Written by
Steven J. Solomon, Esq., CIRA
(Section Editor)
and Nicole Testa, Esq.

While restructuring professionals are typically focused on “saving” businesses, not every business enterprise merits continued existence. A restructuring advisor’s best advice may include shutting down operations before additional debt is accumulated and creditor value is further eroded. Under a developing line of case law, Creditors’ Committees and Bankruptcy Trustees are pursuing claims against accountants, financial advisors, officers, and directors on a “deepening insolvency” theory.

Deepening insolvency occurs when an insolvent company’s life is prolonged and corporate debt continues to increase (including trade debt) at the expense of creditors and shareholders. Theoretically, if the insolvent company ceased operating before the incurrence of additional debt, the company could have frozen losses and preserved asset value.

Fraud or negligence is typically at the root of a deepening insolvency claim. In Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., Inc., third party professionals, including an attorney, an accountant, and an underwriter, issued professional opinions required for the registration of public offerings and the sale of debt securities.¹ At the heart of the lawsuit, the Committee alleged that the professionals participated in a scheme to render opinions filled with multiple fraudulent misstatements and material omissions regarding the companies’ financial statements.² Participation in this fraudulent scheme, the Committee alleged, wrongfully expanded the debtors’ debt beyond their ability to repay, prolonged the corporation’s life, and eventually forced a bankruptcy filing.³ Even though the Third Circuit ultimately ruled that the Creditors’ Committee was tarnished by the debtors’ bad acts and therefore unable to pursue recovery, the impact of Lafferty remains strong. Citing Lafferty, the United States Bankruptcy Court for the Southern District of Florida in In re Flagship Heatlhcare, Inc. upheld a Chapter 7 trustee’s claim against a debtor’s financial advisor under a deepening insolvency theory.⁴

In Flagship, the debtor hired a financial advisor to assist in its identification of acquisition candidates and the analysis, structuring, and negotiating of proposed acquisition transactions.⁵ The financial advisor prepared a valuation, which included a confidential memorandum and financial analysis, in order to justify the significant goodwill number included on the debtor’s balance sheet.⁶ In performing a year-end audit, the debtor’s financial advisor relied on such valuation and concluded it was unnecessary to downwardly adjust goodwill.⁷ The Court found that the trustee’s complaint sufficiently plead an accountant’s duty to exercise due professional care and adhere to all professional and industry standards in rendering valuation opinions under a deepening insolvency theory.⁸ The Court denied the financial advisor’s motion to dismiss holding that the defendants breached their duties by (i) failing to perform a discounted cash flow analysis in accordance with the standards applicable to the valuation of goodwill, (ii) to analyze the debtor’s assets at their lowest levels, and (iii) to value the goodwill over the life of the assets.⁹

The debtor’s reliance on the accountant’s audit in Flagship resulted in a domino effect, which hastened the debtor’s failure. After the issuance of the audit, the debtor continued acquiring other companies and subsequently entered into a $40 million term loan and a $15 million revolving line of credit.¹⁰ As in Flagship, the incurrence of such increased indebtedness may create “operational limitations” which can impair a corporation’s ability to run profitably. “[S]hareholders may under these circumstances miss an opportunity to ‘cut their losses’ by shutting down the operations before management can fritter away whatever valuable assets the corporation still possesses.¹¹ Ultimately, the debtor collapsed under the weight of excessive debt.

In today’s litigation climate, restructuring professionals should remain alert to the telltale signs which could result in deepening insolvency liability. The following is a synopsis of facts which led to the filing of lawsuits under the “deepening insolvency” theory:

• misstating the financial positions of insolvent companies in order to induce the companies to register, offer, and sell additional debt certificates to raise capital;
• preparing unqualified opinion letters and failing to disclose an agreement with the intent to conceal the company’s insolvency;
• failing to detect and disclose misappropriation of corporate funds resulting in increasing indebtedness to trade creditors;
• failing to perform a discounted cash flow analysis in accordance with the standards applicable to the valuation of goodwill and otherwise properly valuing the goodwill;
• preparing audited statements which severely understate tax liability and expenses and overstating net profit and net worth.

The development of case law in the area of deepening insolvency is encouraging Bankruptcy Trustees and Creditors’ Committees to pursue such claims. Especially when liquidation leaves little for unsecured creditors, we can expect to see an increase in lawsuits arising out of this theory. Restructuring advisors must protect themselves from actual liability by keeping abreast of the facts and circumstances under which courts validate in support of deepening insolvency.

Nicole Testa, Esq. is an Associate with Adorno & Yoss, P.A. in the Bankruptcy and Insolvency Department in Miami, Florida, and can be reached at ntl@adorno.com.