Enterprise Liability and the Organization of Production Across Countries

Sharon Belenzon is Associate Professor at Duke University, Honggi Lee is from Duke University, and Andrea Patacconi is Professor at the University of East Anglia. This post is based on their recent paper.

Parent corporations often externalize the risk of tort liability through legally separate subsidiaries. For instance, utility companies in the US often create separate limited liability subsidiaries for each nuclear plant they own, arguably to protect the parent company from liabilities in case of accidents. Manville, a global leader in the manufacture of asbestos-containing products, separately incorporated its non-asbestos operations in the aftermath of asbestos litigation. Philip Morris did the same in response to tobacco litigation. Recently, Google reorganized as the Alphabet group, where a parent company (Alphabet) controls firms such as Google (online search), Verily (biotech and medical instruments) and Waymo (self-driving cars). One possible reason for the reorganization was, again, to prevent risks from spreading from one unit to another. As former Google engineer Anthony Lewandowski recalls, from the very beginning “Google was very supportive of the idea [driverless cars], but they absolutely did not want their name associated with it […] They were worried about a Google engineer building a car that crashes and kills someone.” Now a legally independent subsidiary, Waymo, builds self-driving cars.

How to deal with risk externalization by parent companies is a controversial issue in corporate law. Scholars such as Adolf Berle have long advocated a system where the legal fiction of the separate personhood of subsidiary companies is disregarded, but no consensus on the matter has been reached. Thus, countries differ in their propensity to protect parent and sister companies from the liabilities incurred by other group affiliates, with some countries (e.g. Germany) viewing a subsidiary as an integral part of the group that controls it while others (e.g. Great Britain) emphasizing the legal rather than the economic substance. (The US is an intermediate case. American courts consider parent-subsidiary veil piercing under the general framework used for other cases, with no reference to an overarching enterprise theory imposing special legal regime. Nonetheless, unique features of corporate groups appear to be considered by the courts as piercing factors under the general framework.)

In a recent paper, we examine how enterprise liability—the propensity of legal systems to hold an entire group liable for the losses incurred by one of its affiliates—affects the organization of economic activity across countries. We argue that in countries where enterprise liability is weaker, corporations have a greater incentive to incorporate their units as legally independent subsidiaries (asset partitioning), while also granting these units more decision-making autonomy. In addition, by compartmentalizing risk, asset partitioning also tends to spur investment and growth.

We test these hypotheses empirically by exploiting the variation across countries in the propensity to hold corporate groups liable for the losses incurred by their affiliates. We focus on “piercing the corporate veil” (PCV, hereafter), the key exception to the principle of limited liability. The more inclined the courts are to pierce the corporate veil in cases involving groups and their subsidiaries, the stronger enterprise liability is.

We construct a novel measure of enterprise liability for sixteen countries in Europe, the Americas, and Asia. Countries were scored on a scale of 0 to 5 according to the tendency of their courts to pierce the corporate veil in lawsuits involving corporate group affiliates. (A higher score indicates stronger enterprise liability.) The score was based on a weighted average of five distinct criteria: enterprise approach, variety of legal provisions courts consider in holding the owners liable for the losses of the firms they own, availability of corporate veil piercing outside of bankruptcy cases, availability of corporate veil piercing outside of fraudulent behaviors, and fraction of historical enterprise liability cases in which the corporate veil was pierced. (Annex 1 of the paper provides details on how the measure was constructed.)

Our estimation sample is from the Bureau Van Djik’s Orbis database and consists of 931,018 corporate groups with 1,236,169 subsidiaries across sixteen countries over the period 2002-2014. Firm-level measures of managerial autonomy are from the World Management Survey (WMS). The WMS sample covers around 1,500 firms across eleven countries over the period 2005-2014.

We present three main findings. First, we find that corporate groups in countries with weak enterprise liability tend to partition their assets more finely than groups in countries with strong enterprise liability. According to our estimates, for instance, moving from Great Britain where enterprise liability is the weakest (PCV score of 1.3) to Germany where enterprise liability is the strongest (PCV score of 3.93) is associated with a 16 percent reduction in the number of subsidiaries, conditional on group size and country-level controls, including legal origins. Interestingly, we also find that asset partitioning is more prevalent in industries where downside risk is high, consistent with the idea that asset partitioning is used to compartmentalize risk.

Second, subsidiaries operating in countries with weak enterprise liability also appear to enjoy more decision-making autonomy than subsidiaries operating in countries with strong enterprise liability. For instance, a one point increase in PCV score (meaning stronger enterprise liability) is associated with about a 49 percent decrease in the amount of capital that a subsidiary can invest without a prior authorization from corporate headquarters.

Lastly, we provide causal evidence that asset partitioning, by compartmentalizing risks, facilitates corporate group growth. Using instrumental variable regressions, we show that a 10 percent increase in the number of subsidiaries leads to 3 percentage point increase in yearly revenue growth.

Taken together, our results highlight the importance of risk compartmentalization through incorporation as an important factor in the international organization of production and, in particular, the creation of new subsidiaries. One must be careful in drawing welfare implications from our analysis. On the one hand, shielding parent companies from the liabilities arising from risky projects can encourage experimentation and foster economic growth. Our empirical analysis tends to emphasize such ‘classical’ benefits of limited liability. However, the costs of failed experimentation may disproportionately fall on consumers or other ‘weak’ corporate stakeholders, such as future generations. Striking a balance between these conflicting concerns is difficult and more research is needed to quantify the costs of weak enterprise liability regulation.

The complete paper is available for download here.

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