- Category: Judge Somers
- Published on 02 February 2012
- Written by Judge Somers
Redmond, Brooke Trustee v. Kutak Rock, LLP et al, 10-06246 (Bankr. D. Kan. Feb. 2, 2012) Doc. # 224
SIGNED this 2nd day of February, 2012.
For on-line use and print publication
IN THE UNITED STATES BANKRUPTCY COURT
FOR THE DISTRICT OF KANSAS
BROOKE CORPORATION, et al.,
CHRISTOPHER J. REDMOND,
Chapter 7 Trustee of Brooke
Corporation, Brooke Capital
Corporation, and Brooke Investments,
KUTAK ROCK, LLP, et al.,
CASE NO. 08-22786
ADV. NO. 10-6246
MEMORANDUM OPINION AND ORDER
FINDING THE AMENDED COMPLAINT FAILS TO STATE CLAIMS ON
WHICH RELIEF CAN BE GRANTED AGAINST UNDERWRITERS AND
Case 10-06246 Doc# 224 Filed 02/02/12 Page 1 of 38
GRANTING THE TRUSTEE LEAVE TO FILE AN AMENDED COMPLAINT
The Court has under advisement the Motion to Dismiss All Claims Against the
Underwriters (Motion),1 filed by defendants Sandler O’Neill & Partners, L.P., Macquarie
Holdings (USA) Inc.,2 and Oppenheimer & Co., Inc. (collectively, “Underwriters”).3 The
Amended Complaint,4 filed by Plaintiff Christopher J. Redmond,5 Chapter 7 Trustee for
Debtors Brooke Corporation, Brooke Capital Corporation, and Brooke Investments, Inc.,
alleges common law causes of action for negligence and deepening insolvency against
Underwriters arising out of Brooke Corporation’s (Brooke Corp.’s) retention of
Underwriters in 2005 in conjunction with a follow-on public offering of Brooke Corp.
common stock. Underwriters contend that the Amended Complaint fails to state a claim
for negligence and that deepening insolvency is not a valid cause of action.
The Court holds the Amended Complaint fails to state claims on which relief may
be granted against Underwriters because: (1) The negligence claim fails to identify the
duty alleged to have been breached; and (2) the Kansas Supreme Court would not
recognize the separate tort of deepening insolvency. But the Trustee is granted leave to
1 Dkt. 102.
2 Macquarie Holdings is alleged in the Amended Complaint to be the successor to Fox-Pitt Kelton
Cochran Caronia Waller LLC. Dkt. 67 at ¶ 18.
3 Underwriters appear by James L. Moeller, Brian T. Fenimore, James Moloney, and Clay Britton
of Lathrop & Gage LLP.
4 Dkt. 67.
5 The Trustee appears by Benjamin F. Mann, John J. Cruciani, and Michael D. Fielding of Husch
Case 10-06246 Doc# 224 Filed 02/02/12 Page 2 of 38
file an amended complaint restating his negligence claim.
Underwriters move to dismiss the claims against them under Bankruptcy Rule
7012(b), which incorporates Civil Rule 12(b)(6), and provides for dismissal if the
complaint fails to state a claim upon which relief can be granted. The Motion tests the
legal sufficiency of the allegations — whether they are “a short and plain statement of the
claim showing that the pleader is entitled to relief,” as required by Bankruptcy Rule
7008(a), which incorporates Civil Rule 8(a)(2). Satisfaction of this standard gives “‘the
defendant fair notice of what the . . . claim is and the grounds upon which it rests.’”6
Further, “to withstand a motion to dismiss, a complaint must contain enough allegations
of fact ‘to state a claim to relief that is plausible on its face.’”7 In this case, the principle
question is whether the claims allege legal theories which are cognizable under applicable
ALLEGATIONS OF THE AMENDED COMPLAINT.
The Amended Complaint seeks redress from multiple parties for the economic
collapse of Debtors. Defendant Kutak Rock, LLP, was retained as Debtors’ legal counsel
6 Bell Atlantic Corp. v. Twombly, 550 U.S. 544, 555 (2007) (quoting Conley v. Gibson, 355 U.S.
41, 47 (1957)).
7 Robbins v. Oklahoma, 519 F.3d 1242, 1247 (10th Cir. 2008) (quoting Twombly, 550 U.S. at
8 5B Charles Alan Wright & Arthur R. Miller, Federal Practice & Procedure, Civil, § 1357 at
456-62 (3rd ed. 2004) (“All federal courts are in agreement that the burden is on the moving party to
prove that no legally cognizable claim for relief exists.”).
Case 10-06246 Doc# 224 Filed 02/02/12 Page 3 of 38
as early as 2004 to provide a wide range of legal services. Legal malpractice and other
claims are alleged against the law firm. Debtors’ former officers and directors are sued
for breach of fiduciary duty and other claims. Negligence and deepening insolvency
claims are alleged against Underwriters. This memorandum is concerned only with the
motion to dismiss the claims against Underwriters.
The Amended Complaint alleges the following background facts. Debtor Brooke
Corp., a holding company listed on the NASDAQ Global Market, was a Kansas
corporation, headquartered in Kansas. Debtor Brooke Capital was also a Kansas
corporation headquartered in Kansas, and was a publicly-traded company that was listed
on the American Stock Exchange. Brooke Capital was an insurance agency and finance
company that distributed services through a network of franchise and company-owned
businesses. Brooke Capital owns 100% of the stock of Debtor Brooke Investments.
Brooke Corp. and Brooke Capital are referred to collectively in the Amended Complaint
and in this opinion as “Brooke.”
Debtors, and approximately thirty other affiliated companies, were engaged
primarily in the business of selling insurance and related services through franchisees.
Each franchisee agreed to pay Brooke franchise fees, including an initial franchise fee and
buyer assistance fees, and to share a percentage of its sales commissions with Brooke. In
return, Brooke agreed to provide ongoing services to each franchisee. The costs of
acquisition of agencies and franchises were typically financed through Brooke’s lending
subsidiary. Between 2004 and 2007, Brooke experienced tremendous growth in the
Case 10-06246 Doc# 224 Filed 02/02/12 Page 4 of 38
number of franchisees it had. Brooke’s payroll and other operating expenses increased
very quickly. In many instances, the commissions a franchisee earned were not adequate
to cover the franchisee’s loan payments or other expenses owed to Brooke. Brooke
absorbed the shortfalls and advanced funds to the franchisees to cover them.
The Trustee alleges that Brooke’s business model was unsustainable. According
to the Trustee, Debtors were continuously insolvent from at least 2003 through their
respective bankruptcy filing dates in 2008, but Brooke’s improper accounting practices
resulted in a false appearance of solvency.
In January 2005, in order to raise additional capital, Brooke’s management began
meeting with various underwriters to explore the possibility of a follow-on public offering
of Brooke common stock.9 Defendants Underwriters were retained. The allegations
regarding Underwriters’ activities include the following.
Underwriters undertook due diligence, including a review of Brooke’s franchise
relationships and the background, history, and qualifications of Brooke’s auditors.
Meetings with Brooke’s management, auditors, actuaries, and consultants were held in
February, March, and April 2005, as Underwriters participated in drafting a 2005 S-1,
which was filed with the Securities and Exchange Commission (SEC) on April 21, 2005.
