Digging Deeper: When an Insolvent Corporation Plunges Further into Debt

What can creditors do when an insolvent corporation does not heed the First Rule of Holes: When you're in one, stop digging? The courts in Delaware, which have long been recognized as leaders in corporate and fiduciary law, recently addressed how and to what extent creditors can recover for deepening insolvency—in other words, for causing an already insolvent corporation to become even more insolvent by increasing debt or squandering assets. If the directors, officers or controlling shareholders of an insolvent corporation cause it to take on debt or dissipate assets for their own benefit, creditors can sue for breach of fiduciary duties. And, as a federal bankruptcy court in Delaware concluded earlier this year, when insiders breach these duties, creditors can recover for the deepening insolvency of that corporation as measured by the full extent of the corporation's loss in value since the onset of insolvency. But the availability of deepening insolvency as a measure of damages remains an open question awaiting resolution by the Delaware state courts.

Fiduciary duties following insolvency

When a corporation is solvent, the fiduciary duties of corporate insiders flow to shareholders, who, in the words of the Delaware Supreme Court, "are the ultimate beneficiaries of the corporation's growth and increased value." In contrast, a corporation's obligations to its creditors are largely limited to those specified in the applicable contract, be it a loan agreement, indenture or other commercial contract. But once a corporation reaches insolvency, the fiduciary duties that once flowed to equity-holders divert instead to creditors. Again quoting the Delaware Supreme Court, "the corporation's insolvency makes the creditors the principal constituency injured by any fiduciary breaches that diminish the firm's value." So if an officer, director or other insider of an insolvent corporation raids or misuses corporate assets, the harm now flows to creditors, rather than shareholders.

Under Delaware law, insolvency does not require a bankruptcy filing. Insolvency instead occurs either once the corporation's debts exceed the reasonable market value of its assets with no reasonable prospect that the business can be successfully continued, or once the corporation no longer can satisfy its debts as they become due. Because insolvency turns on complicated (and debatable) facts, a debtor and its creditors may disagree on whether the moment of insolvency has arrived. And the final say may rest with a judge who has had the benefit of expert testimony from accountants and other financial advisors. But once the moment of insolvency arrives, as the Delaware Court of Chancery has explained, "the creditors become the enforcement agents of fiduciary duties because the corporation's wallet cannot handle the legal obligations owed." The court continued: "Because, by contract, the creditors have the right to benefit from the firm's operations until they are fully repaid, it is they who have an interest in ensuring that the directors comply with their traditional fiduciary duties of loyalty and care."

As a practical matter, Delaware courts rarely find an actionable violation of the duty of care in the absence of a conflict of interest. For this reason, breach of fiduciary duty claims more often target the duty of loyalty, which requires that officers and directors place the interest of the insolvent corporation as a whole above all other interests—including their own. Breaches of the duty of loyalty typically arise in one of three contexts. In the first type of breach, the fiduciary appears on both sides of a transaction—for example, if the insolvent corporation transfers assets to companies affiliated with insiders, or borrows funds from such companies at premium rates and with the promise of a short-term payoff. Second, the fiduciary receives a personal benefit not shared by all creditors—for example, when the insolvent corporation uses its limited assets to pay off debt owed to an insider at the expense of other creditors. And third, the fiduciary fails to act in a good-faith belief that his actions are in the corporation's best interests—for example, by failing to act in the face of a known duty to act.

For a time, deepening insolvency gained traction in Delaware and elsewhere as its own separate claim, apart from any cognizable breach of fiduciary duty. But the Delaware Supreme Court held last year that the mere act of causing an insolvent corporation to incur more debt does not, standing alone, subject officers, directors or other insiders to liability. Still, the Delaware Court of Chancery cautioned—in a decision adopted by the Delaware Supreme Court—"The rejection of an independent cause of action for deepening insolvency does not absolve directors of insolvent corporations of responsibility. Rather, it remits [creditors] to the contents of their traditional toolkit, . . . [including claims] for breach of fiduciary duty and for fraud."

