The U.S. Court of Appeals for the Third Circuit has shed some light, and perhaps created more confusion, on a topic that has garnered a lot of attention lately—claims for "deepening insolvency." Deepening insolvency usually rests on an allegation that the debtor corporation was injured because of an artificial expansion of corporate debt and prolongation of corporate life.
In Gary Seitz v. Detweiler, Hershey and Assocs. (In re CITX Corp., Inc.), No. 05-2760 (3rd Cir. Apr. 27, 2006), the Third Circuit arrived at two important conclusions: (i) deepening insolvency is not a valid theory of harm for negligence; and (ii) negligence cannot support a claim for deepening insolvency.
CitX, an Internet company, issued shares of stock during the dot.com boom with the help of another company, PRSI. Through its offering, CitX raised nearly $700,000 while PRSI netted close to $18 million. PRSI turned out to be a fraudulent enterprise and eventually was forced into receivership by the Florida Attorney General. When it was shut down, PRSI owed CitX almost $2.4 million.
Even though CitX was able to sell such an enormous amount of equity, CitX was actually an unsuccessful enterprise, with virtually no assets or income. CitX’s financial statements made the company appear otherwise because with the PRSI receivable, the company appeared to be profitable. In what the Third Circuit described as a Ponzi scheme, CitX provided the company’s financial statements to prospective investors and, in reliance thereon, the investors poured an additional $1 million into the company even after PRSI was shut down.
Through these additional investments, CitX’s corporate existence was artificially prolonged, which allowed the company to accrue millions of dollars of additional debt.
CitX’s financial statements were prepared by an accountant and his accounting firm. When CitX filed for chapter 7 bankruptcy protection, the trustee sued the accountant and his firm for four causes of action: (i) malpractice, (ii) deepening insolvency, (iii) breach of fiduciary duty, and (iv) negligent misrepresentation. The complaint noted that the accountant ignored the fact that CitX’s bookkeeper was the founder’s girlfriend and a high school dropout; that the company was insolvent; that PRSI had been shut down; and that CitX continued to sell stock despite its poor financial condition.
All four causes of action either were dismissed or summary judgment was entered for the defendants in the bankruptcy and district courts. The trustee appealed only the malpractice and deepening insolvency claims to the Third Circuit.
Pursuant to applicable state law, malpractice is a form of negligence, and thus for the malpractice claim the trustee had to show the elements of negligence: (i) the accountant owed CitX a duty, (ii) the account breached that duty, (iii) CitX was harmed and (iv) the breach was causally related to the harm. Analyzing only the third and fourth elements, the circuit court held that the trustee could prove neither.
First, the trustee alleged harm in the form of a deepening insolvency claim.
That is, the trustee alleged that the accountant’s financial statements, relied on by third parties, caused CitX to incur additional debt. Although prior Third Circuit case law recognized that deepening insolvency claims are a form of injury, there was no precedent for holding that deepening insolvency could be a form of injury applicable to an independent cause of action such as negligence.
Given this lack of precedent, the Third Circuit refrained from expanding the reach of deepening insolvency claims, holding that deepening insolvency is unrelated to negligence. Its reasoning was based in part on the fact that the financial statements added equity to the company’s balance statement. Through these financial statements, CitX was able to raise more than $1 million in equity. Because CitX could have used that money to turn the company around instead of wasting these assets on fruitless ventures (as it actually did), the company was harmed not by the deepening insolvency but by the company’s subsequent actions.
The Third Circuit also dismissed the causation element required for a negligence claim. The trustee had attempted to establish causation primarily through an affidavit from CitX’s COO and former board member, Richard Marks. In his affidavit, Marks alleged that the financial statements caused the company to continue selling shares and to take on debt. Without them, Marks reasoned that the company would have taken measures to prevent this from happening.
The problem with the affidavit, the court noted, is that Marks disaffirmed the affidavit in his subsequent deposition. Under the "sham affidavit" doctrine, courts are allowed to disregard affidavits when the testimony contradicts the affiant’s prior deposition testimony. Though in this case the affidavit came first, the deposition later, the court saw no reason that the "sham affidavit" doctrine should not be applied in this context as well Thus, the crux of the trustee’s argument was effectively eviscerated.
As for the deepening insolvency claim, the trustee relied primarily on the argument that the accountant negligently caused CitX’s insolvency.
The Third Circuit noted in a footnote that because the negligence claim had already been dismissed, this argument must fail. More importantly, the court further held that even if negligence could be proven, negligence alone cannot support a claim for deepening insolvency. Applying prior precedent, the court concluded that deepening insolvency claims were appropriate only in the context of fraud; negligence was not sufficient.
In the case at hand, there was no fraud evident, so the appeals court upheld the lower court’s dismissal of the deepening insolvency claim.
This article is presented for informational purposes only and is not intended to constitute legal advice.
