The ability to legally separate risks and liabilities within a corporation is a cornerstone of Corporate America. Subsidiaries, limited-liability corporations (LLCs), franchisor/franchisee arrangements, joint ventures, securitizations, trusts, and other special-purpose entities (SPEs, or variable-interest entities, as regulators now call them) all enable a company to insulate valuable assets and revenue streams from debts or potential liabilities incurred by other parts of the business. As long as a subsidiary is a financially solvent, stand-alone entity that meets certain requirements, the law should not hold its parent responsible for its acts (or vice versa), any more than a supplier is responsible for the acts of a customer.
But these legal walls may not be as impermeable as once thought, thanks to increasing controversy over so-called judgment-proofing techniques. In the wake of Enron’s meltdown, the public and some judges are looking critically at any corporate structure that seems to have been created for the express purpose of shifting, avoiding, or hiding liability or shielding assets from judgments.
“There’s always been some concern about the kind of shell game that goes on when a company puts assets in one subsidiary and liabilities in another,” says Larry Ribstein, a professor at the University of Illinois College of Law. “But Enron, which was hiding liabilities in SPEs from the public and from its own investors, really brought that shell game home. I don’t know whether juries will be more sensitive to the shell game in the wake of Enron, but it’s something that lawyers and executives should be aware of.”
A major battle over judgment-proofing erupted in 2001 when Pacific Gas and Electric Co. filed for Chapter 11. But just a few months before the filing, the huge California utility’s parent, PG&E Corp., had “ring-fenced” an asset-rich subsidiary, a move that critics claim was done solely to shield the assets from creditors. Meanwhile, various dioceses of the Roman Catholic Church, beset by sexual-abuse lawsuits, are seeking to shield real-estate assets from judgments by putting them into trusts and other SPEs. It remains to be seen how these efforts will stand up in court.
You Say IBC, I Say Blimpie
One legal wall between parent and subsidiary cracked in a contracts-dispute case that was heard in the New Jersey Superior Court in December 2000 and upheld on appeal last July. Blimpie International Inc., a restaurant franchisor, had set up a subsidiary, IBC Services Inc., for the sole purpose of leasing from property owners and then subleasing to Blimpie franchisees. The subsidiary observed required corporate proprieties: it had its own board of directors, filed annual reports, and kept a separate bank account. IBC Services never expressly claimed to be Blimpie.
When IBC failed to pay rent on space in an Edison, New Jersey, shopping center, the landlord sued both IBC and Blimpie, claiming that the subsidiary was acting as a conduit for the parent. Generally, in contract cases, courts hold that the landlord is responsible for identifying the nature of and determining the creditworthiness of the entity with which it signs a contract. But in this case, the court ruled that IBC had misled the landlord into thinking it was Blimpie; for instance, the men who signed the contract wore Blimpie uniforms, and correspondence was done on stationery that had Blimpie’s logo. The court ruled Blimpie liable for the rent and interest.