The irrefutable logic of judgment proofing: a reply to Professor Schwarcz.

• Author: LoPucki, Lynn M.
• Position: Response to article by Steven L. Schwarcz in this issue, p. 1

In The Inherent Irrationality of Judgment Proofing,(1) Professor Steven L. Schwarcz raises interesting new arguments against my death of liability thesis. The sheer number of those arguments makes it impossible for me to respond to all of them. The core of Schwarcz's insight is to divide judgment proofing structures into those negotiated at arm's length and those constructed within a single corporate group. I consider his arguments regarding the first set of structures in Part I and the second set in Part II.(2)

1. ARM'S LENGTH TRANSACTION JUDGMENT PROOFING

   To demonstrate the judgment proofing potential of asset securitization, in The Death of Liability I used the example of a hypothetical Exxon Corporation that sold all of its assets through a series of such transactions.(3) The sales were to "bankruptcy-remote" trusts; or corporations that the arm's length purchasers established specifically for the purpose of the asset-securitization transactions. As part of those transactions, Exxon leased the assets back from the buyers and agreed to use them in substantially the same manner as before. From the proceeds of sale, Exxon first paid its creditors and then distributed the remainder to its shareholders as dividends. At the conclusion of these transactions, Exxon operated substantially the same business as before, but had neither assets nor liabilities. Exxon was judgment proof.

   Schwarcz makes three principal arguments in response to this example. First, he argues that the asset securitization did not judgment proof Exxon, the payment of the dividend did. Second, he argues that creditors cannot be hurt by arm's length transactions such as these because the debtor receives equivalent value in return for the assets sold. Third, Schwarcz argues that asset-owning entities ("F2" in his examples) will find that the costs of participation in arm's length judgment proofing exceed the benefits. I respond to each of these arguments separately.

   1. Is Asset Securitization a Judgment Proofing Technique?

      Schwarcz is correct that Exxon could have securitized its assets without judgment proofing itself by paying the dividend,(4) that Exxon could have sold its assets without securitizing them and still judgment-proofed itself by paying the dividend,(5) and that Exxon could have judgment proofed itself even without selling or securitizing its assets, by distributing the assets to shareholders as a dividend.(6) Schwarcz is wrong, however, in concluding that these possibilities refute my contention that asset securitization is a dangerous new threat to liability. To see the fallacy, consider by analogy the invention of a new tool that makes burglary easier. Neither the fact that the new tool has uses other than burglary nor the fact that burglaries could be accomplished without it would prove that the new tool was not a dangerous new threat to the security of homes. Asset securitization is under attack because it appears to be the most efficient, effective judgment proofing tool currently available.

      Schwarcz's principal goal in this section of the article seems to be to distance asset securitization--the innovative business transaction he pioneered while in practice--from its common consequence--reduction in the operating entity's (F1's) ratio of assets to liability risk.(7) Schwarcz attempts to increase that distance by dropping the word "asset" from the phrase I used(8) and treating the issuance of securities by F2 (the "securitization") as the entire transaction in question.(9) By his now strained definition, Exxon, the party Schwarcz himself refers to elsewhere as the "originator" of the "securitization,"(10) is not even a party to it:

      Thus, F1 [Exxon], the very company that is in danger of becoming judgment-proofed by securitization, would not technically be a party to the securitization transaction. More substantively, securitization is merely a way of allowing F2 [the bankruptcy-remote vehicle] to finance the purchase of F1's [Exxon's] assets, with F1 receiving the sale proceeds. Judgment proofing only could result from F1's disposition of those sale proceeds for less than their value. That disposition, if it occurred, would be independent of the securitization transaction.(11) Even if correct, Schwarcz's argument for the "legitimacy"(12) of asset securitization in no way refutes my thesis. Liability will be just as dead whether it dies from asset securitization or from asset securitization followed by a typical disposition of the proceeds.(13)

   2. Does the Judgment Proofing Debtor Receive Equivalent Value in Return?

      Schwarcz argues that if a company wishes to judgment proof itself, it would have to transfer its assets.(14) He then goes on to say that

      It is possible to divide potential recipients of the transfer into three categories: the company's creditors, the company's owners (its shareholders), and third parties other than creditors and owners. A transfer of assets to creditors would be the antithesis of judgment proofing.... 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. Thus, in an arm's length context, none of these transfers causes judgment proofing.(15) Schwarcz's conclusion that these transfers do not cause judgment proofing is wrong as to the creditors and misleading as to the third parties.

