The Deepening Insolvency Theory

Timing is everything when it comes to bankruptcy claims. Any company facing the threat of bankruptcy has a duty to ensure that it maximizes the enterprise value. This means that the company, its lenders, and its managing officers have an inherent duty to ensure that one particular group of stakeholders is not benefitting at the expense of the others.

This means that if the management has sufficient cause to believe that the current valuation of the enterprise is maximum and that keeping the company forcibly afloat for some more time will lead to an erosion in value, they should take immediate and decisive action to wind up the firm.

If they fail to do so, they are essentially aiding the loss of value that a company is experiencing. This loss of value may hit some parties disproportionately. This means that it is likely that some parties may benefit at the expense of the others. This is called “deepening the insolvency” of a firm in legal parlance.

There are special provisions in bankruptcy law for people deemed to be wilfully deepening the insolvency of a firm. The same has been explained in detail in this article.

Meaning of Deepening Insolvency

A firm is deemed to be insolvent when the market value of its liabilities exceeds the market value of its assets. This means that the firm has negative equity and cannot continue to function until an infusion of more funds takes place.

Some activists and lawyers have alleged that vulture funds often collaborate with the management of the firms which are close to insolvency in order to run the business into the ground. They take out more loans when the firm is under duress. These loans are taken at very high-interest rates, and a lot of fees are incurred in order to obtain these loans. Also, it has been observed that new lenders only invest money if they are given priority over existing investors.

Since these loans have a higher priority than the existing loans of the company, the value gets diverted. One group of stakeholders i.e., the new lenders benefits since they get paid a higher interest and also various types of fees. At the same time, the second group of stakeholders i.e., old lenders, are negatively affected since the money which was earlier going to be paid to them will be reduced because their debt now has a lower priority.

Legal Action against Deepening Insolvency

In the United States, many lenders, directors, etc. have been fined a lot of money because they were found to be deepening the insolvency of the firm. Over the course of time, many firms have faced lawsuits initiated by other creditors.

However, deepening insolvency claims have had mixed results in courtrooms. In some cases, companies have had to pay monetary fines, whereas in other cases, the defendants have got away without any financial loss. The problem is that there is a huge inconsistency in how these laws are interpreted and applied in different parts of the United States. This is the reason that the venue where the petition is filed is of paramount importance when filing such cases. The legal fraternity needs to work out a mechanism wherein these laws are applied consistently across the entire country.

Arguments against Deepening Insolvency

Over the years, many companies have argued that the concept of deepening insolvency does not exist. According to them, it is impossible to make a company worse off merely by giving them a loan. This is because, as per the double-entry effect of accounting, the company gets an asset and a liability when a loan is given. The cash infusion as a result of the loan creates an asset, whereas the IOU to the lender creates a liability. This asset and liability cancel out each other, and ideally, the firm is not any worse off than it was before the loan.

According to these critics, it is the subsequent mismanagement of the funds controlled by the firm, which actually causes the problem.

It is true that 100% of firms that end up in bankruptcy court have taken additional financing in their last few days. However, this financing is important in order to make an attempt to revive the business of the firm.

Many firms that are able to revive themselves do not end up in bankruptcy court.

Critics believe that bankruptcy and last-minute loans have a high degree of correlation. However, correlation does not imply causation.

There is no direct logical path which states that additional loans will necessarily reduce the value of the firm. The loan in itself is solvency neutral. Therefore, these critics believe that lenders should not be prosecuted for deepening insolvency. According to them, it is the mismanagement of the funds received, which causes the downfall.

As a result, the management should be the only one prosecuted, that too, if it is explicitly proven that the managers were either negligent or have colluded with an external party.

Critics of deepening insolvency theory also argue that it is completely normal for companies to lose money because of bad financing deals.

Desperate times call for desperate measures, as a result, companies are forced to take loans at high-interest rates. However, this does not make them wilful participants in the downfall of the firm.

There are many other bad decisions that management can make. For instance, they could launch a bad product, invest too much in research, or even acquire a wrong company. These decisions could also cause monetary loss to some stakeholders. If other kinds of bad deals are not prosecuted, then why should bad loans be singled out?

The fact of the matter is that deepening insolvency is a theoretical construct that some judges believe in, whereas others do not. This is the reason why judgments related to this issue are so diverse and varied.