Doctrine of Deepening Insolvency

Banker Resource
February 17, 2014 — 1,294 views  
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The Doctrine of Deepening Insolvency is a theory within the law that prolongs a corporation or company's life beyond the scope of insolvency. This prolongation results in increased debt, decreased reputation and dissipation of current and fixed assets. As of now, these damages are seen by the judicial authorities as a cause of action against the people who made it happen, which in most cases is the management and professional advisers. The company can recover damages with the help of its accountants, investment bankers, attorneys and financial advisers, anyone who has facilitated in the company's mismanagement or has misinterpreted the company's financial condition which has resulted in the loss of assets and bankruptcy.

How do the Damages Occur

The state courts have found damages under various possible theories. The first theory is that there is a possibility that an additional debt can trigger a filing for bankruptcy. This results in administrative and legal costs and many operational limitations. The court has also found damages if there is an undermining of the company's customer and vendor relationships. Other theories include the lack of confidence in the company which could diminish the company's ability to land contracts and prompt anticipatory breach. And finally, the dissipation of assets which is likely to include questions about the extent of debt and whether the debtor's estate is sufficient to recover for the devaluation of assets which is available for distribution to unsecured creditors.

How Businesses Can Stay Protected

There are many ways in which a business can protect itself from this predicament. First, it has to know whether or not it is being artificially prolonged. Here are some of the signs where the business is being prolonged artificially:

  • The business has been running into losses and those losses are being financed in an unhealthy way. Businesses should view this with caution as continued financing through stock offerings or unquestionable loans is an unhealthy practice and a big sign of prolongation.
  • If the entire industry is experiencing a downturn, or even a small sector, then it is best that the business seizes to continue to its operations. If the business continues, it could lead to greater losses
  • Another sign that the business is being prolonged is when the focus of the business is short term profits and not a positive cash inflow. In this situation it is safe to say that the business may already be insolvent and this continued neglect for a positive cash flow could make the situation worse.
  • Although it is a good strategy for a business to stretch out its payables, it is not good when the business is not doing so well. A company that is doing this even though the business is running into losses is actively prolonging the situation.
  • Officers and directors of the company have a huge personal liability to the company where they might have guaranteed their business debt or possess a large stake of the equity. In this situation, they will do their best to keep it alive for a long period. 

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