Deepening Insolvency Trend Expands to Delaware

Spurred on by the current economic downturn, the use and acceptance of deepening insolvency as a cause of action in the bankruptcy arena continues to become more established and recognized. The Third Circuit already aided this development by recognizing deepening insolvency as a cause of action under Pennsylvania law in Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., Inc., 267 F.3d 340 (3d Cir. 2001). Now, the Delaware Bankruptcy Court in In re Exide Technologies, Inc., 2003 WL 22079513 (August 21, 2003) has recognized deepening insolvency — this time as a valid cause of action under Delaware law – in a lawsuit by an unsecured creditors committee against lenders of a bankrupt company.

Background

In 1997, Credit Suisse First Boston and Solomon Smith Barney, as agents, lead a syndicate of 81 other lenders in establishing a $650 million credit facility in favor of Exide Technologies, Inc., and certain of its subsidiaries, all of which are in the stored-energy business. In 2000, these same lenders provided $200 million in additional financing to allow Exide to acquire a competitor, GNB Dunlop. After that acquisition, Exide's financial condition began to deteriorate rapidly. On Oct. 26, 2001, Exide replaced its CFO with a turnaround consultant, at the direction of the lenders. Not long thereafter, Exide and its lenders amended the loan documents to suspend certain financial covenants, in exchange for which the lenders were granted liens on the assets and capital stock of Exide's foreign subsidiaries.

Those amendments were still not enough to salvage Exide. Thus, on Dec. 28, 2001, the parties entered into a third amendment to the loan agreements, this time granting a forbearance — coincidentally scheduled to expire just after the 90-day preference period — in exchange for further guarantees and collateral. Finally, on April 15, 2002, Exide and certain of its subsidiaries filed for bankruptcy protection.

The Committee's Suit

On Jan. 16, 2003, Exide's Official Committee of Unsecured Creditors sued the lenders. Among the causes of action asserted by the Committee was a count to recover against the lenders under a deepening-insolvency theory. The Committee alleged that the Dunlop acquisition allowed the lenders to gain greater control over Exide. In fact, during the time that all the above events transpired, the lenders were directing Exide's actions for their own benefit — hiring financial officers at their direction, granting further liens, timing the filing of the bankruptcy to avoid preferences, and even selectively filing certain subsidiaries but not others — while the company became ever more insolvent. The victims of these machinations, the Committee argued, were Exide's unsecured creditors. The lenders moved to dismiss that count, as well as the rest of the complaint, on various grounds. With respect to the claim for deepening insolvency, the lenders argued the cause was simply not recognized under Delaware law and was otherwise immediately barred by the doctrine of in pari delicto.

Addressing the motion, the Bankruptcy Court agreed that the Delaware Supreme Court had not spoken on the cause of action. Therefore, it fell to the court to predict how the Delaware courts would rule on such a claim, if presented. For guidance on this point, the court turned to the Third Circuit's recent decision in Lafferty. There, the Committee sued several third parties, claiming they had caused the corporation to issue debt securities, thus deepening its insolvency and causing it to become bankrupt. The Circuit employed a three-pronged test to conclude that Pennsylvania courts would recognize the theory because of: 1) its inherent soundness; 2) the growing acceptance of the theory among courts; and 3) the remedial theme of Pennsylvania law, when there is an injury. The Circuit did find the theory to be fundamentally sound, and also noted that it has been increasingly accepted by the courts. That left the final factor. But that factor was easily met by the Lafferty court, because, as in virtually all common law jurisdictions, Pennsylvania common law holds that where there is an injury, the law provides a remedy.

Applying that the same three-pronged analysis to Delaware law, the Exide court found the first two prongs of the test were already satisfied by Lafferty court's analysis. And, once again, the third prong was easily met — Delaware common law also holds that the law provides a remedy where there is an injury. With each prong satisfied, the court concluded that Delaware Courts would recognize the existence of a cause of action for deepening insolvency.

The court also found that the Committee had alleged sufficient facts to support this cause of action, and denied the lenders' motion to dismiss this count. But the court did note that the Committee's deepening-insolvency claim would be subject to the lenders' various defenses, including the in pari delicto defense that had handily defeated the Committee's action in Lafferty.

Conclusion

With a second major ruling in the Third Circuit supporting deepening insolvency, it appears this cause of action is here to stay. And, if other courts adopt the Circuit's three-pronged test, it is fairly inevitable that the cause of action will be sustained in most instances. If Exide is any sign, deepening insolvency has already entered the arsenal of the bankruptcy disenfranchised — the Committee's complaint asserted the cause of action along with more usual and well-established claims for recharacterization, fraudulent and preferential transfers.

Nonetheless, it is still unclear whether the action is one brought derivatively on behalf of the debtor entity or directly by effected creditors. Likewise, the ultimate application of the in pari delicto defense may spell doom for the success of the Exide action.