9 Dkt. 67 at ¶ 196. The Amended Complaint generally refers to “Brooke” (defined to be
collectively Brooke Corp. and Brooke Capital) as to the follow-on offering, although the August 9, 2005,
Underwriting Agreement (Dkt. 103-1) is between Underwriters and Brooke Corp., and Brooke Corp.
common stock is the only stock alleged to have been issued. Since Underwriters have not raised the
apparent confusion of parties, the Court likewise will use “Brooke” when it is not apparent whether both
Brooke Corp. and Brooke Capital or only one of them was involved.
Case 10-06246 Doc# 224 Filed 02/02/12 Page 5 of 38
Underwriters assisted Brooke’s management in responding to SEC comments regarding
Brooke’s 2005 S-1.
On August 9, 2005, the SEC declared the 2005 S-1 effective, and Brooke
announced the pricing of its follow-on offering of 2,500,000 shares of Brooke common
stock at $11.50 per share. On the same date, Underwriters entered into an Underwriting
Agreement (Agreement) with Brooke Corp. whereby they agreed to purchase the Brooke
Corp. shares. On August 15, 2005, Brooke announced the completion of its follow-on
offering of 2,500,00 shares. On August 22, 2005, Underwriters exercised their right to
purchase their over-allotment and purchased an additional 375,000 shares. The gross
proceeds of the offering were $28,750,000.
The Trustee alleges that “Underwriters were experts in accounting and financial
matters and had superior knowledge to Brooke and Brooke Corp.’s Board of Directors
with respect to such matters.”10 It is further alleged that the due diligence conducted by
Underwriters “revealed or should have revealed numerous areas of concern regarding
Brooke and its planned offering of Brooke common stock,”11 and Underwriters “should
have applied heightened scrutiny with respect to the portions of the 2005 S-1 that
addressed these issues or that should have addressed these issues.”12 According to the
Trustee, the 2005 S-1, which Underwriters “helped draft and approved, does not . . .
10 Id. at ¶ 205.
11 Id. at ¶ 214.
12 Id. at ¶ 218.
Case 10-06246 Doc# 224 Filed 02/02/12 Page 6 of 38
identify all of the risks and concerns that the Underwriters had earlier identified for
themselves, presenting a misleading picture of Brooke.”13
Based upon the factual allegations which are summarized above, Count XIV of the
Amended Complaint alleges a negligence claim against Underwriters as follows:
373. At the request of the Board of Directors of Brooke
Corp., Sandler O’Neill, Fox-Pitt Kelton, and Oppenheimer
served as underwriters for Brooke’s follow-on offering of
2,500,000 shares of common stock.
374. In connection with their underwriting, the Underwriters
conducted certain due diligence of Brooke and its planned
375. The Underwriters performed this due diligence
negligently in failing to discover Brooke’s improper financial
accounting practices and its insolvency.
376. Alternatively, to the extent the Underwriters did
discover Brooke’s improper financial accounting practices
and its insolvency, the Underwriters were negligent in failing
to bring Brooke’s improper financial accounting practices and
its insolvency to the attention of Brooke Corp.’s Board of
Directors and in failing to ensure that the 2005 S-1 accurately
addressed these issues so as not to mislead investors.
377. By presenting a misleading picture of Brooke’s finances
and failing to disclose that Brooke was insolvent at the time
of the follow-on offering, the 2005 S-1 allowed Brooke to
raise over $27 million, thereby damaging Brooke by
prolonging Brooke’s corporate life and allowing it to incur
additional debts and waste the capital raised through the
378. Between 2004 and 2008, and because both Brooke and
13 Id. at ¶ 220.
Case 10-06246 Doc# 224 Filed 02/02/12 Page 7 of 38
its lenders believed that Brooke was solvent, Brooke incurred
additional debt, and went from a company that was on the
brink of solvency to a company that has over $450M in
claims against it and its investors.
379. The unlawful prolongation of Brooke’s corporate life
has caused irreparable damage to Brooke and to its general
unsecured creditors in an amount in excess of millions of
The Amended Complaint also alleges a cause of action for deepening insolvency
in Count XIII. After alleging the same first two paragraphs as are alleged in the
negligence claim, Count XIII alleges as follows:
365. The due diligence conducted by the Underwriters revealed or
should have revealed numerous “red flags” regarding Brooke,
including but not limited to areas of concern regarding Brooke, its
financial accounting, and its insolvency.
366. Having been aware of the various “red flags” they
discovered or should have discovered during their due
diligence, the Underwriters should have applied heightened
scrutiny with respect to the portions of the 2005 S-1 that
addressed these issues or that should have addressed these
367. The 2005 S-1, which the Underwriters were retained to
help draft and approve, however, does not identify all of the
risks and concerns that the Underwriters had earlier identified
for themselves and fails to disclose Brooke’s improper
financial accounting practices and insolvency.
368. By presenting a misleading picture of Brooke and
failing to disclose that Brooke was insolvent at the time of the
follow-on offering, the 2005 S-1 allowed Brooke to raise over
14 Id. at ¶¶ 373-379.
Case 10-06246 Doc# 224 Filed 02/02/12 Page 8 of 38
369. This allowed Brooke to continue to operate beyond the point
when it should have liquidated, thereby damaging Brooke by
prolonging Brooke’s corporate life and allowing it to incur additional
debts and to waste the capital raised through the offering.
370. Between 2004 and 2008, and because both Brooke and
its lenders believed that Brooke was solvent, Brooke took on
additional debt, and went from a company that was on the
brink of solvency to a company that has over $450M in
claims against it and its affiliates.
371. The unlawful prolongation of Brooke’s corporate life
has caused irreparable damage to Brooke and to its general
unsecured creditors in an amount in excess of millions of
UNDERWRITERS’ MOTION TO DISMISS
In their memorandum in support of their Motion, Underwriters argue that: (1) The
negligence claim fails under New York law (which is the applicable law as stated in the
Agreement) or, in the alternative, the negligence claim fails under Kansas law;
(2) deepening insolvency is neither a valid cause of action nor a rational theory of
corporate harm; (3) the statute of limitations bars the Trustee’s claims; and (4) in pari
delicto bars the Trustee’s claims because Brooke’s management is primarily responsible
for any harm arising out of the 2005 public offering.16
The Trustee responds that the Agreement is not relevant and that: (1) Kansas law
supplies the applicable law, and the negligence claim is timely under the Kansas statute of
15 Id. at ¶¶ 365-371.
16 Dkt. 103.
Case 10-06246 Doc# 224 Filed 02/02/12 Page 9 of 38
limitations; (2) the Trustee has properly alleged a negligence claim under Kansas law;
(3) deepening insolvency is a recognized, independent cause of action; and (4) either in
pari delicto does not apply to the Trustee or there are facts in issue regarding this
ANALYSIS AND CONCLUSIONS OF LAW.
A. Kansas law controls whether the Amended Complaint states tort claims on
which relief can be granted.
Underwriters argue that their relationship with Brooke is governed by the
Agreement,18 and the choice of law provision of the Agreement requires that the Motion
be decided under New York law. The relevant part of that provision reads:
THIS AGREEMENT SHALL BE GOVERNED BY, AND
CONSTRUED IN ACCORDANCE WITH, THE LAWS OF
THE STATE OF NEW YORK, WITHOUT REGARD TO
CONFLICT OF LAWS PRINCIPLES OF SAID STATE
OTHER THAN SECTION 5-1401 OF THE NEW YORK
GENERAL OBLIGATIONS LAW.19
The Trustee alleges Kansas law applies to the tort claims. The Court therefore begins its
analysis by deciding what substantive law controls the tort claims, whether it is New
York law, as stated in the Agreement, or Kansas law, the law of the forum state. For the
reasons stated below, the Court holds that Kansas law applies.
