Judgment Proofing, Bankruptcy Policy, and the Dark Side of Tort Liability

Article excerpt

One need not be an astute student of the law of obligations to appreciate Professor Schwarcz's comprehensive rebuttal of Professor LoPucki's recent articles on judgment proofing.(1) Schwartz argues compellingly that judgment proofing is not likely to occur in arm's length contexts. Although judgment proofing may be more likely in non-arm's length situations, he also demonstrates persuasively that current doctrine is up to the task without the need for additional regulation.

Schwartz correctly observes that the principal potential victims of judgment proofing are involuntary (i.e., tort) creditors of business debtors.(2) However, neither Schwarcz nor LoPucki gives much attention to the significance of the underlying policies or characteristics of tort liability to the matter of judgment proofing.(3) My observations address tort claims in this context. I shall not devote my brief allotted space to a broad critique of the Schwarcz-LoPucki dialogue. Instead, this essay outlines a different path for future scholarship and policy debates. In particular, that path must pay attention to both the nature and effects of tort liability.

Schwarcz and LoPucki both proceed on the implicit assumption that tort claimants, even claimants against insolvent (judgment proof) debtors, should be paid. Addressing debtors that cannot pay, however, inevitably implicates bankruptcy policy. In my view, the purpose of the bankruptcy system should be the enforcement of legal rights against a debtor in financial distress. Bankruptcy is a branch of civil procedure--a judicial process in which legal fights and entitlements are determined and remedies are provided.(4) Accordingly, the creation and attributes of the legal rights that bankruptcy should enforce are determined primarily by nonbankruptcy state and federal law. These rights include property rights, claims in contract and tort, governmental interests such as claims for taxes and fines, zoning restrictions, licensing requirements, and most other legal relationships with a debtor, such as the interests of the debtor's shareholders, partners, and employees. As a first principle, then, Schwarcz's and LoPucki's intuitions are correct insofar as tort claimants have legally enforceable claims.

When a debtor is insolvent it is sometimes appropriate to apply different rules in the interest of maximizing the recoveries of those with legal entitlements or to achieve other normatively desirable goals. One set of insolvency-based rule changes is the body of doctrine generally known as "fraudulent transfer." Under both Bankruptcy Code section 548 and the Uniform Fraudulent Transfer Act (and the earlier Uniform Fraudulent Conveyance Act), obligations incurred for less than "reasonably equivalent value" ("fair consideration," under the earlier act) are avoidable if they are incurred while the debtor is insolvent.(5) Avoidance based on the inadequacy of value, as opposed to actual fraudulent intent, is often called "constructive" fraud. Although there may be no consensus on the precise normative basis for avoiding transfers of property or the incurrence of obligations by an insolvent debtor for less than reasonably equivalent value, there does seem to be a general consensus that fraudulent transfer law, including the constructive fraud rules, should be retained.(6)

Note that the constructive fraud doctrine appears to catch some purely innocent behavior that has the effect of damaging an insolvent debtor's creditors (by taking away assets or by giving rise to a competing obligation).(7) Stated otherwise, under constructive fraud doctrine a creditor normally should not be allowed to claim an amount that is substantially greater than the value that the creditor has contributed to the debtor.

Many--possibly most--tort claims incurred by an insolvent tortfeasor appear to meet the test for avoidability under fraudulent transfer law. When the debtor's tort liability appears it is unaccompanied by any corresponding asset. …