Many bankers, at one time or another, surely must wish they had followed the advice of Shakespeare's Lord Polonius when he said to Laertes, "Neither a borrower nor a lender be" (Hamlet, Act I Scene 3). To this day, lenders continue to be confounded by creative debtors' counsel who seek to hold them liable not only for refusing to lend,[i] but also for agreeing to lend money to troubled businesses.
Almost all lenders encounter borrowers who are unable or unwilling to meet their contractual obligations to repay their loans. Should a lender forbear and/or advance additional funds to an entity that already has breached a loan contract and whose financial condition continues to deteriorate? Sound business considerations frequently convince a lender to answer "yes," but not without taking more collateral or imposing additional reporting or financial responsibilities on the borrower.
A lender doesn't advance funds in a workout situation for altruistic reasons, of course. Still, it may come as a surprise when, after a series of loan advances in a workout situation, the business fails, and the borrower points a finger at the lender and argues, "You lent us too much money. If you had refused to do so, the company, its creditors, and investors would all be better off." [ii]
Borrowers who refuse to accept responsibility for their financial failures by making such claims may think that they have found the "golden fleece" in some of the new lender liability legal theories. Indeed, some courts are fashioning remedies for borrowers in cases in which lenders have advanced funds to deteriorating businesses. They also are allowing such claims to be pursued by bankruptcy trustees and creditors committees, while nudging various state courts to adopt such theories.
Recent Cases
Recent cases, on their face, seem to expand the number and scope of borrowers' remedies against lenders who forbear from exercising their bargained-for and statutory remedies. Claims of equitable subordination,[iii] "aiding and abetting,"[iv] the "trust fund doctrine,"[v] and new permutations of fraudulent conveyance theory all are causing lenders to think carefully about continuing to do business with insolvent or troubled borrowers.
In addition to entertaining new theories, courts have expanded the group of litigants who can pursue such claims, and they have extended the list of those who could be found liable for them to include accountants and other turnaround professionals. The current "tort of the day" embodying these expansive remedies is a cause of action often labeled "deepening insolvency."
Just as there have come to be a whole group of poorly defined and constantly morphing theories subsumed under "lender liability," so, too, is a list of elements emerging to define deepening insolvency theory. Several courts have identified common elements to define deepening insolvency as a theory of recovery that addresses the fraudulent prolongation of a corporation's life beyond insolvency, resulting in damage to the corporation caused by increased debt.[vi]
The origins of the theory have been traced to the 1980 case of Bloor v. Dansker (In re Investors Funding Corp of N.Y. Sec. Litig.).[vii] In that case insiders of the debtor persuaded creditors and investors to continue to extend credit to a debtor while those investors looted the company. Rejecting an accounting firm's argument that advancing funds caused no harm because the debtor benefited from the funds obtained, the court said, "Not all acts that prolong the artificial solvency of a debtor confer a benefit upon the corporation." Although Bloor was not a case of deepening insolvency per se, subsequent courts nonetheless have seized upon its language and expanded it in support of the theory.
The 3d Circuit Court of Appeals advanced the theory when it explored a claim of deepening insolvency brought by a creditors' committee in Off. Comm. of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340 (3d Cir. 2003). The court first decided that the new cause of action was available in Pennsylvania, even though courts there had not adopted the theory.
In choosing to adopt the new theory—or, more accurately, in determining that Pennsylvania courts would do so if given the chance—the court indicated that the theory was beginning to be accepted by a number of courts. It added that the underpinnings of the theory were sound and that they comported with the general notion of Pennsylvania law "to provide a remedy where there is an injury," a directive that, interpreted broadly, permits judges to address a host of issues if legislatures fail to do so.
Following Lafferty, another court in the 3d Circuit, the U.S. Bankruptcy Court for the District of Delaware, expanded the reach of the deepening insolvency theory. The Exide decision exceeded even the broad parameters of the Lafferty decision.[viii] As in Lafferty, the court in Exide had to determine first whether the relevant court (in this case Delaware rather than Pennsylvania) would recognize the novel cause of action to exist in that state. The Exide court determined that the Delaware courts would also recognize a cause of action for deepening insolvency for reasons similar to those cited in Lafferty.
Although the Lafferty and Exide decisions appeared to embrace the new theory of recovery, the courts in both cases merely refused to throw out claims made against the lenders under deepening insolvency theories. There was no affirmative recovery by any party, and it was left to later proceedings for the plaintiffs to try to demonstrate liability and damages.