17 Dkt. 113.
18 Although a copy of the Agreement is not attached to the Amended Complaint, it is referred to
in ¶ 232. Underwriters submitted a copy as an attachment to the Motion. It may be considered by the
Court when ruling on the Motion. GFF Corp. v. Associated Wholesale Grocers, Inc., 130 F.3d 1381,
1384 (10th Cir. 1997).
19 Dkt. 103-1 at 29, ¶ 16.
Case 10-06246 Doc# 224 Filed 02/02/12 Page 10 of 38
The Amended Complaint alleges jurisdiction under 28 U.S.C. §§ 157 and 1334.
When proceeding “pursuant to the grant of jurisdiction under 28 U.S.C. § 1334 covering
civil actions related to bankruptcy proceedings, federal courts ‘employ the forum state’s
choice of law doctrines where the underlying rights and obligations are defined by state
law.’”20 It is well established in Kansas that “[w]here the parties to a contract have
entered an agreement that incorporates a choice of law provision, Kansas courts generally
effectuate the law chosen by the parties to control the agreement.”21 The question is
therefore whether the parties to the Agreement intended the choice of law section to
control the tort claims.
This question is answered by construing the Agreement. It obligates Underwriters
to purchase 2,500,000 shares of Brooke Corp. common stock, subject to the terms and
conditions of the Agreement. There is no question that Underwriters purchased the stock.
The Agreement does not impose on Underwriters the duties of making a due diligence
investigation, preparing or approving the 2005 S-1, or advising Brooke and its
management, the matters at issue in this litigation.
Rather, under the Agreement, Brooke warranted to Underwriters that submissions
to the SEC complied with applicable law and did not contain any untrue statements of
material fact. Underwriters did not make a similar warranty to Brooke. Brooke also
20 Mukamal v. Bakes, 383 B.R. 798, 815 (S.D. Fla. 2007) (quoting Official Comm. of Unsecured
Creditors v. Donaldson, Lufkin & Jenrette Secs. Corp., 2002 WL 362794, *5 (S.D.N.Y. Mar. 6, 2002)).
21 Brenner v. Oppenheimer & Co., Inc., 273 Kan. 525, 539, 44 P.3d 364, 375 (2002).
Case 10-06246 Doc# 224 Filed 02/02/12 Page 11 of 38
warranted to Underwriters the sufficiency of its accounting controls and that the
“financial statements . . . filed with the Commission as part of the Registration Statement
and included in the Prospectus . . . present fairly the consolidated financial position of the
Company and its subsidiaries” and had, unless otherwise noted, been prepared in
conformity with generally accepted accounting principles.22 Brooke agreed to indemnify
Underwriters for losses, claims, damages, or liabilities arising out of untrue statements of
material fact or omissions in SEC filings.23 The parties agreed that the only information
Underwriters provided to Brooke specifically for inclusion in SEC filings was “the
concession and reallowance figures and the text under the caption ‘Stabilization’
appearing in the Prospectus in the section entitled ‘Underwriting.’”24 Liability arising
from such information is excluded from Brooke’s obligation to indemnify Underwriters.
And Underwriters agreed to indemnify Brooke only for liability arising from such
In the Agreement, Brooke agrees with Underwriters that “in connection with the
sale of the Shares, . . . no fiduciary or agency relationship between Company and any
Underwriter has been created in respect of any of the transactions contemplated by this
22 Dkt. 103-1 at 3, ¶ 1(a)(iv).
23 Id. at 24, ¶ 8(a).
25 Id. at 24-25, ¶ 8(a) and (b).
Case 10-06246 Doc# 224 Filed 02/02/12 Page 12 of 38
Agreement.”26 In a broadly worded paragraph, Brooke “waive[d], to the fullest extent
permitted by law, any claims it may have against any Underwriter for breach of fiduciary
duty or alleged breach of fiduciary duty.”27 The Agreement does not contain an
integration clause stating that it addresses the complete relationship between the parties.
The conduct alleged by the Trustee as the basis for tort liability does not include
matters covered by the Agreement. The Agreement is dated August 9, 2005, which is the
date the S-1 was accepted by the SEC. The actions which are the focus of the Amended
Complaint are the preparation of the S-1, which occurred in February, March, and April
2005, before the date of the Agreement. At oral argument, counsel for the parties agreed
that assistance in the preparation of the S-1 was a service provided by Underwriters, but
this service is not addressed by the Agreement. Although the possibility of a fiduciary
duty between Underwriters and Brooke Corp. is addressed by the Agreement, the
Amended Complaint does not allege a breach of fiduciary duty claim. There is no
contention that the tort claims are liabilities covered by the parties’ respective
The choice of law provision in the Agreement is narrow, stating “this agreement
shall be governed by, and construed in accordance with, the laws of the State of New
York.”28 The Amended Complaint alleges two tort claims, negligence and deepening
26 Id. at 28-29, ¶ 12(a).
27 Id. at 29, ¶ 12(c).
28 Id. at 29, ¶16.
Case 10-06246 Doc# 224 Filed 02/02/12 Page 13 of 38
insolvency, neither of which involve enforcement or construction of the Agreement. The
parties’ intent as expressed in the Agreement provides no basis to conclude that they
either contemplated the tort liability alleged or agreed that New York law would be
applicable to such claims. The Court finds the Agreement’s choice of law provision is
not applicable to the tort claims.
As to tort actions, Kansas follows the rule of lex loci delicti, under which the law
of the state where the injury occurred is the law that applies.29 In this case, the Trustee
alleges tort causes of action injuring Brooke, corporations which are organized and
headquartered in Kansas. The law of Kansas therefore is applicable.
B. Under Kansas law, the fact of the contractual relationship between Brooke
Corp. and Underwriters does not preclude Underwriters’ liability for an
Underwriters rely in part upon the well-established rule of Kansas law that the
existence of a contractual relationship bars the assertion of tort claims covering the same
subject matter as that governed by the contract.30 Under this rule, when the parties have
entered into a contract, the courts do not entertain tort claims when the facts alleged are
precisely the same as those alleged for a breach of contract claim.31 In other words, a
plaintiff may not “bring an action which arises out of the performance of a contract and
29 Ling v. Jan’s Liquors, 237 Kan. 629, 634, 703 P.2d 731, 735 (1985).
30 Ford Motor Credit Co. v. Suburban Ford, 237 Kan. 195, 203-05, 699 P.2d 992, 998-99 (1985)
(quoting Isler v. Texas Oil & Gas Corp., 749 F.2d 22, 23-24 (10th Cir. 1984)).
Case 10-06246 Doc# 224 Filed 02/02/12 Page 14 of 38
call it a tort action.”32 On the other hand, the rule is not so broad as to bar tort claims
when the basic relationship between the parties is contractual. For example, Kansas law
recognizes claims for legal and medical malpractice, even though there is a contract
between the lawyer and client and the physician and patient, as the case may be. A
similar principle of Colorado law, that tort claims are permitted only where the plaintiff
can establish a breach of a duty arising independently of any contract duties between the
parties, has been held not to preclude a negligence claim asserted against an underwriter
by a trustee under a bankruptcy plan.33
The Court holds that the Agreement does not precludes tort claims relating to
Underwriters’ services to Brooke relating to the 2005 follow-on offering. As discussed
above, the tort claims alleged in the Amended Complaint arise from actions distinct from
those addressed by the Agreement.
