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.

What’s the legal history?

The first case to suggest that secured lenders may contribute to their customers’ insolvency was In re Exide Technologies, Inc. In this landmark Bankruptcy Court case, a banking syndicate lent substantial funds to Exide Technologies even though the company had reported significant losses and an insolvent balance sheet. Exide used these funds to support its faltering operations and acquire a competitor.

As Exide’s financial condition deteriorated further after the acquisition, the syndicate received credit enhancements — including additional collateral and guarantees — in exchange for its continuing financial support. The lenders leading the syndicate also acted as advisors and received investment banking fees from the acquisition. Eventually, bankruptcy was inevitable, and the creditors’ committee filed suits against the lenders alleging, among other charges, deepening insolvency.

The court refused the lenders’ request to dismiss the claim. This opened the door for deepening insolvency claims against secured creditors who make risky loans to insolvent borrowers to the detriment of other creditors.

Deepening insolvency claims have had mixed results in court. Courts in several cases, including Trenwick America Litigation Trust v. Ernst & Young and In re Global Service Group, have rejected or narrowed the scope of claims based on the theory of deepening insolvency. So until the legal community clearly defines and consistently applies the concept, the issue will remain a wild card in bankruptcy litigation.

How can lenders minimize exposure?

Properly managed turnarounds can increase creditor recoveries and even avert formal bankruptcy proceedings, thereby permitting borrowers to regain profitability. The fiduciaries of an insolvent business might conclude that the company should continue to operate in order to maximize its long-term wealth-creating capacity — its “enterprise value.” There’s no absolute duty to shut down and liquidate an insolvent corporation. As long as the loan is made without violating the business judgment rule, a court shouldn’t impose liability.

It’s important, however, to carefully review a borrower’s workout plan for omissions, errors and unrealistic assumptions. In some cases, bankruptcy may provide a more viable alternative — then you can lend funds to a debtor-in-possession under court supervision.

What else can you do?

Lenders can find themselves on either side of a deepening insolvency claim. In addition to being charged with contributing to a borrower’s financial distress, a bank may initiate similar charges against owners, directors or insolvency professionals to recoup outstanding loans upon a borrower’s insolvency.

Independent financial advisors can help substantiate or refute deepening insolvency claims, including investigating fraud allegations, unraveling complex transactions, tracing funds or assets, and calculating economic damages. These experts also can objectively assess whether a company’s turnaround plans appear reasonable or, alternatively, whether bankruptcy appears imminent.

Time to pull the plug?

It can be difficult to deny financing to a loyal customer in financial distress. But if your borrower’s financial health adds up to deepening insolvency, it may very well be time to pull the plug.