Pre Bankruptcy Issues: What to Think About Before the Case is Filed
By: Gregory E. Spitzer[1]
Kirkland & Ellis LLP
200 E. Randolph Drive
Chicago, IL60601
Ph: (312) 861-2115
Fax: (312) 861-2200
A.Deepening Insolvency.
1.What is deepening insolvency? It is a claim that the defendant’s conduct in some way fraudulently, or even negligently, extended the life of a corporation such that the result is increased corporate indebtedness and liability and exposure to creditors.[2]
2.What is the nature of the injury caused by deepening insolvency?
i.There are various ways that the accumulation of debt can harm a corporation. When bankruptcy is not inevitable, additional debt may push an insolvent corporation into bankruptcy, which inflicts serious costs on the company. Both bankruptcy and deepening insolvency can harm business relationships, such as those with customers, suppliers and employees. The reputation of a corporation can be seriously harmed even by the mere threat of bankruptcy, and if parties dealing with a company lose confidence in it, the company’s assets can be adversely affected as its business is harmed. One of the central harms of deepening insolvency is the dissipation of corporate assets that occurs by prolonging the life of an insolvent corporation, leaving creditors of the corporation with less than they might have otherwise been able to recover.[3]
ii.If the company is “dissolved in a timely manner,” rather than incurring additional debt that is not likely to help a troubled corporation, then many of these harms may be avoided and what value remains in an insolvent company can be recovered.[4]
3.Application of Deepening Insolvency - A Case Example:
Lafferty[5] is a case in which claims were brought against third parties for fraudulently inducing a corporation to issue debt securities, which deepened the corporation’s insolvency and forced it into bankruptcy. The Court recognized the deepening insolvency claim on three separate grounds: (1) logical soundness; (2) judicial acceptance; and (3) Pennsylvania's preference to provide compensation for injury. As to the logical soundness of the deepening insolvency injury, a corporation is harmed when it is allowed to incur additional liabilities, such as increased debt.[6] As no Pennsylvania cases had dealt with deepening insolvency, the court looked to other jurisdictions and cited Schact v. Brown as support for recognizing the theory of deepening insolvency.[7] The injury alleged was harm to the corporation’s property by the increased debt.[8]
4.Rejection of Deepening Insolvency:
Not all courts have accepted the theory of deepening insolvency. In Askanase v. Fatjo, the court refused to recognize the claim of deepening insolvency, reasoning that once the point of insolvency is reached, equity interest-holders have already lost their equity interest in the company and therefore can not be harmed by any additional losses incurred during insolvency.[9] In Ben Franklin the court ruled deepening insolvency was not a breach of fiduciary duty by the director of an insolvent company to its creditors.[10] In Holland v. Arthur Andersen the court dismissed a complaint against auditors, which alleged false financial statements had been issued, when the plaintiff relied on the claim of deepening insolvency.[11]
5.The Theory Behind Deepening Insolvency:
i.Deepening insolvency began as a claim against officers and directors. The theory was that actions such as borrowing more funds and raising more equity were a breach of their fiduciary duty because the main result of their actions had been to deepen the insolvency of the company and reduce the return to creditors.[12]
ii.The theory is not well defined, nor is it embraced by all courts, with the result that it has been rather creatively expanded to include auditors;[13] lawyers;[14] investment brokers;[15] and secured lenders.[16]
iii.“Essentially, a claim against a lender for deepening insolvency is grounded in the theory that the lender, by (1) extending credit in exchange for additional security (or other enhancement) to a financially troubled borrower where there is little or no hope of financial recovery and (2) causing the borrower to remain in business for the lender's benefit, is extracting value from the borrower at the expense of its unsecured creditors--that is, the unsecured creditors might have been repaid a higher percentage of their claims had the borrower not been "propped up" with additional secured financing, and may assert that the borrower's deepening insolvency caused them financial harm.”[17]
iv.Is deepening insolvency a new cause of action or just a new name?
1.Several academic discussions of deepening insolvency suggest that recognizing it as a new tort is redundant at best and potentially confusing. One commentator posits that deepening insolvency is less an entirely new tort than it is a general factual backdrop.[18] Another commentator believes that deepening insolvency is neither a sensible cause of action nor a rational way to measure damages.[19] He argues that the theory of deepening insolvency is already covered by fraud and breach of the duties of due care and loyalty, and that deepening insolvency does nothing to augment these existing theories. Since there is no consensus as to who may complain of deepening insolvency, it adds uncertainty and confusion with little benefit.[20]
2.Some courts agree that deepening insolvency is not a new claim. In one example, In re Parmalat,the court found that deepening insolvency and breach of fiduciary duty are the same cause of action.[21]
a.The Parmalat court noted that North Carolina courts have barely considered the question of whether deepening insolvency is a valid cause of action under North Carolina law. The court sidestepped the issue and it did not find any need to address that question in the Parmalat case.
b.The Parmalat court believed the injury caused by deepening insolvency is the same as that caused by a breach of fiduciary duty, so there was no need to recognize a new tort.[22]
Note, the court only considered injury to the company. The plaintiff in the case, as a chapter 11 bankruptcy trustee, did not have standing to sue for harm to creditors of the company.[23]
c.Similar treatment was given to the claim of deepening insolvency in Alberts v. Tuft.[24] The court dismissed the claims of deepening insolvency, calling them a “re-packaging” of the claims for breach of fiduciary duty. (The court cited In re Parmalat in support of this premise).
