DD 3/21/06 New "Deepening Indebtedness" Tort threatens lenders . . . or not.

Daily Development for Tuesday, March 21, 2006
by: Patrick A. Randolph, Jr.
Elmer F. Pierson Professor of Law
UMKC School of Law
Of Counsel: Blackwell Sanders Peper Martin
Kansas City, Missouri
dirt@umkc.edu

LENDER LIABILITY; “DEEPENING INDEBTEDNESS:l” Is secured lender that extends additional credit to a failing borrower, allowing it to continue to decline in value, liable to borrower’s unsecured creditors for simple fact of making a bad loan? 

In re Exide Technologies, Inc., 299 B.R. 732 (Bankr. D. Del. 2003) (maybe)

In re Vartec Telecom, Inc., 335 B.R. 631 (Bankr. N.D. Tex. 2005)

The concept known as “deepening indebtedness” is the  notion that a party involved in influencing the behavior of an insolvent company may be liable for postponing the ultimate and virtually certain economic failure of the company, thus exacerbating the injury to junior or unsecured creditors or others who suffer from the “bigger splash” when failure actually occurs.  Tort liability for deepening indebtedness might be claimed against lawyers, accountants, bankers, and other financial and insolvency professionals as well as those with direct fiduciary responsibility for management of the company - directors and other “insiders.”

Whether, in fact, “deepening indebtedness” is a tort and whether it states any theory of liability independent of other existing claims, particularly breach of fiduciary obligation, is a subject that currently is much debated in federal bankruptcy courts.  The issue almost always arises in bankruptcy, although the courts agree that the fundamental question is whether the underlying state law of the state under which the facts arise would recognize the claim.

Needless to say, if the sole basis for finding liability for “deepening indebtedness” is that a lender attempted to prop up a borrower to permit a workout, and, in the end, failed, such potential liability would indeed be frightening to any lender faced with workout proposals.  If, on the other hand, the question is solely whether a defendant that had  an admitted fiduciary responsibility to a debtor company induced the company to make decisions that were in the defendant’s best interests, but the those of the company, then we have nothing more than a restatement of an already existing and well known principle of law.  Numerous recent commentators have tried to identify a theory that lies between these two extremes that justifies identifying it as a new basis of liability.  It remains to be seen whether either commentators or courts will be successful in this endeavor.

In Exide, a creditor group had provided a $650 million credit facility to a company.  Later, when the company was already struggling, the group provided an additional $250 million to permit the company to acquire a competitor.  This proved to be a futile act, and the company’s fortunes rapidly declined after the acquisition.  The creditor group then induced the company to replace its Chief Financial Officer, and thereafter suspended financial covenants in the loan documents and granted a brief forebearance.  Each of these acts - the $250 million loan increase, the suspension of financial covenants, and the final forebearance, were accompanied by the company’s  granting to the creditor group new and enhanced security interests in various assets of the company.  The court seemed particularly impressed that the last forebearance was granted for only days beyond the 90 day preference period, which became relevant when the exhausted debtor company finally folded into bankruptcy.

Unsecured creditors alleged that, in essence, the secured creditor group had propped up the debtor company for the sole purpose of draining from it all possible forms of security, even though there was no hope of financial salvation, so that when bankruptcy arrived, there were effectively no assets available to the unsecured creditors.   The court, analyzing Delaware law, concluded that such actions, if proven, might amount to a separate tort of “deepening indebtedness.” 

The Exide court also found that there was an allegation sufficient to support claims of fraud, insider status of the secured creditor group, “aiding and abetting” a default by the debtor company, fraudulent conveyance, and other bases for  recharacterization of various of the security claims.  Nevertheless, it concluded that there also could be a separate count, based essentially on the same facts, for “an injury to the Debtors’ corporate property from the fraudulent expansion of corporate debt and prolongation of corporate life.” (Citing what is probably the leading case for the theory - Official Comm. of Unsecured Creditors v. R.F. Lafferty & Co., Inc., 267 F.3d 340, 347 (3d Cir. 2001). (interpreting probable Pennsylvania law.)

