Morally Bankrupt: Bankruptcy Law, Corporate Responsibility, and Sexual Misconduct.

• Author: Gross, Adi Marcovich

Table of Contents Introduction I. Escaping Liability for Sexual Misconduct: Bankruptcy as a Loophole A. The Fundamentals of Chapter 11 Bankruptcy i. General Overview ii. Mass Torts in Bankruptcy B. How Corporations Use Bankruptcy to Avoid Liability for Sexual Misconduct i. Restricting Victims' Access to Court ii. Capping Compensation iii. Protecting Third Parties II. How Discharging Sexual Misconduct-Based Claims Distorts Investments A. Capital Providers B. Managers III. Policy Proposals A. Priority v. Exception to Discharge B. Limiting Non-Consensual Third-Party Releases C. Monitoring Effects and Credit Costs Conclusion Introduction

In 2018, the Weinstein Company, once a leading independent movie studio, filed for bankruptcy. (1) The company had been struggling after more than eighty women accused Harvey Weinstein, its chief executive, of sexual misconduct-including rape and sexual assault. (2) Although the company was sold after just several months in bankruptcy and although the purchase price was almost $290 million, (3) Weinstein's victims remained empty-handed for almost three years and ultimately had to settle for a share in a court- sanctioned compensation fund that capped the company's liability at a paltry $17 million. (4)

Harvey Weinstein became a symbol of everything the MeToo Movement sought to combat, and his exposure no doubt encouraged other victims to come forward. Before then, sexual misconduct claims were often not raised, even in relatively egregious cases, which contributed to a significant lack of policing within companies. While this was partially due to a cultural taboo that discouraged victims from speaking up, it was also because sexual misconduct victims generally had limited avenues of legal recourse against the company under existing law. (5) Employees could sue for employment discrimination under Title VII of the Civil Rights Act of 1964 (Title VII). (6) Non-employee victims, however, were relegated to general tort law doctrines, such as vicarious liability and negligent supervision, if they wanted to impose liability on a company. (7)

In the wake of the Weinstein debacle and other MeToo scandals, a number of states began to broaden the legal frameworks available to victims and loosen the applicable statutes of limitation. (8) This expansion may help explain the growth in sexual misconduct claims and the attendant desire by corporations to use bankruptcy to limit liability. Under current law, corporate debtors can block and potentially dispose of such claims in bankruptcy. Unlike individual debtors, who are not permitted to discharge liability for sexual misconduct due to the "willful and malicious" exception to discharge, (9) corporations can take full advantage of the bankruptcy process to dispose of sexual misconduct claims. (10)

This Article examines the use of corporate bankruptcy proceedings to limit liability for sexual misconduct, a practice that has become increasingly prevalent. From a company's perspective, bankruptcy has at least three advantages. First, the automatic stay halts litigation and protects the corporation from most civil lawsuits, which must then be settled through the restructuring plan. (11) Victims who do not participate in the process are barred from taking legal action against the debtor while the bankruptcy proceedings are ongoing. Once a specified majority of creditors approves the plan, the corporation is free of its past debts. (12)

Second, a debtor's plan of reorganization can reduce and cap a company's liability for tort and other claims, since such claimants are usually treated as unsecured creditors. As such, they stand last in line when it comes to payment-far behind secured creditors (mainly banks) (13) and other statutorily preferred groups (e.g., unpaid employees, bankruptcy professionals, and the government). (14) By taking advantage of this priority or "waterfall" structure, a corporate debtor can effectively force tort victims to discount their claims in a bankruptcy proceeding.

