Few issues in bankruptcy law vary as widely across the circuits as does the issue of deepening insolvency and its status as a separate tort.
The Bankruptcy Court for the Northern District of Texas recently predicted in In re VarTec Telecom Inc. that deepening insolvency would not be recognized by Texas state courts as an independent cause of action, and granted a motion to dismiss a count for deepening insolvency for failure to state a claim.
In February 2000, VarTec Telecom Inc. and Rural Telephone Finance Cooperative (RTFC) executed loan agreements providing for a $334 million term loan and a revolving line of credit of up to $200 million. In 2001, VarTec sought approval from RTFC to acquire a number of companies commonly referred to as the Excel companies, or Excelcom Inc. RTFC approved the acquisition, which closed in April 2002. On May 15, 2002, VarTec Holding executed a modification to pledge and security agreement, which added the stock of Excel and several other subsidiaries of VarTec, but did not include any other assets.
Almost immediately thereafter, VarTec began to encounter financial difficulties, prompting RTFC to question the financial viability of VarTec. On Sept. 25, 2002, VarTec Holding executed a second modification to pledge and security agreement, adding the stock of VarTec Resource Services Inc. as additional security held by RTFC.
As a result of VarTec's continual weakened financial condition, RTFC downgraded VarTec's borrower risk rating. Consequently, the parties again amended the loan agreements, with several of VarTec's subsidiaries executing unconditional joint and several guarantees to RTFC which guaranteed the obligations of VarTec under the loan agreements. Similarly, VarTec Holding also executed a guarantee. RTFC further required that VarTec and certain subsidiary guarantors execute and obtain deposit account control agreements, and that other security, cash controls and lien perfection arrangements be made in connection with the third amendment to the loan agreements to perfect security interests in deposit accounts and funds in which RTFC did not previously have a perfected security interest.
In May 2004, in response to further deterioration of VarTec's financial condition, VarTec and RTFC discussed bankruptcy alternatives and began negotiating yet another amendment to the loan agreements. By July 2004, it was apparent that VarTec would have to file a petition for bankruptcy relief, and RTFC's board of directors was so informed. The directors were also advised by RTFC representatives working directly with VarTec of the RTFC representatives' intention to work with VarTec in its bankruptcy filing. Both RTFC and VarTec retained bankruptcy counsel.
On Oct. 7, 2004, prior to VarTec's bankruptcy filing, RTFC arranged for VarTec to pay down the loan agreements by $90 million through a loan to Telephone Electronics Corp., the proceeds of which were transferred to VarTec. Conditioned upon the $90 million pay down of VarTec's indebtedness, RTFC entered into a first amended restated credit agreement, which added additional collateral that RTFC did not have under the prior loan agreements, and positioned RTFC for VarTec's impending bankruptcy filing. VarTec then filed its Chapter 11 petition.
The official committee of unsecured creditors of VarTec Telecom Inc. filed a complaint asserting 10 causes of action against RTFC, including, inter alia, a claim for deepening insolvency. RTFC filed a motion to dismiss the deepening insolvency count for failure to state a claim upon which relief may be granted, pursuant to F.R.C.P. 12(b)(6), as made applicable by F.R.B.P. 7012(b), to which the committee filed a response.
The court articulated the issue in this case as whether deepening insolvency, as pled in the original complaint, is a separate, actionable tort under Texas law. As our readers know, a complaint may not be dismissed for failure to state a claim upon which relief may be granted unless it is clear that the plaintiff can prove no set of facts that would entitle the plaintiff to relief. While the court must consider the facts and all reasonable inferences drawn therefrom in the light most favorable to the nonmovant, the plaintiff must plead specific facts; mere conclusory allegations will not suffice.
Deepening Insolvency
The Bankruptcy Court for the Southern District of New York has defined the theory of deepening insolvency as "the 'fraudulent prolongation of a corporation's life beyond insolvency,' resulting in damage to the corporation caused by increased debt," according to Kittay v. Atlantic Bank of New York (In re Global Serv. Group LLC). In Schacht v. Brown, quoted in the Kittay opinion, the 7th U.S. Circuit Court of Appeals reviewed the denial of a motion to dismiss a complaint alleging breach of fiduciary duty by a corporation's directors.
One of the recovery theories set forth in the complaint was that the corporation was harmed by the prolonging of its life by its corporate fiduciaries, in their effort to siphon off corporate assets. In recognizing the theory of deepening insolvency, the appellate court refused to adopt the position that a corporation may never sue to recover damages alleged to have resulted from the artificial prolongation of an insolvent corporation's life, stating in dictum that this would create a perverse incentive for malfeasant officers and directors to conceal the true financial condition of the corporation from its shareholders.
While deepening insolvency was first recognized as a theory for recovery in such 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, according to Limor v. Buerger (In re Del-Met Corp.), "[t]he action has morphed, both in form - from a breach of statutory duty claim to a form of common law tort liability - and in scope - now reaching lawyers, accountants, bankers and other financial insolvency professionals."
A Creature of State Law
The words "deepening insolvency" are neither contained in the Bankruptcy Code nor do they arise from other federal law. As a result, the VarTec court concluded that courts finding deepening insolvency to be an actionable tort do so by predicting how their respective state courts would rule when reviewing the viability as an as-unrecognized cause of action. The committee asserted that given the opportunity, the Texas Supreme Court would recognize deepening insolvency as a separate and independent claim.
