (2), (4) (2000)

Sabin Willett, The author is a partner in Bingham McCutchen LLP. The views expressed in this article are his own, and not those of his firm or its clients. The author gratefully acknowledges the insights of his partners Edwin Smith, Tina Brozman, and Bill Bates.