The new corporate web: tailored entity partitions and creditors' selective enforcement.

Author:Casey, Anthony J.
Position:II. Tailored Partitions and Selective Enforcement A. Selective Enforcement: A Simplified Example 3. Option 3: Partial Correlation, Tailored Partitions, and Selective Enforcement through Conclusion, with appendix and footnotes, p. 2711-2744
 
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  1. Option 3: Partial Correlation, Tailored Partitions, and Selective Enforcement

    In this section, I explore considerations that arise when the firm is looking to go forward with two partially related projects. Entrepreneur's two projects will be LuxuryOne (her luxury hotel) and EconoRoom (her budget hotel). The risks facing a luxury hotel on the lakeshore and a budget hotel near the airport are correlated across some dimensions but quite distinct across others. Conventional accounts imply that there is a binary switch at some point along the continuum. For a lot of correlation, integrate; for very little, partition. This assumes that in a world of partial correlation, the parties must simply accept the second best. The parties bear the costs of partitioning if they are less than the costs of integration, and vice versa.

    But this ignores the tools available to lenders and borrowers to create value in structuring deals. If it were possible to tailor the partition, lenders could reserve the option to respond to firm-wide signals (96) globally and uncorrelated project-specific signals locally on a case-by-case basis.

    There are several dimensions across which risk can be partially correlated. In the hotels example, these might include real estate markets, luxury- and economy-hotel markets, geographic hotel markets, and Entrepreneur's skill at managing the two types of businesses. While the real estate near O'Hare and on the lakeshore will be equally affected by the general economy in Chicago, a dramatic shift in crime near downtown Chicago might affect only the real estate value of LuxuryOne. Similarly, the impact of shifts in the tourism business will be highly correlated between the projects. But a decline in local tourism (vacationers from the suburbs) may affect LuxuryOne without affecting EconoRoom. And while Entrepreneur may be an astute businesswoman with a knack for property management, her experience with luxury hotels may not translate into success with the budget traveler staying next to the airport.

    I focus on Entrepreneur's management sifilis. Assume that Bank still has the expertise that it takes to monitor both projects. This is not like the oil refinery business. But Bank's monitoring will produce different signals about the business in different states of the world. Assume that Bank looks at the cash flows and operation reports of a hotel to know whether management is doing its job. The borrower has agreed to provide accurate books and records to Bank on a quarterly basis. When Bank receives reports from LuxuryOne, it receives one of three signals: 1) no new information; 2) management is incompetent at everything; or 3) management is incompetent at just the luxury-hotel business. When it receives reports from EconoRoom, it receives a similar set of signals: 1) no new information; 2) management is incompetent at everything; or 3) management is incompetent at just the budget-hotel business. As discussed above, signals two and three may trigger defaults in some cases. (97) In other cases, the firm will look for a default to act on an unrelated signal.

    As a starting point, Bank's desire to limit the flow of internal capital markets is not on its own a compelling explanation for partitions here. (98) An internal-capital-markets theory would suggest that a large bank may finance all projects of the firm but require the debtor to create entity partitions simply to restrict the flow of capital between projects. The limitation on this story is that the cross-liability provisions are a direct path for capital to flow from one project-entity to another. LuxuryOne, Inc. might borrows funds secured by the assets of EconoRoom, Inc. When it does so that is the functional equivalent of moving capital from EconoRoom, Inc. to LuxuryOne, Inc.

    EconoRoom, Inc. will have reduced borrowing capacity, and LuxuryOne, Inc. will have increased borrowing capacity. Indeed, parties often draft credit agreements to allow any entity to draw on the total amount of the revolving loan. The loan may be for $1 billion to be allocated among the entities as the debtor sees fit. In those cases, the lenders do not restrict the flow of capital between the project-entities. If anything, the provisions allow the capital to flow at the managers' discretion while maintaining the lender's option to choose which asset to enforce against. (99)

    Some have suggested that the partitions serve Bank's interest in getting accurate and separate books and records for each project. Under certain circumstances, Entrepreneur may have an incentive to obscure signals about her incompetence on a given project. Secretly moving assets from one project to an-another may accomplish this smokescreen. It will be at least marginally easier to do this under a one-entity structure. (100) Commingling funds within one legal entity will likely be easier to defend ex post as mere incompetence rather than outright fraud. In a partitioned firm, assets can technically be smuggled across legal boundaries, but there will be more hoops for Entrepreneur to intentionally jump through in order to create a smokescreen. Those hoops make it easier to verify the fraudulent intent.