C. The tort claims are not subject to dismissal based upon expiration of the
statute of limitations.
One of the grounds for dismissal urged by Underwriters is expiration of the statute
of limitations. The Court rejects this argument.
Under bankruptcy law, a trustee has a grace period of two years after the date of
filing of the bankruptcy petition to pursue claims existing on the date of filing.34 This
32 Beeson v. Erickson, 22 Kan. App.2d 452, 456, 917 P.2d 901, 905 (1996).
33 Smith ex rel. Boston Chicken, Inc., v. Arthur Andersen, L.L.P., 175 F.Supp. 2d 1180, 1207 (D.
34 11 U.S.C. § 105(a).
Case 10-06246 Doc# 224 Filed 02/02/12 Page 15 of 38
action was filed within two years of the date of Brooke’s filings, October 28, 2008. The
question is whether the claims would have been timely under state law if brought on the
date of filing. Under Kansas law, the controlling statute of limitations for tort claims is
K.S.A. 60-513(a)(4). It provides an “action for injury to the rights of another, not arising
on contract, and not herein enumerated,” shall be brought within two years.35 But, when
the “fact of injury is not reasonably ascertainable until some time after the initial act,” the
limitations period does not begin to run “until the fact of injury becomes reasonably
ascertainable to the injured party.”36
Underwriters argue that the fact of injury arising out of the 2005 public offering
was reasonably ascertainable in August 2005, when the stock was sold, or at least by
October 28, 2006. In support, they rely on the allegations of the Amended Complaint,
contending that the Trustee has essentially admitted the fact of injury was ascertainable
by such date in his allegations against Brooke Corp.’s directors for breach of fiduciary
duty. Those allegations include, among other things, that the directors failed “to
recognize the impropriety of the 2005 public offering”37 and that they knew or should
have known as early as February 2003 that Brooke was insolvent. The Trustee responds
that Underwriters misconstrue his claim — that the alleged injury did not occur at the
time of the 2005 public offering but occurred later when, because of the proceeds of the
35 K.S.A. 60-513(a)(4).
36 K.S.A. 60-513(b).
37 Dkt. 103 at 19 (quoting Dkt. 67 at ¶ 292).
Case 10-06246 Doc# 224 Filed 02/02/12 Page 16 of 38
public offering, Brooke was able to prolong its corporate life and incur and take on
additional debt.38 Further, it is argued that the fact of injury could not have been
reasonably ascertained until Brooke’s improper accounting practices were identified in
When the fact of injury becomes reasonably ascertainable is a question of fact.
The Amended Complaint alleges that Brooke continued in business until 2008 based upon
a false belief of solvency. Under the Trustee’s allegations, it is plausible that the fact of
the injury alleged to have been caused by Underwriters’ conduct relating to the 2005
stock offering was not reasonably ascertainable until after October 28, 2006. The claims
against Underwriters will not be dismissed based upon the statute of limitations defense.
D. The negligence claim fails to identify the duties which are alleged to have
Under Kansas law, the existence of a duty owed by the defendant to the plaintiff is
an essential element of a negligence claim.39 What duties, if any, Underwriters owed to
Brooke under the circumstances of this case is not easily determined, as there is a dearth
of case law addressing an underwriter’s common law duties to an issuer. The briefs of
the parties reflect this problem, as neither presents a fully-developed argument supported
by case law addressing underwriter liability under the common law.
Underwriters, as their primary argument in support of dismissal of the negligence
38 Dkt. 113 at 5 (citing Dkt. 67 at ¶¶ 369-71 and 377-379).
39 E.g., Roe v. Dept. of Social and Rehab. Servs., 278 Kan. 584, 592, 102 P.3d 396, 403 (2004).
Case 10-06246 Doc# 224 Filed 02/02/12 Page 17 of 38
claim, argue that as a matter of law an underwriter has no duty to an issuer. Underwriters
cite two cases, neither of which the Court finds persuasive. The first is In re Quintus
Corporation,40 where the Chapter 11 trustee filed an adversary complaint against the
debtor’s lead underwriter for the debtor’s initial public offering, alleging liability for
causing the IPO shares to be underpriced. The uncontroverted facts established that the
lead underwriter, because of a conflict of interest arising from its ownership of stock of
the issuer, had retained an independent underwriter to recommend the maximum price of
the offering, and this price was accepted by the issuer. The lead underwriter’s motion for
summary judgment on the negligence claim was granted. The court found that any such
claim was barred because the trustee did not show a duty independent of the lead
underwriter’s contract with the issuer, and that the lead underwriter did not have a duty to
set the maximum price. The case does not stand for the general proposition that as a
matter of law, there is no extra-contractual duty owed by an underwriter to an issuer.
The second case is HF Management,41 a case which does not even involve
underwriter liability. In that case, an employer had brought an action against former
employees and competitors alleging breach of non-solicitation agreements and unfair
competition. The lower court disqualified the law firm representing the employer due to
its work in connection with the competitor’s initial public offering. The appellate court
40 Gwynne v. Credit Suisse First Boston (USA), Inc. (In re Quintus Corp.), 397 B.R. 710 (Bankr.
D. Del. 2008).
41 HF Mgmt. Servs., LLC, v. Pistone, 34 A.D.3d 82, 818 N.Y.S.2d 40 (N.Y. App. Div. 2006).
Case 10-06246 Doc# 224 Filed 02/02/12 Page 18 of 38
reversed. In doing so, it observed that “the creation of a fiduciary duty from
underwriter’s counsel to the issuer of securities makes no sense under the federal
securities laws,” and in support of that conclusion, agreed with the plaintiff’s observation
that “there is no conceivable basis for any conclusion that the due diligence is being
performed for the issuer’s benefit.”42 It is this last statement upon which Underwriters
rely in this case. It is dicta used to support a ruling on an issue far removed from this
case. This Court ascribes little weight to the statement.
In their reply brief, Underwriters cite four additional cases for the proposition that
“other courts around the country join New York in confirming than an underwriter owes
no duty of disclosure to any party other than investors.”43 But the cases are insufficient to
convince the Court that Underwriters’ position is correct, particularly under Kansas law.
The first case, Enron Corporation,44 concerned a claim by institutional investors
alleging the defendant bank fraudulently induced them to purchase certificates of
beneficial ownership interests in an Enron special-purpose entity. Underwriters rely on
the court’s observation, when discussing a fraud claim, that the plaintiffs did not allege
any relationship which would give rise to a duty to disclose, not that the law precludes
42 Id., 34 A.D.3d at 87, 818 N.Y.S.2d at 44.
43 Dkt. 133 at 6.
44 In re Enron Corp. Secs., Derivative & “ERISA” Litig., 761 F.Supp. 2d 504 (S.D. Tex. 2011).
Case 10-06246 Doc# 224 Filed 02/02/12 Page 19 of 38
such a duty.45 Underwriters also cite a footnote from an earlier decision in the Enron46
litigation for the proposition that even where an underwriter has a duty of disclosure, the
duty extends only to purchasers. But that footnote was included in a ruling on a motion
for summary judgment in a case for securities fraud under § 10(b) of the 1934 Securities
Exchange Act. The Trustee’s negligence claim is under the common law. Two of the
cases cited by Underwriters in their reply brief actually support the Trustee. Union
County47 is a case by an issuer of bonds against underwriters, alleging state law claims.
