"Is Deepening Insolvency Alive?," by Julia A. Chincheck and Daniel J. Cohn

By: Julia A. Chincheck, Daniel J. Cohn
The Community Banker Magazine
Fall 2013

      Although not a common theory of recovery in West Virginia, courts from around the country, including Virginia, Ohio, and Pennsylvania, our sister states, have been confronted since 2003 with the theory of “deepening insolvency.”  Deepening insolvency is the wrongful prolongation of a company’s life beyond insolvency, which results in damage to the company caused, for example, by increased debt, dissipation of assets, and/or negative reputation.  These claims are often brought against corporate officers and directors, but they have also been asserted against lenders.  In the context of lender liability, deepening insolvency typically involves a claim by or on behalf of the company that a lender, knowing the company was insolvent, exerted some influence or control over the company in the process of the lender’s extending additional credit to the insolvent company. 

        After a 2003 Delaware decision recognized deepening insolvency as a cause of action under state law, the concept of deepening insolvency began to gain recognition among other courts.  Since then, courts generally have taken one of three different approaches when addressing the concept of deepening insolvency.  Some courts recognize deepening insolvency as a theory or measure of damages for some other cause of action brought by a plaintiff.  Others recognize deepening insolvency as a separate and discrete cause of action that can be brought, distinct from any other causes of action.  Finally, still other courts reject the theory altogether.

        While the West Virginia Supreme Court of Appeals has not spoken on the issue of deepening insolvency, one opinion of the United States District for the Southern District of West Virginia has suggested that deepening insolvency can be a method of measuring damages.  In that case, the federal court held that an expert’s damages calculation using a “subset” of a deepening insolvency analysis was a reasonable and proper quantification of the appropriate damages.  Other courts outside of West Virginia that have recognized deepening insolvency as a theory or measure of damages have noted that, although not a cause of action, it can be used to calculate damages associated with some other cause of action, such as fraud or breach of fiduciary duty.  Jurisdictions that have at some point or another been attributed to recognize deepening insolvency as a theory or measure of damages include the District of Columbia, Florida, Illinois, Kansas, Louisiana, Maine, New York, North Carolina and Texas. 

        Those courts that have chosen to recognize deepening insolvency as a separate cause of action typically have done so based on the principle that the law provides a remedy where there is an injury.  Although these courts have recognized deepening insolvency as an independent cause of action, that cause of action still requires some wrongful prolongation of corporate life that leads to damage to the company.  Among the states in which this theory has been recognized as a cause of action are Michigan and New Jersey.

        While some courts, as discussed above, either have adopted deepening insolvency as an independent cause of action or as -- perhaps in West Virginia’s case -- a theory or measure of damages, still others have rejected the concept altogether.  One court noted that the theory is obscure, is duplicative of existing legal theories and remedies, and is not identified in authoritative treatises.  Among others, courts in Tennessee, Ohio, and Virginia have rejected deepening insolvency.

        Recently, we began to see a change in the treatment of deepening insolvency.  The latest trend appears to be one that, as discussed above, either rejects the theory outright or limits previous cases that had recognized deepening insolvency to their facts.  Despite this latest trend moving away from deepening insolvency, lenders in West Virginia should still be cognizant of a potential claim under this theory in connection with extensions of credit to companies that are in financial distress or in bankruptcy.

        Should you require more information, please feel free to contact Julia A. Chincheck or Daniel J. Cohn.  Ms. Chincheck is an experienced partner at Bowles Rice LLP, working primarily in bankruptcy, transactional matters, and commercial litigation in the firm’s Commercial and Financial Group.  Mr. Cohn is an associate in the firm’s Commercial and Financial Group, practicing in bankruptcy, transactional matters, and commercial litigation.  Bowles Rice LLP is general counsel to the Community Bankers of West Virginia.