| EXECUTIVE SUMMARY |  Deepening insolvency is a relatively new and developing legal theory. Courts have disagreed about whether deepening insolvency is a stand-alone tort claim or simply a basis for seeking damages related to fraud, professional malpractice or another claim. If an auditor is alleged to have “missed” an accounting irregularity in an audit or the performance of other services, and eventually the company fails, a claim for deepening insolvency might be asserted. The core of the deepening insolvency theory is that an insolvent corporation and/or its creditors are harmed when a defendant fraudulently or negligently plays a role in increasing a corporation’s debt and exposure to creditors, or in depleting its assets by artificially prolonging the corporation’s life. Kelly M. Hnatt, Esq., is a partner in the law firm of Willkie Farr & Gallagher LLP, in New York City. Her e-mail address is khnatt@willkie.com. |
As courts continue to expand theories for holding auditors liable to clients and third parties—particularly in connection with business failures—the concept of deepening insolvency is gaining prominence. This article focuses on the issues raised by this emerging claim and on its ramifications for auditors. Courts have disagreed about whether deepening insolvency is a standalone tort claim or simply a basis for seeking damages related to fraud, professional malpractice or another claim. Indeed, there is some question about whether deepening insolvency should be a viable basis of recovery at all. One thing is clear—deepening insolvency generally creates increased risk of exposure to legal action for audit professionals, particularly related to troubled businesses. In some cases, the theory may create additional scrutiny of the auditor’s consideration, required by Statement on Auditing Standards no. 59, of an entity’s ability to continue as a going concern. In an ordinary negligence or fraud case, damages are limited to actual losses that the plaintiff suffers, often measured in lost profits, a decrease in asset values or increased costs. The deepening insolvency theory seeks recovery for the expansion of corporate debt and the prolonged life of the corporation. But there have been few cases that recognize deepening insolvency as a cause of action rather than as a damages theory.
Insolvency is generally understood, from a balance sheet perspective, as a financial condition such that the sum of the entity’s debts is greater than the fair value of a company’s assets. What deepening insolvency cases have also focused on, however, is cash flow insolvency—when a company incurs debt that would be beyond its ability to pay in future years—and low capital insolvency—when a company engages in a transaction or business that its capital base cannot support. The phrase deepening insolvency appears to have had its origins in the mid-1980s in litigation concerning failed businesses. The AICPA has followed this controversial theory as it has been presented to various courts. In the case of Crowley v. Chait , (No. 06-2209) pending in the Third Circuit Court of Appeals, the AICPA filed a friend-of-the-court brief in support of PricewaterhouseCoopers LLP. The case involves an appeal by PricewaterhouseCoopers following a trial in New Jersey federal court relating to claims made against the audit firm after the insolvency of Ambassador Insurance Co. The insurer’s Vermont regulator asserted negligence claims on grounds that if the outside auditor had conducted a proper audit, the regulator would have learned that Ambassador was near insolvency and would have placed the company into receivership 20 months sooner. The AICPA argued against application of deepening insolvency damages on a claim for professional negligence. THE COURTS’ VIEWS
Recent court decisions demonstrate a lack of consistency in application and acceptance of this theory. For example, there is a debate whether deepening insolvency is a stand-alone claim or just another theory of damages for a negligence or fraud claim. In Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340 (3d Cir. 2001), the Third Circuit predicted that Pennsylvania would recognize such a “claim”— though it did not specify the required elements of the claim—if fraud were alleged. In a separate case that has been interpreted by many observers as a blow to deepening insolvency, the Delaware Chancery Court explicitly rejected the claim under Delaware law, challenging one of the tenets on which the theory was based. In Trenwick America Lit. Trust v. Ernst & Young LLP, et al., 906 A.2d 167 (Del. 2006), affirmed by the Delaware Supreme Court, a litigation trust formed in the wake of an insurer’s bankruptcy was granted the right to bring claims belonging to the company’s key operating subsidiary. The trust sued the company’s former directors and several advisers, including two accounting firms, for permitting the company and its subsidiaries to engage in certain ill-advised transactions and acquisitions, resulting in substantial debt. The accounting firms were alleged to have helped to conceal the true financial condition of the company, as well as to have “signed off” on the transactions. The Delaware court questioned a key premise of the deepening insolvency theory. “If the board of an insolvent corporation, acting with due diligence and good faith, pursues a business strategy that it believes will increase the corporation’s value, but that also involves the incurrence of additional debt, it does not become a guarantor of that strategy’s success. That the strategy results in continued insolvency and an even more insolvent entity does not in itself give rise to a cause of action.” The court noted, however, that plaintiffs could use other claims already developed by the courts, such as fraud, malpractice, or in the case of directors, breach of fiduciary duty. The Delaware court did not address explicitly whether deepening insolvency remains a valid theory of damages, though its criticism of the premise may suggest its view.
