Legal Entities as Transferable Bundles of Contracts

The following post comes to us from Kenneth Ayotte, Professor of Law at Northwestern University, and Henry Hansmann, Professor of Law at Yale University.

The large modern business corporation is frequently organized as a complex cluster of hundreds of corporate subsidiaries under the common control of a single corporate parent. General Electric, for example, has over 1500 subsidiaries, most of them wholly-owned. What is the purpose of all these subsidiaries? Do they exist only as a means of avoiding taxation and regulation? Or are there real efficiency gains that subsidiaries can help unlock?

In our paper, Legal Entities as Transferable Bundles of Contracts, which was recently made publicly available on SSRN, we provide new theory and supportive evidence that help explain a relatively unexplored benefit of subsidiaries. We focus, in particular, on the advantages of subsidiary entities in enhancing the transferability of a business unit. The theory not only sheds light on corporate subsidiaries, but illuminates a basic function of all types of legal entities, from partnerships to nonprofit corporations.

Many of the modern firm’s key assets come in the form of bilateral contracts, in which both parties to the contract are exposed to performance risk from the other party. Take, for example, the movie rental company, Redbox, which is a wholly-owned subsidiary of Coinstar. Many of Redbox’s key assets are contractual, including agreements with movie studios to acquire DVDs, and revenue sharing agreements with companies like Wal-Mart that house Redbox kiosks. Real estate, such as corporate headquarters and processing facilities, are frequently acquired through long-term leases.

When contracts are bilateral, both the firm’s owner(s) and the firm’s contractual counterparties are exposed to the risk of opportunism regarding the potential transfer (assignment) of the firm’s key contracts. The owner faces opportunistic holdup by counterparties if counterparty consent is required to assign contracts in a sale of the entire firm. The firm’s counterparties, in turn, are exposed to opportunistic assignment if the owner can assign contracts on an individual basis without consent. We show that this bilateral opportunism problem can be mitigated through bundled assignability: the owner is permitted to assign her contracts freely, but only as a bundle. The components of the bundle of contracts (which constitutes much of the firm itself) provide assurance of performance to counterparties. And free transferability, in turn, gives the owner liquidity without risk of holdup. Most importantly — and least appreciated in the literature and the case law — bundled assignability increases the owner’s incentive to make valuable investments in the firm.

We explain why subsidiary entities provide the simplest reliable means of creating bundled assignability. Further, we support our analysis with the first empirical study of assignment clauses in commercial contracts. Firms, we show, commonly provide for bundled assignability in their contracts, and they use legal entities to define the boundaries of transferable bundles. This suggests that, in practice, contracting parties are aware of the forces underlying our theory.

The full paper is available for download here.

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One Comment

  1. Kate
    Posted Sunday, May 27, 2012 at 10:22 am | Permalink

    And I suppose all the subsidiaries have nothing to do with protecting the rest of the corporate conglomerate from risk – of counterpart non performance, or tort liability, etc…. ?

    It seems to me that the excessive use of subs in recent times is an abuse of the corporate form. Not only are shareholders protected from risk, but the company itself is protected from risk. And the point of the corporate form – encouraging investment – is moot, given the one-shareholder wholly owned sub context.