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University of Chicago Law Review

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605

Abstract

The typical large corporation divides itself into numerous subsidiaries but then overrides the liability barriers between them by having the subsidiaries and the parent company cross-guarantee each other's major debts. Previous scholarly theories of the corporate group cannot explain why. The leading theory posits that the subsidiaries make it easier for creditors to evaluate risk because they enable each creditor to lend against a discrete asset pool within the broader enterprise. But any such efficiency would be undercut by the guarantees, which transmit credit risk across subsidiary boundaries. This Article argues that the combination of subsidiaries and intragroup guarantees reflects a type of shareholder opportunism termed correlation-seeking. Because the insolvency risks of the entities in the typical corporate group are highly correlated, the intragroup guarantees provide the group's shareholders with a one-way bet. The guarantees lower the interest rates on the guaranteed debts, thus enriching the shareholders as long as the group stays solvent. And if the group falls insolvent, the triggering of liability on the guarantees makes no difference to the shareholders, whose equity stakes are wiped out anyway. The guarantees instead dilute the recoveries of the group's nonguaranteed creditors. This separation of burden and benefit induces firms to form too many subsidiaries and to overuse guarantees, thereby undermining transparency, complicating bankruptcy proceedings, and introducing other distortions. Current fraudulent transfer doctrine perversely upholds those guarantees that are most likely to be overused. Doctrinal reform based on risk correlations would deter guarantee overuse and would reduce bankruptcy courts' dependence on the controversial remedy of substantive consolidation.

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