In In re CITX Corp. (Seitz v. Detweiler Hershey & Assoc., PC), 448 F.3d 672, 2006 U.S. App, LEXIS 13141 (3rd Cir. May 26, 2006), the debtor was also alleged to have been an illegal Ponzi scheme. The Chapter 7 Trustee filed suit against the accounting firm for, inter alia, deepening insolvency. The District Court granted summary judgment to the defendants.
The twist in CITX, a case under Pennsylvania law, was that the deepening insolvency claim was based upon allegations of negligence (the complaint “barely makes out, and his evidence completely fails to support, any allegation of fraudulent conduct on [Defendant’s] part”). The issue before the Court, therefore, was whether a cause of action for deepening insolvency could be based upon negligence, as opposed to fraudulent conduct? The Court answered “no.”
First, let’s review the Lafferty case, in which the Court held that “Deepening Insolvency” was a valid cause of action under Pennsylvania law. In Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., Inc., 267 F.3d 340 (3rd Cir. 2001), the debtor corporations were alleged to have been Ponzi schemes” and the Committee filed suit against third-parties for, inter alia, fraudulently inducing the debtors to issue debt securities, thereby “deepening their insolvency.” At issue (for purposes of this post) was “whether ‘deepening insolvency’ is a valid theory that gives rise to a cognizable injury under [Pennsylvania] state law. The Court found that the Pennsylvania state courts had not addressed the issue, and there were no other state or federal cases on point.
… [W]e conclude that, if faced with the issue, the Pennsylvania Supreme Court would determine that "deepening insolvency" may give rise to a cognizable injury. First and foremost, the theory is essentially sound. Under federal bankruptcy law, insolvency is a financial condition in which a corporation’s debts exceed the fair market value of its assets. 11 U.S.C. § 101(32). Even when a corporation is insolvent, its corporate property may have value. The fraudulent and concealed incurrence of debt can damage that value in several ways. For example, to the extent that bankruptcy is not already a certainty, the 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. …. Aside from causing actual bankruptcy, 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, calling into question its ability to perform, thereby damaging the corporation’s assets, the value of which often depends on the performance of other parties. … In addition, prolonging an insolvent corporation’s life through bad debt may simply cause the dissipation of corporate assets.
The Lafferty opinion continues —
These harms can be averted, and the value within an insolvent corporation salvaged, if the corporation is dissolved in a timely manner, rather than kept afloat with spurious debt. As the Seventh Circuit explained in Schacht v. Brown: Cases [that oppose "deepening insolvency"] rest upon a seriously flawed assumption, i.e., that the fraudulent prolongation of a corporation’s life beyond insolvency is automatically to be considered a benefit to the corporation’s interests. This premise collides with common sense, for the corporate body is ineluctably damaged by the deepening of its insolvency, through increased exposure to creditor liability. Indeed, in most cases, 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. Thus, acceptance of a rule which would bar a corporation from recovering damages due to the hiding of information concerning its insolvency would create perverse incentives for wrong-doing officers and directors to conceal the true financial condition of the corporation from the corporate body as long as possible.
Growing acceptance of the deepening insolvency theory confirms its soundness. In recent years, a number of federal courts have held that "deepening insolvency" may give rise to a cognizable injury to corporate debtors.
Significantly, one of the most venerable principles in Pennsylvania jurisprudence, and in most common law jurisdictions for that matter, is that, where there is an injury, the law provides a remedy. See 37 Pennsylvania Law Encyclopedia, Torts § 4, at 120 (1961) ("For every legal wrong there must be a correlative legal right.") (citation omitted). Thus, an identifiable and compensable injury is essential to the existence of tort liability, Schweitzer v. Consolidated Rail Corp., 758 F.2d 936, 942 (3d Cir. 1985), but once an injury has occurred, "tort law attempts to place the injured party in the same position he occupied before the injury," Hahn v. Atlantic Richfield Co., 625 F.2d 1095, 1104 (3d Cir. 1980) (construing Pennsylvania tort policy). Similarly, where a contractual "breach occurs, contract law seeks to give to the nonbreaching party the benefit of his or her bargain, to put him or her in the position he or she would have been in had there been no breach." 1 Summary of Pennsylvania Jurisprudence Torts § 1.1 (2d ed. 1999). Thus, where "deepening insolvency" causes damage to corporate property, we believe that the Pennsylvania Supreme Court would provide a remedy by recognizing a cause of action for that injury.
In sum, we believe that the soundness of the theory, its growing acceptance among courts, and the remedial theme in Pennsylvania law would persuade the Pennsylvania Supreme Court to recognize "deepening insolvency" as giving rise to a cognizable injury in the proper circumstances.
(many citations omitted)(bold emphasis added). I will stop here to note that while the Court was addressing the issue of whether Deepening Insolvency was a distinct cause of action, the language arguably is geared more toward Deepening Insolvency as a measure of damages. Not surprisingly, this distinction has been the source of much discussion and commentary.
Now, to CITX, where the issue was whether the cause of action of “Deepening Insolvency” could be based upon allegations of negligence.
