World’s largest digging machine.

If you find yourself in a hole, stop digging. 

Insiders who keep shoveling after a company sinks into insolvency may find themselves defendants in a case under a deepening insolvency theory (hypothesis, really).  Digger-defendants usually include officers, directors, and auditors who enable a company to keep losing money.

Courts have lately shown little joy with the deepening insolvency hypothesis.  The Third Circuit tried to bury it in In re CitX Corp., Inc., 448 F.3d 672 (3d Cir. 2006).  Some courts respectfully disagree, e.g., In re Greater Southeast Community Hosp. Corp. I, 353 B.R. 324 (Bankr. D.D.C. 2006), but the trend — for now — favors the excavators.

Yet deepening insolvency has a compelling logic.  Once a company no longer can pay its debts, the interests of equity holders become irrelevant.  Insiders should focus on maximizing repayments to creditors and ought not embark on some bold plan to revive the value of equity.

Blawgletter suspects that judicial hostility to deepening insolvency elides the shift in insiders’ legal loyalties once the company crosses into insolvency.  The business judgment rule still may protect their decisions, but, my goodness, investing even more of other people’s resources in a failing enterprise instead of cutting losses strikes Blawgletter as a pretty clear sign of recklessness.

Your thoughts, please.

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