The inherent irrationality of judgment proofing.

• Author: Schwarcz, Steven L.

Liability is "one of only two principal means by which governments enforce law."(1) Yet recent articles in the Yale Law Journal and the Stanford Law Review assert that liability is dying: "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" by bifurcating the ownership of assets from the liabilities associated with operating those assets in a business.(2) These bifurcated structures are made possible, the argument goes, by computer technology which reduces the costs of record keeping.(3) As a result, business "[j]udgment-proofing strategies have become cheaper and easier to execute"(4) and purportedly are becoming more pervasive: "Some large businesses now employ [such judgment-proofing strategies] 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 [and] the process may well be irreversible."(5)

This article attempts to refute these assertions. First, I demonstrate that none of the examples put forth in the scholarship stands for the proposition claimed--that innovative business transactions give rise to judgment proofing. Then I show that by focusing on the structuring of business transactions, the scholarship obscures the conceptual divide between arm's length business transactions intended for judgment proofing, and non-arm's length judgment proofing structures.(6) Yet the different motivations, perspectives, and costs inherent in each have crucial ramifications for the analysis.

In an arm's length judgment proofing transaction, each company will seek independent gain. Therefore the structuring of an arm's length business transaction, no matter how innovative, is unlikely to result in judgment proofing because no company will give up value without demanding equivalent value in return. It is, nonetheless, theoretically possible that unrelated companies could enter into arm's length judgment proofing transactions to take value from future involuntary creditors. I argue, however, that those transactions are unlikely to occur because, from the perspective of the company needed to assist the judgment proofing, potential costs may well exceed the company's benefits.

In a non-arm's length structure, on the other hand, the judgment proofing transaction takes place between related parties. Judgment proofing then is more likely than in an arm's length transaction because its benefits need only exceed its costs from the perspective of the controlling company. Non-arm's length judgment proofing structures, however, are not innovative and have long been regulated by law, which imposes costs that appear to outweigh any potential benefits.

The importance of distinguishing between arm's length and non-arm's length judgment proofing is not limited, however, to the different economic treatment of those transactions.(7) Social psychology accentuates the distinction. Professors Jolls, Sunstein, and Thaler recently noted that "[t]raditional law and economics is largely based on the standard assumptions of neoclassical economics. These assumptions are sometimes useful but often false. People display bounded rationality...."(8) By applying bounded rationality to the economics of judgment proofing,(9) I find that, in an arm's length transaction, the costs of judgment proofing are magnified because the parties will be risk averse. In a non-arm's length judgment proofing, however, those costs are minimized because the parties are more likely to take risks. Therefore theory alone cannot be used to predict the spread of non-arm's length judgment proofing transactions. Empirical data confirm, however, that non-arm's length judgment proofing is unlikely to increase in the future.

I conclude that existing constraints on judgment proofing are already adequate, and the law is likely to evolve additional restrictions as necessary. Accordingly, there is no need to impose regulatory responses. Indeed, to do so could indiscriminately restrict the value creation that comes with business and financial innovation.

To provide a context for my analysis, I begin by reviewing the current scholarly debate.

1. THE DEBATE

   The debate presently centers on the work of two prominent scholars, Lynn LoPucki, the A. Robert Noll Professor at Cornell Law School, and James J. White, the Robert A. Sullivan Professor at the University of Michigan Law School. The former argues that liability is dying, while the latter counters that assertion. My analysis parallels the work of these scholars in two ways: It focuses on business judgment proofing strategies(10) and measures the impact of these strategies by their effect on future involuntary creditors such as tort creditors and holders of statutorily imposed claims who cannot protect themselves(11) (as opposed to contract creditors who voluntarily extend credit and therefore can protect themselves by demanding financial information about the company and, if necessary, requiring guaranties or collateral(12)).

   1. LoPucki

      Professor LoPucki contends that two basic types of judgment-proofing strategies are relevant to business debtors: secured debt strategies, in which unsecured claims of involuntary creditors are subordinated to secured claims;(13) and third-party ownership strategies, in which ownership of valuable assets is transferred to third parties.(14) Secured debt strategies are "so deep-rooted in culture that they are virtually impossible to change."(15) Third-party ownership, however, represents a potentially damaging form of judgment proofing that could be susceptible to regulation.

      He argues that there are two approaches to third-party ownership. In the first, the parent-subsidiary strategy, "the debtor isolates the most valuable assets of the business in an entity other than the one that conducts the liability-producing business activity."(16) LoPucki describes a typical parent-subsidiary structure as follows:

      [T]he company [Operations, Inc.] incorporates a subsidiary (Finance, Inc.), and retains ownership of all the stock. As Operations sells its products, it creates accounts receivable. Operations sells the accounts to Finance, and distributes any proceeds beyond its immediate cash needs to its shareholders [leaving Operations with minimal assets]. Finance pays for the accounts by borrowing on an unsecured basis from a bank. If operations sells defective products and incurs liability, [the tort creditors' claims are subordinate to the bank's claim because the] bank claims the assets of Finance as an unsecured creditor while the [tort] creditors claim them as a shareholder."(17) This "parent-subsidiary ownership strategy," he alleges, "is in wide use among the largest companies in America [and l]imiting liability ... is the principal reason for" employing that strategy.(18)

      The other approach to third-party ownership, LoPucki contends, is asset securitization, "by far the most rapidly growing segment of the U.S. credit markets."(19) In a securitization, a company transfers fights in income-producing assets(20)--such as accounts receivable, loans, or lease rentals--to a special purpose vehicle, or "SPV." The SPV, in turn, issues securities to capital market investors and uses the proceeds of the issuance to pay for the assets.(21) The investors, who are repaid from collections of the assets, buy the securities based on their assessments of the value of the assets. Because the SPV (and no longer the company) owns the assets, their investment decisions often can be made without concern for the company's financial condition. Thus, viable companies that otherwise cannot obtain financing, because of a weakened financial condition, now can do so. Even companies that otherwise could obtain financing now will be able to receive lower-cost capital market financing.(22)

      Whereas the parent-subsidiary structure is time honored, asset securitization is a relatively new phenomenon that has become widespread with the help of computers.(23) LoPucki sees it as a fundamental shift in the way that companies deal with liability--a shift that has "enormous potential" for judgment proofing:

      By selling any asset to a bankruptcy-remote entity and leasing it back, the debtor can transform it into an "income-producing" asset that can then be securitized.... Through asset securitization, a company potentially could divest itself of all of its assets, yet continue to use all of those assets in the continued operation of its business. To grasp the enormous potential, assume that, through a series of asset securitizations, Exxon Corporation disposes of all of its assets. As the cash from these transactions becomes available, Exxon distributes the cash to its shareholders in the form of dividends, leaving the company with neither assets nor liabilities. (I will refer to this judgment-proof Exxon as "Zero-Asset Exxon.") Because Exxon contracts to continue use of each asset even as Exxon sells it, the operations of Zero-Asset Exxon remain exactly as they were when it was a multibillion dollar company. But as a result of the asset-securitization transactions and the distribution of the proceeds, Zero-Asset Exxon is now judgment proof.(24) Accordingly, LoPucki warns, "[a]sset securitization may be the silver bullet capable of killing liability."(25) LoPucki next argues that existing constraints on judgment proofing,(26) as well as radical reform responses, would be inadequate.(27) He therefore concludes that innovative third-party ownership structures, such as asset securitization and parent-subsidiary ownership, will kill business liability.(28)

      LoPucki more recently has observed 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...