Create a Corporate Veil to Manage Your Product Liability Risks

Now that we’ve completed our legal briefing on product liability, it’s time to look at two very important questions for any business. First of all, the legal question of how we can manage product liability risk. This is where the advice of a lawyer is especially important. And then after that, we’re going to look at the strategic question, is there any way in which we can use product liability law to create value for our company? So in terms of risk management, I think it’s useful to think of three different types of risk management. One type is strategic, the second type is structural, and the third type is operational.

So let’s start with the strategic question relating to risk management, and at its highest level the strategic question is, should we manufacture a product, or should we drop a product? For example, there have been studies of CEOs that have indicated that roughly half the companies in America have dropped products, because of product liability risks. And in many cases, this makes sense. But my concern is in making this strategic decision of whether to sell a product or drop a product managers and decision makers are asking the wrong question. When I work with business executives, I find that when they make this strategic decision, they often ask this question.

If we manufacture and sell this product, will we be sued, and will we be liable for damages? And if the answer is yes, then they’re inclined to drop the product. To me, that’s the wrong question, because it ignores the theory underlying product liability. Remember, product liability is based on the theory of spreading the risk among all consumers. So to me, the key question should be not, will we be held liable? But the question should be, can we spread the risk among the people who buy the product by raising the price of the product?

So a classic example occurred several years ago when tobacco companies entered into a settlement with various states in which the tobacco companies agreed to pay $206 billion dollars. Now, on the surface, you would think, well, this will destroy the tobacco companies coming up with that huge amount of damages. However, in fact, the tobacco companies were harmed very little, and in fact they continued to thrive, because they simply raise the price of a pack of cigarettes by 76 cents, and that combined with various savings from reduced advertising caused them to continue to do very well in business.

Now, I’m not recommending that you get into tobacco sales or manufacture, but my point is when you make the strategic decision, make sure you’re asking the right question. The question is not, who will be liable for damages? The question should be, are we manufacturing and selling a product in which we can spread a risk of loss by raising the price of the product? Okay, the next risk management tool is a very important tool. It goes far beyond product liability, the structural question. And in looking at this question, let’s see if you could fill in this blank. This is from former president of Columbia University. What is the single greatest discovery of modern times, and even electricity is far less important?

This discovery provides the only possible engine for carrying on international trade on a scale commensurate with modern needs and opportunities. Can you fill in that blank? Please hit pause, and try to answer this question.

The answer to the question is limited liability. Limited liability is what enables our modern system of business, both nationally and internationally. And I think you’re probably all aware of how limited liability works. With limited liability, you and I as investors, you and I as entrepreneurs, can invest in a business, and that business provides a veil that protects us from liability to the creditors of the business, the corporate veil.

So if the corporation that we’ve invested in goes into bankruptcy, the creditors cannot come after us as individuals. The creditors cannot take our cars, our homes, and our assets. Those liabilities are absorbed by the corporate veil. This device is also very useful when it’s not you and I making the investment but when it’s a company making the investment, and we call this company a parent corporation. A parent corporation will Invest in a subsidiary corporation, and that subsidiary corporation protects the parent from liability. So if you are facing a particular type of liability such as product liability, such as environmental liability, liability in any form, you can try to isolate that liability in your subsidiary.

And if you find yourself in a situation where you might be betting the company, because the liability is so great, you can put the subsidiary out of business, but your parent assets are still protected. This can even be used within a company, for individual operations of the company. Once I taught in an executive program, and one of the people in the program was the CEO of a large grocery chain. And she told me that one of their grocery stores was having problems with liability. People were slipping and falling and suing this particular store. And so they incorporated only that store as a separate subsidiary to protect the parent company from liability.

This is especially useful in international operations where, for example, you might have a US parent corporation operating through a foreign subsidiary. The parent corporation is interested in protecting its assets from liability in other countries. I was personally involved in this a few years ago when I was associate dean for executive education at the Ross School of Business, and I wanted to set up a center in Hong Kong. Before doing so, I asked a Hong Kong law firm for advice. Should we set up this operation in Hong Kong as a subsidiary or as a branch office? And this is the advice, this is a direct quote from the letter I received from the Hong Kong lawyers.

The disadvantage of using a branch office is that the university would be subject to any liability incurred in Hong Kong. The advantage in using the subsidiary model is that any liability incurred in Hong Kong is limited to your Hong Kong subsidiary. So in other words, if there’s a huge liability problem, we could close down the subsidiary, but the liability would not pass to the parent corporation. Just as a sidelight, I decided to use the branch office model, in this case, because creation of a subsidiary was complicated for tax and other reasons, and I felt that liability risk was fairly minimal.

Now, there is a major risk in creating a subsidiary

as it applies to product liability or to any other type of liability, and that is that a court might pierce the corporate veil. Here’s an example. We have a world-class race car driver by the name of Mark Donohue. His involved in a race, the tires on his car are defective, they caused a crash, and they kill Mark Donohue. His estate, the creditor here, wants to sue the United Kingdom subsidiary that produced the tires, but they also want to pierce the veil of that subsidiary and go after the US parent corporation. I’m not sure exactly why, but my guess is that they want to get into the US legal system where we have jury trials and higher damage awards.

In this case, the court allowed piercing of the corporate veil, because the US parent did not treat the subsidiary as if it were an independent corporation. In other words, they controlled the subsidiary to such an extent that you couldn’t distinguish the two. This is the way the situation was described in an article in Forbes Magazine. Big companies get into trouble over the question of whether they have dominated subsidiaries to the extent they are indistinguishable from the parent.

Courts look at a number of other factors besides control in deciding whether to pierce the corporate veil. For example, was the subsidiary undercapitalized? Is it just a shell with very few assets? Does the parent call the subsidiary a division or a department? Does the parent freely transfer assets back and forth between the subsidiary and the parent?

Does the subsidiary observe legal requirements? Do they file their annual reports? Do they have regular meetings of the board of directors? Do they keep minutes of those meetings, etc., the way any corporation would, and is the direct involvement of the parent in subsidiary operations? For example, is the parent involved in designing the products made by the subsidiary? So the point here is lawyers can do a great job in setting up a subsidiary designed to protect the parent corporation, for instance, in a product liability scenario, but managers have to be very careful in making sure the subsidiary operates on an independent basis.

This not only applies when a US parent is operating abroad, it can also apply when a foreign parent wants to operate in the United States. There’s a case involving AKZO Nobel, a chemical company based in the Netherlands. They set up a US subsidiary, and somebody wants to sue the Dutch parent in the United States. And the court said, no, you can’t sue the parent, because AKZO allowed the subsidiary to operate independently. There was no interference with the subsidiary’s marketing, management, purchasing, or pricing. So, very important concept using subsidiaries as a structural matter to isolate liability in product liability cases, environmental cases, etc.

Now, in the next segment, we’re going to look at the last strategy for minimizing liability, for managing risk, and that relates to minimizing your contract exposure and your tort exposure.