3.One potential benefit of recognizing deepening insolvency as a separate claim is that it might spur officers and directors to take action earlier. There are currently few incentives for directors to place a firm in bankruptcy before it is too late to salvage anything.[25] The claim of deepening insolvency could provide incentives for officers, directors and lenders to not run a firm into the ground, and to file a timely bankruptcy proceeding so that some assets of the business remain for the creditors.
6.Holding Secured Lenders Liable Under Deepening Insolvency.
i.The Exide decision is a recent example of a case where the court held that secured lenders could be found liable on deepening insolvency claims.[26] The Exide case reveals certain dangers which lenders may encounter as they attempt workouts with their borrowers.[27]
ii.Facts: Secured lenders loaned additional funds to Exide Technologies, Inc., after the initial loan, in exchange for significant additional collateral and guaranties. As the debtor’s financial condition rapidly deteriorated, the lenders directed debtor to replace its chief financial officer, and amended the loan documents to temporarily suspend certain financial conditions in exchange for liens on all of debtor’s foreign subsidiaries’ assets and stock.[28]
iii.The U.S. Bankruptcy Court indicated that where a secured lender exerted enough control over a failing borrower, allowing the borrower to continue to operate through the extension of credit, despite its continuing decline in value, the lender could face liability to the borrower’s unsecured creditors for the claim of deepening insolvency.[29]
iv.The Lender’s Risk: Cause for Concern.
1.Exide demonstrates how the deepening insolvency claim can also expand beyond the traditional lender’s role.
Credit Suisse First Boston was sued individually and as administrative agent, sole book manager, joint lead arranger and class representative for a syndicate of banks and institutions identified as pre-petition banks (some eighty-one banks and other lenders). Salomon Smith Barney was sued as joint lead arranger, syndication agent and class representative for the pre-petition banks.[30]
2.Potentially Massive Liability.
a. At the confirmation hearing, the court rejected a proposed settlement of $8.5 million because it was below “the lowest range of reasonableness.”[31] Even more frightening, the liability of the lender may be expanded greatly beyond the loan amount because claims for the entire value of the business failure are possible.[32]
b.Some case law has suggested damages for deepening insolvency should be measured by the amount of unpayable debt that was wrongfully incurred after the company entered insolvency.[33] One commentator believes this way to measure deepening insolvency damages does not fit with the traditional understanding of corporate injury: that the measure of damages should be based on the decline or impairment of a corporations profits or assets.[34]
One Fifth Circuit case states that when a claim of deepening insolvency is made, “damages are measured by the dissipation of assets or increased debt load occurring after the false representation of solvency was made.”[35]
7.How can secured lenders protect themselves from claims of deepening insolvency?
1.Lenders risk a claim of deepening insolvency whenever they extend additional credit to assist the reorganization efforts of the debtor. One of the most important factors is CONTROL. The main challenge lenders face is protecting themselves from financial risk without incurring the potentially enormous risk of a deepening insolvency claim. What should a lender do?:
a.Avoid over collateralization.
b.Avoid control mechanisms.
c.Avoid making hiring and firing decisions.
d.Avoid seizing extra collateral in exchange for temporary relief.
2.There are no de facto tests yet to determine when deepening insolvency is a potential risk. The area is too new and still developing for clear tests to be established.
3.Rather than extend more credit to a debtor that is already insolvent in an attempt to extract the debtor from insolvency, secured lenders may be well advised to exercise their rights to force a debtor into bankruptcy proceedings and “possibly make the same loan in a DIP facility.”[36]
4.One concern is that the risk of a claim of deepening insolvency will deter valid lender actions. The risk of insolvency must be balanced against making wise lending decisions. Lenders should not be so cautious that they do not take prudent actions for the borrower or the lender. The answer should not be to reject all requests for restructuring or workouts, extensions of credit and the like.[37]
8.Other recent cases dealing with deepening insolvency.
i.One Maine case recognized the ability to consider damages under a deepening insolvency claim.[38] The case cited Schact v. Brown in a footnote, which found that the increased exposure to creditor liability brought on by deepening insolvency damages the corporate body.[39]
ii.A Pennsylvania case recognized the tort of deepening insolvency, and found a claim based on deepening insolvency was not barred by the economic loss doctrine.[40] The economic loss doctrine prevents a claimant from recovering under tort law for negligence where the only harm is to the product itself, the idea being that when a product harms itself, any recovery should be under contract law.[41] The defendant had attempted to use the economic loss doctrine to support its theory that only breach of contract law should apply to its actions and not deepening insolvency.
