Summary
Listed companies with operations in the United States face growing product liability, environmental and related litigation threats. Some of the world’s largest corporate groups have seen billions erased from their market capitalization overnight. Yet most listed companies still ignore the best defense available for managing their litigation exposure: ring-fenced subsidiaries. This failure has—and will—hit share prices hard if and when analysts start to price in major litigation risk from non-strategic operations.
A gap in expertise is the root cause. Proper ring-fencing requires more than separate legal entities and a colorful organizational chart. It requires the group parent to assess what would happen if the affected subsidiary actually filed for bankruptcy. Would the parent be responsible for some or all of its debts? Why? These questions demand specific expertise beyond the ken of the generalist litigators on which most healthy listed companies rely. So, when trouble comes, listed companies must accept parent-level responsibility for subsidiary debts, or scramble to create ad hoc defenses of limited efficacy too close in time to a bankruptcy event for which they could have been better prepared.
This memorandum is a collection of insights for clients who are trying to think ahead about litigation risk and corporate structure. It is an insolvency lawyer’s attempt to explain how robust and lasting separateness can be established in the United States today, and why it is worth attention in the board room now for every major corporate group that could face material litigation exposure in the United States.
Ring-Fencing Is a Virtue Not a Sin
Dispel at the start the impulse that a corporate parent should be responsible for all debts of its subsidiaries. There is no legal or moral obligation for a parent company to guarantee all known and unknown subsidiary debts. To the contrary, absent special circumstances, the owner of a U.S. company is liable to creditors only to the extent of capital invested. The powerful U.S. laws that protect owners from subsidiary creditors—if successfully invoked—apply even if the subsidiary is operated as part of an integrated corporate group, and irrespective of whether the subsidiary is taxed as a corporation, partnership or disregarded entity.
This is not a new idea. Limited liability dates back to the Dutch East India Company and predecessors. Centuries of public policy reinforce the norm that business is risky and it is prudent to use subsidiaries to allocate adequate but finite capital to specific business lines. The law reflects that norm. It will test whether a subsidiary’s initial capitalization is adequate, and it will restrict or claw back withdrawals that render a subsidiary insolvent. But the law does not require overcapitalization—either at formation or in distress—nor does it require an owner to place other business lines at risk when one business line is failing.
Limited liability is consistent with centralized management control, integrated corporate operations and efficient tax planning. So long as a subsidiary is solvent, the fiduciary duties of the managers of the subsidiary run solely for the benefit of the parent company and, therefore, the rest of the corporate group. This period of solvency-before-a-crisis is the time to ring-fence by creating appropriate commercial, financial and governance structures, typically without the need to involve outside non-legal professionals.
Importantly, limited liability applies to involuntary litigation creditors, as well as financial, trade and other voluntary creditors. In other words, the principle of limited liability is not established by bargaining with creditors in advance of the event. Instead, the principle of limited liability is established by creating a business entity for an appropriate purpose and capitalizing it adequately for the litigation and other risks expected at the time the business was established.
Bargaining from a Position of Strength
A decision to ring-fence a subsidiary is not a decision to abandon it. Parents merely gain the option to walk away, and the concomitant ability to negotiate better terms with litigation creditors if they choose to continue group support.
We have seen many times how proper ring-fencing helps corporate defendants negotiate successful settlements at all stages of product liability, mass tort or similar litigation. If the litigation involves primarily individual plaintiffs, ring-fencing can reduce settlement costs and limit the contagion effect where isolated lawsuits quickly increase in scale. In a class action context, lead plaintiff counsel will focus on the presence or absence of ring-fencing as a critical factual question that drives the amount and the structure of their settlement demands. And once the defendants and lead counsel strike a deal, ring-fencing can be a key to limit opt-outs and facilitate court approval of the settlement as reasonable.
We also use ring-fencing to negotiate better terms when the parent does decide to advance funds to a troubled subsidiary. It is curious that so many parent companies choose to lend to troubled subsidiaries on an unsecured basis, rather than advancing on a secured basis or structuring basic creditor rights. In a recent product liability matter for a multinational client, we were able to begin mediation by explaining to assembled plaintiff counsel that the last three years of operations and litigation defense had been financed with hundreds of millions of dollars of secured loans from the corporate parent, and that all of this recent secured debt ranked senior to litigation claims on the manufacturing business they were suing.
