Class AMPs: withdrawing the corporate veil on judgment proofing.

Author:Muir, William A.
Position::Administrative monetary penalties - Canada
 
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I INTRODUCTION: THE DUAL TRAGEDY OF LAC-MEGANTIC II THE JUDGMENT PROOF PROBLEM i. Solutions to Judgment Proofing ii. Piercing the Corporate Veil iii. Director's Liability a. Director's Acquiescence b. Administrative Monetary Penalties c. Principal-Agent Problem III CLASS-BASED ADMINISTRATIVE MONETARY PENALTIES i. Overview ii. Implementing Class AMPs a. Absolute liability and the Business Judgment Rule b. Information and Control: Incentivizing Internal Whistle-blowing c. Size of the AMPs d. Administrative Advantages of Class AMPs iii. Issues in Implementing Class AMPs a. Contingent Compensation b. Mitigating Stigma IV CONCLUSION I INTRODUCTION: THE DUAL TRAGEDY OF LAC-MEGANTIC

On July 6, 2013, in Lac-Megantic, Quebec, an unattended freight train carrying crude oil derailed, spilling 7,119,000 litres of oil near Lac-Megantic's quiet main street. The resulting fire and explosions killed at least 47 people, destroyed over 40 buildings, and caused damages estimated anywhere between $200 million and $1 billion dollars. (1) Montreal, Maine & Atlantic Railway Ltd. (MM&A), the railway operating the train, disclosed only a $25 million insurance policy before filing for bankruptcy protection with the Quebec Superior Court. (2) Unless MM&A's US-based parent company Rail World is held liable, litigation against MM&A alone will not yield sufficient funds to cover the damage caused by its operations, and leave the town of Lac-Megantic with just the memory of its loss.

If Rail World is found liable for the catastrophe caused by its subsidiary MM&A, the people of Lac-Megantic may well receive full compensation for their losses. Rail World could be liable if the court holds Rail World directly responsible (3) or pierces its corporate veil and holds Rail World liable through MM&A. (4) But what happens if Rail World is ultimately found not liable, leaving MM&A to face liability alone? In this situation, a corporation may not be able to draw on further assets to cover its liability, would declare bankruptcy, and leave a portion of the tort claim or criminal sanction unpaid. This is the dual tragedy of Lac-Megantic: not only has catastrophe occurred, but MM&A may also be judgment proof by failing to cover its liabilities and leaving its victims without full compensation.

This dual tragedy is the result of a central problem in corporate law. Corporations may avoid full responsibility for the consequences of their operations if they do not have sufficient assets to cover their liability--the judgment proof problem. This paper introduces a solution to judgment proofing through a statutory form of vicarious liability: class-based administrative monetary penalties (class AMPs). Class AMPs are absolute liability sanctions imposed on corporate officeholders in the event that the corporation goes bankrupt and has outstanding tort liability. Rather than pierce the corporate veil and assign liability to shareholders, class AMPs would hold corporate officers liable in classes according to the information and control available to their respective offices. Class AMPs would incentivize officers to report judgment proof risk and pressure their corporations to cover the potential liability with sufficient insurance or capitalization. By realigning corporations' incentives to internalize uncovered liability to third parties, class AMPs would reduce excessive risk-taking and preempt the need for piercing the corporate veil. More importantly, class AMPs would avoid over-deterrence by imposing less severe sanctions on directors and officers than comparable vicarious liability regimes. AMPs are able to give regulators administrative flexibility to impose circumstance-appropriate penalties and mitigate the severity of liability or criminal sanctions. (5) With this flexibility, class AMPs would be better suited than current regulatory strategies to set an optimal level of deterrence and control judgment proofing without unduly restricting corporate operations.

In this paper, I will first review current approaches to resolving uncovered liability and discuss their limitations in Part II: The Judgment Proof Problem. In Part III: Class-based Administrative Monetary Penalties, I will delineate how class AMPs would assign liability to officeholders and how their quantum would be calculated. Parts III.iii and IV will address potential issues in implementing the class AMP regime and conclude, respectively.

