Excerpts from: Richard Squire, Strategic Liability in the Corporate Group

Richard Squire - Fordham University School of Law

When a business firm gets big enough, it reliably does two things. First, it reconfigures itself into a corporate group by dividing itself into a multitude of commonly owned subsidiaries.1 Second, it causes the various entities in this group to guarantee each other’s major outside debts.2 Previous scholarly theories of the corporate group can explain the subsidiaries or the guarantees, but not both. Most prominently, Richard Posner has argued that firms form subsidiaries in order to compartmentalize credit risk, thus reducing information costs for creditors by enabling them to lend against only those divisions of the firm they understand best.3

Posner’s theory implies that the corporate group is like a sturdy ocean freighter, neatly divided into watertight compartments that prevent a failure in one division from flooding the cargo stowed elsewhere. In reality, however, the insides of most corporate groups are not nearly so orderly. Instead of following clean functional lines, their bulkheads are often jumbled and in a state of disrepair. And, rather than being watertight, the partitions leak—indeed, they are rigged to leak—in rough financial seas.

The seeming saboteurs are the group’s managers, who compromise the cargo holds by causing the entities in the group to guarantee each other’s major outside debts. Each such guarantee gives the lender who receives it the right, if its own borrower entity defaults, to assert a claim against the guarantor entity and, if the guarantor is bankrupt, to recover a portion of the guarantor’s assets at the expense of the guarantor’s own creditors. The consequence is that the legal boundary between the borrower and the guarantor no longer compartmentalizes risk. The creditors of the guarantor are exposed not only to the risk that the guarantor will fail but also to the risk that the borrower will. And in the typical corporate group, the original borrower issues a reciprocal guarantee to the guarantor’s own major lender, thereby compromising the liability barrier in the reverse direction as well.

This Article offers a theory of the corporate group that can explain both of its salient features: the swarm of subsidiaries that partitions the group’s assets and the web of guarantees that pierces the asset partitions on behalf of select lenders. The theory argues that the perforated internal structure of the corporate group reflects a type of shareholder opportunism termed correlation-seeking. When a corporation engages in correlation-seeking, it intentionally incurs contingent liabilities that are especially likely to come due when the corporation is insolvent.4 Corporate groups are able to engage in correlation-seeking because the entities that constitute such groups tend to thrive or fail in unison. This commonality of fate means that intragroup guarantees, at the time they are issued, transfer value from the group’s nonguaranteed creditors to its shareholders. As long as the group stays solvent, the guarantees benefit the shareholders by lowering the interest rates on the guaranteed loans. And if the group falls insolvent and defaults on its loans, the triggering of the guarantees makes no difference to the shareholders, whose equity stakes in the guarantor entities are wiped out anyway. Instead, the guarantees dilute the bankruptcy recoveries of the group’s nonguaranteed creditors.

I.  Social Costs of Correlation-Seeking

A value transfer away from a corporate group’s creditors confers a benefit on the group’s shareholders that has nothing to do with wealth creation. The transfer acts like a subsidy, stimulating demand for the guarantee and its related elements beyond efficient levels. Overuse of the guarantee contract itself is socially costly because intragroup guarantees undercut the informational benefits to creditors, first described by Richard Posner, that arise from asset partitioning.5 Each guarantee increases the number of group members that the guarantor’s creditors must appraise and monitor to get an accurate sense of the risk they bear. Creditors who anticipate this increase in their information costs will charge higher interest rates. But the group’s managers will issue guarantees anyway as long as the increase in borrowing costs attributable to the forgone efficiencies is smaller than the decrease in interest costs on the guaranteed loans attributable to the value transfers.

Overuse of the second element of the intragroup guarantee—the underlying loan—occurs because the expected wealth transfer artificially reduces the firm’s borrowing costs. Intragroup guarantees with high internal correlations reduce interest rates on the guaranteed loans primarily by pledging creditor wealth rather than shareholder wealth. Because borrowing seems cheaper, firms will engage in more of it, producing higher debt–equity ratios and hence greater risk of financial distress.6

Finally, correlation-seeking via the intragroup guarantee encourages overuse of the corporate form because it requires a corporation (or other limited liability entity) to introduce a liability partition between assets whose changes in value are correlated. The resultant entity overgrowth undermines appraisal and monitoring efficiencies by breaking down the relationship between the subsidiary structure and the real, functional distinctions among the firm’s assets.