Deepening insolvency as a measure of damages for breach of fiduciary duty

Creditors thus retain substantial recourse when an insolvent debtor plunges itself deeper into debt. But where the debtor's insiders operate the insolvent corporation for their own benefit, can creditors recover for the corporation's drop in value? Federal courts applying Delaware law have split on the availability of deepening insolvency as a measure of damages for breach of fiduciary duty. One recent Delaware federal court decision asserted that "deepening insolvency has been rejected as a valid cause of action or a theory of damages under Delaware law." But just weeks later, the federal bankruptcy court in Delaware took the opposite view, holding that creditors still may recover damages for deepening insolvency under Delaware law.

In Miller v. McCown De Leeuw & Co. (In re The Brown Schools), the bankruptcy trustee alleged that the debtor's controlling shareholder and directors breached their duties to creditors by operating the insolvent corporation to generate profit for themselves at the expense of the corporation and its creditors. For example, the trustee alleged that the corporation restructured its debt in order to prefer debts owed to insiders over those owed to other creditors. Beyond that, the trustee alleged that the debtor sold $64 million in assets in a transaction that allowed it to funnel $1.7 million to insiders—proceeds that should have remained with the insolvent corporation for the benefit of all creditors. The trustee last alleged that the debtor engaged in a series of fraudulent transfers to subsidiaries for little or no consideration, "thereby leaving [the debtor] that much less to pay [its] own creditors." Among other things, the trustee sought damages of at least $22 million—the alleged reduction in value to the debtors' assets following insolvency as a result of the insiders' misconduct.

The bankruptcy court rejected the debtor's argument that the trustee's claims should be dismissed as a disguised stand-alone claim for deepening insolvency, which would not be permitted under Delaware law. The court instead held that the trustee's allegations of self-dealing in deepening the debtors' insolvency—by preferring debts owed to insiders and channeling sale proceeds to insiders at the expense of other creditors—supported claims for breach of the duty of loyalty, corporate waste and civil conspiracy.

The bankruptcy court also rejected the debtor's argument that the creditors could not invoke the increase in insolvency as a measure of the damages for the insiders' breach of fiduciary duty. As one court of appeals explained, deepening insolvency can damage a corporation by: (1) forcing an otherwise avoidable bankruptcy, which adds costs while limiting flexibility; (2) causing the corporation to expend resources in the repayment of debt, thus increasing the risk of liquidation; and (3) causing the dissipation of corporate assets. As another court observed, "deepening insolvency was first recognized as a theory for recovery in actions for breach of fiduciary duty alleging that officers or directors deepened the insolvency of the corporation and reduced or eliminated any return for creditors." Under this logic, culpable insiders are liable for an insolvent corporation's drop in value while they operated it for their own benefit—even if the lost value exceeds the insiders' personal gains or investment in the corporation. As the Delaware bankruptcy court concluded, the extent of deepening insolvency can be an appropriate measure of damages under Delaware law when insiders continue to run an insolvent corporation—reducing its value by incurring debt or looting assets—in breach of their fiduciary duties. But the final say will some day rest with the Delaware Court of Chancery and the Delaware Supreme Court.

Conclusion

Creditors confronting a distressed corporation should continue to evaluate whether the company has fallen into the hole of insolvency, recognizing that the corporation may insist that it remains on level ground. Disputed or not, once the company enters insolvency, enforcement of the officers', directors' and controlling shareholders' fiduciary duties to the corporation falls on the creditors. If insiders instead dig the corporation deeper into insolvency as they pursue self-dealing transactions, they may be in breach of those duties. If so, under the deepening insolvency measure of damages, creditors may recover from them the corporation's full reduction in value following insolvency, even if the company lost far more than the insiders themselves gained. For now, courts considering Delaware law have disagreed on the availability of deepening insolvency as a measure of damages. For the final word on this open question, creditors and corporate insiders alike must look to the Delaware state courts.