Outside auditors were defendants in a Pennsylvania case— In re CitX Corp., 448 F.3d 672 (3rd Cir. 2006)—involving an Internet company that incurred millions of dollars in debt before declaring bankruptcy. The bankruptcy trustee sued the company’s outside accountants for, among other things, malpractice in their compilations of the failed business’s financial statements and deepening insolvency. The Third Circuit held that the trustee’s attempt to use deepening insolvency, a theory of damages, for an independent cause of action, such as malpractice, was not permissible under Pennsylvania law. As noted earlier, however, if assertions of fraud were made against the auditor, then a deepening insolvency claim would be permissible. In another recent, unpublished decision, NCP Litig. Trust v. KPMG, no. ESX-L-4707-02 (2007), a New Jersey Superior Court refused to dismiss claims of negligence and negligent misrepresentation for which the type of injury asserted was deepening insolvency against a public company’s outside auditor, KPMG. The audit firm’s client was Physician Computer Network Inc. (PCN), which declared bankruptcy after two officers allegedly engineered a plan to inflate the company’s earnings and understate its expenses through sham transactions, improper revenue recognition, and failure to accrue certain employee-related expenses. The audit firm issued unqualified audit opinions on the financial statements allegedly reflecting these improper transactions and accounting errors. The audit firm eventually discovered the irregularities and withdrew its prior opinions, and restatements of previously issued financial statements occurred. In connection with its bankruptcy reorganization plan, PCN contributed its claims, including those against the audit firm, to a litigation trust to address the injuries to the failed business—not injuries to its shareholders or creditors. The defendant audit firm asserted that the trust had no legal standing to pursue the claims against the firm because the failed business itself did not suffer harm—rather, if anyone did, it was its creditors and shareholders. The court rejected the position under New Jersey law. The court permitted claims to proceed against the auditor for negligence and negligent misrepresentation for allegedly failing to discover the fraud earlier, prolonging the existence of PCN, leading to additional unnecessary expenses and delaying the eventuality of bankruptcy. As the above cases show, if an auditor is alleged to have “missed” an accounting irregularity in an audit or the performance of other services, and eventually the company fails, a claim for deepening insolvency might be asserted.
At least one case also has looked at whether the inadequate performance of procedures under SAS no. 59, The Auditor’s Consideration of an Entity’s Ability to Continue as a Going Concern, may also give rise to deepening insolvency liability. The auditor’s focus under SAS no. 59 is whether there is substantial doubt about a company’s ability to continue to meet its obligations as they come due without either substantial disposition of assets outside the ordinary course of business, restructuring of debt, externally forced changes to operations, or similar actions. Importantly, an auditor need only look forward one year under SAS no. 59. Moreover, the auditor is not responsible for predicting future conditions or events. In Fehribach v. Ernst & Young LLP, 493 F.3d 905 (7th Cir. 2007), the Seventh Circuit considered the scope of an auditor’s duties related to SAS no. 59 when the plaintiff, the bankruptcy trustee of frozen food distributor Taurus, sought deepening insolvency damages from Ernst & Young. The company’s CFO had inflated the company’s sales and accounts receivable in daily reports that Taurus provided to the bank. She was ultimately convicted of fraud, and Taurus’ bankruptcy soon followed. The trustee claimed E&Y should have provided a going-concern qualification in the audit year preceding the CFO’s misappropriations, and that had it done so, the company owners would have realized that the company was going to fail and would have liquidated, avoiding at least $3 million in debt that the company incurred while it remained in business The court found that an auditor’s failure to address adequately a company’s ability to continue as a going concern could give rise to a malpractice claim against the auditor. Yet the court made clear the limitations of the SAS no. 59 obligations. Specifically, the court said that an auditor has no duty to investigate external matters in the course of its SAS no. 59 consideration. Rather its obligation extends only to discovery therein during the engagement. The court noted that accounting firms are not expected to be experts in their clients’ business environments, and therefore did not permit deepening insolvency damages because the auditor had not failed to perform duties under SAS no. 59. What does this mean for the audit professional? Plaintiffs continue to seek to expand damages for which an auditor can be held liable. Some states may permit stand-alone deepening insolvency claims; others may permit deepening insolvency damages related to fraud, professional malpractice or another claim; and others may question the concept altogether. Auditors should be particularly alert to the possibility of deepening insolvency allegations, particularly when dealing with troubled businesses. 
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Fraud and the Financial Statement Audit: Auditor Responsibilities, a CPE self-study course (#181822)
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