Entity shielding and the rule of debt-follow-asset and its benefits.

By Sneha Murali

School of legal studies, Cusat, Ernakulam

Legal personality has been regarded as one of the essential characteristics of modern corporations. Legal rules make each individual a distinct legal entity, meaning that she has the authority to enter into contracts in her name and that she owns a pool of assets (her property) that bonds her performance of those contracts. Section 9 of the Indian companies act, 2013, affects making the association a legal entity. It is a separate entity from its shareholders/members. The company decides its name and seal. The assets of the company are held by the company and are separate from its member’s assets. Indeed, “contracting entity” might be a more appropriate name than “legal entity” (or “juridical person”), as the critical factor is the entity’s ability to enter into contracts in its own right. 

Today, it is common to reserve the term “legal entity” (or “juridical person”) for “artificial” persons — such as business corporations, limited liability companies, nonprofit corporations, or municipalities — as opposed to “natural” persons. However, there is nothing inevitable about endowing individual human beings with the powers to own assets and make contracts.  Instead, individuals have these powers only if the law recognizes them.  Moreover, often it has not. Ancient Rome is an example. Since a corporation is a legal entity separate from its shareholders, its assets are usually shielded from its shareholders’ creditors. Scholars refer to this arrangement as entity shielding and generally consider it as an efficient arrangement.

The term entity shielding refers to the rules that protect a firm’s assets from the owner’s creditors. It covers the firm’s assets from the owner’s creditors and creditors from other business ventures, thus preserving those assets for the firm’s creditors in modern legal entities.

 Entity shielding takes three forms: –

Weak entity shielding merely gives the claims of firm creditors priority over those of personal creditors. This rule characterizes the modern general partnership.

Strong entity shielding adds a rule of liquidation protection to the protections of weak entity shielding. Liquidation protection restricts both firm owners’ and their personal creditors’ ability to force the payout of an owner’s share of the firm’s net assets — conceptually distinct traits but that, for reasons we will explore, usually come paired. The modern business corporation provides a familiar example of strong entity shielding: not only do corporate creditors enjoy a prior claim to the corporation’s assets, but they are also protected from a shareholder or his creditors attempting to liquidate those assets. 

Complete entity shielding describes a regime whereby non-firm creditors — including creditors of the firm’s (beneficial) owners, if any — lack any claim to firm assets. Common contemporary examples of entities with this trait include nonprofit corporations and charitable trusts. The manager’s creditors and the beneficiaries do not enjoy any claim to the organization’s assets, which only bond contractual commitments made in its name.

All entity forms used by modern commercial firms exhibit entity shielding. Unlike owner shielding, entity shielding can be achieved only through the special property rules of entity law. For this reason, we believe that entity shielding is the sine qua non of the legal entity, and we divide legal entities into weak entities, strong entities, and complete entities based on the degree of entity shielding they provide.

It would be nearly impossible to develop effective entity shielding without special rules of law. Entity shielding limits personal creditors’ rights by subordinating their claims on firm assets to firm creditors, and strong entity shielding also limits their ability to liquidate firm assets. Although a firm’s owners, in theory, could achieve either of these results by negotiating for the requisite waivers in all contracts with their creditors, the negotiation of such waivers, beyond involving high transaction costs, would be fraught with moral hazard. Each waiver would improve the firm creditors’ position and benefit all firm owners by decreasing the firm’s borrowing costs. However, each waiver would also increase personal borrowing costs, and that cost would be borne entirely by the owner who negotiated the waiver. Each owner would thus face an incentive to act opportunistically by omitting the waivers from personal dealings. 

Moreover, other owners and firm creditors would find such omissions very difficult to police given the significant freedom individuals enjoy in their  dealings.

 Many owners exacerbate the problem by making monitoring more difficult and heightening the conflict between personal and collective interests. The policing problem is further compounded if shares of ownership are freely transferable so that the set of owners is constantly changing. These problems can be solved only by impairing personal creditors’ rights without their contractual consent (and often even without notice). Doing that requires a special rule of property law respecting assets committed to the firm, and entity law provides that rule. The primary virtue of legal entities is that they impose property rules that slice through the hazards of pursuing entity shielding by contract. However, this virtue is also a potential vice since a legal device that enables an individual to impair creditors’ rights without their consent invites abuse. 

Benefits

Entity shielding provides lots of benefits. It provides economic advantages by reducing information costs and solving problems associated with joint ownership. All entity shielding forms reduce creditor monitoring costs by protecting creditors from risks they cannot easily evaluate. As all forms of entity shielding enable creditors to specialize in particular asset pools, they also enable bankruptcy courts to specialize with comparable benefits. Thus, it reduces the administrative costs of bankruptcy. When a rule of liquidation protection is added to the priority of claim for entity creditors, increasing the degree of entity shielding from weak to strong additional benefits can be realized, perhaps the most important of protecting a firm’s going-concern value. 

The right to withdraw assets at will can be valuable to an owner of a firm. By reducing the need for a firm’s owners to monitor each other’s non-firm financial affairs, entity shielding reduces the costs to owners of bringing on additional equity investors, particularly when they are not family, friends, or others are particularly easy to monitor or trust. This, in turn, makes it easier for individuals to make equity investments in multiple firms and diversify risk. While this is true for all types of entity shielding, it is particularly true for strong entity shielding because of the advantages of liquidation protection. Liquidation protection reduces the need for owners to monitor each other’s personal affairs. It also reduces the importance of restrictions on who may become an owner, thereby promoting shares’ free transferability. 

Conclusion

These observations imply that although the law has lifted one constraint on forming strong entities the need to protect entity creditors and investors, it is just beginning the task of sorting through a second constraint, the need to protect third-party creditors unaffiliated with the entity itself. This task may ultimately require a rich and subtle jurisprudence, both inside and outside of bankruptcy. We expect these problems of entity shielding to play a dominant role in the next organizational law evolution phase.

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