The New Corporate Web: Tailored Entity Partitions and Creditors’ Selective Enforcement

Abstract

Firms have developed sophisticated legal mechanisms that partition assets across some dimensions and not others. The result is a complex web of interconnected affiliates. For example, an asset placed in one legal entity may serve as collateral guaranteeing the debts of another legal entity within the larger corporate group. Conventional accounts of corporate groups cannot explain these tailored partitions. Nor can they explain the increasingly common scenario where one creditor is the primary lender to all or most of the legal entities in the group.

This article develops a new theory of selective enforcement to fill these gaps. When a debtor defaults on a loan, the default may signal a failure across the entire firm or it may signal an asset- or project-specific failure. Tailored partitions give a primary monitoring creditor the option to select between project-specific and firm-wide enforcement depending on the signal it receives. In this way, firm-wide risks and failures can be addressed globally while the costly effects of project-specific risks and failures can be locally contained. This option for precision makes monitoring and enforcing loan agreements less costly and, in turn, reduces the debtor’s overall cost of capital.

These concepts of selective enforcement and tailored partitions have important implications for legal theory and practice. In addition to providing a cohesive justification for the web of entity partitions and cross liabilities that characterize much of corporate structure today, they also inform how bankruptcy courts should approach a wide range of legal and policy issues from holding-company equity guarantees and good-faith-filing rules, to fraudulent transfers and ipso facto clauses.

Keywords: bankruptcy, firms

JEL Classification: K20