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

The following post comes to us from Anthony Casey, Assistant Professor of Law at the University of Chicago Law School. It is based on his recent article, “The New Corporate Web: Tailored Entity Partitions and Creditors’ Selective Enforcement,” which is available here

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.

In a new article, I develop a 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. Thus, where two projects are partially but not fully related – say with a luxury hotel and a budget hotel – the firm can tailor partitions to allow common risks and failures to be dealt with collectively and independent risks and failures to be dealt with in a targeted and contained fashion. This option for precision makes monitoring and enforcing loan agreements less costly and, in turn, reduces the debtor’s overall cost of capital.

In the budget- and luxury-hotels example, consider a scenario where one hotel’s default sends the sophisticated creditor one of two signals: 1) managers are generally incompetent and the problems will spread to the other hotel; or 2) managers are incompetent on a project-specific basis and the problems will not spread. Tailored partitions give the creditor the option to take action against the entire firm in response to signal 1 (by way of the cross-liability provisions) or only as to the specific project in response to signal 2.

The first option is valuable because it allows the creditor to act on general signals to contain firm-wide losses. It need not wait for the second hotel to default to assert its enforcement rights. The second option – project-specific enforcement – is valuable because it reduces the significant ancillary effects caused by firm-wide responses to project-specific problems and prevents other parties from opportunistically forcing the default to spread.

The recognition of 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. This assumes different creditors will specialize in monitoring different projects within one firm. But that is not how things look on the ground. Increasingly common is the structure where a single sophisticated creditor has the expertise to monitor both the firm as a whole and the various projects individually. Theories of tailored partitions and selective enforcement can explain this. The central creditor loans to each legal entity while creating these valuable selective-enforcement options.

These options can only be created by combining entity partitions with cross liabilities. The failure to recognize that point generates confusion for the courts and introduces supposed puzzles and complexities that do not exist in the real world. For example, some hold the view that firms undo the entire effect of entity partitioning by causing affiliated legal entities to agree to cross-liability provisions. These scholars puzzle at why a corporation would partition an entity just to re-integrate it at the next moment. Why create this corporate web when the firm could just partition or not partition?

The concepts of tailored partitions and selective enforcement provide an answer to dislodge this riddle and reveal major implications for laws of finance and bankruptcy. 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.