Claims for Deepening Insolvency Put Insurers, Directors,Officers At Risk

During these tough economic times, many businesses–both insurersand insureds–are facing tough, if not dire, economic straits. Tomake matters worse, the insurance industry is laboring under theestimated $40 billion in losses arising from September 11.

Some companies will inevitably be faced with the grim choice offighting to stay alive or “pulling the plug.” Too often, abusinesss management–officers and directors especially–believe theyshould go down with the proverbial ship. Even when their businessis clearly heading toward its financial demise, they struggle untilthe bitter end to save it or just keep it alive.

There are many reasons management may fight hard to save abusiness. But frequently, the unspoken driving force is the beliefthat their business, like some living thing, must be kept alive atall cost.

While this reasoning may be compelling, it does not necessarilyhold in most instances. In fact, keeping a business alive when itis increasingly clear that it is beyond saving may create personalliability for management.

For the directors and officers of insurance companies, potentialclaims for deepening insolvency must be a component of any decisionon the viability of their companies. At the same time,deepening-insolvency claims by creditors may give rise to liabilityunder directors and officers liability and under errors andomissions policies.

More and more, courts are recognizing causes of action broughtby bankruptcy trustees, insurance-company liquidators or creditorsagainst officers, directors, and even their accountants, based onthe “deepening-insolvency” theory. The thrust of this cause ofaction is that management either negligently or fraudulentlyextended the life of a business, causing creditors to extend creditor eliminating possible recovery by other interest holders becauseof managements failure to face the facts.

Typically, these causes of action are based on two distincttypes of claim: a mismanagement claim against the officers anddirectors, and a misrepresentation claim against both managementand the auditors.

Perhaps the most-widely publicized of these lawsuits arose in1998 out of the Delorean Motor Co. bankruptcy case. There, a juryfound the companys auditors liable for $46 million because theyconcealed the deepening insolvency of their client. The jury inthat case found that the company was damaged by financialstatements that misrepresented its true state of solvency, thuspermitting further debt to be accumulated during the “artificialprolongation” of its corporate life.

This theory has also been applied against officers and directorsof insurance companies who misrepresent their financial status toregulators. For example, in Transmark, USA, Inc. v. State ofFlorida, Department of Insurance, the Florida Department ofInsurance sued the officers and directors of Transmark,the parent company of Guarantee Security Life Insurance Company,alleging that they had concealed the true financial status of theinsurance company from regulators. The receiver sought $300 millionin damages.

Likewise, a judge in Pennsylvania awarded nearly $140 million incompensatory and punitive damages against a single officer ofCorporate Life Insurance Co., in part on the basis of the insuranceliquidators deepening-insolvency theory.

And just last November, the Fifth Circuit Court of Appealsrecognized the growing prevalence of this theory in FloridaDepartment of Insurance v. Chase Bank of Texas, N.A. There, aFlorida Department of Insurance liquidator sued Chase Bank on thegrounds that a representation it made to regulators prolonged aninsurers life (Western Star Insurance Company), allowing it tobecome further mired in debt.

Because of the potential for liability under this theory, aninsurance companys management must be concerned about more thanmerely its survival. It must also be concerned about whether it isartificially–and wrongfully–prolonging the life of the company andcausing damage to others.

At the same time, D&O insurers must be asking themselves thesame questions with respect to their insureds.

It is certainly difficult to determine when any particularbusiness should “throw in the towel,” but there are a fewsign-posts to watch out for. If directors and officers findthemselves in the following circumstances, it may be time toconsider other alternatives:

The business is experiencing repeated losses and financing themin unhealthy ways. A business suffering recurring losses andfinancing those losses with additional debt may be a primecandidate for a deepening insolvency claim.

The entire industry or sector is experiencing a downturn.Management may be trying to turnaround a business in a dyingsector. Extending the companys life therefore is ultimately apointless endeavor.

A company is managing for income and not cash flow. A companythat fails to ensure that it has sufficient funds to meet itsmonthly obligations, and is instead focusing on short-term income,should reexamine its survivability.

The companys payables are increasingly stretched-out. Whilestretching payables may be a part of surviving lean economic times,a businesss payables may simply be stretched too far to ever have arealistic hope of recovery.

Avoiding personal liability. Often, directors or officers whohave personally guaranteed their businesss debt fight to keep italive, hoping to limit their personal liability. Individuals inthese circumstances need to take a close look at their possibleexposure to a deepening-insolvency cause of action.

Any accounting irregularities. Loud alarms should be sounding ifa company is using accounting irregularities simply to maintain itsexistence.

Any of these warning signs should cause management to take ahard look at a companys real chances for turnaround and survival.Given the possible exposure to a deepening-insolvency claim,management should be undertaking this analysis without delay, and,if necessary, should seek truly independent, third-party financialadvisors for a frank assessment of the chances of their businessssurvival.

Luis Salazar is a shareholder in the bankruptcy practice ofGreenberg Traurigs Miami office. He can be reached [email protected].

Reproduced from National Underwriter Property &Casualty/Risk & Benefits Management Edition, May 6, 2002.Copyright 2002 by The National Underwriter Company in the serialpublication. All rights reserved.Copyright in this article as anindependent work may be held by the author.