The death of liability.

Author:LoPucki, Lynn M.

Think of the liability, system as a poker game. Each person, corporation, or other entity in the economy is a player. Players risk their chips, that is, their wealth, by tossing them into the pot, that is, investing them in liability-generating economic activity. Chips contributed to the pot are at risk of loss; the system can take them to satisfy liability. Chips withheld are not at risk.

This poker game has an odd twist to it. Withholding chips does not reduce significantly the amounts players can win or players' likelihood of winning. Even players who don't put any chips in the pot - that is, players who are judgment proof - can keep playing the game and are eligible to win.

Why do players put chips in the pot? No rule requires them to do so. There are social, cultural, and economic pressures. But mostly, they do so for convenience. A wealthy player who wants that wealth available for use, but not in the pot to be lost through liability, must build arcane legal structures and document them through extensive record keeping.

In recent years, computer technology has dramatically reduced the cost of record generation and, consequently, the cost of keeping chips out of the pot. Major players are reducing their stakes. By doing so, they are breaking down the social norms and cultural barriers that prevent further reductions. The process is feeding on itself. Soon no one will have significant chips in the pot. When that happens the fundamental nature of the game will change. Liability will die.

Law is a system for controlling human behavior. In contemporary society, governments enforce law by essentially two mechanisms: incarceration and liability. These roughly correspond to the two spheres of the legal system: the criminal and the civil. In the criminal sphere, the wrongdoer is threatened with imprisonment; in the civil sphere, the wrongdoer is threatened with deprivation of wealth.(1) Liability is crucial because it is one of only two principal means by which governments enforce law.(2)

The liability system enforces liability through the entry and forcible collection of judgments for the payment of money. Although liability is most closely associated with products liability and other tort actions, money judgments are also the means for enforcing contracts, civil rights, labor and employment law, environmental regulations, federal tax law, intellectual property law, most kinds of property rights,(3) and just about every other kind of law on the books. Without liability, the American legal system would be radically different.

The liability system currently is mired in controversy over who should be liable, for what conduct, and for how much money. Yet this grand debate may be over the arrangement of the deck chairs on the Titanic. To hold a defendant liable is to enter a money judgment against the defendant. Unless that judgment can be enforced, liability is merely symbolic.

The system by which money judgments are enforced is beginning to fail. The immediate cause is the deployment of legal structures that render potential defendants judgment proof.(4) The liability system has long accepted that those who do not have the financial ability to pay judgments do not pay them. The system employs a complex web of social, economic, and legal constructs to determine who can or cannot pay. Those constructs can be, and are, manipulated by potential defendants to create judgment-proof structures. Many of the constructs are so deep-rooted in culture that they are virtually impossible to change. Included among them are secured credit, shareholder limited liability, national sovereignty, and the ownership of property.

These constructs have existed in their current form for a considerable period. Their strategic manipulation has long been regarded as a problem for the liability system. Probably most individuals and businesses are either judgment proof,(5) or capable of rendering themselves so between commencement of a civil action against them and the entry of judgment. The system has nevertheless been able to function passably well. In most industries, liability insurance has been readily available at modest cost, leaving system participants with only modest incentives to adopt judgment-proof structures. Transaction costs, public relations considerations, and social norms have kept the largest businesses from judgment proofing themselves. Although those businesses could avoid liability if they so chose, they find it more cost effective to pay.(6)

In recent years, the introduction of computer technology has dramatically altered the equation by reducing the costs of recordkeeping. Judgment-proofing strategies have become cheaper and easier to execute.(7) Some large businesses now employ them and market forces are driving their competitors to do the same. The social norms that prohibit their use among reputable businesses have begun to erode. As this Article will show, the process may well be irreversible.

The method by which I explore this approaching change is a combination of systems analysis and strategic analysis. Systems analysis is an established discipline that has been applied to law only recently.(8) The analyst begins by identifying a law-related system(9) for analysis - here, the system for awarding and enforcing money judgments. The analyst treats the system as goal-seeking, and infers its goals from observations of its operation.(10) For example, the goals I attribute to the system for enforcement of money judgments are to determine what wealth judgment creditors should be able to reach and then to assist them in reaching it. This anthropomorphization of systems may be disconcerting to some readers, but its necessity is a fundamental postulate of systems analysis. Given the manner in which law-related systems evolve, the intentions are more accurately attributable to the system than to particular participants in system design, such as legislators.

Strategic analysis is a developing technique for facilitating the application of systems analysis to law-related systems. The essence of the technique is to view classes of participants in a law-related system - for example, secured creditors, debtors, and judgment holders - as goal-seeking. To the extent possible, the analyst attributes goals based on empirical observation of participants' actions.(11) The analyst identifies incentives generated by the law-related system for participants, the strategies by which the participants do or might achieve their objectives, and finally, the constraints on the use of those strategies.(12) The principal incentive considered in this Article is the avoidance of liability. The principal strategies are those by which potentially liable entities can render themselves judgment proof.

Strategies are changes in conduct by a system participant made with the intention to improve the participant's treatment by the system. System designers, such as legislators, judges, and influential commentators, intend to foster some strategic action by system participants. For example, they design the system to reward diligent recordkeeping in order to promote diligent recordkeeping. But participants in a system often devise strategies not contemplated, or at least not intended, by the system designers. Strategies of the former type will be referred to as "system-intended"; those of the latter as "system-unintended."(13) When the analyst discovers system-unintended strategies, the analyst considers what strategies the system can employ to prevent their continued use.

From such an analysis, this Article concludes that currently effective judgment-proofing strategies are fully capable of defeating the liability system. The remaining barriers that constrain use of these strategies - principally expense and cultural resistance - are in decline. The system has available to it a number of radical strategic responses by which some commentators think liability might be saved. They include abolishing shareholder limited liability, granting involuntary creditors priority over secured creditors such as mortgage holders, and extending liability to all who trade with those who have liability. Even if these responses are implemented, they are unlikely to rescue the liability system. Strategies are available by which participants could continue to render themselves judgment proof. The ultimate causes of this system failure are that: (1) the system is unwilling to bar those without wealth from engaging in liability-producing activity; and (2) the system lacks an effective conceptual framework for attributing wealth to those engaged in liability-producing activity. Mandating a modest level of financial responsibility for everyone engaged in liability-generating activity(14) might preserve the liability system, but only as a ghost of its former self.

Finally, it should be noted that only tort and statutorily imposed liability are at risk of death. Contract liability can be preserved through private contracting. The paradigmatic transaction is one in which a closely held corporation seeks a bank loan. Banks routinely condition such loans on personal guarantees from the owners. The result is a system in which shareholders of closely held companies have limited liability to their tort creditors, but unlimited liability to their bank lenders.(15) To return to the poker metaphor, tort liability is confined to the chips in the pot, while contract liability reaches into the players' pockets and may even tap their friends and family.

The argument proceeds in four parts. Part I describes nine basic principles on which the liability system is constructed, and which serve as the foundation for judgment-proof structures. Part I also explores the difficulty of altering each principle, should such alteration be considered a desirable means of undermining judgment-proofing strategies. Part II describes the four basic types of structures that permit a business or person to...

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