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A nexus of contracts theory of legal entities

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  • Ayotte, Kenneth
  • Hansmann, Henry

Abstract

In this paper, we develop a theory that explains why firms are so commonly organized as legal entities that are formally distinct from their owners. A legal entity permits an owner to create a firm as a bundle of contracts that can be transferred to someone else, but only if they are transferred together. This bundled assignability allows for a balancing of several potentially conflicting interests. First, the owner who assembles the contracts wants liquidity – that is, the ability to transfer the contracts and cash out. Second, the firm's contractual counterparties want protection from opportunistic transfers that will reduce the value of the performance they have been promised. And third, the owner wants long-term commitments from the firm's counterparties to protect the value of her investments in the bundle. Because transfers of equity interests in a legal entity will generally not be considered assignments of the entity's contracts, entities reduce the contracting costs of creating bundled assignability. We find that owners will prefer bundled assignability when investments in the bundle are alienable from the owner; but when investments are specific to the owner, contracts that prohibit changes of control are optimal.

Suggested Citation

  • Ayotte, Kenneth & Hansmann, Henry, 2015. "A nexus of contracts theory of legal entities," International Review of Law and Economics, Elsevier, vol. 42(C), pages 1-12.
    • Handle: RePEc:eee:irlaec:v:42:y:2015:i:c:p:1-12
    DOI: 10.1016/j.irle.2014.10.001
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    References listed on IDEAS

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