While this reasoning may be compelling, it does not necessarily hold in most instances. In fact, keeping a business alive when it is increasingly clear that it is beyond saving may create personal liability for management.

For the directors and officers of insurance companies, potential claims for deepening insolvency must be a component of any decision on the viability of their companies. At the same time, deepening-insolvency claims by creditors may give rise to liability under directors and officers liability and under errors and omissions policies.

More and more, courts are recognizing causes of action brought by bankruptcy trustees, insurance-company liquidators or creditors against officers, directors, and even their accountants, based on the “deepening-insolvency” theory. The thrust of this cause of action is that management either negligently or fraudulently extended the life of a business, causing creditors to extend credit or eliminating possible recovery by other interest holders because of managements failure to face the facts.

Typically, these causes of action are based on two distinct types of claim: a mismanagement claim against the officers and directors, and a misrepresentation claim against both management and the auditors.

Perhaps the most-widely publicized of these lawsuits arose in 1998 out of the Delorean Motor Co. bankruptcy case. There, a jury found the companys auditors liable for $46 million because they concealed the deepening insolvency of their client. The jury in that case found that the company was damaged by financial statements that misrepresented its true state of solvency, thus permitting further debt to be accumulated during the “artificial prolongation” of its corporate life.

This theory has also been applied against officers and directors of insurance companies who misrepresent their financial status to regulators. For example, in Transmark, USA, Inc. v. State of Florida, Department of Insurance, the Florida Department of Insurance sued the officers and directors of Transmark, the parent company of Guarantee Security Life Insurance Company, alleging that they had concealed the true financial status of the insurance company from regulators. The receiver sought $300 million in damages.

Likewise, a judge in Pennsylvania awarded nearly $140 million in compensatory and punitive damages against a single officer of Corporate Life Insurance Co., in part on the basis of the insurance liquidators deepening-insolvency theory.

And just last November, the Fifth Circuit Court of Appeals recognized the growing prevalence of this theory in Florida Department of Insurance v. Chase Bank of Texas, N.A. There, a Florida Department of Insurance liquidator sued Chase Bank on the grounds that a representation it made to regulators prolonged an insurers life (Western Star Insurance Company), allowing it to become further mired in debt.

Because of the potential for liability under this theory, an insurance companys management must be concerned about more than merely its survival. It must also be concerned about whether it is artificially–and wrongfully–prolonging the life of the company and causing damage to others.

At the same time, D&O insurers must be asking themselves the same questions with respect to their insureds.

It is certainly difficult to determine when any particular business should “throw in the towel,” but there are a few sign-posts to watch out for. If directors and officers find themselves in the following circumstances, it may be time to consider other alternatives:

The business is experiencing repeated losses and financing them in unhealthy ways. A business suffering recurring losses and financing those losses with additional debt may be a prime candidate for a deepening insolvency claim.

The entire industry or sector is experiencing a downturn. Management may be trying to turnaround a business in a dying sector. Extending the companys life therefore is ultimately a pointless endeavor.

A company is managing for income and not cash flow. A company that fails to ensure that it has sufficient funds to meet its monthly obligations, and is instead focusing on short-term income, should reexamine its survivability.

The companys payables are increasingly stretched-out. While stretching payables may be a part of surviving lean economic times, a businesss payables may simply be stretched too far to ever have a realistic hope of recovery.

Avoiding personal liability. Often, directors or officers who have personally guaranteed their businesss debt fight to keep it alive, hoping to limit their personal liability. Individuals in these circumstances need to take a close look at their possible exposure to a deepening-insolvency cause of action.

Any accounting irregularities. Loud alarms should be sounding if a company is using accounting irregularities simply to maintain its existence.

Any of these warning signs should cause management to take a hard look at a companys real chances for turnaround and survival. Given the possible exposure to a deepening-insolvency claim, management should be undertaking this analysis without delay, and, if necessary, should seek truly independent, third-party financial advisors for a frank assessment of the chances of their businesss survival.

Luis Salazar is a shareholder in the bankruptcy practice of Greenberg Traurigs Miami office. He can be reached at [email protected].

Reproduced from National Underwriter Property & Casualty/Risk & Benefits Management Edition, May 6, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.