Notwithstanding these limitations, commentators have predicted that Lafferty and Exide give rise to a broad new theory of recovery. Against this background, the scope of the deepening insolvency tort recently was analyzed thoughtfully and placed in a more limited perspective in a decision by the 2d Circuit's U.S. Bankruptcy Court for the Southern District of New York.
In Kittay v. Atlantic Bank of N.Y. (In re Global Serv. Group LLC), 316 B.R. 451 (Bankr. S.D.N.Y. 2004), the court stated that a claimant seeking to recover under this new theory 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.
The court rejected the deepening insolvency claim in the case, finding that it was not sufficient merely to plead that the bank made a loan that it knew or should have known the borrower could never repay. "This may be bad banking, but it isn't a tort," the court said. "A third party is not prohibited from extending credit to an insolvent entity; if it was, most companies in financial distress would be forced to liquidate."[ix]
Fighting Back
In addition to the logical analysis of Kittay, economic reality will limit deepening insolvency claims. Successful prosecution of such claims would, over time, put an end to loans to troubled businesses. There would be few forbearance agreements, and to avoid deepening insolvency claims, lenders would foreclose more often at their first opportunity. But it is not clear how the theory will be used in the short term.
In the meantime, there are other defenses to this new claim. The party raising the claim must show damages. In many, if not most, situations that arise, a lender has a security interest in most or all assets of its borrower and finds itself underwater. In such a case, deepening insolvency hurts only the lender, who would get nothing in a liquidation because subordinate, or unsecured, creditors and equity investors already would have been out of the money.
Other defenses courts seem to recognize include the doctrine of in pari dilecto, which dictates that "a plaintiff may not assert a claim against a defendant if the plaintiff is responsible for the claim." The Lafferty court noted the "application of the in pari delicto doctrine is proper under the Bankruptcy Code." The trustee stands in the shoes of the debtor and "take[s] no greater rights than the debtor himself had."[x]
Conclusion
As in the prior seminal lender liability case of American Lumber and most of its progeny, it is clear that a lender that is merely doing its job of maximizing its assets—without doing so on the backs of creditors—should be free of liability if a troubled company eventually goes under. However, if an extended period of forbearance results in a long liquidation that forces or encourages third parties to incur debt that will not be repaid, it is clear that courts may attempt to fashion remedies against lenders that benefit at the expense of those other creditors.
Accordingly, lenders must proceed cautiously in any forbearance situations in which a borrower continues to do business with other entities and to incur debts to them. But this is not just a defense to such claims. It is also good banking
[i] Courts also have employed various types of the lender liability theory on such failures to lend. See e.g. K.M.C. Co. v. Irving Trust Co., 757 F.2nd 752, 763 (6th Cir. 1985).
[ii] Or increasingly more often, the bankruptcy trustee, creditors' committee, or liquidating trust representing the interest of miffed creditors who may or may not stand to bring such claims.
[iii] Berquest v. First Natl. Bank of St. Paul (In re American Lumber Co.), 5 B.R. 470 (D. Min. 1980). Current cases dealing with deepening insolvency must be viewed in the context of the acts under which they arose. In the recent past, there were many attempts to expand the scope of the American Lumber decision, one of the seminal cases imposing lender liability based on a lender's exercise of undue control over its borrower to the detriment of other creditors. A sober look at that case, however, would lead the reader to the conclusion that to find a lender culpable for such control, to justify subordination of its claims, the actions of the lender must be some egregious misconduct. (The lender controlled the only source of cash, paid only creditors that would benefit the bank, took security interest in all assets, and had a controlling interest in stock of debtor).
[iv] Kittay v. Atlantic Bank of N.Y. (In re Global Serv. Group LLC), 316 B.R. 451 (Bankr. S.D.N.Y. 2004).
[v] F.D.I.C. v. Sea Pines Co., 692 F.2d 973, 976-77 (4th Cir. 1982) cert. denied, 461 U.S. 928 (1983).
[vi] Schacht v. Brown, 711 F.2d 1343, 1350 (7th Cir. 1983), cert. denied, 464 U.S. 1002 (1983).
[vii] 523 F. Supp. 533 (S.D.N.Y. 1980).
[viii] Off. Comm. of Unsecured Creditors v. Credit Suisse Boston (In re Exide Tech., Inc.), 299 B.R. 732 (Bankr D. Del. 2003).
[ix] Id. at 459.
[x] Lafferty, 267 F.3d at 356.
Reprinted with permission from the March 2005 issue of The Journal of Corporate Renewal, copyright sign Turnaround Management Association.