Last, a bankruptcy plan can sometimes release third parties, including managers, parent entities, and insurers from liability. (15) In recent cases, courts have granted these third parties a general release, even though such parties had not sought bankruptcy protection themselves (and even though the individuals would not have been entitled to releases due to the "willful and malicious" exception had they filed for personal bankruptcy). (16)

This Article suggests that, because bankruptcy law allows managers and certain capital providers to externalize the costs of workplace sexual misconduct, the system helps to perpetuate such misconduct. In other words, because managers and corporate boards are insulated from damage, they are less likely to invest resources to combat sexual misconduct. In addition, this Article suggests that the managers' ability to insulate themselves from liability, even when they are themselves the perpetrators of the sexual misconduct at issue and even when shareholders stand to suffer loss, may create agency costs: managers might be too eager to file for bankruptcy, even when it is not in their shareholders' best interests. (17)

Moreover, because the bankruptcy waterfall structure shields secured lenders from sexual misconduct costs, the risk of misconduct is not priced in debt markets. Indeed, while the MeToo movement sparked equity investors' interest in sexual misconduct risks and prompted changes in equity investment practices, the movement has had only a minimal effect on lenders. (18) Thus, sexual misconduct risks are priced in equity markets but not in debt markets, distorting the capital markets and allowing corporations with sexual misconduct issues to access debt markets at a low price-one that does not reflect the true costs of their behavior. Thus, they have not had to change their conduct to reduce their financing costs.

To avoid this result, this Article proposes that sexual misconduct costs be shifted back to managers and lenders by re-ordering the statutory waterfall to prioritize sexual misconduct-based claims and limiting third-party releases. Using empirical evidence drawn from the environmental arena, (19) this Article posits that changes in bankruptcy priorities can change the way lenders perceive and address sexual misconduct risks. It suggests prioritizing sexual misconduct-based claims could encourage lender monitoring, promote efficient resource allocation that accurately prices social harms, and potentially reduce wrongful corporate and managerial behavior.

This Article makes several contributions to the literature. Traditionally, in discussing lender monitoring, scholars have focused on the borrower's financial results (20) and environmental risks. (21) This Article, however, reveals lenders' potential role in monitoring social risks, and provides another explanation why tort victims should come ahead of other lenders in the bankruptcy waterfall and joins many distinguished scholars who already support this position (albeit outside the sexual misconduct arena). (22) Indeed, uncovering lenders' potential role in monitoring sexual misconduct risks has broad implications for other environmental, social and governance (ESG) matters. To be clear, this Article does not seek to expand corporate purpose or lender responsibility to include social obligations. Instead, it reveals how the current design of bankruptcy law allows lenders and other stakeholders to ignore (or discount) social risks as business risks and, consequently, reduces their motivation to price and monitor for such risks.

This Article also extends the literature about the impact of bankruptcy on inequality. (23) Many scholars have already recognized that because bankruptcy discharge exceptions (such as the one for "willful and malicious injury") are strictly enforced against individuals from vulnerable communities, those debtors are deprived of a fresh start. Corporations, on the other hand, enjoy broader discharge rules, allowing them to use loopholes in the bankruptcy system opportunistically. This Article sheds light on this disparity in treatment and shows how high-level executives can manipulate the bankruptcy system to be released from such liabilities, even in the absence of an individual bankruptcy filing.

Finally, this Article's most significant contribution is that it illustrates how bankruptcy law inadvertently perpetuates sexual misconduct as it often denies victims' access to courts, limits their compensation, and distorts monitoring incentives by insulating managers and secured lenders from liability. This analysis contributes to the broader discussion of corporate abuse of the bankruptcy system (especially in mass tort cases) by exploring the long-term social effects it potentially creates. (24)

This Article proceeds as follows: Part I explains how sexual misconduct-based claims are treated in bankruptcy. This Part analyzes recent corporate bankruptcies triggered by sexual misconduct scandals and shows how corporations use bankruptcy to avoid liability for sexual misconduct. Part II explains why corporations historically placed less emphasis on policing sexual misconduct and how bankruptcy law contributes to this problem. This Part shows how the law distorts incentives for managers and capital providers to invest resources in fighting sexual misconduct. Part III provides policy suggestions and argues sexual misconduct-based claims should be preferred or nondischargeable in bankruptcy. Part III also advocates restricting third-party releases in sexual misconduct-driven bankruptcies. Finally, the last section analyzes the economic consequences of the proposed policy, focusing on its effects on monitoring and credit pricing.

1. Escaping Liability for Sexual Misconduct: Bankruptcy as a Loophole

   This Part explains how corporations take advantage of bankruptcy law to avoid liability for sexual misconduct. Section I.A.i. provides...