Judgment proofing: a rejoinder.

• Author: Schwarcz, Steven L.
• Position: Response to articles by Lynn M. LoPucki and Charles W. Mooney, Jr. in this issue, p. 55, 73

Professors LoPucki and Mooney have responded to my article, The Inherent Irrationality of Judgment Proofing,(1) and I have been granted the opportunity to write a short rejoinder. Given page limitations and the fact that Professor Mooney and I are in agreement on the fundamentals, I discuss only Professor LoPucki's response.(2) Both that response and my rejoinder follow my analytical approach of dividing judgment proof structures into two categories: arm's length and non-arm's length.

My central points are straightforward. I don't claim that judgment proofing never will occur, merely that it is unlikely to cause, in LoPucki's words, the "death of liability." Arm's length judgment proofing transactions are unlikely because they necessarily require the assistance of an independent company. However, the costs to the independent company are apt to exceed any benefits to the judgment proofed company. As a matter of social psychology, the independent company also will be risk averse in assessing those costs.(3) Non-arm's length judgment proofing transactions, on the other hand, are not always subject to the same real or perceived costs, and therefore are more likely to occur. But non-arm's length judgment proofing is not new--the legal system historically has imposed a range of restrictions that tend to discourage it. Empirical data suggest that these restrictions are sufficient; to the extent they become insufficient, the law is likely to evolve additional restrictions as necessary.

The remainder of this rejoinder responds to LoPucki's more detailed comments.

1. ARM'S LENGTH JUDGMENT PROOFING

   Professor LoPucki argues that asset securitization is a "dangerous" new judgment proofing technique,(4) comparing it to "the invention of a new tool that makes burglary easier."(5) That argument fails for three reasons. As I pointed out(6) and LoPucki himself admits,(7) securitization itself does not cause judgment proofing. Rather, judgment proofing would require an independent and unrelated disposition of assets to shareholders,(8) which could occur without securitization.(9) Secondly, even if one were to argue that securitization generates cash proceeds which could be paid to shareholders more easily, I have shown that no one will invest in a securitization where the company obligated for repayment makes itself judgment proof by disposing of the invested proceeds.(10) Indeed, the more nefarious that company is, the less likely that investors will trust it to perform its repayment obligation. Finally, LoPucki's comparison fails ab initio because a tool that makes burglary more efficient may have no legitimate uses, whereas securitization has a wide range of beneficial uses. The possible misuse of a beneficial tool should not undermine its legitimacy. Even a computer, for example, might be used as a burglary tool.(11) It makes burglary easier by enabling the burglar to track his successful break-ins and sales to third-party fences. Indeed, LoPucki himself argues that computers are the ultimate engines behind much judgment proofing. Computers, however, have other uses than burglary (or judgment proofing), and burglaries (and judgment proofing) can occur without computers. The possibility that a good tool can be used to make it easier to perform a bad action does not prove that the tool is bad. The key question is whether the dangers of misuse of the tool--whether computers or securitization--outweigh the beneficial uses.

   LoPucki also claims, without citing any authority, that the "common consequence" of securitization is "reduction in the operating entity's (F1's) ratio of assets to liability risk."(12) That claim, however, is not only wrong but may be irrelevant. It is wrong because that ratio could not decrease without the disposition of assets to shareholders, a disposition that, if it occurs, would be independent of the securitization transaction.(13) In fact, the common consequence of a securitization is to leave that ratio unchanged.(14) LoPucki's claim also would be irrelevant if, notwithstanding a reduced ratio of assets to liabilities, sufficient assets remain to enable F1 to pay its liabilities.(15)

   LoPucki then focuses away from securitization onto more fundamental issues, questioning first my observation that the company wishing to judgment-proof itself (F1) receives equivalent value in return.(16) In that context, he disagrees that a transfer of assets to pay creditors would be the antithesis of judgment proofing. His rationale is that payment of voluntary creditors, such as bank lenders, could prejudice involuntary creditors, such as tort creditors, if the debtor is ultimately insolvent.(17) That may be so, but it is irrelevant. Preferential payment by an insolvent company always could prejudice remaining creditors, which is precisely why bankruptcy law avoids such preferential payments.(18) Finally, he alleges that my core statement--that a transfer of assets to unrelated third parties should not cause judgment proofing because no rational company will give away its assets without demanding equivalent value in return--is "true on its face, but misleading in context."(19) His rationale appears unresponsive to my statement, however, since he refers only to third party creditors and shareholders whereas I refer to third parties "other than creditors and owners [shareholders]."(20)

   Next, LoPucki claims that I don't quantitatively prove that the costs of judgment proofing necessarily outweigh its benefits.(21) All observers, however, know that the costs and benefits of judgment proofing cannot be precisely quantified, at least with our current data and understanding.(22) Indeed, the uncertainty that results from the inability to quantify these amounts makes it inherently risky for F2 to assist in F1's judgment proofing. Moreover, in an arm's length context, F2 will be risk averse and therefore prone to exaggerate these risks.(23) F2 is therefore unlikely to expose itself to liability by assisting in F1's judgment proofing.

   The inability to quantify these amounts also raises the issue of burden of proof. If it seems (based on LoPucki's arguments, intuition, and modeling) that the new financial tools he complains of lead to a major danger of judgment proofing, then the burden is on those promoting those tools to demonstrate that danger is clearly outweighed by benefits. On the other hand, if it seems (based on arguments, modeling, and intuition that I have tried to articulate) that the dangers of those tools are exaggerated and their benefits are large, then the burden...