In 2007, I represented Grant Thornton in its challenge of a deepening insolvency claim in Minnesota. The decision by the Minnesota Court of Appeals in the case—Julia A. Christians, Trustee for the Bankruptcy Estate of Technimar Industries Inc. v. Grant Thornton LLP—could provide useful lessons for accounting firms.
Technimar planned to manufacture a product used, among other things, to make kitchen countertops. The company required an expensive piece of equipment for the manufacturing process. To get the money needed to fuel the operation, Technimar entered into a series of complex financial arrangements, the final piece of which was a bond offering.
During the bond offering, Technimar failed to disclose to its lender and the public entities guaranteeing a portion of the debt that it had fundamentally altered the payment terms of the equipment contract. Technimar had secretly obligated itself to an accelerated repayment schedule that, if not met, would relieve the manufacturer of the obligation to deliver the necessary equipment.
Technimar failed to account for this agreement in its financials. The company could not meet the repayment schedule. It defaulted on the bond and never received the necessary equipment. Ultimately, the company declared Chapter 7 bankruptcy.
The bankruptcy trustee sued Grant Thornton, contending Technimar was insolvent at the time of the bond offering and that the inability of the auditors to discover the accelerated repayment agreement “deepened” the insolvency by allowing the company to accumulate debt it could not repay.
The Minnesota Court of Appeals affirmed the lower court’s award of summary judgment in favor of Grant Thornton on all counts. The court held that Minnesota did not recognize an insolvent corporation’s taking on debt to be a distinct form of damages and thus refused to recognize deepening insolvency as a damage theory. The court also ruled the trustee failed to establish any causal nexus between the actions of the auditors and the alleged damages.
With regard to the deepening insolvency allegations, the court found that the mere accumulation of debt by an insolvent corporation was not evidence of damages. The court noted that additional debt is balance-sheet neutral; that is, every addition to a corporation’s liabilities is offset by an equal addition to a corporation’s assets. The court relied on a 2005 article by bankruptcy lawyer Sabin Willett titled “The Shallows of Deepening Insolvency.” The court, following Willett’s analysis in The Business Lawyer article, found that any harm to the corporation could be remedied through traditional damage theories such as asset diminution or lost profits.
When a client is nearing insolvency or becomes insolvent, accountants can do several things to try to lessen the likelihood of a deepening insolvency lawsuit. First, respect the adage “know thy client.” Have your client’s past actions shown caution or aggressiveness with respect to their public statements and actions? Has the client implemented and followed your advice regarding best practices?
The more you document your advice, procedures, testing and communications in such cases, the better.
Bring appropriate concerns to the attention of the company’s board of directors so the directors can take whatever action they deem necessary and not later point to the accountants and claim they would have acted if they had known about the problem.