Risk Management

Deloitte Is Protected in “Insolvency” Ruling

A Pennsylvania judge says that a firm that improperly keeps a company out of bankruptcy may not be liable, unless it is negligent in other ways, too.
Alan RappeportJune 19, 2008

A recent Pennsylvania Court ruling favoring Deloitte & Touche seems to restrict a company’s ability to win a case against an accountantcy for actions that lead to the company’s “deepening insolvency,” unless the accountant is negligent in other ways as well.

The issue arose in a lawsuit that Reliance Insurance Co. filed in the state’s Commonwealth Court against Deloitte & Touche, over allegations that the accountancy improperly certified that the insurer’s loss reserves in 1999 was reasonable. That caused Reliance to take underwriting losses on payments that it could not really make, to avoid the wrath of regulators, and to go deeper into debt when it should have declared bankruptcy, according to The Legal Intelligencer newspaper.

The ruling was seen as a blow to a legal theory that had been gaining popularity. Under that theory, which accountancies and other firms, as well as company directors, worried could be costly to them, an action by a party that — by itself — leads a company deeper into insolvency subjects that party to liability for the consequences of the insolvency.

Reliance “was insolvent, and continued to operate before filing for bankruptcy protection,” Joseph Monteleone, of the law firm of Tressler, Soderstrom, Maloney & Priess LLP tells CFO.com. “I would characterize this as a win for Deloitte even though the case goes on with a number of other allegations against them.”

The decision, by Senior Judge James Gardner Colins, concludes that the degree of responsibility that an accountancy has, along with its overall negligence, must be factored in when considering the issue of deepening insolvency. J.B. Heaton, of the law firm of Bartlit Beck Herman Palenchar & Scott LLP, describes deepening insolvency as the “fraudulent expansion of corporate debt and prolongation of corporate life.”

Calls by CFO.com to Deloitte and Reliance seeking comment on the ruling were not immediately returned.

From executives to auditors, any person or entity that enables deepening insolvency may be liable, the theory goes. Laws vary from state to state, and third-party actions that benefit shareholders, rather than maximize recovery for creditors, can also give rise to liability. Such a result can give creditors another pot of money for their claims. Recently, for example, a federal bankruptcy judge ruled that in the case of educational-institution operator The Brown Schools, the private equity firm of McCown De Leeuw, along with Brown Schools’ directors, were liable for damages of $22 million for wrongfully keeping Brown Schools out of bankruptcy. As long as Brown Schools was solvent, according to the judge’s ruling, McCown De Leeuw and the Brown directors were able to continue to pay themselves.

Pennsylvania is not the first court to reign in the issue of deepening in solvency as a liability. In 2006 the Delaware Court of Chancery, concerned that it might “chill” corporations from taking on debt, also rejected deepening insolvency as an independent cause of action. “This [Delaware] decision, as well as a few others earlier this year, suggests that the tide may be turning, and the theory of deepening insolvency may be in retreat,” wrote William Smith and David Topol, partners at Wiley Rein LLP, at the time.

Monteleone says it is a “heartening trend” that the theory is being shot down before allegations become more common. Although such laws vary by state, he says, accounting firms will likely be relieved that two powerful courts have come out against deepening insolvency.

“It’s one less arrow that plaintiff has to shoot at them,” Monteleone says. “Deepening insolvency has become kind of a dirty word.”