In re Greater Southeast Community Hospital Corp., (Alberts v. Tuft), 2006 B.R. 2419 (Bankr. D.C. September 21, 2006).

The Trustee for the Liquidating Trust filed suit against former officers and directors, and the debtors’ former law firms, alleging that the defendants furthered a Ponzi scheme. One of the claim asserted by the trustee was deepening insolvency, which the court had already concluded was not a viable separate tort. In re Greater Southeast Cmty. Hosp. Corp. I, 333 B.R. at 516-17. Given the recent cases on the subject (See discussion about Lafferty and CitX), the court revisited the issue.

Since the court issued its opinion in October, the Third Circuit has had occasion to reflect on its ruling in Lafferty. In CitX, the Third Circuit considered whether an accountant for an internet company could be held liable for the deepening insolvency of the company where the accountant was allegedly negligent in his review of the company’s finances. 448 F.3d at 674. The Third Circuit clarified that, notwithstanding its descriptions of deepening insolvency as a "type" or "theory" of injury in Lafferty, id. at 677 (quoting Lafferty, 267 F.3d at 349), it had never held that deepening insolvency was "a valid theory of damages for an independent cause of action." Id. at 677. The court also concluded that "a claim of negligence cannot sustain a deepening [] insolvency cause of action." Id. at 681.

These conclusions give the court serious pause. Although CitX involved different facts, n9 and although the decision is not binding on this court, the Third Circuit’s reinterpretation of Lafferty contradicts the conclusions reached by this court in its earlier opinion, thereby calling into question the court’s reliance on that case in that opinion. The court has therefore been especially careful in its review of the CitX decision.

n9 In CitX, the debtor company’s accountant supposedly deepened the debtor’s insolvency by approving financial statements that allowed the debtor to solicit funds from investors despite its financial distress, which allowed the struggling company to continue operating and, through the subsequent machinations of its management, acquire more debt. The Third Circuit found this theory of harm too attenuated to state a claim for negligence, concluding that "[a]ny increase in insolvency (i.e., the several million dollars of debt incurred after the $ 1,000,000 investment) was wrought by CitX’s management, not by [the defendant]." CitX, 448 F.3d at 677. In contrast, Alberts alleges that the D & O Defendants, with the assistance of the Law Firm Defendants, directly increased the debt load of the debtors.

The Court then attempted to reconcile the Third Circuit’s opinions in Lafferty and CitX. 

Having conducted this review, the court remains convinced that it reached the right result in its prior opinion. There is no way to make sense of Lafferty without concluding that the deepening of a company’s insolvency can be harmful; otherwise, the Lafferty court could not have concluded that fraudulent conduct leading to the deepening of a company’s insolvency constitutes tortious activity. Nor is this court aware of any common law principle holding that an injury sustained as a result of one tort (fraud) is somehow not an injury when it is caused by a different tort (negligence), as the CitX court seems to suggest. The cause of an injury might determine whether a tort occurred, but it does not determine whether the injured person suffered an injury in the first place.

The court is equally unmoved by the Third Circuit’s decision to restrict recoveries for deepening insolvency to actions involving fraud. If deepening insolvency were treated as a separate cause of action rather than as a theory of harm, it would make sense to require a higher threshold of scienter than mere negligence lest the tort expose directors and third parties to a standard of care that they otherwise would never have owed in the first place. Cf. Drabkin v. L & L Constr. Associates, Inc. (In re Latin Inv. Corp.), 168 B.R. 1, 4-5 (Bankr. D.D.C. 1993). n10 CitX attempted to resolve this inherent problem (i.e., the danger that the scienter requirement for the "tort" of deepening insolvency would be unduly broad) by imposing a fraudulent intent requirement instead.

n10 If a third party gives advice that encourages corporate management to deepen the corporation’s insolvency, the third party ought to be held responsible for an independent tort of deepening the corporation’s insolvency only if that third party knows that her advice will further a tort. See Restatement (Second) of Torts § 876(b) and comment d. To the extent that the court suggested in Latin Investment that knowledge of a fraudulent (versus negligent) tortious act is required, it went too far. 168 B.R. 1 at 4-5.

The Lafferty court, however, did not fix its star upon the notion that deepening insolvency was a tort. Instead, it concluded that the accumulation of debt by an insolvent entity could, in certain circumstances, be harmful to the corporation. Lafferty, 267 F.3d at 349-50. n11 These injuries can occur as a result of management’s negligence just as easily as they can due to management’s fraud, and management (unlike a third party with no special relationship to the company) owes a duty of care to its corporate client. The link made by the CitX court between deepening insolvency and fraudulent intent is therefore an arbitrary one unless one makes the equally arbitrary determination that deepening insolvency is a (hitherto unknown) tort of its own, in which case officers and directors who, without engaging in fraud, breach–even grossly breach–their duty of care in a harmful manner would be insulated from their wrongdoing.

n11 The Lafferty court described this harm as follows: [T]he incurrence of debt can force an insolvent corporation into bankruptcy, thus inflicting legal and administrative costs on the corporation. . . . When brought on by unwieldy debt, bankruptcy also creates operational limitations which hurt a corporation’s ability to run its business in a profitable manner. … In addition, prolonging an insolvent corporation’s life through bad debt may simply cause the dissipation of corporate assets. Lafferty, 267 F.3d at 349-50 (citations omitted).

Rather than attempt to "discover" a separate common law tort which must then be neutered, this court prefers to treat deepening insolvency as the theory of harm that it was always meant to be, and will rely on other, more established (not to mention less convoluted) common law causes of action to ascertain whether the defendants in this case have engaged in a legal wrong for which Alberts is entitled to recover. Unless and until this court is told differently by a higher court in its own circuit, deepening insolvency will remain a viable theory of damages in this jurisdiction regardless of whether the injury occurred as a result of negligence or fraud.

Finally, the court addressed the measure of damages for the “harm” of deepening insolvency —

This is not to suggest that the damages sought by Alberts are an accurate gauge of the injuries suffered by the debtors due to their alleged deepening insolvency. Alberts seeks to recover for "the increased amount of insolvency suffered by the [d]ebtors" (Compl. P 370). This calculation might have represented a fair valuation of the harm caused to the creditors of DCHC (assuming that the debt was never repaid), but Alberts has no standing to protect creditors’ interests. Instead, he will need to prove that DCHC and its subsidiary corporations were actually harmed by the defendants’ allegedly excessive borrowing habits, and then quantify that harm. The damages arising from these injuries (if proven) may be larger or smaller than the amount of excess debt acquired by the debtors, but they will almost certainly not be the same. n13

n12 Put another way, Alberts will need to quantify the impact of the debt accumulated by the debtors due to the defendants’ actions on the debtors’ business operations, not the amount of debt incurred. Specifically, he will need to show that the debtors’ chances of falling into bankruptcy increased due to the defendants’ actions (and then quantify the costs of bankruptcy for the debtors), that the defendants’ conduct prevented the debtors from performing in a profitable manner (and then quantify the cost to the debtors caused by that impairment), or that the defendants’ actions forced the debtors to dissipate corporate assets that would have been retained otherwise (and then quantify the value of those assets). ….

n13 If the evidence shows that the debtors would have been a failure no matter how well DCHC’s management behaved (an admittedly unlikely prospect given that all but one of the debtors have successfully reorganized), Alberts may not be able to recover anything at all.