Fundamentally, the court took the view that Delaware law will provide that “where there is an injury, the law provides a remedy,” and that (presumably) recognizing this new tort might provide a remedy where other causes of action would prove inadequate.  It conceded, however, that a predicate to liability for this tort is conduct that also would be tortious under various other existing theories.  The Exide court did not actually reach the point of concluding that a “simply negligent” judgment to try to help a debtor bail out of trouble might lead to liability for third parties.  Clearly those pushing this tort theory ultimately hope to push it in that direction.

Vartec has facts that involve arguably less egregious alleged conduct, although the dollar amounts are also immense and the losses equally severe.  The original secured creditor group provided about $550 million in financing, and approved the use of that financing to make what proved to be a disastrous acquisition.  Then, when the debtor proved to be in trouble, the lenders extended the financing in exchange for bigger and bigger pieces of the available assets of the debtor company as security.  Ultimately, all of the assets of the acquired company secured the original indebtedness as well as the assets of the additional company.  Ultimately, over $100 million was extracted from the company as a pay down on indebtdness even while bankruptcy talks were conducted, but in this case the company didn’t survive the ninety day preference period.

Although the court acknowledged that it might be appropriate to address behavior of officers or directors who breach their fiduciary duties by holding them liable for the consequences of deepening indebtedness through artificially extending the life of the company, it concluded that extended such liability to others who themselves are struggling to assist the company to work out its problems seemed unnecessary.  It stated that the tort concept had “morphed, both in form - from a breach of statutory duty claim to a form of common law tort liability - and in scope - now reaching lawyers, accountants, bankers and other financial and insolvency professionals . . . This is where things start to get a little murky.”

The court acknowledged that other federal courts had identified the tort as available under Pennsylvania law, Tennessee law, and (as indicated) Delaware law.  But it noted that courts applying New York law and District of Columbia court had rejected the gambit.

The court noted, as had the New York decision, that merely extending the life of a failing company will not lead to liability, even if losses occur to third parties, unless the action amounts to a breach of a separate duty or another actionable tort.  Therefore, it concluded that the concept of “deepening indebtedness” is nothing more than a theory of damages for violation of already recognized duties.  Despite the fact that Texas, also, recognizes the principle of a “remedy for every wrong,” there was no basis for creating an additional tort where adequate remedies exist for the wrongful conduct in question.

Comment 1:   The debate in these cases seems almost metaphysical.  Why not recognize admitted wrongful conduct as a tort?  What’s the harm?  But, as suggested, there may be future harm as a more nebulous kind of “grab bag” tort is stretched to cover behavior that does not amount to truly egregious self serving conduct and simply amounts to exercise of poor economic judgment.  When one is doing no more than trying to protect one’s own desperate credit position in the face of incipient failure of a major debtor, there ought to be some discretion permitted.  In fact, digging into the debtor to improve one’s security position, even when there may be no hope of the debtor’s economic recovery, probably is good banking following the bad judgment.  In the end, the court stated a rather sweeping conclusion:

“The wilful and malicious lending of money is not a tort in Texas and likely will not be recognized as one anytime soon through a theory of deepening insolvency.  To maintain a cause of action against a lender under such a theory, the complaint must show that the lender took over control of the operations of the debtor and then breached its fiduciary duties.”

Comment 2:   The editor has commented before in these reports that the new phenomenon in commercial loan securitization of the high risk securitized investors (the “B Piece” holders) becoming special servicers on their own securitzed packages may lead to interesting lender decisions to prolong the life of a dying borrower so as to create revenues or move assets that slop over to the B Piece holder’s trough.  It will be interesting to see whether the deepening indebtedness tort will reach these servicers.

Comment 3: How different is this theory from the “predatory servicing” claims that we are seeing in residential lending?  Normally, there is a different plaintiff - the gulled borrower instead of the foxed unsecured creditors.  And isn’t this a significant difference?  If the borrower still has, in fact, a form of free will morally and intellectually, even if its choices are all gloomy, should those who benefit from the borrower’s last flailings have a duty to dodge the money thrown at them?

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