The introduction to this Sullivan & Cromwell memo really got my attention. It opens with:

Listed companies with operations in the United States face growing product liability, environmental and related litigation threats. Some of the world’s largest corporate groups have seen billions erased from their market capitalization overnight. Yet most listed companies still ignore the best defense available for managing their litigation exposure: ring-fenced subsidiaries. This failure has—and will—hit share prices hard if and when analysts start to price in major litigation risk from non-strategic operations.

The memo explains that ring-fencing goes beyond veil piercing. It’s focused on protecting a parent entity from creditor tactics that would be employed in a subsidiary bankruptcy.

In some cases, ring-fencing simply increases the leverage of the parent in litigation settlement discussions by clarifying that only invested equity capital is at risk. In other cases, ring-fencing is essential to permit a successful Chapter 11 filing to manage the subsidiary’s litigation liabilities without recourse to the group. And, in many cases, the ‘option’ created by ring-fencing is not called upon because the litigation threat dissipates or can be absorbed by equity capital already invested in the subsidiary.

Ring-fencing can help corporate defendants negotiate successful settlements in product liability or mass-tort litigation. For example:

In a class action context, lead plaintiff counsel will focus on the presence or absence of ring-fencing as a critical factual question that drives the amount and the structure of their settlement demands. And once the defendants and lead counsel strike a deal, ringfencing can be a key to limit opt-outs and facilitate court approval of the settlement as reasonable [. . .]

In a recent product liability matter for a multinational client, we were able to begin mediation by explaining to assembled plaintiff counsel that the last three years of operations and litigation defense had been financed with hundreds of millions of dollars of secured loans from the corporate parent, and that all of this recent secured debt ranked senior to litigation claims on the manufacturing business they were suing.

The memo explains what’s involved in a ring-fencing review. It includes an 8- to 10-page list of specific questions covering topics like legal separateness, group financing and cash management, IP rights, allocations of assets & liabilities, sources of agency and direct exposure, points of contact and intercompany claims, tax matters, insurance coverage and subsidiary officers & directors.

– Meredith Ervine