Though several courts recently have ruled that deepening insolvency is not a separate cause of action, this legal theory is not dead. Recently, a Pennsylvania state court has determined that although deepening insolvency is not an independent cause of action, a plaintiff may seek damages for deepening insolvency where another cause of action, such as professional negligence, is alleged.
Action Against the Auditor
In Ario v. Deloitte & Touche LLP, No. 734 M.D. 2002 (Pa. Commw. Ct. June 13, 2008), the Insurance Commissioner of Pennsylvania, as statutory liquidator of the Reliance Insurance Company, filed an action for breach of fiduciary duty against the directors and officers of Reliance, and against Reliance's auditor, Deloitte & Touche ("Deloitte"). The action alleged negligence, malpractice, misrepresentation and breach of contract. The complaint against the directors and officers eventually settled, leaving only Deloitte's motion for summary judgment before the court.
For a number of years through 1999, Deloitte provided auditing and actuarial services to Reliance and various related entities, including Reliance's parent company, Reliance Financial Services ("RFS"), and the publicly traded insurance holding company that wholly owned RFS, Reliance Group Holdings ("RGH"). In the complaint, the liquidator alleged that Deloitte prepared faulty financial statements over the years, prompting the directors and officers of Reliance to pay its parent companies more than $500 million in cash.
Moreover, the liquidator claimed that Deloitte violated auditing standards and committed actuarial malpractice by wrongly certifying in 1999 that Reliance's loss reserves were reasonable, when they were in fact severely deficient. According to the complaint, because of this alleged malpractice, Reliance's surplus was artificially inflated, and permitted Reliance to evade the strict regulatory scrutiny to which it normally would have been subjected.
In addition, Reliance paid RGH another $91.4 million in June and July, 2000 (the "Upstream Payments"), which, combined with massive underwriting losses— alleged to be $134 million—deepened Reliance's insolvency, the complaint stated.
Deepening Insolvency
After swiftly granting summary judgment on the issue of the $91.4 million Upstream Payments,1 the court turned its attention to the issue of first impression: whether the liquidator could claim deepening insolvency damages against Deloitte.2
The court examined key federal cases involving the deepening insolvency theory, beginning with In re CitX Corp., 448 F.3d 672 (3d Cir. 2006). The court noted that in CitX, the trustee in the bankruptcy case of an Internet company filed an action against the accounting firm that had compiled financial statements for the company, alleging malpractice and deepening insolvency. In CitX, the U.S. Court of Appeals for the Third Circuit affirmed the district court's grant of summary judgment in favor of the accounting firm, holding that deepening insolvency was not a "valid theory of damages for an independent cause of action."
In Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., 267 F.3d 340 (3d Cir. 2001), the Third Circuit was faced with a claim brought by the creditors' committee on behalf of two corporate debtors "alleging that certain third parties had fraudulently induced the corporations to issue debt securities, which deepened their insolvency and ultimately forced them into bankruptcy." Although the case was dismissed on other grounds, the Third Circuit held that "deepening insolvency was a valid cause of action under Pennsylvania law."
In order to reconcile the seemingly stark dichotomy presented by the conclusions in CitX and Lafferty, the Ario court looked to a subsequent district court case, Official Comm. of Unsecured Creditors of Allegheny Health, Educ. and Research Found. v. PricewaterhouseCoopers, LLP, 2007 U.S. Dist. LEXIS 3331 (W.D. Pa. 2007), which juxtaposed the facts of each case. As the court noted, "The Allegheny Health Court explained that in CitX Corp., the accountants prepared a mere compilation and expressly stated that it would not audit or review financial statements, whereas, in Allegheny Health, the accountant prepared audited financial statements." The Ario court found this distinction "compelling."
Actions for Audited Statements
As the court explained, "In an audited engagement, the accountant assumes responsibility for the accuracy of the figures presented in the financial statements... In an unaudited engagement, the accountant does not warrant and is not responsible for the ultimate accuracy of the report if the figures supplied by the client are erroneous." After noting that Pennsylvania law does not insulate accountants from being sued for negligence, the court reached the crux of its decision:
[W]here deepening insolvency damages are sought, if the underlying action is based on a compiled financial statement, as in CitX Corp., deepening insolvency damages may not be available. However, where, as in Allegheny Health, the accountants have prepared an audited financial statement and the plaintiff has asserted independent causes of action, such as negligence, based upon the compiled financial statement, deepening insolvency damages are available. Thus, we conclude that while we do not recognize the deepening insolvency theory as an independent cause of action, if negligence is alleged and proven, the plaintiff may use the deepening insolvency matrix in calculating the damages caused by defendant's negligence.
Turning to the facts of Ario, the court observed that the liquidator alleged that Deloitte negligently audited Reliance's financial statement, and thus "caused, among other things, Reliance to pay debts it did not owe, increased Reliance's liabilities, and deflected regulatory scrutiny." Also, the liquidator sought to recover damages based on independent causes of action, namely negligence, breach of contract, and aiding and abetting breach of fiduciary duty.
Finding that a genuine issue of material fact existed as to proximate causation, the court denied Deloitte's motion for summary judgment regarding the claim for $134 million in underwriting losses.
Editor's note: For previous coverage of deepening insolvency claims, see CRaB Alert, June 2008, p. 10, "Deepening Insolvency Claim Unsuccessful," and November 2007, p. 1, "Delaware High Court Affirms 'Deepening Insolvency' Ruling."
Footnotes
1. The court concluded that there was no evidence that Deloitte breached any duty owed to Reliance with regard to the issuance of the Upstream Payments.
2. In its summary judgment motion, Deloitte did not challenge the liquidator's malpractice allegations. Rather, Deloitte argued that (i) summary judgment was appropriate because deepening insolvency damages are not available under Pennsylvania law as a matter of law and (ii) the liquidator could not establish that Deloitte's conduct was the proximate cause of any damages suffered by Reliance.
This article is presented for informational purposes only and is not intended to constitute legal advice.