II.  Using Fraudulent Transfer Law to Streamline Corporate Groups

The social costs of correlation-seeking become evident when a corporate group fails and a bankruptcy court is tasked with sorting out its internal affairs. Formally, the court is supposed to calculate each creditor’s recovery based on the financial status of the creditor’s particular debtor entity. But the combination of entity overgrowth and apathetic internal recordkeeping often makes this task infeasible. Bankruptcy judges therefore resort to the doctrine of substantive consolidation, a kind of Gordian knot solution that cuts through the partitions between subsidiaries and pays out all creditors based on the value of the group’s combined assets. Commentators and appellate courts worry that this doctrine gives bankruptcy judges too much power to abrogate contracts and override the corporate form, and they admonish them to use it sparingly.7 Yet the judges often have little practical choice in the matter, as the administrative costs of untangling the typical group instead of collapsing it would consume much of its remaining value.

Unlike substantive consolidation, fraudulent transfer law provides an equitable remedy that could eliminate the value transfers generated by intragroup guarantees without collapsing a group’s subsidiary structure. Fraudulent transfer statutes enable a court to set aside a claim against a debtor—including a claim on a guarantee—if the claim results from a contract that when created was likely to harm creditors. If bankruptcy courts used this remedy to police overuse of intragroup guarantees, then creditors could cut back on their own monitoring efforts, and the cost of credit would fall. In addition, firms would be forced to streamline their subsidiary structures, as they could no longer use intragroup guarantees to insulate their most sophisticated lenders from the consequences of artificial asset boundaries and slipshod accounting. Firms would be more likely to form their subsidiaries along functional lines and would arrive in bankruptcy with internal boundaries that were fewer in number and easier for courts to honor.

Unfortunately, the special fraudulent transfer doctrines that courts have developed for intragroup guarantees bear no relationship to the actual economics of the arrangement. Those doctrines assume that the fee a lender pays in exchange for a guarantee—conventionally known as the “premium”—will be large enough to offset the guarantee’s expected burden on the guarantor’s general creditors. As a result, the doctrines focus on whether the premium, which normally is paid to the borrower in the form of an interest-rate discount on the guaranteed loan,8 was passed on to the guarantor.9 If it was, perhaps because the guarantor and borrower were financially or operationally interlinked, then courts deem the guarantee to be enforceable in full.

The problem with this approach is that the premium paid for an intragroup guarantee will be large enough to neutralize the expected burden on the guarantor’s creditors only in one special case: when the insolvency risks of the guarantor and borrower are uncorrelated. If instead their fortunes are positively correlated, then the guarantee will reduce the expected recoveries of the guarantor’s creditors even if the full premium is paid directly to the guarantor. Moreover, the fates of a borrower and a guarantor will be correlated whenever the two entities are financially or operationally interconnected. In this way, current doctrine causes courts to uphold precisely those intragroup guarantees that are most likely to transfer value from creditors to shareholders.

Courts could both simplify fraudulent transfer law and do a much better job preventing overuse of intragroup guarantees if they decided challenges to such arrangements based on the following question: Was a strong positive correlation between the fortunes of the borrower and the guarantor evident when the guarantee was issued? If the answer is yes, the court can be sure that the cost to the borrower of the guaranteed loan was artificially low, as the loan was subsidized by a value transfer from creditors to shareholders. A strong positive correlation would be easy to establish, as it will exist whenever a guarantor and borrower are financially tied or produce complementary outputs. And a correlation-based doctrine for intragroup guarantees could be developed that is fully consistent with fraudulent transfer statutes as they are now written.

Acknowledgments:

Copyright © 2012 University of Chicago Law Review.

Richard Squire is an Associate Professor at Fordham University School of Law.

