NBER WORKING PAPER SERIES TOWARDS A LEGAL THEORY OF THE FIRM: THE EFFECTS OF ENTERPRISE LIABILITY ON ASSET PARTITIONING, DECENTRALIZATION AND CORPORATE GROUP GROWTH Sharon Belenzon Honggi Lee Andrea Patacconi Working Paper 24720 http://www.nber.org/papers/w24720 NATIONAL BUREAU OF ECONOMIC RESEARCH 1050 Massachusetts Avenue Cambridge, MA 02138 June 2018 The authors appreciate the support and comments from Ashish Arora, Nick Bloom, Wesley Cohen, Alfonso Gambardella, and John Van Reenen. All errors are our own. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research. NBER working papers are circulated for discussion and comment purposes. They have not been peer-reviewed or been subject to the review by the NBER Board of Directors that accompanies official NBER publications. © 2018 by Sharon Belenzon, Honggi Lee, and Andrea Patacconi. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source. Towards a Legal Theory of the Firm: The Effects of Enterprise Liability on Asset Partitioning, Decentralization and Corporate Group Growth Sharon Belenzon, Honggi Lee, and Andrea Patacconi NBER Working Paper No. 24720 June 2018 JEL No. K0,K12,O43,P1 ABSTRACT Limited liability is a key attribute of the corporate form and one of the most important institutional innovations of the nineteenth century. However, when the owner of a corporation is another corporation as in many corporate groups, an important justification for limited liability— to protect small, passive investors from unlimited losses—is severely weakened. Accordingly, countries differ considerably 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. In this paper, we construct a novel country-level measure of enterprise liability, the propensity of courts to hold an entire group liable for the obligations of one of its subsidiaries. Using data from sixteen countries in Europe, the Americas, and Asia, we examine how enterprise liability affects firm boundaries, internal organization, and corporate group growth. We find that in countries where enterprise liability is weaker, groups tend to partition their assets more finely into distinct legally independent subsidiaries and grant their subsidiaries more autonomy. Groups also tend to grow faster. This paper highlights one underappreciated channel—risk compartmentalization through incorporation —through which legal systems affect economic outcomes. Sharon Belenzon Andrea Patacconi Fuqua School of Business Norwich Business School Duke University University of East Anglia 100 Fuqua Drive Norwich, NR4 7TJ, Durham, NC 27708 United Kingdom and NBER [email protected] [email protected] Honggi Lee Duke University Fuqua School of Business [email protected] 1 Introduction Entrepreneurs are unlikely to invest when the risks associated with private enterprise are too great. In an important book, Rosenberg and Birdzell (1986) argue that a key reason why the West grew rich was that, in Europe, several important institutions were created that reduced the risks associated with private enterprise. These institutions include reforms that recognized property rights and reduced the risk of expropriation by political elites (North and Thomas, 1973; Acemoglu, Johnson and Robinson, 2005), the development of a comprehensive and predictable commercial law (Weber, 1961; La Porta, Lopez-de-Silanes, Shleifer and Vishny, 1998), and the diffusion of economic associations without kinship (Dari-Mattiacci, Gelderblom, Jonker and Perotti, 2017; De la Croix, Doepke and Mokyr, 2018). One way to reduce entrepreneurial risk is through incorporation and limited liability. Several schol- ars, including Rosenberg and Birdzell, have stressed the importance of the limited liability corporation. Columbia University president Nicholas Murray Butler wrote in 1911 that \in my judgment the limited liability corporation is the greatest single discovery of modern times. [. ] Even steam and electricity are far less important than the limited liability corporation, and they would be reduced to comparative impotence without it".1 Harvard University president Charles W. Eliot noted that limited liability is \the corporation's most precious characteristic and by far the most effective legal invention made in the nineteenth century".2 Limited liability is important because it reassures investors that their losses will be limited to the amount they have invested in a company. Because downward risk is bounded, limited liability encourages entrepreneurship, the formation of large firms, the separation of ownership and control, and the develop- ment of liquid capital markets. However, limited liability may also encourage excessive risk taking, as the costs of failed economic enterprise are partly externalized to other stakeholders. It is also possible to use incorporation and limited liability to compartmentalize liabilities, thus pre- venting risks from spreading across business units. For instance, Roe (1986) notes that Manville, a global leader in the manufacture of asbestos-containing products, separately incorporated its non-asbestos op- erations in the aftermath of an asbestos litigation. Philip Morris CEO Hamish Maxwell admitted to analysts that he formed a holding company \to better insulate each business from obligations and li- abilities incurred in unrelated activities" (quoted from Roe, 1986: 5). Schlissel, Peterson and Biewald (2002) note the increasing use of multi-tiered group structures to own nuclear power plants in the US 1The quote is from a speech titled \Politics and Economics"to the 143rd Annual Banquet of the Chamber of Commerce of the State of New York in 1911. Available at: https://babel.hathitrust.org/cgi/pt?id=coo.31924093105660;view=1up;seq=59. 2This quote is from Bainbridge and Henderson (2016). 2 and argue that such structures provide a financial shield to owners in case of accidents.3 Google recently restructured its operations as the Alphabet group. Bloomberg (2017) reports that a potential advantage of the new structure is that it \helps keep potential challenges in one business from spreading to another [. ] By separating them, it allows the parent company to limit the exposure of the various obligations of the LLCs". 4 '5 In this 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 firm boundaries, internal organization and corporation growth.6 Using a simple model, we show that weaker enterprise liability encourages corporations (i) to more finely partition their assets into separate legally independent units and (ii) to grant these units more decision-making autonomy. Indeed, headquarters benefit more from asset partitioning and can feel more confident about delegating authority to subsidiary managers if the consequences of bad decisions are not likely to spread to other units.7 Moreover, because risks are better compartmentalized when assets are more finely partitioned, (iii) asset partitioning also tends to spur investment and growth.8 We test these hypotheses empirically by exploiting the fact that there is substantial variation across countries in the propensity to disregard the separate legal personality of an affiliated entity and hold the whole corporate group liable for its losses. Our analysis focuses on the fundamental exception to limited 3Schlissel et al. (2002: 2) write that \Over the last ten years, the ownership of an increasing number of nuclear power plants has been transferred to a relatively small number of very large corporations. These large corporations have adopted business structures that create separate limited liability subsidiaries for each nuclear plant, and in a number of instances, separate operating and ownership entities that provide additional liability buffers between the nuclear plant and its ultimate owners". One goal of these structures is arguably to \provide a financial shield for the parent/owner if an accident, equipment failure, safety upgrade, or unusual maintenance need at one particular plant creates a large, unanticipated cost". 4See https://www.bloomberg.com/news/articles/2017-09-01/alphabet-wraps-up-reorganization-with-a-new-company- called-xxvi. 5As these examples suggest, externalization of risks is likely to be salient especially when involuntary creditors (e.g., tort creditors) are involved. We elaborate on this important issue in Section 2.2 and in the conclusion. 6The term \enterprise liability"is not universally agreed upon. Some legal scholars (e.g., Bainbridge and Henderson, 2016) use this term to refer only to the case when sister companies are held liable (a \horizontal"form of liability, or veil piercing), thus distinguishing that notion from the traditional or \vertical"notion of liability involving a company and its owners. Here, however, we follow the majority of commentators and use the term enterprise liability to encompass both notions of liability (horizontal and vertical) in the context of corporate groups. Thus, \enterprise"refers in this paper to the unified economic group of corporations (where control is exerted