The financial collapse of a corporation raises significant questions regarding its shareholders and creditors' ex ante allocation of the risk that such a collapse might occur. In bankruptcy, most of these risk allocation issues relate to the priority of particular creditors' claims against the assets of the failed business. But determining priority first requires some reasoned means of identifying the assets against which creditors may assert their claims. In many cases, this question is simply one of locating and distributing assets. However, when bankrupt firms have conducted their operations through a complex web of subsidiary corporations, each holding distinct assets and having separate liabilities, the question becomes much more complex.
As a general rule, bankruptcy law respects the separations between commonly owned corporations. Regardless of the ownership structure of corporate entities, assets and liabilities of related corporations are treated as distinct for the purpose of a reorganization or liquidation. In a growing number of cases, however, bankruptcy courts have invoked the doctrine of substantive consolidation to disregard the separations that commonly owned corporate entities would have enjoyed under non-bankruptcy law.
This Article examines the effect of substantive consolidation on voluntary creditors rather than tort and other involuntary claimants. Commentators have taken a renewed interest in the question of tort priority, and have established a convincing case for eliminating limited liability within corporate groups for the benefit of tort claimants. Limiting liability within corporate groups externalizes the risk to tort claimants because unlike voluntary creditors, tort claimants are unable to bargain for protection against, or compensation for, the increased risk limited liability imposes. Because voluntary creditors theoretically can bargain for protection against any increase in risk caused by limited liability, these creditors may have less of a need for the protection substantive consolidation provides.
Thus, the impact of substantive consolidation on voluntary and involuntary credit relationships may be analyzed separately. Notwithstanding notable exceptions, most bankruptcy cases do not involve large numbers of tort claims. Further, the consolidation rule adopted with respect to tort claimants need not affect the rule applied to voluntary claimants.
Thus limited, this Article looks to the economic principles underlying separate incorporation and limited liability in order to determine whether corporate groups should be consolidated in bankruptcy. Part I discusses the courts' application of substantive consolidation. This Part concludes that the courts' conceptions of creditor expectations render the doctrine extremely uncertain and unprincipled.
Part II examines the rationale for limited liability. This Part introduces a transaction cost analysis premised on the ability of parties to allocate the risks of corporate failure through contract. This analytical model focuses on the effect of the default rule governing risk allocation on the costs of the contracting process. Part II argues that corporate law rules governing risk allocation should comport with most investors' and lenders' preferences. This approach would reduce transaction costs by minimizing the parties' need to contract around the corporate law rules.
Part III examines the organization of the production of goods and services in firms and across markets. It also discusses the importance of limited liability to various organizational structures. This analysis concludes that limited liability is fundamental to the efficiencies generated by horizontally related and conglomerate firms, but is less necessary to vertically integrated firms. Thus, those who invest in and lend to entities that operate as a component of a larger, vertically related production process are less likely to be satisfied with the baseline rule of limited liability.
Parts IV and V consider the impact of limited liability on particular risks faced by creditors. Part IV offers a model of risk analysis that divides risk into two components-enterprise risk and misappropriation risk. Misappropriation risk is defined as the risk that shareholders will force management to take actions that increase the risk of firm failure. This type of risk is distinguished from enterprise risk-the irreducible variability in the earnings of the business. Limited liability increases misappropriation risk by increasing opportunities for asset shifting after the rate of interest on debt is fixed. Parts IV and V also examine the existing controls on misappropriation risk. These Parts conclude that the misappropriation risk created by limited liability in vertically integrated corporate groups is not adequately restricted by existing constraints.
Finally, Part VI provides a model for substantive consolidation that looks primarily to the level of vertical integration between the entities sought to be consolidated. The Article proposes that courts should typically consolidate entities that constitute components of vertically integrated operations. Firms comprising parts of other types of organizations should be consolidated only in rare circumstances.
Christopher W. Frost, Organizational Form, Misappropriation Risk, and the Substantive Consolidation of Corporate Groups, 44 Hastings L.J. 449 (1993).