    Still, I find this point to be weak support for the claim that partially correlated assets are partitioned to deter fraud. The hoops implicit in a partition can be created (at least roughly) by covenants. Thus, entity partitioning created to deter fraud will, in most cases, be unnecessary. And when fraud is occurring, it is not at all clear that the extra hoops created by legal partitioning will do much to deter someone who has already accepted the more significant expected threshold costs of committing fraud.

    More important to Bank than the relatively rare case of fraud will be what it can do with the signals of non-fraud risk that it receives. If Bank receives signal one from both projects (no new information), it does nothing. It does not matter how the firm structured its partitions. If Bank receives signal two from both projects (firm-wide incompetence), it enforces against both projects.

    But Bank's response becomes more complicated when it receives signal two from LuxuryOne and signal one from EconoRoom. If the assets are integrated in one legal entity, Bank will enforce against both assets. Signal two tells it as much about EconoRoom as about LuxuryOne, and the value-maximizing response is to call all the loans before the incompetence worsens or spreads. This is not possible when the assets are fully partitioned into separate legal entities. Without cross liability, signal two is a default by LuxuryOne, while signal one is not a default by EconoRoom. In this scenario, Bank must sit on the information that EconoRoom is about to crash until it defaults separately. Bank cannot preemptively intervene the way it could if the entities were integrated. In the meantime, EconoRoom is depreciating in value.

    Management and equity will have strong incentives to take on self-interested, risky projects that have negative expected value for LuxuryOne as a whole. To see why, consider a firm that is likely to fail. Managers have to make a choice about how to use the firm's remaining assets. If they take a conservative approach, the firm can be wound down with some value left for the creditors (but none for equity). Now let's say that there is also a risky alternative that will destroy the firm's entire value ninety-nine times out of one hundred but has a one-in-a-hundred chance of creating a huge payout that will save the business. The managers and the equity-holders get the upside of the risky project and bear none of its downside. They prefer a 99% chance of total failure to a 100% chance of moderate failure.

    Ex post, Bank in this scenario wishes that the entities were integrated. But the solution is not for Bank to demand integration ex ante. To see why, consider what happens when Bank receives signal one from LuxuryOne (no new information) and signal three from EconoRoom (project-specific incompetence). This situation essentially captures the world in which Entrepreneur has proved to be a successful manager of luxury hotels but an incompetent manager of budget hotels. Here, Bank wants to enforce only against EconoRoom and leave Entrepreneur to run LuxuryOne.

    The following example demonstrates this intuition. Let's say that when Bank made both loans, it expected a 10% return (adjusted for risk) from each. Assume also that Bank has limited capital and that if it had more capital it could take advantage of other investment opportunities with a 9% expected return. A year has passed, and Bank has received a signal of failure at EconoRoom but not LuxuryOne. Now the expected return on the remaining value of EconoRoom is 5%; LuxuryOne still has an expected return of 10%. The rational action for Bank is to call a default, and cash out only the loan to EconoRoom, and reinvest the money at 9%. Any recovery against LuxuryOne would lead to a loss of 1% in expected returns. Trying to recover losses on the EconoRoom loan from the value of LuxuryOne would be akin to the sunk-cost fallacy. The best that Bank could do is reinvest the money recovered from LuxuryOne in the market at 9%. When Bank calls a default against LuxuryOne or an integrated entity that owns it, however, the debtor might even be able to use a bankruptcy proceeding to force a renegotiation of the loan at somewhere between 9% and 10%--even when the loan prohibits prepayment or refinancing! (101)

    The facts as I have assumed them to be until now--with no other creditors --might still allow Bank to limit its actions to just the EconoRoom assets in a world of no partitioning. Bank could call a default, take a lien, and threaten foreclosure on some or all assets. Firms with one creditor cannot generally file for bankruptcy, and so Entrepreneur would not be able to do much more than threaten state-court litigation.

    But few firms have one creditor, (102) and...

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