The committee relied on Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., where the 3rd Circuit predicted that the Pennsylvania Supreme Court would recognize the tort of deepening insolvency, as no state court had yet addressed the issue. In formulating this prediction, the 3rd Circuit examined three factors: the soundness of the theory; its growing acceptance among the courts; and the concept that every wrong must have a legal remedy.
The Bankruptcy Court for the District of Delaware adopted the Lafferty court's reasoning in Official Comm. of Unsecured Creditors v. Credit Suisse First Boston (In re Exide Techs. Inc.), as did the Bankruptcy Court for the Northern District of Ohio in In re LTV Steel Co. Inc. In the instant case, the committee urged the Texas bankruptcy court do the same.
In its analysis, the Texas bankruptcy court reviewed the decisions of other federal courts whose respective states had not yet ruled on the viability of deepening insolvency. For example, the court in Del-Met, relying on Lafferty, found that the state Supreme Court would recognize deepening insolvency as an actionable breach of duty to a corporation.
However, the Del-Met court concluded that deepening insolvency was not a "stand-alone" tort, but an actionable breach of a separate duty owed to a corporation. This duty arguably arose because the complaint alleged that certain creditors took over the management and control of the debtors, which led to duties that were either fiduciary or special in nature. The torts alleged in the complaint were breaches of fiduciary duty and aiding and abetting breaches of fiduciary duty.
Similarly, the court in Global Serv. rejected deepening insolvency as a separate claim under New York law, relegating it to a theory of damages that may result from the commission of a tort. The Global Serv. court noted that the majority of federal courts to consider the viability of the deepening insolvency theory have either treated it as a theory of damages or have raised serious questions about its viability. The VarTec court pointed out that like Global Serv., other recent decisions have also rejected deepening insolvency as a separate cause of action.
Texas state courts have not yet recognized the theory of deepening insolvency, and the 5th Circuit has questioned its viability in Florida Dep't of Ins. v. Chase Bank of Texas Nat'l Ass'n. The bankruptcy court in the instant case found that Lafferty largely relied upon for the decisions by the courts finding the legal theory to be sound, was a fraud case where the deepening insolvency of the corporation could have been considered as part of the breach of the officers' and directors' fiduciary duty owed to the corporation.
The court found the Global Serv. court's declaration that "one seeking to recover for 'deepening insolvency' must show that the defendant prolonged the company's life in breach of a separate duty, or committed an actionable tort that contributed to the continued operation of a corporation and its increased debt" has borne itself out under examination.
In VarTec, the court concluded that the Texas Supreme Court would not adopt deepening insolvency as a separate tort because the injury caused by it is substantially duplicated by torts already established in Texas. The court also stated that as a bankruptcy court, it should avoid establishing new law in the state where neither the Supreme Court nor the lower courts have spoken on the issue. It held, therefore, the plaintiff must show the defendant has committed some already-recognized tort before the plaintiff can set forth a valid claim for damages under deepening insolvency.
A Stand-Alone Tort
In its analysis, the VarTec court did analyze the theory of deepening insolvency as a potential stand-alone tort. Under Texas law, the elements of a tort are duty, breach of that duty, proximate causation and injury. The court got hung up on the first element - it found no general independent duty to exist in connection with a deepening insolvency claim. For example, in cases where officers and directors have been held liable for the deepening insolvency of a corporation, they had separate fiduciary duties to the corporation imposed by law that they breached, because they misrepresented the state of their corporations' balance sheets. In cases closer to the facts of the instant case, lenders have been found liable for the deepening insolvency of their borrowers, but only in situations in which they had taken control of the corporation.
In Texas, the relationship between a borrower and a lender is not usually fiduciary or special in nature so as to impose any extra-contractual duties on the lender. Where Texas courts have found such a duty, the findings have rested on extraneous facts and conduct not present in this case. To recover damages for the deepening insolvency of a corporation by the RTFC in the instant case, the committee would have to show that the RTFC did more than just allow VarTec to go deeper into insolvency, to become more insolvent or to exist past the point of insolvency. It would have to show that the RTFC controlled the business activities of VarTec, or in the context of the present motion to dismiss, put forward specific, well-pled facts showing that the RTFC was controlling VarTec's business activities, giving rise to a duty under Texas law.
The facts as pled by the committee in the original complaint, even considered in the light most favorable to the committee, did not contain specific facts to show that the RTFC controlled the actions or took on the management responsibilities of VarTec. As such, the court dismissed count 10 of the original complaint.
Conclusion
With this decision, the Bankruptcy Court for the Northern District of Texas falls in line with Global Serv. The "willful and malicious lending of money" is not a tort in Texas, and the court opined that this type of activity would probably not be recognized as such any time soon. Instead, in order to maintain a cause of action against a lender under such a theory, the plaintiff must allege that the lender took over control of the debtor's operations and breached its consequent fiduciary duties thereafter. Because the committee did not do so in this case, the court dismissed its claim.
Rudolph J. Di Massa, Jr., a partner at Duane Morris, concentrates his practice in the areas of commercial litigation and creditors' rights. He is a member of the American Bankruptcy Institute, the American Bar Association and its business law section, the Commercial Law League of America, the Pennsylvania Bar Association and the business law section of the Philadelphia Bar Association.
Matthew E. Hoffman practices in the area of business reorganization and financial restructuring. He is admitted to practice in New Jersey and Pennsylvania.
Reprinted with permission from The Legal Intelligencer, © ALM Media Properties LLC. All rights reserved.