9.Lenders Claims Against Borrowers.
i.Can lenders use deepening insolvency against a borrower’s principals? Case law is still sparse on this issue, but one case that has considered the question found that deepening insolvency is not a breach of fiduciary duty by the director of an insolvent company to its creditors.[42]
ii.There have not yet been any cases involving real estate where a lender made a claim of breach of fiduciary duty against a borrower who was in the zone of insolvency. Interestingly, though, one court believes that Delaware case law suggests that controlling shareholders may be liable to creditors for breach of fiduciary duty while the corporation is insolvent.[43] However, this question of state law was never reached by the court because the shareholder’s shares were held in a voting trust over which the defendants exercised no control, so the claims against them were dismissed.[44]
B.Stay waivers.
1.During a restructuring or a workout, it can be very beneficial to the lender to have the borrower waive its right to the automatic stay that the bankruptcy code provides for debtors. A stay waiver can benefit the lender by offering it much needed protection, and it can be beneficial to the borrower as a bargaining tool with which to induce a wary lender.
2.Enforcement. Not all courts agree as to whether stay waivers should be enforced or not.
i.State of the Law: Since Shady Grove held in 1998 that stay waivers can be enforced, not much has changed in the case law. Some courts are willing to enforce a stay waiver, making them a potentially effective tool for lenders in the pre-bankruptcy period. Courts will consider several different factors when deciding whether or not to enforce a waiver. For example, if the debtor has a certain amount of equity, something more than an inconsequential amount, the waiver is unlikely to be enforced. Lenders also must show that the debtor’s reorganization plan is likely to fail. If it looks like the plan may succeed, courts will not enforce the waiver.
ii.The Shady Grove Decision: In Shady Grove, the prepetition waiver was a factor in considering whether to grant relief from the stay with regard to a debtor’s office building.[45] The court looked at six factors when deciding whether to enforce the waiver and lift the stay:
1.The sophistication of the debtor and its counsel.
2.Whether there was any equity in the property.
3.The likelihood that the debtor’s reorganization plan would be successful.
4.Whether any consideration was given for the restructuring agreement by the lender.
5.Whether there were any significant third party interests that would be negatively affected by lifting the stay.
6.Whether there was any change of circumstance at the time the waiver was to be enforced.
iii.In Shady Grove, the court found all of these factors to weigh in favor of the lender and the waiver was enforced. The debtor was a sophisticated developer represented by counsel;[46] there was no equity in the property;[47] there was no “reasonable prospect” that debtor’s plan would be successful;[48] the debtor had received substantial consideration in the restructuring agreement;[49] there were no third party interests at stake;[50] and there was no change in circumstances that the court found compelling at the time the waiver was to be enforced.[51]
iv.Some other factors that courts have considered when looking at stay waivers:
One court indicated that a knowing and intelligent consent to an explicit waiver of the automatic stay may receive deference, but where a waiver lacked specificity and knowing consent, the court refused to enforce it.[52]
v.Cases following Shady Grove:
1.Shady Grove was followed by the Second Circuit in Frye, where the court found that the equities appeared to favor enforcement of the waiver, but more information was needed to make a final determination:[53] Specifically, evidence as to whether there was sufficient equity in the collateral, the probability of a successful reorganization, and whether the waiver would prejudice other creditors.
2.Shady Grove was followed by the Eleventh Circuit in Desai, wherein the waiver language had been negotiated by a sophisticated debtor in the context of arriving at a consensual plan, which strongly supported enforcing the waiver.[54] However, in this case the lender failed to show there was no equity and that the reorganization plan would not work.
3.Mirant Corp. cites Shady Grove as an example of one of the “rare cases” where a court enforced a prepetition waiver of bankruptcy rights.[55] The court distinguished Mirant from Shady Grove on the other creditor factor (i.e., in Shady Grove there had been no other creditors who would suffer from debtor’s loss of the automatic stay, whereas in Mirant not only were there other creditors, but their claims exceeded $11 billion).
vi.Case enforcing stay waivers:
In Excelsior the court found the debtor had bargained away the protection of the automatic stay in its previous reorganization plan. The court enforced the waiver as part of its policy of favoring settlement agreements.[56]
vii.Some courts refuse to enforce the stay waiver, or limit its scope. See In re Sky Group International, Inc., 108 B.R. 86 (Bankr. W.D. Pa. 1989); Farm Credit of Central Florida, ACA v. Polk, 160 B.R. 870 (M.D. Fla. 1993); In re Jenkins Court Associates Limited Partnership, 181 B.R. 33(Bankr. E.D. Pa. 1995); In re Pease, 195 B.R. 431 (Bankr. D. Neb. 1996) cited by the recent case In re Church, 328 B.R. 544 (8th Cir. BAP (Iowa),2005) for the premise that “courts will not enforce a prepetition agreement that denies a debtor bankruptcy relief.” (at n.14).