Transparency in Corporate Groups

This Article addresses a remarkable blind spot in American law: the failure to apply the well-established principles of secured credit to prevent inefficiency, confusion, and fraud in the manipulation of the webs of subsidiaries within corporate groups. In particular, “asset partitioning” has been a fashionable subject in which the central problem of non-transparency has been often mentioned, but little addressed. This Article offers a concept for a new system of corporate disclosure for the benefit of creditors and other stakeholders. It would require disclosure of corporate structures and allocations of assets among affiliates to the extent the affiliates are to be treated as independent legal entities. Enforcement would follow the secured creditor model: the failure to treat each corporation as an independent entity throughout its life would sacrifice corporate independence. The approach suggested is informed by Australia’s experience with one implementation of such a system.

The need for reform arises from the fact that the modern corporate group is a shape-shifter. It appears one moment as a single muscular mass, often operating under a brand famous everywhere, while in the next instant, some of its subsidiaries deal separately with lenders, suppliers, employees, customers, and government authorities in a fog of names and identities. The resulting harm usually arises in the context of financial distress, when the long-ignored or obscured corporate form reemerges from the lawyers’ briefcases.

The immense gift of limited liability is regularly trivialized operationally, with executives finding themselves captains of a legal armada of limited-liability vehicles, each of which may have billions of dollars in assets or nearly none. Executives can order transfer of a king’s ransom of assets among those vehicles at the flick of a properly coded email. The transfer can occur with little thought to the financial consequences or can be made as part of a carefully plotted manipulation of those consequences. In either case, it is often made with no notice to various interested parties, including most of the armada’s creditors. For that reason, corporate-form rules tend to favor dominant lenders and insiders who have full knowledge of a group’s corporate structure.

A number of factors obfuscate the “liability structures” of corporate groups. Four of the most important are asset partitioning, intra-group guarantees, trademarks, and consolidated financial statements. In combination, they obscure the financial position of a corporation within a corporate group. In this article I discuss the cases of Nortel Corporation and Caesars Palace as leading examples. They are instructive examples for several reasons, including the fact that both are international cases. Asset partitioning is often preferred to secured credit as a method of creditor priority in the financing of cross-border groups. I also discuss the weakness of existing ex post remedies for injured creditors. These remedies are slow and very expensive. Often, they are effectively unavailable.

In Nortel, management had not only created a confusing internal mess as to its assets, but also with respect to its liabilities. The consequence was huge litigation expense—over $2 billion—and a drawn-out legal process ultimately requiring a joint televised trial in Wilmington and Toronto. In Caesars, the court-appointed examiner’s summary of his 1,787 pages of findings was unusually concise:

The principal question being investigated was whether in structuring and implementing these transactions assets were removed from CEOC to the detriment of CEOC and its creditors. The simple answer to this question is “yes.”

The examiner concluded that the creditors might well be entitled to recover billions of dollars in diverted assets.

The experience in Australia suggests that disclosure is a feasible solution for this problem and that group liability would be appropriate relief. Larger corporations are offered a choice between filing financial statements for each subsidiary in a corporate group or filing cross-guarantees that make every affiliate in the group liable for every other affiliate’s debts. It appears that many companies have chosen the alternative of group liability. There have been various challenges and difficulties, but this procedure offers an important example of the feasibility of bringing order to the corporate group chaos. Adoption of a rule with similar effect might be a first step toward reform in the United States.

The development of my proposed project would take some time and likely would proceed step by step, starting with simple rules and building from that base as experience may dictate. On the down side for lawyers, this approach would threaten some of their carefully sculpted corporate structures. On the other hand, this approach would increase work for transactional lawyers and for accountants through systematic checkups to ensure continuing respect for the corporate entity, including disclosure. As an offset, it would materially reduce the need for litigators.

The complete article is available for download here.