Protect Yourself Against Insolvency

12/16/2016 Jeff Babiak

Protecting yourself against “deepening insolvency”

Your borrower is in financial trouble. It’s attempting a turnaround and is asking you to continue to advance funds under its working capital line. As you apply professional criteria to your customer’s request, keep this in mind: Your financial institution could be held accountable by your customer’s creditors under the legal theory of “deepening insolvency” if the customer seeks bankruptcy protection.

What is deepening insolvency?

Balance sheet insolvency occurs when a business’s assets no longer exceed its liabilities, thereby preventing the company from repaying its debt. One court defined it as the “fraudulent prolongation of a corporation’s life beyond insolvency, resulting in damage to the corporation caused by increased debt.” Mismanagement, misrepresentations and fraud can cause or hasten insolvency.

Deepening insolvency has emerged in some jurisdictions as a creative remedy for creditors who allege a company delayed filing for bankruptcy and, instead, unnecessarily prolonged corporate life as the result of obtaining loans while already insolvent. By taking on additional debt or equity financing, a company compounds its insolvency and significantly impairs its ability to repay creditors.

Since deepening insolvency emerged in the 1980s, it has been alleged against directors and officers who breach their fiduciary obligations. It has also been alleged against professional advisors and secured creditors who help conceal the extent of financial turmoil, support unrealistic workouts and exert undue control over distressed customers.

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