summary chapter 5 Flashcards
The asset partitioning function of corporate law has two aspects
entity shielding A consequence of legal personality which ensures that the claims of corporate creditors have priority over shareholders (and their creditors) to the company’s asset pool
limited liability (or owner shielding) shields the assets of the firms owners (the shareholders) from the claims of the firms creditors
Asset partitioning also has a subtle impact on the firms creditors.
As creditors recourse is limited to corporate assets, lenders need only evaluate and monitor these assets, lowering their overall cost. The limitation also facilitates specialization by creditors, because those with expertise in evaluating and monitoring assets of the type owned by the firm will be able to offer cheaper credit
However, asset partitioning brings potential agency problems that may arise between debtors (shareholders) and creditors. In this case, agency problems can arise primarily in three ways:
shareholders may siphon assets out of the corporate pool in favor of themselves. This kind of action, which is something referred to as “asset dilution” (or asset diversion), increases shareholders personal wealth, but harms creditors by reducing the assets available to satisfy their claims
Creditors interests may be harmed by an increase in the reiskiness of the firms business, in particular through “asset substitution”. Here shareholders sell assets used in low-risk business activities to pay for the acquisition of assets used in high-risk business activities. Shareholders can benefit from an increase in the riskiness of the firms cash flows, because if things go well, all the extra goes to them, whereas if things go badly, they lose no more than they already had at stake. Creditors, however, will be harmed in this change, as it increases the probability that the firm will not generate sufficient cash to repay them
Shareholders may benefit at creditors expense by increasing the firms overall borrowing. If “new” creditors end up sharing the firms assets with “old” creditors in the event of failure, this reduces the expected recoveries of the old creditors should the firm default. This benefits the shareholders by enabling them, in effect, to have the benefit of finance from the old creditors on terms which, in light of the addition of the new creditors, now looks to ofavorable. This effect is sometimes referred to as “debt dilution”
Asset partitioning can also arise agency problems between creditors and creditors.
The entity shielding function of organizational law gives priority to the claims of a legal entitys creditors against its assets, ahead of the claims of its owners and their creditors. If the entity cannot pay its creditors in full from its assets, then the law must ensure shareholders receive no further payent. The way in which this is done is to give creditors the power to substitue themselves as owners, ousting the shareholders
an unpaid creditor may seek a court order enforcing its claim against the debtor assets, and
ordinarily the threat of such enforcement gives the debtor an incentive to repay. Once the firm has defaulted generally on its credit obligations, then its creditors have the option to become owners of all its assets.
However, the creditors will then face a coordintation problem. if each acts individually to enforce, this will very quickly result in the break up of the firms business as the firms assets are worth more kept together than broken up. The creditors would collectively be better off by agreeing not to enforce, and instead restructuring the firms debts.
Each creditor nevertheless has an incentive to enforce individually: those who do so first will get full payment, reather than a less than complete payout in a restructuring.
to the extent that corporate law seeks to control shareholder-creditor agency problems in solvent firms, it does so through ex ante strategies
affiliation strategy - mandatory disclosure:
Creditors generally do not contract without obtaining information from the borrower about its financial performance, unless they can rely on reputation and other publicly available information. Corporate law facilitates these transactions by requiring companies to disclose certain basic information
Rulse strategy: legal capital:
The rules strategy seeks to provide protection for them in a standardized form. The most important rules traditionally relate to “legal capital”. These can apply to at least three separate aspects of corporate finance:
Prescibing a minimum initial investment of equity capital (minimum capital) - amongst our jurisdictions, only those in europe impose minimum equity investment thresholds for access to the corporate f orm (i.e. “minimum capital” rules)
Restrictions on payments out to shareholders (distribution restrictions) - company laws generally restrict distributions to shareholders – including dividends and share repurchases – in order to prevent asset dilution
Triggering acetions that must be taken following serious depletion of capital (loss of capital)