It is important to remember, however, that ring-fencing is a shield and not a sword. It only works if it is grounded in bona fide commercial relationships between a parent company and a subsidiary, and if the subsidiary was formed for a legitimate business purpose and initially capitalized appropriately for its activities. In this respect, ring-fencing should never be about “asset-stripping”; instead it is a means to avoid accidental over-capitalization and to confirm that arrangements are clear and appropriately documented so they hold up to creditor and court scrutiny.
The benefits of ring-fencing improvements increase with time. Some structural improvements in the parent-subsidiary relationship will be subject to unwind or challenge if the company is insolvent at the time the steps are taken, or if an insolvency occurs shortly thereafter. Some improvements harden only after the expiration of seasoning periods or statutes of limitations. Some improvements depend on establishing an ordinary course of business between the parent and the subsidiary, which can take time to establish. And, surprisingly often, the parent company is found to be subsidizing the subsidiary by charging less than fair price for corporate services, intellectual property, working capital and intercompany support—and the elimination of this subsidiary sooner rather than later yields a meaningful decrease in the value exposed to subsidiary creditors. Like planting a tree: the best time to ring-fence a subsidiary was in the past; the second-best time is now.
How to Ring-Fence Effectively
Most U.S. lawyers have a working understanding of the doctrine of “veil piercing,” under which creditors can disregard the corporate form of a subsidiary and pursue its owner. When a U.S. subsidiary is formed, counsel typically attends to basic formalities intended to ensure that a corporation is regarded as legally distinct from its owner. But these steps are rarely important in modern U.S. bankruptcies. There are dozens of more effective ways for creditors to hold a parent responsible than a veil-piercing lawsuit.
Effective ring-fencing is a practical exercise. It must create defenses to the predictable creditor tactics that will be employed in the event of a subsidiary bankruptcy. This, in turn, requires a review of, among other things: intercompany contracts, working capital arrangements, shared property (especially intellectual property), dividend and loan history, tax sharing obligations, regulatory relationships, public disclosure, cross-defaults, employee compensation and indemnification arrangements, group pension liabilities, the fiduciary duties of subsidiary officers and directors, and how intercompany payables are settled in the cash management system. Ring-fencing also requires a deep dive into the direct claims that creditors may bring against a parent corporation for its own acts and omissions, such as claims for aiding and abetting the subsidiary in deceptive advertising or procurement practices or claims based on the parent’s statutory liability as a control person under environmental or other laws.
In general, there are several areas of inquiry to focus on when conducting a ring-fencing review. We typically begin with a preliminary conversation and follow that up with an 8- to 10-page list of specific questions organized by topic. The usual topics are:
- Formal (or Legal) Separateness
- Group Financing and Cash Management
- Intellectual Property Rights
- Allocation of Other Assets and Liabilities
- Sources of Agency and Direct Exposure
- Points of Contact and Intercompany Claims
- Tax Matters
- Insurance Coverage
- Subsidiary Officers and Directors
Over the past few years, these exercises have invariably led to ring-fencing improvements, the implementation of which has in some cases been followed by serious financial distress.
End Games
Ring-fencing creates additional options for the parent in the case of future financial distress. In some cases, ring-fencing simply increases the leverage of the parent in litigation settlement discussions by clarifying that only invested equity capital is at risk. In other cases, ring-fencing is essential to permit a successful Chapter 11 filing to manage the subsidiary’s litigation liabilities without recourse to the group. And, in many cases, the “option” created by ring-fencing is not called upon because the litigation threat dissipates or can be absorbed by equity capital already invested in the subsidiary. In any case, given the litigation environment in the United States, we suspect few corporate groups will decide later that they paid the matter too much attention now.
About the Author
Andy Dietderich is Co-Head of S&C’s Global Finance & Restructuring Group. He focuses on helping U.S. and multinational companies address balance sheet challenges and navigate periods of financial distress. Andy regularly represents companies in out-of-court restructurings, Chapter 11 cases, strategic bankruptcy investments and difficult corporate governance disputes. Andy has spent his entire career at S&C, joining the firm in 1996 and becoming partner in 2004.