Do No Harm: The Theory Of 'Deepening Insolvency'

There may come a time in the life cycle of a borrower when there is a covenant default, the borrower is on the ropes and the lender is being asked to continue to advance funds under the working capital line while the borrower tries to accomplish a turnaround. The purpose of this Tip is not to discourage a prudent lender from working with a borrower, but to put everyone on notice that a lender's decision to continue to support a borrower after it flounders in its turnaround effort may come under review by the bankruptcy court.

In the case of Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., Inc.; * Cogen Sklar, LLP 267 F.3d 340; (3rd Cir 2001), the United States Court of Appeals held that certain outside advisers to the debtor induced the debtor to issue additional debt at a time that it was insolvent, causing the debtor to deepen its insolvency, ultimately leading to bankruptcy. The decision confirmed the lower court's ruling that the unsecured creditors were entitled to damage awards against some but not all of the advisers. Until this decision, damages were generally not awarded to creditors against third parties advising the debtor during its pre-bankruptcy struggle unless a fraud was involved.

In this case, the Third Circuit accepted the legal theory that there was a separate cause of action arising from the actions of a third party adviser, called "deepening insolvency." Under Lafferty, if a lender continued to lend to a debtor and the debtor's financial condition got worse then the lender might be liable under a separate cause of action for "deepening insolvency," even if there was no demonstration of fraud or negligence on the part of the lender.

The most interesting part of the decision is that the court did not rely on any bankruptcy theory or "federal common law," but rather found that the cause of action arose under Commonwealth of Pennsylvania corporate law. Unfortunately, no Pennsylvania case law supported this conclusion. Therefore, to uphold Lafferty in any other state would require that the state or federal court interpret the specific corporate law of the state.

In the intervening six years a number of courts have looked at the Lafferty decision and whether under the applicable state law there was a separate cause of action for "deepening insolvency." Some courts have treated "deepening insolvency" just as a measure of the damages caused by the fraud or negligence of third parties, including lenders.

The...