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  • Writer's pictureKirk Hartley

Professor Rhee Offers a New Proposal on the Legal Reform Needed to Compensate Tort Victims of Insolv

Persons injured by torts are involuntary creditors of the entity which committed the tort. And, today, we see increasing examples of insolvent companies failing to pay anything close to full value for massive harms spread over many years and continents. For product liability examples, consider the American car companies which used bankruptcy to largely walk away from various tort liabilities (a position later modified), bankrupt former makers of asbestos products, and various insolvent entities which produced or sold "Chinese drywall" that ruin homes and businesses. On the financial side, consider insolvent financial fraudsters such as Madoff, Lehman, AIG, and Countrywide. All of the insolvent companies shifted their risks and losses to the tort victims, which is both unjust and lousy economic policy. Happily, there is more emerging academic discussion on means to end the injustice, human suffering, and economic folly which arise from tolerating limited liability corporations which fail without leaving behind assets sufficient to cover the risks they take, and the losses they cause.

One proposal for dealing with insolvent tortfeasors is a March, 2011 "Legal Workshop" article in the William & Mary Law Review: Bonding Limited Liability. The article is by Professor Robert Rhee of the University of Maryland. His cv describes a business law professor with an MBA, and a work background in law, finance and investment banking.

Professor Rhee’s paper is interesting, but is limited to a modest proposal. The proposal is modest because his proposal includes the explicit assumption that ending limited liability is politically infeasible, and explicitly excludes "long tail" torts from the scope of the tort claims to be addressed by his proposal. In short, he proposes using state or federal law to impose a corporate bonding requirement to a create a trust fund of money that would generate interest . Accrued interest would be paid out only to tort victims who 1) file suit prior to insolvency and 2) win a judgment through trial or summary judgment (that is, no settled claims.)

Professor Rhee opens the article with an abstract statement of the problem:

"Limited liability is the essential attribute of the corporate form. Although abolishing limited liability is politically infeasible, the rule is troubling as to tort creditors. Unlike contract creditors, they are not factors of production in the “nexus of contracts.” Tort law is the wrench in the smooth machinery of the contractarian explanation of limited liability. With perfect information, no reasonable society would grant the right of limited liability if a firm would produce merely a transfer payment from tort victim to shareholder, or worse, the firm’s activity would impose a net social cost. Such a society would be morally or economically bankrupt. With uncertainty as the reality, the ex ante assumption must be that every firm would be socially productive. Limited liability marches in tandem with the spirit of enterprise—the expectation of profit, a residual gain after all liabilities are paid. A good faith belief that one will not externalize the cost of liability is implied. (emphasis added)."

Professor Rhee’s statement of the issue is in my view far too narrow because he argues as if the world either has perfect information, or it does not. Reality, however, is not so binary.

On the side of financial fraud and insolvents, we collectively know, for example, that finance entities take massive risks which can collapse financial systems. The only uncertainty is when and how often some entities will fail. Surely these supposedly brave financial swashbucklers should pay the full price for the risks they create.

On the product liability side, we collectively know that cigarette companies and chemical companies are selling toxins. It is certain that too many cancer rates have been marching steadily upwards for decades, that the global costs of cancer exceed $ 1.5 trillion per year, and that multi-generational cancers are occurring. The uncertainty is how many people will die or suffer from which ones of the myriad different diseases caused by their products, and the financial costs of the diseases. Surely these merchants of death and pain should pay the the full price for harms caused by their continuing sale of known and suspected toxins.

On money and scale, Professor Rhee’s proposal offers a perhaps useful means to address small scale problems, such as a car wreck and personal injuries caused by an employee of a small entity that failed financially. He calculates that if a corporate bond is $2,000 and returns are 6%, then "[b]ased on the number of corporations and LLCs in California, Delaware, and New York at the end of 2008, these states would have collectively held over $7 billion in bond principal and would earn over $400 million per annum, which would be available to compensate tort victims."

Professor Rhee’s article is a positive, forward step on the journey towards confronting the reality that tort victims are involuntary creditors of insolvent entities, and that bankruptcy law is doing at best a lousy job of protecting their interests. Lawyers and policy-makers need to force the issues forward to create effective and creative solutions for coping with the massive annual, global human suffering and economic waste caused by insolvent limited liability entities.

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