Although the opinion includes the statement quoted by Underwriters, that “it is well-
accepted that underwriters generally owe no duty to the issuer of securities,”48 the court
nevertheless denied the underwriter’s motion for summary judgment. As to the breach of
fiduciary duty claim, the court found that the trier of fact could conclude that the
underwriter went “beyond the ‘role’ of underwriter and undert[ook] some additional duty
to the County.”49 Likewise, it held that a trier of fact could find a duty of disclosure
sufficient to support a negligence claim.50 In the final case, Certain Underwriters at
45 Id. at 556.
46 In re Enron Corp. Secs., Derivative & “ERISA” Litig., 610 F.Supp. 2d 600, 626 n. 25 (S.D.
47 Union County v. Piper Jaffray & Co., Inc., 741 F.Supp. 2d 1064 (S.D. Iowa 2010).
48 Id. at 1102.
49 Id. at 1108.
50 Id. at 1109.
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Lloyd’s,51 although the court dismissed a counterclaim for negligence against certain
underwriters because “the facts pled do not indicate that Underwriters owed [the
counterclaim plaintiff] a duty of care,” the dismissal was with leave to amend since it
appeared that the counterclaim could be amended “to allege such facts, such as by adding
allegations related to [the] parties’ alleged oral agreement.”52
The Trustee, when opposing the Motion, cites several cases for the proposition that
“underwriters have a well-established duty to adequately investigate an issuer.”53 In the
first case, Smith ex rel. Boston Chicken v. Arthur Andersen,54 the court denied certain
underwriters’ motion to dismiss a negligence claim brought by a bankruptcy plan trustee,
finding the complaint made a “prima facia showing that the Underwriter Defendants
failed to meet . . . professional standards and the Company’s reasonable expectations.”55
The second case, Suprema Specialities,56 and the third case, Citiline Holdings, Inc.,57 are
not relevant since they concerned some underwriters’ alleged liability under federal
51 Certain Underwriters at Lloyd’s, London v. Real Estate Prof’ls Ins. Co., 2007 WL 4249078
52 Id. at *10.
53 Dkt. 113 at 7.
54 175 F.Supp. 2d 1180.
55 Id. at 1207.
56 In re Suprema Specialities, Inc., Sec. Litig., 438 F.3d 256 (3rd Cir. 2006).
57 Citiline Holdings, Inc., v. iStar Fin., Inc., 701 F.Supp. 2d 506 (S.D.N.Y. 2010).
Case 10-06246 Doc# 224 Filed 02/02/12 Page 21 of 38
The Trustee also relies on the general principle of Kansas tort law that a duty can
arise from circumstances which require one to exercise a certain degree of care to prevent
a foreseeable injury to another.58 He argues that Underwriters had a duty to exercise
reasonable care because Brooke was a foreseeable plaintiff, the probability of harm was
foreseeable, and there is no public policy against imposing a duty on Underwriters.59 Of
necessity, these general principles are very broad and fluid. There is no Kansas case law
applying them to underwriters of stock offerings. Neither of the parties have cited any
Kansas cases which are alleged to have arisen in circumstances analogous to this case
where a duty was either found to exist or to be absent.
Based upon the foregoing, the Court declines to rule as a matter of law at this early
stage of the litigation that under Kansas law, Underwriters owed no duty to Brooke.
Some courts have found underwriters to have common law duties, and the Court is not
convinced that the Kansas Supreme Court would rule otherwise.
However, the Amended Complaint fails to define the duty or duties alleged to have
been breached. For purposes of their respective arguments, both parties have construed
the Amended Complaint and stated in their briefs the duties they understand to be in
issue. For example, the Trustee argues that “the Underwriters had a duty to adequately
investigate Brooke, to discover Brooke’s improper financial accounting practices and
58 Dkt. 113 at 10 (citing Durflinger v. Artiles, 234 Kan. 484, 488, 673 P.2d 86, 91-92 (1983) and
59 Id. at 11 (citing Berry v. Nat’l Med. Serv., Inc., 41 Kan. App.2d 612, 616-17, 205 P.3d 745,
Case 10-06246 Doc# 224 Filed 02/02/12 Page 22 of 38
insolvency, to disclose these issues to Brooke directors, and to ensure that the 2005
Offering materials adequately and accurately disclosed Brooke’s improper financial
accounting practices and insolvency.”60 But there are no express allegations of such
duties in the Amended Complaint. The word “duty” is not used in the Amended
Complaint in relation to Underwriters. The Trustee’s brief places reliance upon general
principles of Kansas negligence law imposing a duty of reasonable care to protect others
from foreseeable harm. But at oral argument on the Motion, counsel for the Trustee
emphasized the law of professional negligence. Neither the Court nor Underwriters can
identify with certainty the duty or duties which the Trustee alleges have been breached.
Since the existence of a duty is an essential element of a negligence claim, Count
XIV of the Amended Complaint is subject to dismissal for failure to state a claim on
which relief can be granted.
E. The Court finds Count XIII of the Amended Complaint, deepening
insolvency, does not state a claim on which relief can be granted, but predicts
that the Kansas Supreme Court would accept deepening insolvency as a
theory of harm.
A commentator describes the theory of deepening insolvency as positing “that the
defendant — typically the board, a lender, an auditor, or someone else with a ‘deep
pocket’ — should have taken action to liquidate or wind down the company and did not;
as a result the company was less valuable at the time it ultimately was shut down, leaving
less money available to distribute to creditors than the company would have provided
60 Id. at 9-10.
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earlier.”61 Underwriters make a two-pronged attack upon deepening insolvency, arguing
that it is neither a valid cause of action, nor a rational theory of corporate harm.
Much has been written in cases and commentary on the subject of deepening
insolvency, and positions are far from consistent. In 2005, one bankruptcy court
described the situation as follows:
[T]he emerging theory of “deepening insolvency” has not
been uniformly applied nor universally embraced. See, Sabin
Willet, The Shallows of Deepening Insolvency, 60 Bus. Law.
549 (Feb.2005); Jo Ann J. Brighton, Deepening Insolvency,
23–3 Am. Bankr. Inst. J. 34 (Apr.2004). Some courts have
recognized “deepening insolvency” as an independent tort.
See, e.g., Official Committee of Unsecured Creditors v. R.F.
Lafferty & Co., Inc., 267 F.3d 340 (3d Cir.2001); In re
Del–Met Corp., 322 B.R. 781 (Bankr. M.D. Tenn.2005); In re
Exide Technologies, Inc., 299 B.R. 732 (Bankr. D. Del. 2003).
Concluding that “deepening insolvency” constituted a valid
cause of action under Pennsylvania law, the court in Lafferty
characterized the essence of the action as the “fraudulent
expansion of corporate debt and prolongation of corporate
life.” Other courts have viewed “deepening insolvency” as a
measure of damages, not as an independent cause of action.
Schacht v. Brown, 711 F.2d 1343 (7th Cir.1983); In re Global
Service Group, LLC, 316 B.R. 451 (Bankr. S.D.N.Y. 2004).