  1. In 2010, the one hundred US public companies with the highest annual revenues reported an average of 245 major subsidiaries, with 114 as the median. Only five reported fewer than five major subsidiaries. These figures are based on the companies’ most recent annual reports as of August 17, 2010, and for many firms do not include nonsignificant subsidiaries that need not be disclosed under SEC rules. See SEC, Regulation S-K, 17 CFR § 229.601(b)(21). The set of public companies with the highest revenues was drawn from data published by Fortune and excludes General Motors, Fannie Mae, and Freddie Mac, which on the data collection date were in bankruptcy or conservatorship. See Fortune 500, Fortune (May 3, 2010), online at http://money.cnn.com/magazines/fortune /fortune500/2010/full_list/ (visited Apr 26, 2011).
  2. In their latest annual reports as of August 17, 2010, sixty-three of the one hundred US public companies with the highest annual revenues reported current use of intragroup guarantees. However, companies that report on a consolidated basis generally are not required to disclose intragroup guarantees under standard accounting rules. See Financial Accounting Standards Board (FASB), FASB Interpretation No 45: Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others *27 (2002), online at http://www.fasb.org/cs /BlobServer?blobcol=urldata&blobtable=MungoBlobs&blobkey=id&blob where=1175820925751&blobheader=application/pdf (visited Feb 4, 2011). A limited exception applies under SEC rules to intragroup guarantees issued on the performance of registered securities. See SEC, Regulation S-K, 17 CFR § 210.3-10(b). For these reasons, the proportion of large firms that use intragroup guarantees is likely to be significantly higher than the 63 percent figure implied here.
  3. Richard A. Posner, The Rights of Creditors of Affiliated Corporations, 43 U Chi L Rev 499, 507–09, 516–17 (1976). For other articles that develop Posner’s theory, see Henry Hansmann, Reinier Kraakman, and Richard Squire, Law and the Rise of the Firm, 119 Harv L Rev 1333, 1344–45 (2006); Henry Hansmann and Reinier Kraakman, The Essential Role of Organizational Law, 110 Yale L J 387, 399–401 (2000).
  4. See Richard Squire, Shareholder Opportunism in a World of Risky Debt, 123 Harv L Rev 1151, 1156–58 (2010).
  5. Posner, 43 U Chi L Rev at 516–17 (cited in note 3).
  6. See Squire, 123 Harv L Rev at 1181 (cited in note 4).
  7. See, for example, In re Owens Corning, 419 F3d 195, 208–09 (3d Cir 2005) (“No court has held that substantive consolidation is not authorized, though there appears nearly unanimous consensus that it is a remedy to be used ‘sparingly.’ ”); In re Gandy, 299 F3d 489, 499 (5th Cir 2002) (noting that substantive consolidation is “an extreme and unusual remedy”); In re Bonham, 229 F3d 750, 767 (9th Cir 2000) (noting that “resort to consolidation should not be Pavlovian” and “should be used sparingly”); Eastgroup Properties v Southern Motel Association, Ltd, 935 F2d 245, 248 (11th Cir 1991) (observing that the doctrine should be used “sparingly”); In re Augie/Restivo Baking Co, 860 F2d 515, 518 (2d Cir 1988) (warning against “the dangers in forcing creditors of one debtor to share on a parity with creditors of a less solvent debtor”); J. Maxwell Tucker, Substantive Consolidation: The Cacophony Continues, 18 Am Bankr Inst L Rev 89, 89 (2010) (“Substantive consolidation obliterates the corporate form.”); Hansmann, Kraakman, and Squire, 119 Harv L Rev at 1402 (cited in note 3) (encouraging courts to apply substantive consolidation “with a healthy appreciation for the history and economic functions of entity shielding”); Timothy E. Graulich, Substantive Consolidation—A Post-modern Trend, 14 Am Bankr Inst L Rev 527, 528–30 (2006) (arguing that substantive consolidation conflicts with corporate separateness, runs contrary to settled creditor rights, and has become “wholly unpredictable” in application).
  8. See, for example, Posner, 43 U Chi L Rev at 505 (cited in note 3).
  9. Consider, for example, the leading case, Rubin v Manufacturers Hanover Trust Co, 661 F2d 979, 991–92 (2d Cir 1981) (“If the consideration given to {a borrower} has ultimately landed in the {guarantor’s} hands . . . then the {guarantor’s} net worth has been preserved.”).

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