A Pennsylvania state court has reportedly ruled, in an unpublished opinion, that the Pennsylvania Insurance Commissioner may pursue a theory of damages against the accountant of an insolvent insurer based on a legal claim of “deepening insolvency.”  See Ario v. Deloitte & Touche, PICS No. 08-1013 (Pa. Commw. Ct.).  “Deeping insolvency” refers to the improper prolongation of the life of an insolvent corporation — usually by outside advisers, such as auditors or lawyers — resulting in harm to the corporation that would have been mitigated by a timely declaration of bankruptcy.

The case arose out of Deloitte’s auditing of Reliance Insurance Company, which subsequently was declared insolvent.  The plaintiff, Pennsylvania Insurance Commissioner Joel Ario, alleges that Deloitte improperly certified Reliance’s loss reserves, thereby permitting Reliance to escape regulatory scrutiny beyond the point in time when Reliance should have been declared to be insolvent.  The court concluded that, if the Commissioner is able to demonstrate liability on a professional accounting malpractice claim, he would be permitted to pursue a damages theory based on Reliance’s increased liabilities during the alleged period of time.

The decision seems to run counter to the conclusion reached by the U.S. Court of Appeals for the Third Circuit, which previously had predicted that the Pennsylvania Supreme Court would reject a “deepening insolvency” theory of damages for an “independent” cause of action (i.e., any cause of action other than a cause of action for deepening insolvency).  In re CitX Corp. Inc., 448 F.3d 672 (3rd Cir. 2006).  In CitX, a bankruptcy trustee for a bankrupt company brought an action against the company’s accounting firm that had compiled the company’s financial statements.  (“Compilation,” unlike auditing, does not require the accountant to verify the information provided by the client).  In connection with his malpractice claim, the trustee alleged that the debtor was harmed “in the form of ‘deepening insolvency.’”  In that case, the Third Circuit predicted that the Pennsylvania Supreme Court would not recognize such a theory of damages for an independent cause of action.

In reaching its decision, the Pennsylvania state court closely examined the opinion in CitX, but ultimately distinguished the decision on the basis that the Deloitte case involved an audit where the CitX case involved a compilation.  The court’s basis for distinguishing CitX, however, clearly contradicts the Third Circuit’s broader prediction that Pennsylvania would not recognize a deepening insolvency theory of damages for an independent cause of action.

The Ario v. Deloitte & Touche decision is the latest in a series of recent decisions that appear to have revived the legal theory of “deepening insolvency” and these recent decisions suggest that before long, appellate courts in Pennsylvania and elsewhere will be asked to weigh in on this legal issue of great significance to outside accountants and lawyers.