In Thabalt v Chait (Nov. 2008), the U.S. Court of Appeals for the Third Circuit upheld an award of damages against PriceWaterhouseCoopers LLP (PWC) based on PWC’s alleged negligent audit of the Ambassador Insurance Company. Plaintiff, the Vermont Insurance

Commissioner, claimed that PWC failed to disclose that Ambassador was insolvent, thereby allowing Ambassador to continue to write new insurance policies for 20 months before it was placed into receivership and liquidated. Claims under those policies ultimately cost Ambassador more than it collected from the premiums, plus interest and other investment income on the premiums.

The district court had held that these losses, which had an impact on Ambassador’s solvency and increased Ambassador’s liabilities, were recoverable under New Jersey law. PWC appealed from the trial court’s judgment, contending, among other things, that damages based on a theory of “deepening insolvency” were not recoverable under New Jersey law.

The Third Circuit reviewed the case law on “deepening insolvency,” distinguishing its 2006 decision in In re CitX Corp., in which it had held that, under Pennsylvania law, “deepening insolvency” was not a “valid theory of damages” or “an independent form of damage.” The court tried to distinguish CitX on the ground that the immediate result of the alleged negligent audit there was to increase CitX’s capital and reduce its debt. Thus, the court said – without explanation – that the ultimate harm from the extension of CitX’s corporate life was caused by management, not the auditor. The court viewed Ambassador’s situation differently, saying “[t]he audit in the present case had an immediate negative consequence, as contrasted with the immediate positive consequence following the audit in CitX.”

Unconvincing as that distinction may be, the fact that Thabalt arose under New Jersey law allowed the Third Circuit to rule differently. The court noted that “[a]lthough neither the New Jersey legislature nor the New Jersey Supreme Court has authorized a ‘deepening insolvency’ cause of action . . . there has been a trend among the state’s courts toward recognizing ‘deepening insolvency’ damages.”

The Thabalt court then analyzed the New Jersey Supreme Court’s 2006 decision in NCP Litigation Trust v KPMG (NCP I) and the 2007 trial court decision on remand in that case (NCP II), noting that both decisions appeared to fit “deepening insolvency” within traditional tort damage elements of increased liabilities, decrease in fair asset value and lost profits. Yet, the Third Circuit’s prediction was framed cautiously: “[W]e are not as resolute that New Jersey would not recognize deepening insolvency as a cause of action or as a theory of damages. . . . We hold that traditional damages, stemming from actual harm of a defendant’s negligence, do not become invalid merely because they have the effect of increasing a corporation’s insolvency.”

Considerable debate remains as to whether a mere increase in corporate liabilities constitutes an injury to the corporation. Companies obviously can and do benefit from taking on debt and other liabilities. When those liabilities go unpaid, courts continue to wrestle with the question of whether this constitutes an injury to the corporation itself or simply to its creditors. The Third Circuit opinion suggests that courts are moving toward acceptance of “deepening insolvency” – at least when it can be seen to incorporate damages traditionally recognized under tort law. Whether the New Jersey Supreme Court will expressly sanction “deepening insolvency” as a separate cause of action remains to be seen.