The theory of “deepening insolvency” has also been rejected
outright. Bondi v. Citigroup, Inc., 2005 WL 975856 (N.J.
Super. L. 2005).62
Although some deepening insolvency cases fail to distinguish between deepening
61 Russell C. Silberglied, Don’t Throw Away Your Deepening Insolvency Materials Just Yet, 2009
Norton Ann. Survey of Bankr. Law 7, __ (2009), available on Westlaw at 2009 NRTN-ASBL 7 (quoted
text appears at p. 2 in downloaded pdf file).
62 Rafool v. Goldfarb Corp. (In re Fleming Packaging Corp.), 2005 WL 2205703, *7 (Bankr.
C.D. Ill. 2005).
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insolvency as an independent cause of action and as a theory of harm for a separate tort,
the arguments in this case require the Court to separately consider these related issues.
1. The Court predicts that the Kansas Supreme Court would reject
deepening insolvency as an independent cause of action under the
circumstances alleged by the Trustee.
When opposing Underwriters’ Motion, the Trustee urges63 this Court to find
deepening insolvency to be an independent tort under Kansas law based upon the
reasoning of Lafferty,64 a 2001 Third Circuit opinion often identified as a leading
appellate decision recognizing deepening insolvency as an independent tort. It defined
deepening insolvency as “an injury to the Debtors’ corporate property from the fraudulent
expansion of corporate debt and prolongation of corporate life,”65 and predicted that
Pennsylvania tort law would provide a remedy by recognizing a cause of action.66
Lafferty has been followed by some courts67 and rejected by others.68 The case law
addressing deepening insolvency is voluminous.69 One commentator observes that
63 Dkt. 113 at 18-24.
64 Official Committee of Unsecured Creditors v. R.F. Lafferty & Co., Inc., 267 F.3d 340 (3rd Cir.
65 Id. at 347.
66 Id. at 351.
67 E.g., Smith v. Arthur Andersen LLP (In re Boston Chicken, Inc.), 421 F.3d 989, 1003-04 (9th
68 E.g., Alberts v. Tuft (In re Greater Southeast Cmty. Hosp. Corp., I), 333 B.R. 506, 516-17
(Bankr. D.D.C. 2005).
69 See Tracy Bateman Farrell,“Deepening Insolvency” as Cause of Action in Tort, 23 A.L.R. 6th
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“[u]ntil 2006, deepening insolvency was gaining ‘growing acceptance’ in bankruptcy
courts. However, more recently, federal courts have scaled back deepening insolvency
claims and damages assertions.”70
There are no decisions by the Kansas appellate courts or the Tenth Circuit
addressing the question of whether the tort is recognized under Kansas law. The task
before this Court is therefore to predict what the Kansas Supreme Court would hold if
presented with the question in this case.
“Kansas courts have a long history . . . of looking to the decisions of the Delaware
courts involving corporation law, as the Kansas Corporation Code was modeled after the
Delaware Code.”71 This reliance on Delaware law includes matters relating to the
obligations of corporate directors.72 The decision of the Delaware Chancery Court in
Trenwick,73 which held that under Delaware law there is no independent tort of deepening
insolvency, is therefore very persuasive in predicting Kansas law.
In Trenwick,74 the court granted a company’s former corporate directors’ motion to
dismiss a claim of deepening insolvency. The plaintiff was a litigation trust which had
70 Silberglied, 2009 Norton Ann. Survey of Bankr. Law at ___, available on Westlaw at 2009
NRTN-ASBL 7 (quoted text appears at p. 2 in downloaded pdf file).
71 Arnaud v. Stockgrowers State Bank, 268 Kan. 163, 165, 992 P.2d 216, 218 (1999).
72 Burcham v. Unison Bancorp, Inc., 276 Kan. 393, 77 P.23d 130 (2003).
73 Trenwick Am. Litig. Trust v. Ernst & Young, L.L.P., 906 A.2d 168 (Del. Ch. 2006), aff’d by
unpub. op. adopting lower court’s reasoning, sub nom. Trenwick Am. Litig. Trust v.Billet, 931 A.2d 438
74 Id. at 204-06.
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been formed in reorganization of a subsidiary of an insurance holding company. The
trust brought an action against former directors of the holding company on various
claims, including deepening insolvency. The trust alleged that the defendants
fraudulently concealed the true nature and extent of the company’s financial problems by
expanding the amount of debt undertaken; that the directors knew the company would not
be able to pay the increased debt, but fraudulently represented to creditors and other
outsiders that the debt would be repaid; that the life of the corporation was prolonged and
its insolvency increased; and that as a result, the corporation suffered damages. The
Court, in a well-reasoned opinion, found the concept of deepening insolvency empty. It
began its analysis by observing that, “Delaware law imposes no absolute obligation on
the board of a company that is unable to pay its bills to cease operations and to liquidate.
Even when the company is insolvent, the board may pursue, in good faith, strategies to
maximize the value of the firm.”75 If the board does so, “it does not become the guarantor
of that strategy’s success.”76 If continued insolvency or increased insolvency results, this
alone does not give rise to a cause of action, because the directors are protected by the
business judgment rule.77 However, the court also stated that rejection of an independent
tort cause of action for deepening insolvency does not absolve directors of insolvent
corporations of responsibility.
75 Id. at 204.
76 Id. at 205.
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Rather, it remits plaintiffs to the contents of their traditional
toolkit, which contains, among other things, causes of action
for breach of fiduciary duty and for fraud. The contours of
these causes of action have been carefully shaped by
generations of experience, in order to balance the societal
interests in protecting investors and creditors against
exploitation by directors and in providing directors with
sufficient insulation so that they can seek to create wealth
through the good faith pursuit of business strategies that
involve a risk of failure. If a plaintiff cannot state a claim that
the directors of an insolvent corporation acted disloyally or
without due care in implementing a business strategy, it may
not cure that deficiency simply by alleging that the
corporation became more insolvent as a result of the failed
This Court finds the reasoning of Trenwick to be sound, and predicts with
confidence that the Kansas Supreme Court would follow Trenwick if the motion to
dismiss the deepening insolvency claim had been filed by the former directors of Brooke
Corp., against whom the Trustee also asserts a claim for deepening insolvency in this
adversary proceeding. The question is whether the Kansas Court would extend that
position to a deepening insolvency claim against Underwriters, who were retained by
The Court concludes that it would and predicts that Kansas would not recognize
deepening insolvency as an independent tort when it is asserted against Underwriters,
rather than the former directors. Although in contrast to the law applicable to the
obligations of directors, there is no well-developed law concerning the duties of
Case 10-06246 Doc# 224 Filed 02/02/12 Page 28 of 38
underwriters to an issuing corporation, the general principles of tort law are up to the task
fulfilled by the well-developed Delaware law concerning the duties of directors. Kansas
tort law can balance the “societal interests” of protecting creditors against exploitation by
underwriters and provide underwriters with sufficient insulation so they can in good faith
pursue the objectives of the corporation in making public offerings pursuant to business
strategies. If directors of Brooke as a matter of law are not liable for a separate tort of
deepening insolvency, the underwriters involved in precisely the same transactions should
be similarly situated. If the Trustee cannot state a claim against Underwriters for
negligence, fraud, or some other recognized tort, that deficiency cannot be cured by
alleging the result of Underwriters’ conduct was deepening insolvency. Count XIII is
therefore dismissed for failure to state a claim on which relief can be granted.79
2. The Court predicts that the Kansas Supreme Court would accept
deepening insolvency as a theory of harm.
