University of Virginia Legal Working Paper Series
University of Virginia John M. Olin Program in Law and Economics Working Paper Series
Economic and Legal Boundaries of Firms
Article comments
Forthcoming: Virginia Law Review (2007)
Abstract
Two types of theories of the firm have emerged in scholarship. Economic theories concern the allocation of control rights and residual claims: A firm is a group of assets under common ownership. Legal theories focus on the legal significance of firm boundaries: Each firm is a legal person. Thus, assets may be economically integrated under common control and yet be partitioned between distinct legal entities. This paper presents a theory of legal boundaries that focuses on the choice of capital structure, and traces the interplay between economic integration and legal partitioning. Many capital structure decisions, including both financial and governance features, are personal in the eyes of the law and they must be made firm-wide: for example, the issuance of debt or of equity, the adoption of takeover defenses and the composition of the board of directors. Yet, the determinants of optimal capital structure are often asset-contingent: for example, the amount of leverage, the desirability of takeover defenses and the number of independent directors may vary with the industry. The resulting tension is significant in the choice of firm boundaries. If two groups of assets have divergent capital structure demands – in that the optimal design of financial and governance rights related to each group is different – then either the assets are put in separate firms that tailor capital structure to their respective asset groups or they are combined in a single firm with a blended capital structure. We suggest that “legal” integration in a single firm sacrifices efficiency in some cases, but not in others. Where the efficiency losses are large enough to offset countervailing advantages from legal integration, we expect legal partitioning to occur. We demonstrate that legal partitioning may undermine the benefits from economic integration, even if the discrete firms are kept under common control (as that concept is defined in law). Our theory offers new explanations of the structure of combinations (e.g. mergers or acquisitions) and divestitures (e.g., spin-offs, carve-outs or securitizations).
Subject Area
Law and Economics
Recommended Citation
Edward M. Iacobucci and George G. Triantis,
"Economic and Legal Boundaries of Firms"
(June 2006).
University of Virginia Legal Working Paper Series.
University of Virginia John M. Olin Program in Law and Economics Working Paper Series.
Working Paper 31.
http://law.bepress.com/uvalwps/olin/art31
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