Organizational Form, Misappropriation Risk, and the Substantive Consolidation of Corporate Groups

Authors

Christopher W. Frost

Abstract

This Article presents an economic analysis of the doctrine of limited liability in bankruptcies involving multi-tiered corporate groups. It focuses on substantive consolidation, a bankruptcy doctrine the application of which results in the combination of assets and liabilities of related companies for purposes of bankruptcy distributions. Substantive consolidation's effect is to abrogate the normal corporate rule of limited liability within corporate groups.

Professor Frost examines the doctrine under a transaction cost analysis that explores the impact substantive consolidation may have on creditors' and shareholders' allocation of the risk of financial disaster. The premise of the transaction cost model is that corporate laws, including limited liability, form a backdrop against which parties bargain over risk allocation. If parties are to develop rational estimates of risk allocation, the rules forming the backdrop must be relatively predictable. Professor Frost criticizes courts' inconsistent application of substantive consolidation because this unpredictability may increase transaction costs.

The Article then presents an economic analysis of corporate organization and risk in an effort to determine those organizational structures that most heavily rely on limited liability between components of a corporate group as a baseline risk allocation. It develops a model of risk analysis that divides the risk of firm failure into two components: enterprise and misappropriation risk. Professor Frost argues that the general rule of limited liability between related corporations should be respected in bankruptcy when the corporations are horizontally related or members of a conglomerate group. Because the separate incorporation of vertically integrated components creates a greater risk of misappropriation, he concludes that related corporations engaging in a single, vertically integrated production process should be treated as a single entity in bankruptcy.

Recommended Citation

Christopher W. Frost, Organizational Form, Misappropriation Risk, and the Substantive Consolidation of Corporate Groups, 44 Hastings L.J. 449 (1993).
Available at: https://repository.uclawsf.edu/hastings_law_journal/vol44/iss3/1