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The Problems And Possibilities In Suing A Bankrupt Company

Monday, Feb. 25, 2002

This is Part One of a two-part series by Professor Sebok on tort litigation, bankruptcy, and Enron. Part Two of this series will appear next week, on March 4. - Ed.

The problem with using tort litigation to address the Enron collapse and its harms, however, is that it is only effective if there is money to recover. Tort law is not criminal law: people can't be thrown in jail to pay off the damages assessed against them. Even punitive damages are ineffective against an insolvent defendant like Enron.

The real question facing any lawyer who wants to use tort law to "do justice" in the Enron mess is this: Whom should I sue? In this column and the next, I will explore how the reality of insolvency affects the options available to a lawyer confronted with corporate wrongdoing.

Using Tort Law to Compensate Not Just Physical, But Financial Injuries

It may seem initially strange to think of addressing Enron through tort law. After all, many scholars believe that the primary purpose of tort is to insure that citizens are compensated for the physical injuries that they suffer as the result of another citizen's intentional or negligent conduct - not for financial injuries like stock losses.

Moreover, surveys suggest that the vast majority of people who are physically injured as a result of negligence relating to car accidents, defective products, and medical malpractice never sue, and are never compensated. Shouldn't they come first? Why, one might ask, should we divert resources-lawyers, judges and experts-from cases of physical injury to cases involving the loss of mere money?

The answer to this is very complex, but it can be summed up in two simple words: history and democracy. Historically, tort law has led a schizophrenic life in the courts. Much of tort law in the Eighteenth and Nineteenth Centuries was concerned with raw, physical injury. But much of tort law was also concerned with the economic relations between people.

Indeed, one could argue that nonphysical interests, such as reputation and economic advantage, were more strictly protected in the Nineteenth Century than physical integrity was. This emphasis probably reflected a class bias. Until the Nineteenth Century, tort law was in the hands of, and therefore served the interests of, society's wealthy, educated elite - who tended to focus on their own reputation and wealth, not factory workers'safety.

Then, over the course of the Twentieth Century, the relationship between tort law and society changed. Tort law became more interested in helping workers and consumers, and, as a result, it became more focused on the question of physical injury.

However, as tort law became more democratic, so did the stock market. Whereas economic activities such as buying shares and investing in financial instruments were once the exclusive province a narrow elite, by the end of the Twentieth Century the stock market had become an integral part of American society. When Jesse Jackson flew down to support the Enron employees, he was going down to help workers who had not been injured in an industrial accident, but whose pensions had been destroyed in a financial disaster.

A Good Case for A Security Law Class Action?

Even someone who is familiar with this history, and knows that tort law may compensate economic as well as physical injury, might still wonder if tort law is really the place to look to remedy the injuries the Enron debacle has caused - or if federal and state securities laws should be the focus instead.

Obviously, any investor whose stock investment has gone from $90 per share to 70 cents per share will look first to the securities laws. It is likely that Enron-the firm itself-would be found liable to investors for having engaged in misrepresentations that resulted in inflated share prices.

Class action suits based on this type of theory - the theory of fraudulent misrepresentation - are quite common. Indeed, they are so common, that in 1998 the Congress tried to make it more difficult for plaintiffs' firms to bring such suits, to avoid the "fishing expeditions" that may follow a sharp drop in stock price even when there is no other evidence of wrongdoing. But a class action suit again Enron would be no mere fishing expedition; it is already clear that sharks are in the waters. This case is precisely the kind of class action suit that makes sense, not the kind Congress likely had in mind when it tried to make such suits harder to bring.

The Problem With a Shareholders' Class Action Against a Bankrupt Company

There is one crucial catch, however: Enron is in bankruptcy. That means that, assuming that the plaintiffs win, they will have to deal with other creditors, and a shrinking pool of assets.

The insurance that Enron carried will not be adequate to satisfy all claims. Furthermore, Enron's insurance carriers may balk at covering fraud claims based on acts of deceit by managers motivated by personal gain - and the insurance policy may well exclude such claims, as many do.

And when insurance runs out, or does not cover a loss, for a bankruptcy company, shareholders are last in line, and usually out of luck. The law reasons that when they bought their shares, they accepted downside risk as well as upside risk - unlike creditors, whom the law sees as having simply made a relatively riskless business transaction upon which Enron was supposed to make good, and who thus get higher priority.

Why A Shareholders' Derivative Action Against Directors Won't Work Either

Even if the shareholders could win the factual case, which would require proof that the directors breached their fiduciary duty to monitor the "rogue" managers who caused the company's collapse, their recovery, on a per-person or per-share basis, would be minuscule. No matter how wealthy the directors might be, their personal assets would have to be divided among tens of thousands of shareholders and former employees.

Directors and Officer's insurance probably won't help, either. As with Enron's own insurance, it may not be written to cover intentional misconduct. Moreover, the policy limit is likely far too low to go far towards addressing a financial disaster like Enron.

Tort Law to the Rescue?

Is there any hope, then, for the Enron shareholders? There might be - but it likely will not come from suits against Enron or its directors. In other mass tort cases in which insolvency seemed to be an insuperable barrier between thousands of victims and their recovery, the strategy attorneys used was to search out new defendants. That will very likely be the strategy in Enron, too.

Take the asbestos litigation - in which hundreds of thousands of injured workers sued a small number of highly culpable asbestos manufacturers. Within ten years, all the defendants were going bankrupt, and it seemed that many sick workers would therefore get nothing or close to nothing. But the asbestos attorneys, rather than giving up, went after new defendants. They sued, for instance, companies that assembled products that contained asbestos.

Whether this strategy will work remains to be seen. But its logic is obvious, and it will doubtless be used in Enron too.

In the Enron case, the next set of defendants will be the accountants and lawyers who assisted Enron and who, arguably, enabled the reckless conduct that resulted in the loss of so many persons' life savings. Yet although Arthur Andersen and Enron's attorneys have been widely blamed in the media, it may not be as easy to hold them accountable under the law for any wrongdoing they may have committed. Extending liability to professionals for economic loss is difficult - more difficult, for example, than extending liability to an assembler of parts in a products liability case, like the asbestos litigation, where the injury was physical.

The hurdles that the plaintiffs will have to cross in order to sue Enron's professional helpers are very high, and will depend critically on a number of special legal doctrines. I will examine the details of the case against Enron's accountants and lawyers in my next column.

Anthony J. Sebok, a FindLaw columnist, is a Professor of Law at Brooklyn Law School, where he teaches Torts, among other subjects. Professor Sebok has written several columns on mass tort litigation for FindLaw; they can be located in the archive of his columns on the site.

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