This past summer, the Minnesota Court of Appeals held that "deepening insolvency" is not a recognized theory of damages in Minnesota. Christians v. Thornton, 733 N.W.2d 803 (Minn. App. 2007). In September, the Supreme Court of Minnesota denied a petition to review, 2007 Minn. LEXIS 572 (Minn. Sept. 18, 2007), leaving in place a decision that is an enormous relief to officers and directors of troubled companies, to banks that have lent to troubled companies, and to professionals such as lawyers, accountants and investment brokers who have provided services to troubled companies.
Christians arose from the bankruptcy of Technimar Industries, Inc., a company that had hoped to manufacture an agglomerated stone product from a facility in northern Minnesota. To pay for the necessary equipment, Technimar's investment banker arranged for the City of Cohasset, where the facility was located, to issue industrial-revenue bonds. Through a series of arrangements, Technimar essentially underwrote a substantial portion of the bonds. However, its financials, which were audited by the defendant Grant Thornton, did not indicate this obligation. Had the financials been correct, they would have reflected that Technimar was insolvent. After this time, Technimar took out additional loans before defaulting on the bonds and filing for bankruptcy. A trustee was appointed who brought an action against Grant Thornton in state court alleging, primarily, auditor malpractice and breach of contract. For damages, the trustee claimed that Technimar was harmed by the deepening of its insolvency.
Over the past decade a number of federal courts have recognized a theory of damages called "deepening insolvency" where a defendant's wrongful action caused an insolvent corporation to incur further debt. As the court stated in Christians, "The concept presumes that, in taking on additional unpayable debt, a corporation might be harmed by operational limitations, strained corporate relationship, diminution of corporate assets, and the legal and administrative costs of bankruptcy." 733 N.W.2d at 810. Although there is no consensus regarding how to measure deepening insolvency damages, courts often assume that the corporation was injured to the extent of the deepening, suggesting that defendants could be liable for that full amount.
Other federal courts have gone so far as to find a new cause of action in various states' common law. For example, the Third Circuit has articulated Pennsylvania's tort of deepening insolvency as the "fraudulent expansion of corporate debt and prolongation of corporate life." Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340, 347 (3d Cir. 2001). While the Third Circuit has limited this to fraudulent conduct, see Seitz v. Detweiler, Hershey and Associates, P.C. (In re CITX Corp.), 448 F.3d 672, 681 (3d Cir. 2006), other courts have suggested that negligence could trigger liability. Smith v. Arthur Anderson LLP, 421 F.3d 989, 995 (9th Cir. 2005). This cause of action has the potential to override the business judgment rule to add a new substantive duty—a duty to liquidate rather than risk further operations—that complicates efforts to rehabilitate a struggling corporation.
Christians firmly holds that Minnesota does not recognize deepening insolvency as a theory of damages. It reached this conclusion in two steps. First, the court rejected the additional-loans component of deepening insolvency damages because loans are balance-sheet neutral. "[E]very addition to a corporation's liabilities is offset by an equal addition to the corporation's assets." 733 N.W.2d at 811. The corporation is not damaged simply because it carries more debt. The court then stated, "Once the deepening-insolvency theory is stripped of the additional-loans component, we are unable to discern what recoverable harms the concept captures that the ordinary measures of damages in auditor-malpractice and breach-of-contract claims do not." Id. In other words, to the extent that this theory makes any sense, the law already recognizes damages under other theories.
Those who work with corporations near insolvency will be relieved by Christians for two reasons. First, refusing to recognize the additional-loans component of damages reduces the likelihood of strike suits. The additional-loans component of damages can be quite large and nearly all corporations in bankruptcy will have gone through a period of increasing debt-load. This makes outside professionals an attractive target. Second, although the court only held that deepening insolvency is not a recognized theory of damages, a deepening insolvency cause of action is likely dead in the water in Minnesota courts. The court was unreceptive of the development.
Despite Christians, a federal court could still find that Minnesota would recognize deepening insolvency, either as a theory of damages or as a cause of action. Where a state's supreme court has not articulated the law, federal courts take their best guess, giving intermediate court decisions such as Christians only persuasive weight. For example, a recent case from the bankruptcy court in the district of Delaware recognized a deepening insolvency cause of action in Delaware law despite a recent state court decision that reached the opposite conclusion. Compare Miller v. McCown De Leeuw & Co. (In re The Brown Schools), 368 B.R. 394 (Bankr. D. Del. 2007), with Trenwick America Litigation Trust v. Ernst & Young, L.L.P., 906 A.2d 168 (Del. Ch. 2006).
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While Christians is significant, the deepening insolvency theory still poses a risk for those who participate in the rehabilitation of failing corporations.