Legal-System Arbitrage and Parent-Subsidiary Capital Structures

Abstract:     
This paper develops a new theory of the capital structure of parent-subsidiary organization based on legal-system arbitrage: The optimal capital structure for the parent-subsidiary organization minimizes the value of the ex post opportunism options created by the organization's ability to selectively renegotiate claims of the component legal entities. This theory explains the complex mix between parent and subsidiary debt financing observed in most parent-subsidiary organizations, particularly multinational corporations and conglomerates, even in the absence of tax and private information effects. Optimal capital structures minimize the default premia associated with the organization's overall financing package by equating the marginal enforceability of debt contracts across subsidiaries. Consistent with empirical findings in Kolasinski (2009), we show that significant borrowing at the subsidiary level is optimal. Consistent with empirical findings in Desai et al (2004), we show that the parent corporation's utilization of subsidiary debt financing is positively related to the creditor-friendliness of the legal regime in which the parent company operates. Further, our model shows firms operating across legal boundaries gain from obtaining some financing even in the locations featuring less creditor-friendly legal regimes, though they will aim to structure debt ex ante to commit to ex post renegotiation under the most efficient regimes. In addition, our model produces many new empirical predictions regarding issues such as the optimal allocation of capital and overall financing policy.

Number of Pages in PDF File: 52

Keywords: Conglomerate, Capital structure, Debt renegotiation, Multinational corporation, Parent-Subsidiary Organizations

JEL Classification: G15, G32, G33, G38, K4

working papers series