In addition to arguing that Count XIII, deepening insolvency, should be dismissed,
Underwriters also attack deepening insolvency as a valid theory of harm. The Court
79 Even if the tort as defined by Lafferty were recognized in Kansas as urged by the Trustee,
Count XIII would be subject to dismissal. Although Lafferty defines the tort as “injury to corporate
property from the fraudulent expansion of corporate debt and prolongation of corporate life,” Count XIII
fails to allege sufficient facts to establish the elements of the tort. There is no allegation that
Underwriters’ conduct was fraudulent or similarly wrongful. Count XIII does not even include an
allegation of negligence. Although one could possibly infer negligence from the allegations of Count
XIII, the Trustee has not argued that negligence is sufficient under Lafferty, and the Third Circuit, which
decided Lafferty, has rejected negligence as a basis for a claim of deepening insolvency. In re CitX Corp.,
Inc., 448 F.3d 672 (3rd Cir. 2006). The Court has not located any cases recognizing the tort of deepening
insolvency based upon negligence, in contrast to fraudulent or other intentional conduct. The Trustee
seems to believe that prolonging the life of an insolvent corporation, which results in deepening the
insolvency, states a claim for relief for relief under the tort of deepening insolvency. This is not what
Lafferty and its progeny hold. Deepening insolvency is not a strict liability tort.
Case 10-06246 Doc# 224 Filed 02/02/12 Page 29 of 38
understands “theory of harm” to refer to an injury, and that a valid theory of harm refers
to an injury for which the law recognizes a right to compensation, however measured.80
This basis for recovery of damages is alleged both in the negligence claim, Count XIV,
and the deepening insolvency claim, Count XIII. Although the issue as to the validity of
this theory of harm would appear to be moot since the Court has held that neither count
states a claim on which relief can be granted, the Court addresses this issue since it may
be relevant to the Trustee’s decision whether to file a second amended complaint and, if
he does so, to the allegations he will include.
For the following reasons, the Court declines to rule that the Kansas Supreme
Court would reject deepening insolvency as a theory of corporate harm. The Delaware
Chancery Court, when rejecting deepening insolvency as a stand-alone tort, did not
consider whether deepening insolvency should be recognized as a theory of corporate
harm or a measure of damages. This Court therefore looks to the developing case law and
commentary addressing this issue.
The Third Circuit, when recognizing the tort of deepening insolvency in its
Lafferty decision, described the injury to be redressed by the tort of deepening insolvency
Under federal bankruptcy law, insolvency is a financial
condition in which a corporation’s debts exceed the fair
80 Some reported decisions fail to distinguish between a theory of harm and a measure of
damages, but these are separate concepts. Damages, one form of a remedy, are awarded as compensation
for the harm. Measure of damages is “[t]he basis for calculating damages to be awarded to someone who
has suffered an injury.” Black’s Law Dictionary (9th ed. 2009).
Case 10-06246 Doc# 224 Filed 02/02/12 Page 30 of 38
market value of its assets. [Citation omitted.] Even when a
corporation is insolvent, its corporate property may have
value. The fraudulent and concealed incurrence of debt can
damage that value in several ways. For example, to the extent
that bankruptcy is not already a certainty, the incurrence of
debt can force an insolvent corporation into bankruptcy, thus
inflicting legal and administrative costs on the corporation.
[Citation omitted.] . . . Aside from causing actual bankruptcy,
deepening insolvency can undermine a corporation’s
relationships with its customers, suppliers, and employees.
The very threat of bankruptcy, brought about through
fraudulent debt, can shake the confidence of parties dealing
with the corporation, calling into question its ability to
perform, thereby damaging the corporation’s assets, the value
of which often depends on the performance of other parties.
[Citation omitted.] In addition, prolonging an insolvent
corporation’s life through bad debt may simply cause the
dissipation of corporate assets.
These harms can be averted, and the value within an
insolvent corporation salvaged, if the corporation is dissolved
in a timely manner, rather than kept afloat with spurious
A leading case on deepening insolvency as a theory of harm is the Seventh
Circuit’s Schacht82 decision. The liquidator of an insurance company brought suit against
officers, directors, and a parent corporation who allegedly continued the insurer in
business past the point of insolvency and looted the insurer of its most profitable and least
risky business. The court rejected the argument that there is a “general rule prohibiting a
corporation from suing for damages caused by the artificial prolongation of its life.”83
81 Lafferty, 267 F.3d at 349-350.
82 Schacht v. Brown, 711 F.2d 1343 (7th Cir. 1983).
83 Id. at 1350.
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The argument was found contrary to the common sense notion that a corporation is
inevitably “damaged by the deepening of its insolvency, through increased exposure to
Deepening insolvency as a theory of harm was thoughtfully examined by the
bankruptcy court in Greater Southeast Community Hospital.85 The trustee of a
liquidating trust under the debtor’s Chapter 11 plan sued the debtor’s former officers and
directors alleging breach of their fiduciary duties by misusing corporate assets and by
allowing the debtor to undertake additional debt in a fiscally irresponsible manner. The
court found deepening insolvency to be a theory of harm, not a separate tort, and held that
it applies whether the injury occurred as a result of negligence or fraud.86 As to the
measure of damages, the court observed the trustee “will need to prove that [the debtor]
and its subsidiary corporations were actually harmed by the defendants’ allegedly
excessive borrowing habits, and then quantify that harm. The damages arising from these
injuries (if proven) may be larger or smaller than the amount of excess debt acquired by
the debtors, but they will almost certainly not be the same.”87
Recovery of damages for a claim of deepening insolvency caused by negligence
85 Greater Southeast Cmty. Hosp. Corp. I, 353 B.R. 324.
86 Id. at 338.
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was at issue before the Third Circuit in Chait,88 a 2008 opinion. The insurance
commissioner for the State of Vermont sued an accounting firm on behalf of a defunct
insurance company. The allegations were that the accountants negligently issued audit
opinions that materially understated the company’s loss reserves, that but for the audits,
the company would not have continued to write new insurance policies, and that because
of the inaccurate audits, the commissioner acted too late. A jury found in favor of the
commissioner. On appeal, the accountant-auditors argued deepening insolvency cannot
be used as a measure of damages for an independent cause of action such as malpractice,
citing Lafferty and CitX.89 The court rejected this argument, finding “a trend among [New
Jersey’s state] courts toward recognizing ‘deepening insolvency’ damages,”90 and holding
under New Jersey law that “[w]hen a plaintiff brings an action for professional negligence
and proves that the defendant’s negligent conduct was the proximate cause of a
corporation’s increased liabilities, decreased fair market value, or lost profits, the plaintiff
may recover damages in accordance with state law.”91
The Court recognizes that there are also courts92 that have rejected deepening
88 Thabault v. Chait, 541 F.3d 512 (3rd Cir. 2008).
89 Id. at 518 and 520.
90 Id. at 521.
91 Id. at 520.
92 E.g., Official Committee of Unsecured Creditors v. BNP Paribas (In re Propex Inc.), 415 B.R.
321, 331 (Bankr. E.D. Tenn. 2009) (rejecting deepening insolvency both as a separate tort and as a
“measure of damages” under Tennessee law, stating, “[s]ince damages under Tennessee law are already
available for fraud and breach of fiduciary duty and, since those damages are, after all, designed to
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insolvency as a theory of harm, and commentators have questioned its soundness.93
However, as one commentator has noted, perhaps “the present debate about ‘deepening
insolvency’ as a damages model is more one about labeling than substance.”94 The Court
agrees. A theory of harm (or a damage model) is different from a measure of damages.