Spurred on by the current economic downturn, the use and acceptance of deepening insolvency as a cause of action in the bankruptcy arena continues to become more established and recognized. The Third Circuit already aided this development by recognizing deepening insolvency as a cause of action under Pennsylvania law in Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., Inc. , 267 F.3d 340 (3d Cir. 2001). Now, the Delaware Bankruptcy Court in In re Exide Technologies, Inc., 2003 WL 22079513 (August 21, 2003) has recognized deepening insolvency — this time as a valid cause of action under Delaware law – in a lawsuit by an unsecured creditors committee against lenders of a bankrupt company.

Background

In 1997, Credit Suisse First Boston and Solomon Smith Barney, as agents, lead a syndicate of 81 other lenders in establishing a $650 million credit facility in favor of Exide Technologies, Inc., and certain of its subsidiaries, all of which are in the stored-energy business. In 2000, these same lenders provided $200 million in additional financing to allow Exide to acquire a competitor, GNB Dunlop. After that acquisition, Exide's financial condition began to deteriorate rapidly. On Oct. 26, 2001, Exide replaced its CFO with a turnaround consultant, at the direction of the lenders. Not long thereafter, Exide and its lenders amended the loan documents to suspend certain financial covenants, in exchange for which the lenders were granted liens on the assets and capital stock of Exide's foreign subsidiaries.

Those amendments were still not enough to salvage Exide. Thus, on Dec. 28, 2001, the parties entered into a third amendment to the loan agreements, this time granting a forbearance — coincidentally scheduled to expire just after the 90-day preference period — in exchange for further guarantees and collateral. Finally, on April 15, 2002, Exide and certain of its subsidiaries filed for bankruptcy protection.

The Committee's Suit

On Jan. 16, 2003, Exide's Official Committee of Unsecured Creditors sued the lenders. Among the causes of action asserted by the Committee was a count to recover against the lenders under a deepening-insolvency theory. The Committee alleged that the Dunlop acquisition allowed the lenders to gain greater control over Exide. In fact, during the time that all the above events transpired, the lenders were directing Exide's actions for their own benefit — hiring financial officers at their direction, granting further liens, timing the filing of the bankruptcy to avoid preferences, and even selectively filing certain subsidiaries but not others — while the company became ever more insolvent. The victims of these machinations, the Committee argued, were Exide's unsecured creditors. The lenders moved to dismiss that count, as well as the rest of the complaint, on various grounds. With respect to the claim for deepening insolvency, the lenders argued the cause was simply not recognized under Delaware law and was otherwise immediately barred by the doctrine of in pari delicto.

Addressing the motion, the Bankruptcy Court agreed that the Delaware Supreme Court had not spoken on the cause of action. Therefore, it fell to the court to predict how the Delaware courts would rule on such a claim, if presented. For guidance on this point, the court turned to the Third Circuit's recent decision in Lafferty. There, the Committee sued several third parties, claiming they had caused the corporation to issue debt securities, thus deepening its insolvency and causing it to become bankrupt. The Circuit employed a three-pronged test to conclude that Pennsylvania courts would recognize the theory because of: 1) its inherent soundness; 2) the growing acceptance of the theory among courts; and 3) the remedial theme of Pennsylvania law, when there is an injury. The Circuit did find the theory to be fundamentally sound, and also noted that it has been increasingly accepted by the courts. That left the final factor. But that factor was easily met by the Lafferty court, because, as in virtually all common law jurisdictions, Pennsylvania common law holds that where there is an injury, the law provides a remedy.

Applying that the same three-pronged analysis to Delaware law, the Exide court found the first two prongs of the test were already satisfied by Lafferty court's analysis. And, once again, the third prong was easily met — Delaware common law also holds that the law provides a remedy where there is an injury. With each prong satisfied, the court concluded that Delaware Courts would recognize the existence of a cause of action for deepening insolvency.

The court also found that the Committee had alleged sufficient facts to support this cause of action, and denied the lenders' motion to dismiss this count. But the court did note that the Committee's deepening-insolvency claim would be subject to the lenders' various defenses, including the in pari delicto defense that had handily defeated the Committee's action in Lafferty.

Conclusion

With a second major ruling in the Third Circuit supporting deepening insolvency, it appears this cause of action is here to stay. And, if other courts adopt the Circuit's three-pronged test, it is fairly inevitable that the cause of action will be sustained in most instances. If Exide is any sign, deepening insolvency has already entered the arsenal of the bankruptcy disenfranchised — the Committee's complaint asserted the cause of action along with more usual and well-established claims for recharacterization, fraudulent and preferential transfers.

Nonetheless, it is still unclear whether the action is one brought derivatively on behalf of the debtor entity or directly by effected creditors. Likewise, the ultimate application of the in pari delicto defense may spell doom for the success of the Exide action.