The essential structure of judgment proofing.

• Author: LoPucki, Lynn M.
• Position: Protecting corporate assets from legal judgments

In order to insulate itself against debts resulting from unfavorable judgments, a business entity may seek to operate unencumbered by significant assets. In this essay, Professor Lynn LoPucki revisits this issue of "judgment proofing" and responds to arguments that large businesses cannot operate in judgment-proof conditions. He identifies a single structure that describes virtually all judgment proofing: a division of risks of liability and assets into two or more separate entities sharing a symbiotic relationship. An "operating entity" conducts the business activities and carries the risks of tort liability, while an "owning entity" owns the business assets. While the two entities are bound together by contract, the bifurcation of assets and risks shields the business from judgment debt. Professor LoPucki argues that current law cannot collapse the two entities into one for purposes of satisfying judgments, and concludes that large businesses of any type can successfully render themselves judgment-proof.

In The Judgment Proof Problem,(1) Steve Shavell demonstrated that judgment-proof debtors have suboptimal incentives to exercise care or purchase liability insurance. Such debtors will tend to impose above-optimal levels of risk on third parties and to carry insufficient liability insurance. Carried to its logical extreme, the "judgment-proof problem" is that judgment-proof debtors can commit torts with impunity.

The immediate implications of Shavell's 1986 observations were in the fields of tort and insurance law. But concern about judgment-proof debtors quickly spread to the fields of corporate and commercial law as scholars in those fields recognized the broader implications of Shavell's analysis. The revered institutions of corporate limited liability and secured credit were, in Shavell's terms, judgment proofing. Whenever they mattered at all, they generated the judgment-proof problem.

In response to the skewed incentives of judgment-proof debtors, corporate and commercial law scholars proposed drastic changes in established doctrine. Those proposals included abolishing corporate limited liability,(2) granting tort creditors priority over secured creditors,(3) and carving out a portion of secured creditors' collateral for the benefit of unsecured creditors.(4) The most troubling critique of each such proposal was the same: debtor-strategists would be able to end run the reforms.(5)

In The Death of Liability,(6) an article published ten years after The Judgment Proof Problem, I argued that the proposed reforms were futile. Not only would adjustments to the liability system fail to restore mathematically precise levels of deterrence,(7) but judgment proofing would overwhelm and destroy that system.(8)

A persistent objection to The Death of Liability thesis has been that large businesses cannot practically operate in judgment-proof conditions.(9) For example, in his response to The Death of Liability, Professor James J. White argues that lenders and other contract creditors force large businesses to maintain substantial unencumbered equities on which tort creditors are able to free-ride.(10) A broader version of the objection notes that unencumbered cushions of equity serve a variety of functions within the large firm, some of which are not yet well understood. No one has yet demonstrated that significant numbers of large firms can operate without cushions of equity.

The discussion of this objection has been hampered by the wide variety of forms in which large businesses and judgment proofing exist. Demonstrating that firms of a particular variety can employ a particular device to operate in judgment-proof condition does not necessarily prove that firms of other varieties could do so. Attempts to discuss the objection typically dissipate into disputes over the practicality of employing a particular judgment-proofing device in a particular industry. The problem is complicated by an almost complete lack of probative empirical evidence.(11) As a result, the debate has been locked in the academic equivalent of door-to-door fighting.

As a means of overcoming that limitation, this essay argues that all, or substantially all, judgment proofing has a single essential structure: a symbiotic relationship between two or more entities, in which one of the entities generates disproportionately high risks of liability and another owns a disproportionately high level of assets. Through the contract that unites them, the two entities allocate between them the gains from judgment proofing.

Typically, the asset-owning entity guarantees payment of selected contract obligations of the liability-generating entity (the "operating entity") as necessary for the latter to continue in business. This guarantee does not encompass the tort obligations of the operating entity. The guarantee may be a simple contract, or may be a regulated form such as a standby letter of credit or payment insurance. In some cases, no guarantee may be issued. Thus, it is possible to describe all, or substantially all, judgment-proofing mechanisms, whether employed by large buscnesses, small businesses, or individuals, in a single model. This model makes it possible to identify the assumptions necessary to prove that any business or individual can operate in a judgment-proof condition.

This essay focuses on the application of this model in the context of the large firm because skepticism about the practicality of judgment proofing has focused on that context. In that context, proof of the model relies upon two propositions. The first, argued in Part I, is that any large business can be divided into two components--one with the bulk of the tort liability, the other with the bulk of the assets and the contract liability--and the division can be accomplished without significant change in the operation of the business. The second, argued in Part II, is that the law cannot collapse the two parts into one because it cannot find a principle for inclusion; that is, it cannot separate the two parts from each other or from the business environment. The essay concludes that large businesses of any type can operate in a judgment-proof condition.

1. SPLITTING BUSINESSES INTO ASSET-OWNING AND OPERATING ENTITIES

   Judgments are enforced only against assets owned by the judgment debtor.(12) To own no assets is to be judgment-proof. Some businesses do operate without owning assets of significant value.(13) For example, a business may lease all of the assets used in its operations or may have granted a security interest in those assets to secure a debt in excess of the value of the assets. In either case, the debtor is judgment-proof in the sense that the debtor has no assets from which the creditor can recover.

   Others have argued, however, that it is impractical to operate a large business in such a posture.(14) Efficiency requires that the business have unencumbered assets. Such a "cushion" of unencumbered assets is necessary to enable the business to meet its financial obligations during periods when the business is not profitable. A business without unencumbered assets would be swamped--and bankrupted--by the slightest adversity.

   Accepting for purposes of argument that such a cushion is necessary, it does not follow that it is impossible to operate a large business in a judgment-proof condition. Though the business and the assets are both necessary, they need not be contained in the same legal entity. The judgment proofer's solution to the problem described in the preceding paragraph is to separate the business into two or more legal entities that continue in a symbiotic relationship. One of these entities, the "owning entity," owns the unencumbered assets of the business. The other, the "operating entity," engages in the potentially liability-generating activity.

   Why does this separation defeat liability? In nearly every instance, liability is generated by employees, but damages can only be collected from assets. Figure I shows that liability is initially a link between the tort victim and the employee of the business. The doctrine of respondeat superior transmits the liability to the employing (operating) entity. Once liability has been fixed against that entity, it can be collected from the assets owned by that entity. The weakness in the liability system is the lack of any generally applicable requirement that operating entities own assets.(15)

   [Figure I ILLUSTRATION OMITTED]

   To complete the judgment-proof structure, the judgment proofer introduces a second entity to own the assets of the business. As shown in Figure II, the two entities ordinarily are linked by...