Deepening Insolvency Comes Up for Air

Posted by Kathy Bazoian Phelps

     Deepening insolvency is alive and well, at least in the Eastern District of New York. That court recently found that deepening insolvency is an appropriate measure of damages resulting from a breach of fiduciary duty claim. Federal Nat’l Mtge. Assoc. v. Olympia Mortgage Corp., 2014 U.S. Dist. LEXIS 79479 (E.D.N.Y. June 10, 2014).

     Olympia Mortgage moved for entry of judgment on its claims for breach of fiduciary duty, among others, against Avruhum Donner, who was the former president and a principal shareholder of Olympia. The court found that, “Donner owed a fiduciary duty to Olympia, that he breached that duty, not only by causing the fraudulent transfers to be made, but also by engaging in various schemes to disguise Olympia's financial condition, and that, as a result of this breach, Olympia incurred damages in the form of increased indebtedness to Fannie Mae, among others.”

     In measuring damages on the breach of fiduciary duty claim, the court allowed the use of deepening insolvency to calculate the amount of the loss. The court reasoned as follows:

    With respect to the $43,918,500.42 claim, Olympia argues that Donner used the Check Kiting, Nominee Loan and other schemes to infuse cash into the company and to hide its liabilities, thus enabling Olympia to continue operating even though it was insolvent. Olympia further asserts that this continued appearance of solvency permitted the continued perpetration of the fraud against Fannie Mae, resulting in the increase of Olympia's liability to Fannie Mae from around $3 million in December 1997 to around $43 million in October 2004, and that Donner is liable for the entire increased amount.

    The theory on which Olympia relies, "deepening insolvency," posits that an "insolvent corporation suffers a distinct and compensable injury when it continues to operate and incur more debt." In re Global Service Group, LLC, 316 B.R. 451, 457 (Bankr. S.D.N.Y. 2004). Some courts have found deepening insolvency to provide an independent cause of action, while others have treated it as a theory of damages. See id at 457-58 (collecting cases). In this Circuit, deepening insolvency is considered "a basis for damages that may result from the commission of a separate tort." In re Allou Distributors, Inc., 395 B.R. 246, 264-65 (Bankr. E.D.N.Y. 2008). Thus, one seeking to recover under this theory "must show that the defendant prolonged the company's life in breach of a separate duty, or committed an actionable tort that contributed to the continued operation of a corporation and its increased debt." Global Service Group, 316 B.R. at 458. Here, there can be no doubt that Donner's participation in the Check Kiting and Nominee Loan schemes amounted to a breach of his fiduciary duty. And the evidence submitted provides an adequate basis upon which to infer that the perpetration of these schemes served not only to prolong the life of an already insolvent Olympia, but also to increase its debt to Fannie Mae while simultaneously depleting the assets available for repayment. I am satisfied that Olympia's $43,918,500.42 liability to Fannie Mae was caused, in no small part, by Donner's breach of his fiduciary duty, and Olympia's motion for the entry of default judgment in that amount is granted.

     For a more detailed discussion about the theory of deepening insolvency, either as an independent claim for relief or as a theory of damages, see The Depths of Deepening Insolvency: Damage Exposure for Officers, Directors and Others and The Ponzi Book: A Legal Resource for Unraveling Ponzi Schemes.