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Separate but Liable

Companies have walled off valuable assets in subsidiaries for decades. Are those walls starting to crack?

1Mar

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.


Legal observers find this case important because it is a contracts case, not a tort (or noncontract, damage or injury) case. In tort cases — specifically product-liability (asbestos) and mass-disaster cases — corporate parents are sometimes found liable for the acts of separate subsidiaries, especially if a judge believes that the subsidiary's assets are insufficient to cover the plaintiff's legitimate claims.



Foreign Affairs

In a recent paper, Juan Zùñiga, special counsel with law firm Heller Ehrman White & McAuliffe LLP in San Diego, highlights another circumstance in which parent companies may find themselves unexpectedly vulnerable: when they are held liable for the acts of foreign subsidiaries.


Zùñiga cites a recent case in which 14 employees of a Mexican subsidiary of Salant Corp. were killed in a bus accident while being transported to a textile factory owned by Salant's Mexican subsidiary. The bus was old, had few safety features, and was operated by an inexperienced driver. Mexican law would have capped damages at $30,000 for each plaintiff, so the plaintiffs' lawyer went after the parent corporation in Texas state court — alleging that it made the decision to buy the substandard bus in the United States and transport it to Mexico, and that it hired the inexperienced driver. The judge in the case refused a motion for dismissal by Salant's attorneys.


"When the judge refused to throw the case out, it scared the pants off [Salant's] insurance company," says Zùñiga. "They didn't want to set a 'veil-piercing' precedent if they lost." As a result, Salant and its insurers settled the case out of court for $30 million, says Zùñiga. He adds that a U.S. company with a domestic subsidiary might have been found similarly liable, but because damages are often capped in foreign countries, plaintiffs have an extra incentive to go after deep-pocketed parents. In addition, federal law allows foreign plaintiffs to sue U.S. parent corporations for human-rights violations committed by their foreign subsidiaries, employees, or representatives.



Timing Is Everything

Although the law is unclear, in order for legal walls between parent and subsidiary to stand, several crucial rules should be followed, says Zùñiga. A subsidiary should be properly capitalized, should have its own bank accounts with no commingling of money, and should probably have its own executives and board of directors. Courts have allowed the piercing of the corporate veil if a subsidiary is shown to have acted as an "alter ego" of its parent, if the parent exerts more control over the subsidiary than would be expected of a normal investor, or if the actions of a parent directly caused the subsidiary to incur a liability.


However, even when a company respects all these limits, courts have started looking more carefully at other, less black-and-white factors when deciding if a subsidiary and a parent are actually one and the same. The law suggests that companies may not set up an entity for the sole purpose of fraudulently hiding assets from creditors or plaintiffs. The difference between "hiding" and "restructuring" is often a matter of timing and spin. Even if a company already had an entity in place when the liabilities were incurred, the case may be complicated, say experts. It's when new entities are created after the fact that things really get murky.



Power Play

Take, for example, Pacific Gas and Electric Co., the bankrupt California utility and wholly owned subsidiary of PG&E Corp. In December 2000, the utility was having trouble paying its wholesale-power debts. PG&E Corp. also owned another subsidiary, National Energy Group, which held the bulk of its assets not regulated by the state of California. PG&E Corp., in a move it claimed was solely to protect National Energy Group's credit rating, created a new entity called NEG LLC, to which PG&E Corp. transferred all its stock in National Energy Group in exchange for membership in the LLC.


Three months later, Pacific Gas and Electric Co. filed for Chapter 11 bankruptcy protection (PG&E Corp. did not). Creditors allege that the utility had fraudulently transferred billions in dividends in PG&E Corp. even as it sank into insolvency. But even if the creditors prevail in court, says Lynn LoPucki, a professor at UCLA School of Law, the new LLC structure blocks creditors from accessing the value of the assets in National Energy Group. All that creditors could get is PG&E Corp.'s economic interest in the new LLC — but not the voting rights. And without the voting rights, creditors wouldn't be able to get money, says LoPucki. (California Attorney General Bill Lockyer has filed a lawsuit against PG&E Corp., claiming that its asset transfers were in violation of utilities regulations.)


The PG&E case is an uncommonly vivid example of suspect timing. Another is the aggressive attempt by various dioceses of the Roman Catholic Church to move real estate into trusts or separate corporate entities to shield it from the multitude of sexual-abuse cases being filed and settled across the United States.


In 1997, the Diocese of Dallas was hit with a $119 million jury award (later reduced) in a suit filed by 11 victims of sexual abuse by a priest. Shortly thereafter, church officials filed to amend the titles to property in the diocese to indicate that the bishop owned the property "for the benefit of" the individual parishes, essentially creating a trust. According to reports, church officials said that the switch was "for clarification." The "clarification," however, was never tested: in 1998, just as the asset issue was about to go to court, the diocese settled the case for $23.4 million.


One thing is clear: plaintiffs, attorneys general, and the courts are increasingly willing to hold corporate parents responsible for the liabilities of a subsidiary. And if the latter is set up strictly for purposes of judgment-proofing, it may not have a prayer in court.



Kris Frieswick is a senior writer at CFO.

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