ARTICLE CONTENTS INTRODUCTION I. CROSS LIABILITIES, THE CORPORATE WEB, AND CONVENTIONAL THEORIES OF ASSET PARTITIONS A. Cross Liabilities B. The Conventional Models of Asset Partitions C. Limitations on the Conventional Model II. TAILORED PARTITIONS AND SELECTIVE ENFORCEMENT A. Selective Enforcement: A Simplified Example 1. Option 1: Perfect (or High) Correlation and Integration 2. Option 2: No Correlation and the Benefits of Partitions 3. Option 3: Partial Correlation, Tailored Partitions, and Selective Enforcement 4. An Aside About Security Interests B. Variations on a Common Theme: Holding Company Guarantees and Subordinated Primary Creditors 1. Holding-Company Guarantees and Stock Pledges 2. Subordinated Primary Creditors III. IMPLICATIONS FOR LAW AND THEORY A. Good-Faith Filing B. Fraudulent Transfer Law C. Bankruptcy and Ipso Facto Clauses IV. THE SELECTIVE ENFORCEMENT THEORY: LIMITATIONS AND CRITIQUES A. Creditor Opportunism B. Differentiating Motives CONCLUSION APPENDIX: SPECIFIC PROVISIONS A. Cross Defaults/Cross Guarantees B. Cross Guarantees of Payment/Cross Guarantees of Collection INTRODUCTION
Legal scholars have only a basic understanding of dynamic corporate groups. Existing theories demonstrate that assets of a common economic enterprise might be separated to partition risk, (1) create withdrawal rights, or securitize assets in bankruptcy-remote entities. (2) But these theories leave unsolved a puzzle created by the various combinations of partitions and overlapping obligations that exist in many large corporate groups today. This Article introduces a theory of tailored partitions and selective enforcement to shed some light on that puzzle. By revealing nuanced motives that drive the specific design of many entity partitions and the contractual relationships that connect them, these concepts move us closer to a cohesive theory that will permit us to understand the modern corporate web that binds assets within an economic enterprise.
Firms regularly separate assets and place them in different legal entities to create value. (3) That value may come from risk partitions, withdrawal rights, regulatory compliance, tax planning, or some other source. Existing scholarship often examines these partitions as if firms either fully isolate assets by a legal partition or fully integrate them in one entity. In other words, partitions are considered to be the result of a binary, all-or-nothing decision. (4) I argue that this dichotomy is unrealistic and has muddied the theoretical waters.
In reality, firms can tailor the impact and degree of any legal partition to create a precise structure. Certain contract provisions--such as cross guarantees, cross defaults, and holding-company guarantees (collectively, cross-liability provisions) (5)--can be coupled with legal partitions to create a web of commonly owned assets, targeted liabilities, and precise enforcement options. The prevalence of these tailored partitions is apparent in the capital structures at the core of many recent corporate bankruptcies. The coupling of legal partitions and cross-liability provisions was visible in the bankruptcies of Kodak, Dana Corporation, Calpine, Residential Capital, Visteon, MSR Resorts, and many other corporations. (6) In each of these cases, the debtor filed as a group of commonly owned legal entities. For example, while Kodak is a single economic firm, the "Kodak bankruptcy" was actually the administrative consolidation of sixteen different bankruptcy proceedings. Each of the sixteen debtors was its own legal entity, but they were commonly owned, and each entity had cross guaranteed the secured debt of the other entities. (7)
While bankruptcy proceedings make these structures particularly salient and transparent, we can also observe this corporate structure when large public corporations take on major debt. The public filings associated with those transactions reveal the prevalence of tailored partitions. The secured debt that JCPenney recently took on ($1.85 billion), for example, was cross guaranteed by all of JCPenney Company, Inc.'s domestic subsidiaries. (8)
I show that these tailored partitions create value by allowing the debtor and its creditors to achieve a balance between specific and general creditor enforcement in response to varying signals of project failures. (9) Where two projects are partially but not fully related--say a luxury hotel and a budget hotel--the firm can tailor partitions to allow common risks and failures to be dealt with collectively and to permit independent risks and failures to be addressed in a targeted and contained fashion. The availability of these enforcement options lowers the firm's cost of capital because creditors can more effectively monitor risk and respond to defaults. (10)
Recognizing this structural option changes the analysis of corporate groups. Under conventional models, creditors with no specialized expertise loan to the firm as a whole while creditors with expertise focus on particular projects. These models assume that different creditors will specialize in monitoring different projects within one firm. (11) But that is not how things look on the ground. It is increasingly common for a single sophisticated creditor (12) to monitor both the firm as a whole and the various projects individually. My theory of tailored partitions and selective enforcement can explain this. The central creditor loans to each legal entity while creating cross-liability provisions. When one entity defaults on its loan, the creditor then possesses a valuable selective-enforcement option: it can 1) call a firm-wide default; or 2) selectively waive or ignore some defaults while taking action on others. The second option allows the creditor to focus remedial action on a specific project.