The well-reasoned cases allowing the damage model do not define the damages in terms
of a comparison of balance sheets before and after the alleged wrongful act. They require
proof of specific itemized damages, such as increased liabilities and lost profits,
proximately caused by a breach of a legally recognized duty.95 “The fact that . . .
damages . . . may be labeled deepening insolvency damages does not change the fact that
they can be classic damages too; despite the similarity, the difference is in the proof: not
just a comparison of balance sheets, but proof of specific, actual, itemized damages
proximately caused by the wrongdoing.”96
provide full compensation for injuries suffered, it must be asked what the Tennessee courts would have to
gain by recognizing deepening insolvency as a new tort or as a measure of damages heretofore
overlooked in the long march of corporate jurisprudence.”).
93 Sabin Willett, The Shallows of Deepening Insolvency, 60 Bus. Law. 549 (2005) (arguing that
extending credit does not deepen insolvency).
94 Silberglied, 2009 Norton Ann. Survey of Bankr. Law at ___, available on Westlaw at 2009
NRTN-ASBL 7 (quoted text appears at p. 9 in downloaded pdf file).
95 See Kittay v. Atlantic Bank (In re Global Serv. Group, LLC), 316 B.R. 451, 458 (Bankr.
S.D.N.Y. 2004) (“[p]rolonging an insolvent corporation’s life, without more, will not result in liability
under either [deepening insolvency as an independent tort or deepening insolvency as a damage theory].
Instead, one seeking to recover for ‘deepening insolvency’ 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.”).
96 Silberglied, 2009 Norton Ann. Survey of Bankr. Law at ___, available on Westlaw at 2009
NRTN-ASBL 7 (quoted text appears at p. 8 in downloaded pdf file).
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In Kansas, “[t]he purpose of the tort law is to make an injured party whole.”97
“‘One who commits a tortious act is liable for the injury and loss that are the natural and
probable result of his wrongful act.’”98 The Court can identify no principle of Kansas law
which would prohibit as a matter of law the recovery of damages sustained as a result of
the wrongful prolongation of corporate existence and predicts the Kansas Supreme Court
would allow such recovery.
Further, this issue is before the Court on a motion to dismiss. The Trustee has not
had an opportunity to develop his theory of injury and resulting damages. Assuming the
elements of tort liability under Kansas law are established, the damages claimed by the
Trustee may redress the harm suffered by Brooke because of the wrongful prolongation
of its operations.
F. The defense of in pari delicto does not provide a basis to dismiss the
Trustee’s claims against Underwriters.
As an alternative argument in support of their motion to dismiss, Underwriters rely
upon the defense of in pari delicto. This “common-law defense . . . prohibits a party from
recovering damages arising from misconduct for which the party bears responsibility,
bears fault, or which resulted from his or her wrongdoing.”99 When, as in this case, a
97 Hayes Sight & Sound, Inc., v. ONEOK, Inc., 281 Kan. 1287, 1306, 136 P. 3d 428, 442 (2006).
98 Ettus v. Orkin Exterminating Co., Inc., 233 Kan. 555, 562, 665 P.2d 730, 737 (1983) (quoting
Foster v. Humburg, 180 Kan. 64, Syl. ¶ 5, 299 P.2d 46, 48 (1956)).
9927A Am. Jur. 2d, Equity § 103, available on Westlaw at AMJUR EQUITY § 103 (database
updated November 2011).
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bankruptcy trustee is enforcing causes of action belonging to the debtor, “the trustee . . .
stand[s] in the shoes of the debtor and ‘take[s] no greater rights than the debtor himself
had’”100 as of the date the bankruptcy petition was filed. This means that if the defense of
in pari delicto would have barred a claim brought by Brooke on the date of filing, it also
bars the Trustee’s claims. Since the claims alleged arise under Kansas law, the Court
looks to Kansas law when considering Underwriters’ position that in pari delicto bars the
claims against Underwriters.101
Kansas has recognized the principle of in pari delicto, which requires a weighing of
the wrongful act of each party.102 But since the Court has held that Kansas would not
recognize the tort of deepening insolvency, it is not necessary to address whether the
defense would apply to that cause of action.
There is no doubt that in pari delicto does not bar a negligence claim against
Underwriters. Under Kansas negligence law, comparative fault, not in pari delicto,
100 Sender v. Buchanan ( In re Hedged-Investments Assocs., Inc.), 84 F.3d 1281, 1285 (10th Cir.
1996) (quoting H.R. Rep. No. 595, 95th Cong., 1st Sess. 368, reprinted in 1978 U.S.C.C.A.N. 5963,
6323, and citing 11 U.S.C. § 541).
101 Lafferty, 267 F.3d at 361 (Cowen, J., dissenting: “Like the majority, I agree that in evaluating
the affirmative defense at issue here — the in pari delicto doctrine — we apply state law for the
plaintiffs’ state causes of action.”).
102 Goben v. Barry, 234 Kan. 721, 727, 676 P.2d 90, 97 (1984) states as follows:
[In pari delicto] requires when “the wrong of the one party equals that of
the other, the defendant is in the stronger position.” 27 Am. Jur. 2d,
Equity § 141, p. 676. This requires the court to weigh the wrongful acts
of each party. The purpose is to avoid allowing an overwhelmingly
offensive act of the defendant to stand merely because the plaintiff’s
conduct was also wrongful, although slight.
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addresses the issue of liability when the plaintiff as well as the defendant or defendants are
alleged to be at fault. This doctrine, codified at K.S.A. 2010 Supp. 60-258a(a), is as
follows: “The contributory negligence of a party . . . does not bar that party . . . from
recovering damages for negligence resulting in . . . property damage or economic loss, if
that party’s negligence was less than the causal negligence of the party or parties against
whom a claim is made, but the award of damages to that party must be reduced in
proportion to the amount of negligence attributed to that party.” Under the law of
comparative negligence, the allocation of each party’s proportionate negligence is a
question of fact.103
For the foregoing reasons, the Court rejects Underwriters’ argument that in pari
delicto provides an alternative basis to dismiss the claims against them.
G. The Trustee is granted leave to file an amended complaint consistent with
For the above reasons, the Court has found that the Amended Complaint fails to
state claims against Underwriters on which relief can be granted. However, since the
Court has determined that a negligence claim against Underwriters may be recognized
under Kansas law, the Court grants the Trustee leave to file an amended negligence claim
against Underwriters, if he so wishes. Any such amended complaint shall be due on or
before 28 days after the entry of this order.
103 Scales v. St. Louis-San Francisco Ry. Co., 2 Kan. App.2d 491, 498, 582 P.2d 300, 306 (1978).
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The Amended Complaint fails to state claims against Underwriters on which relief
can be granted. If a second amended complaint against Underwriters is not filed within 28
days of the entry of this order, the claims against Underwriters will be dismissed with
IT IS SO ORDERED.
# # #
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