Entity Partitioning and Tailored Bankruptcy

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The partitioning of businesses into separate legal entities has been the focus of financial and legal study for decades. This literature has looked at the implications of legal separations across various dimensions such as corporate governance, limited liability, tax, and risk partitioning. In a recently published article, No Exit: Withdrawal Rights and the Law of Corporate Reorganizations, Douglas Baird and I look at the intersection of entity partitioning and bankruptcy law.

Many recent high-profile bankruptcy cases have presented complicated questions of how legal entities should be treated in the bankruptcy process. These cases were particularly challenging because the entity partitioning before the courts could not be explained by traditional considerations such as risk allocation and limited liability. These entities were set up in a way that partitioned off assets that were part of one interconnected economic operation that could not function without the partitioned assets. The structures did not provide a liability shield and each part shared in the risk of the entire operation.

In response to these cases, the bankruptcy courts have tended to push against the edges of black-letter bankruptcy law and blur the boundaries between legal entities. The motivation for this tendency is easy to identify: The courts, all else equal, want to preserve going concern value. And that is best accomplished (from their ex post view) by keeping entities that are part of one economic enterprise together. But this tendency may be undercutting a new form of bankruptcy that has evolved to address some of the central challenges to efficient bankruptcy design.

In our article, we suggest that entity partitioning provides a middle ground between systems of mandatory bankruptcy and bankruptcy by free design. Because bankruptcy law operates on legal entities, not on firms in the economic sense, sophisticated investors can tailor the bankruptcy system in ways that reduce both the collective-action costs of a free-design system and the monitoring and incentive costs of a mandatory system. This option – which we refer to as tailored bankruptcy – allows investors to place assets in separate entities to create specific withdrawal rights (not otherwise available in a mandatory bankruptcy regime) that discipline firms that encounter avoidable financial distress. This provides the benefits of contingent withdrawal rights that have long been recognized as substitutes for costly monitoring of debtors. But in contrast to a regime of free contracting, the tailoring we examine allows investors to acquire the right to opt out of bankruptcy only if they take particular steps that are discrete and visible. This limits the information and coordination costs that would otherwise face lenders in a free-design system.

By allowing a limited number of investors to opt out of bankruptcy in this particular, discrete, and visible way, investors as a group may be able to both limit the risk of bargaining failure and at the same time enjoy the disciplining effect that a withdrawal right brings with it.

The full article is available here.

1 Comment

  1. brookeellenmcdonald

    Interesting summary of your article on how to partition entities in the most cost-effective way and tailor the bankruptcy system. This seems like an important solution in enabling investors to separate themselves from one another in the bankruptcy process so should they choose to.

    As a Twin Cities Burnsville bankruptcy lawyer I mostly deal with consumer bankruptcy, so it is interesting to read on the design of bankruptcy for legal entities. I’ll be curious to read your article.

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