[The Trustee’s] contention that negligence can suffice for deepening insolvency has some support. For example, the Ninth Circuit Court of Appeals recently suggested that deepening insolvency does not require intentional conduct. See Smith v. Arthur Andersen LLP, 421 F.3d 989, 995 (9th Cir. 2005) (recognizing deepening insolvency when the allegations were that the defendants "misrepresent[ed] (not necessarily intentionally) the firm’s financial condition to its outside directors and investors"); see also Bondi v. Bank of Am. Corp. (In re Parmalat Sec. Litig.), 383 F. Supp. 2d 587, 601 (S.D.N.Y. 2005). Indeed, Lafferty relied, in a string cite of five cases, on one case suggesting that negligence would suffice. 267 F.3d at 350-51 (citing Gouiran Holdings, Inc. v. DeSantis, Prinzi, Springer, Keifer & Shall (In re Gouiran Holdings, Inc.), 165 B.R. 104, 107 (E.D.N.Y. 1994)).
In addressing this question, we note that Lafferty holds only that fraudulent conduct will suffice to support a deepening-insolvency claim under Pennsylvania law. See id. at 347 (defining the injury as a "fraudulent expansion of corporate debt and prolongation of corporate life"); id. at 349 (referring to the "fraudulent and concealed incurrence of debt"); see also Corporate Aviation Concepts, Inc. v. Multi-Serv. Aviation Corp., 2004 U.S. Dist. LEXIS 17154, No. Civ. A. 03-3020, 2004 WL 1900001, at *4 (E.D. Pa. Aug. 25, 2004) (holding that only fraudulent conduct will suffice for a deepening-insolvency claim); OHC Liquidation Trust v. Credit Suisse First Boston (In re Oakwood Homes Corp.), 340 B.R. 510, 2006 WL 864843, at *20 (Bankr. D. Del. 2006) (same). We know no reason to extend the scope of deepening insolvency beyond Lafferty’s limited holding. To that end, we hold that a claim of negligence cannot sustain a deepening-insolvency cause of action.
So… Deepening Insolvency is a cause of action in Pennsylvania, but it is a cause of action that much be based upon fraud (or at least something much more than negligence). What is the distinction between this and simply asserting a claim for fraud, with "deepening insolvency" a factor in the measure of damages? Reading the Lafferty opinion, it seems that is the substance of the discussion. However, CITX also involved a claim for malpractice against the defendant accounting firm, and the Trustee sought to assert deepening insolvency as a measure of damages with respect to the malpractice claim –
Our only opinion to address "deepening insolvency," Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340 (3d Cir. 2001), defined it, in predicting Pennsylvania law, as "an injury to [a debtor’s] corporate property from the fraudulent expansion of corporate debt and prolongation of corporate life." Id. at 347. In that opinion, we concluded that deepening insolvency was a valid Pennsylvania cause of action. Id. at 344. Although we did describe deepening insolvency as a "type of injury," id. at 347, and a "theory of injury," id. at 349, we never held that it was a valid theory of damages for an independent cause of action. Those statements in Lafferty were in the context of a deepening – insolvency cause of action. They should not be interpreted to create a novel theory of damages for an independent cause of action like malpractice. n8
n8 By this we do not mean to imply that deepening insolvency would be a valid theory of damages for any other cause of action, such as fraud, and Lafferty did not so hold.
Also, we note that Seitz did not provide sufficient evidence to allow a reasonable jury to find harm. Assuming for the sake of argument that Detweiler’s financial statements allowed CitX to raise over one million dollars, that did nothing to "deepen" CitX’s insolvency. Rather, it lessened CitX’s insolvency. Cf. Sabin Willett, The Shallows of Deepening Insolvency, 60 Bus. Law. 549, 552-57 (2005) (discussing loans). Before the equity infusion, CitX was $ 2,000,000 in the red (using round numbers for ease of discussion). With the added $ 1,000,000 investment, it was thereby insolvent only $ 1,000,000. This hardly deepened insolvency. Any 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 Detweiler.
The crux, then, is the claim that the $ 1,000,000 equity investment allowed CitX to exist long enough for its management to incur millions more in debt. But that looks at the issue backward. As noted, the equity investment was hardly harmful to CitX. Its management surely misused the opportunity created by that investment; that was unfortunate. But they could have instead used that opportunity to turn the company around and transform it into a profitable business. They did not, and therein lies the harm to CitX. Put another way, [t]he 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." Id. at 575. n9
n9 In any event, even Seitz’s counsel acknowleged that deepening insolvency as a measure of damages merely replicates malpractice damages. In a letter to counsel for Detweiler that Seitz’s counsel wrote in January 2005, he concedes that "the damages analyses under the deepening insolvency theory and under the malpractice theory are identical."
The CITX Court also acknowledged in a footnote the discussion that arose from its Lafferty opinion –
n11 Though Lafferty and the economic tort it interpreted Pennsylvania law as approving for fraudulent conduct have provoked much comment, see, e.g., William Bates III, Deepening Insolvency: Into the Void, Am. Bankr. Inst. J., Mar. 2005, at 1; J.B. Heaton, Deepening Insolvency, 30 Iowa J. Corp. L. 465 (2005); Willett, supra,that issue is not before us. Even if it were, we cannot revisit the correctness of that interpretation of Pennsylvania law. See In re Merck & Co. Sec. Litig., 432 F.3d 261, 274 (3d Cir. 2005) (noting that only the Court en banc can overrule a precedential decision). Although some courts in this Circuit have extended Lafferty’s reasoning to other states, see, e.g., OHC Liquidation Trust v. Credit Suisse First Boston (In re Oakwood Homes Corp.), 340 B.R. 510, 2006 WL 864843, at *16-17 (Bankr. D. Del. 2006) (holding that Delaware, New York, and North Carolina would recognize the cause of action), nothing we said in Lafferty compels any extension of the doctrine beyond Pennsylvania.