Deepening Insolvency Not an Emerging Threat

In reading the article, “ Deepening Insolvency: An Emerging Threat,” by Kelly M. Hnatt, Esq., (Feb. 08, page 40) and the related article, “From the Defense: How to Combat a Deepening Insolvency Claim ,” by Michael E. Keyes, Esq., (Feb. 08, page 44) I was taken aback, as both articles indicate that over the last number of years, more and more claims of deepening insolvency have not survived the courts’ scrutiny. However, the editors of the JofA have painted a picture, through the title of the first article and by their highlighting of certain phrases, that this is an emerging threat, which it is not. If anything, in the last 18 months, the courts (the Second, Third and Seventh Circuits, the Delaware Supreme Court, as well as others) have issued opinions stating that deepening insolvency is not a tort.

A deepening insolvency claim is a claim against officers, directors, lenders, accountants and other advisers that assist an insolvent entity, or an entity that is in the zone of insolvency, in obtaining financing or prolonging the life of the entity to the detriment of the entity or the creditors.

Although the theory of deepening insolvency first arose in 1980, it was a non-issue until 2001, when the Third Circuit in Official Committee of Unsecured Creditors v. R.F. Lafferty & Co. Inc. (267 F.3d 340) ruled that Pennsylvania law would provide a cause of action under the theory of deepening insolvency. However, in the 2006 case In re CitX Corp  (448 F.3d 672), the Third Circuit, in rejecting the claim of deepening insolvency, commented that while it “cannot revisit the correctness” in its interpretation of Pennsylvania law in Lafferty, nothing “compels any extension of the doctrine [deepening insolvency] beyond Pennsylvania.”

Since CitX and (as Ms. Hnatt points out) the 2006 Delaware Chancery case affirmed in 2007 by the Delaware Supreme Court, Trenwick America Litigation Trust v. Ernst & Young LLP, et al., more and more courts have rejected the theory that deepening insolvency is a separate tort. The courts have further indicated that if there was fraud, then fraud should be raised.

Auditors should always be aware that their actions or inactions are subject to lawsuits and to review by the courts, but by painting this as an emerging issue that auditors need to worry about, it does both the authors and the JofA an injustice.

M. Jacob Renick, CPA, CIRA, CDBV, CFE
White Plains, N.Y.