The large, modern business corporation is frequently organized as a complex cluster of" hundreds of corporate subsidiaries under the common control of a single corporate parent. Our Article provides new theory and supportive evidence to help explain this structure. We focus, in particular, on the advantages of subsidiary entities in providing the option to transfer some or all of the firm's contractual rights and obligations in the future. The theory not only sheds light on corporate subsidiaries but also illuminates a basic function of all types of legal entities, from partnerships to nonprofit corporations.
We show that when, as is common, some of a firm's key assets are contractual, both the .firm's owner(s) and its contractual counterparties are exposed to the risk of opportunism relating to the assignment of the contracts. The owner .faces opportunistic holdup by counterparties if counterpart' consent is required to assign contracts in a sale of the entire firm. The firm's counterparties, in turn, are exposed to opportunistic assignment if" the owner can freely assign contracts without consent. This bilateral opportunism problem can be mitigated through bundled assignability: the owner is permitted to assign her contracts freely but only as a bundle. The components of the bundle of' contracts (which constitute much of the firm itself)provide assurance of performance to counterparties. And .free transferability, in turn, gives the owner liquidity' without risk of holdup. Most importantly--and least appreciated in the literature and the case law--bundled assignability increases the owner's incentive to make valuable investments in the firm.
We explain why legal entities provide the simplest, most reliable means of creating bundled assignability: Further, we support our analysis with the first empirical study of assignment clauses in commercial contracts. Firms, we show, commonly provide for bundled assignability in their contracts, and they use legal entities to define the boundaries of transferable bundles. This suggests that our theoretical model accurately captures the motivations of contracting parties in practice.
TABLE OF CONTENTS INTRODUCTION I. CURRENT THEORIES OF LEGAL ENTITIES A. The Economic Theor3, of the Firm: Property Rights ....... B. The Law and Economics Perspective: Creditor Monitoring II. A NEW THEORY: BUNDLED ASSIGNABILITY A. The Law of Bundled Assignability B. A Sketch of Our Theory III. A NUMERICAL EXAMPLE OF THE THEORY A. Investments in Complementarities B. Contracts and Assignability' C. Credit Risk D. Investment with Bundled Assignability E. Investment with Individual Assignability F. Comparing Individual and Bundled Assignability IV. CONSEQUENCES OF CHANGING THE ASSUMPTIONS A. Bundling Contracts with Assets Owned Outright B. Other Sources of Complementarities C. Other Sources of Inefficient Assignment D. Renegotiation in the Shadow of Assignment E. Residual Liability F. The Parent Company Has Other Assets and Liabilities. G. The Costs of Nonassignability V. ACHIEVING BUNDLED ASSIGNABILITY WITH AND WITHOUT LEGAL ENTITIES VI. EMPIRICAL EVIDENCE OF BUNDLED ASSIGNABILITY VII. FURTHER IMPLICATIONS A. Bankruptcy Law and Individual Assignability B. Licenses for Intellectual Property CONCLUSION APPENDIX A: ROBUSTNESS CHECKS 1. Bundling Contracts to Assets 2. Other Sources of Complementarity 3. Other Sources of Inefficient Assignment 4. Renegotiation in the Shadow of Assignment APPENDIX B: TABLES APPENDIX C: EXAMPLE OF EXPLICIT BUNDLED-ASSIGNABILITY CLAUSE INTRODUCTION
Despite all of the ink that has been spilled on the subject over the last two centuries, we still lack a full understanding of the many roles played by legal entities. To be sure, the basic structure and benefits of the most conspicuous type of legal entity--the publicly traded business corporation--are generally familiar. (1) Less familiar, however, are corporate subsidiaries. Today, each of the largest 100 companies in the United States has, on average, about 250 distinct subsidiaries that are large enough to be reported in the firm's securities filings and presumably many more that are smaller. (2) Most of these subsidiaries are wholly owned and consequently controlled by the parent company. Why do firms routinely adopt this structure, rather than managing their various activities as unincorporated divisions within the parent firm's corporate shell? What is the purpose of these subsidiary entities?