      To understand how payments to creditors judgment proof a debtor, consider an example in which Exxon has assets with a value slightly in excess of $40 billion and liabilities to unsecured bank lenders of exactly $40 billion. Exxon sells its assets for their fair market value and pays $40 billion of the proceeds to the banks. Exxon now has assets of nominal value and no liabilities. By leasing its assets back, it is able to continue to operate its business in the same manner as before the transaction. Prior to this transaction, a tort creditor who won a judgment against Exxon in the amount of $10 billion could reasonably have expected to recover eighty percent of that amount.(16) After payment of the proceeds of the asset securitization to the banks, such a tort creditor would have been able to achieve only a nominal recovery. The investors who replaced the banks in Exxon's financial structure--the purchasers of securities in the asset securitization--would be the absolute owners of all of the assets used in Exxon's business. That is judgment proofing.(17)

      Schwarcz responds that although "it may be so" that "payment of voluntary creditors, such as bank lenders, could prejudice involuntary creditors, such as tort creditors," that "is irrelevant."(18) He explains that "[p]referential payment by an insolvent company always could prejudice remaining creditors, which is precisely why bankruptcy law avoids such preferential payments."(19) Schwarcz misses the point of my example. Exxon made the payments in my example while solvent, and long before the prebankruptcy preference period. They are not avoidable as preferences.(20) Nor, I am confident, could Professor Schwarcz propose a law that made them avoidable without casting doubt on most of the asset securitization transactions described in footnote 21.

      Schwarcz's assertion that an arm's length transfer of assets to an unrelated third party does not cause judgment proofing is tree on its face, but misleading in context. Firms that sell to third parties assets they continue to use generally have a plan for the use of those proceeds. For most firms whose asset securitization transactions have recently been reported in the press, that plan was to pay creditors or shareholders.(21) To the extent the proceeds were so applied, those transactions reduced the assets available to future creditors, thereby judgment proofing the originators.(22)

   3. Do the Costs of Judgment Proofing Outweigh the Benefits?

      To explain why he thinks it irrational for an owning entity (F2) to participate in a transaction that judgment proofs an operating entity (F1) Schwarcz defines and uses two variables. He designates "the amount of value that judgment proofing is expected to take from [judgment] creditors" as [Delta],(23) and "the amount of compensation that F2 [the asset-owning entity] would require" for participating in the transaction as [Kappa].(24) Schwarcz concedes that "judgment proofing may occur" if [Kappa] is less than [Delta].(25) Schwarcz notes that [Kappa] must exceed F2's judgment proofing costs or F2 would have no incentive to enter into the transaction. He then discusses four categories of such costs: financing premiums, increased liability risks, reputation costs, and agency costs.(26) Schwarcz argues that the costs in each category are large and concludes that in total they "may well exceed [Delta]."(27) He then notes that the operating entity (F1) will need to keep some portion of [Delta] to reward it for the judgment proofing effort, which further reduces the amount of costs the judgment proofing transaction can carry.(28) Schwarcz then adds reference to other costs that judgment proofing will impose on the operating entity, which include tax on the sale of assets, loss of liquidity, increased risk of bankruptcy, high agency costs as a result of possible liquidation, and possible civil and criminal liability for directors and shareholders as a result of judgment-proofing the company.(29) Finally, Schwarcz adds that the owning company (F2) will be risk averse in deciding whether to engage in the transaction because it would do so solely for gain rather than to avoid loss.(30) He concludes that "[a]s an economic matter, therefore, arm's length judgment proofing is a dubious strategy."(31)

      The first thing to note about this argument is the absence of any attempt to quantify [Delta] or any of the factors that supposedly combine to overwhelm it. Schwarcz is arguing that simply because there are a lot of factors and they seem, as he describes them...