In the budget- and luxury-hotels example, consider a simplified scenario in which the budget hotel's default sends the sophisticated creditor one of two signals: 1) managers are generally incompetent, and the problems will spread to the luxury hotel; or 2) managers are incompetent only at managing the budget hotel, and the problems will not spread. Tailored partitions give the creditor the option to take action against the entire firm in response to signal one (by way of the cross-liability provisions) or only as to the specific project in response to signal two (by waiving its formal rights under the cross-liability provisions).
The first option--firm-wide enforcement--is valuable because it allows the creditor to act on general signals to contain firm-wide losses. The creditor need not wait for the second hotel to default to assert its enforcement rights. Many of the large bankruptcies mentioned above fit this model. Kodak's bankruptcy was precipitated by a general demise of its business. While its traditional operations were shrinking because of technological changes in the market, the firm had also failed to move aggressively into new digital markets. (13) At the same time, the company was burdened by massive post-employment obligations resulting from a decade of workforce reduction. (14) Its potentially profitable licensing business was stalled in litigation with the likes of Apple, RIM, and HTC. (15) Throw in an unprecedented financial crisis, and it is not surprising that the bankruptcy of Kodak included all of its domestic entities. (16) One can safely assume that the primary creditors would have prevented any restructuring efforts that did not address all operations.
The second option--project-specific enforcement--is valuable because it reduces the significant ancillary effects caused by firm-wide responses to project-specific problems (17) and prevents other parties from opportunistically forcing the default to spread. Examples of these project-specific enforcement actions are less common in the bankruptcy dockets because one of the benefits of contained enforcement is that it allows the primary creditor to avoid bankruptcy proceedings altogether. When a creditor can limit the hold-up power held by others, it can push for an out-of-court restructuring more effectively. Examples of creditors opting for project-specific enforcement are therefore more likely to take the form of waived guarantees in enforcement actions. For example, Sunstone Hotels let ten of its forty-two hotels go into default (18) when it experienced financial trouble. Because of a cross-default provision in its bond indenture, this move gave the bondholders the right to call a firm-wide default that would have likely collapsed the entire enterprise into bankruptcy. The bondholders opted to forgo the firm-wide enforcement option and voted to amend the indenture to remove the threat of cross default. This allowed Sunstone (and its bondholders) to walk away from ten hotels (including the W in San Diego) without triggering the rights of any other creditors on the thirty-two remaining properties, including Hilton, Marriott, and Renaissance hotels across the country. (19)
As I demonstrate below, firm-wide enforcement is not available when there are partitions without cross liability, and project-specific enforcement is not available without legal partitions. Intuitively, one might think that project-specific enforcement could be achieved through security interests. But in a world with multiple creditors, this is not the case. (20)
The failure to recognize that tailored partitions create these valuable options causes confusion in the courts and introduces unnecessary puzzles and complexities. For example, some scholars hold the view that corporations undo the entire effect of entity partitioning by causing affiliated legal entities to agree to cross-liability provisions. (21) These scholars wonder why a corporation would partition an entity just to re-integrate it at the next moment. Why create a corporate web when the firm could just partition or not partition? (22)
The concepts of tailored partitions and selective...