II THE JUDGMENT PROOF PROBLEM

The judgment proof problem is two-fold: (1) a judgment proof corporation cannot provide sufficient compensation to tort victims in the event of catastrophe, and (2) it will take excessive risk, increasing the likelihood that catastrophe will occur. First, a defendant who does not have sufficient assets or insurance cannot cover the full cost of a successful plaintiff's damages claim, leaving the plaintiff partially uncompensated. Second, judgment proof corporations, which take on risk of losses greater than their available assets, incur no further risk when operating in an increasingly dangerous manner (6) and are no longer concerned with an increase in the potential magnitude of their losses. Once the potential liability of one catastrophic event from a single operation exceeds the corporation's assets, (7) the corporation no longer faces any incentive to limit the maximum potential liability because there are no additional assets at stake. (8) The corporation effectively has "nothing left to lose" and has no motive to take further care. (9) The corporation's decision to take no further care, however, disregards the additional potential costs that may still be incurred by third parties. The corporation then does not internalize the full social cost of its operations, ultimately resulting in a cost of harm borne by the government or the public. The judgment proof problem leads to undeterred, suboptimal, socially costly operations that increase the risk of harm and leave tort victims uncompensated.

Judgment proofing can result from strategic use of corporate limited liability, which insulates owners and shareholders from liability for the actions of the corporation. (10) A corporation can then use limited liability and plan to be judgment proof, to ensure it does not bear the full cost of its operations in the event of catastrophe. This can occur where the corporation has restructured itself to divest its assets (asset-stripping) or has purchased insufficient insurance. With divestiture of assets, a corporation is split into parent and subsidiary, where the parent strips the subsidiary of the corporation's assets, leaving the judgment proof subsidiary to perform the risky operation. When catastrophe occurs, the subsidiary is sued while the assets remain protected with the parent company. With insufficient insurance, corporations reduce operating costs by failing to purchase sufficient insurance to cover all possible liability, trading off the increased risk of bankruptcy for higher interim profit.

Corporations have also used other strategies to achieve judgment proofing such as hiring third party contractors, which, in the past, was sufficient to insulate an organization from responsibility. (11) In this situation, a corporation would hire a subcontractor to perform risky operations so that if catastrophe did occur, then only the subcontractor, and not the corporation, could be sued. Moreover, corporations not only shielded themselves by outsourcing riskier tasks, but they often denied responsibility for the decisions of their officers. (12) By construing the actions, errors, or mistaken judgment of officers as unauthorized or outside the scope of their employment, corporations could disown responsibility for any adverse consequences arising in the course of their operations. (13)

  1. SOLUTIONS TO JUDGMENT PROOFING

    Academics continue to debate whether the judgment proof problem is good justification for setting aside limited liability. The most commonly proposed solution, the equitable remedy of piercing the corporate veil, operates as an exception to limited liability and holds other parties liable for the debts of the judgment proof corporate defendant. Courts may also hold directors and officers vicariously liable for the actions of their corporations, where there has been direct involvement of the individual officer or where the officer knew of and acquiesced to the operation that gave rise to the harm. Both piercing the corporate veil and vicarious liability are ex post sanctions that victims may use to claim compensation through tort.

    Aside from these two ex post resolutions, there are three ex ante methods of solving the judgment proof problem through regulation: (1) direct regulation of risky operations; (2) regulation of insurance liability coverage; and (3) the imposition of minimum asset requirements. (14)

    First, the regulator's preferred response to uncovered liability from catastrophic torts is generally ex ante regulation that reduces the frequency and severity of catastrophic harms. (15) By anticipating specific dangers, the legislature may implement restrictions or minimum safety procedures that reduce the likelihood that the dangers will materialize into catastrophes.

    Second, the legislature may mandate minimum insurance coverage for operations in a particular industry. Sufficient mandatory insurance guarantees enough funds to cover any liability, with the insurance premiums written off as a cost of business.

    Third, if no insurance is available, Professor Jull and other commentators have proposed a form of secured corporate bond where corporations must demonstrate sufficient assets to engage in operations. (16) The secured corporate bond functions as a "form of collateral that is pledged to ensure repayment of the issuer's obligation." (17) The corporate bond approach would guarantee sufficient funds to cover a corporation's liability and induce the corporation to take care, since unlike...

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