This question has been largely neglected in both the legal and the economics literature. An answer is important, however, for both law and practice. Courts and regulators must often decide whether to respect the corporate boundaries between commonly owned subsidiaries for purposes of accounting, veil piercing, taxation, and regulation. Bankruptcy courts have the power to "substantively consolidate" corporate groups, merging both the assets and the liabilities of a parent corporation's subsidiaries as if they were simply managerial divisions within a single corporate shell. If wholly owned subsidiaries are typically formed just for opportunistic reasons, such as misleading creditors or avoiding taxation or regulation, there may be a strong case for refusing to treat them as separate entities. If, conversely, subsidiaries commonly serve important economic functions, then the failure to respect the independent character of those subsidiaries when taxing or regulating them, or when sorting out creditors' claims in bankruptcy, comes at a price that should be taken into account.
We explore in this Article what we believe to be one important reason-though clearly not the only reason--for organizing a set of activities as a distinct legal entity, even when that entity is wholly owned by another entity. Our explanation not only throws light on the role served by corporate subsidiaries but also illuminates the functions served by legal entities more generally. Our theory focuses on the great utility of legal entities in facilitating transferability, particularly when a firm's value depends greatly on its contractual rights. Legal entities provide a low-cost means of assembling complementary contracts into discrete bundles that can be freely transferred to a new owner, but only if the contracts are transferred together as a bundle. We refer to this feature as "bundled assignability."
Our theory explains why bundled assignability can be an efficient economic configuration. Bundled assignability constrains opportunism on the part of both the business's owner(s) and its contractual counterparties--its suppliers, employees, and customers--that can arise when transferability is at issue. With these opportunism problems minimized, owners have a greater incentive to make investments that add complementary value to the bundle.
We also explain why legal entities are useful tools in creating bundled assignability, and we present empirical evidence supporting our claim. In particular, we find that bundled assignability is a common feature of commercial contracts in practice, and legal entities are the predominant means of achieving it. To our knowledge, we are the first to provide theory and supportive empirical evidence on assignment terms in commercial contracts. Our theory and evidence also allow us to offer perspective on bankruptcy doctrine governing the transferability of contractual rights and obligations and to understand some of the current features of that doctrine.
We proceed as follows: Part I discusses briefly the current legal and economic theories of legal entities that are closest to the theory we propose here and that this Article builds upon. Part II explores the concept of bundled assignability, discussing first the ways in which bundled assignability is facilitated by current legal doctrine through the relationship between contract assignability and legal entities, followed by an intuitive sketch of our own theory of the economic efficiencies offered by bundled assignability. Part III, the heart of this Article, illustrates our theory with a numerical example. Part IV shows that the central elements of the bundled assignability theory continue to hold under a variety of plausible changes in the example's background assumptions. Part V explores the value of legal entities in establishing bundled assignability. Part VI presents empirical evidence on the prevalence of bundled assignability in commercial contracts, and Part VII discusses further implications concerning bankruptcy doctrine and intellectual property rights.
CURRENT THEORIES OF LEGAL ENTITIES
To set the stage for our analysis, it's helpful to take a brief look at existing theories of the functions served by legal entities, particularly entities with a single owner, such as corporate subsidiaries. We set aside entities-and particularly subsidiaries--that are created principally to segregate assets and activities into distinct (and usually somewhat arbitrary) pools for ease of compliance with taxation or regulation. For example, firms operating in multiple jurisdictions may choose to subincorporate their operations in each jurisdiction to aid them in complying with--or taking advantage of-differences in the tax regimes across those jurisdictions. And a company with a captive insurance business will generally want to subincorporate that business for the sake of segregating, from the firm's other assets, the capital that regulators require it to hold as a reserve to back its insurance policies. We are interested here, instead, in the more basic economic functions served by legal entities in facilitating coordination of activities among the principal participants in an enterprise, namely its owners and the persons with whom the enterprise has contractual relationships, such as its employees, suppliers, and customers. That is, we are concerned with the utility of segregating activities into distinct legal entities even in the absence of taxation and...