SOMMARIO:

I Introduction. - Diversification and Asset Partitioning - 1.1. Multidivisional firms, economies of specialization and the economic rationales for diversification. - 1.2. Diversification and the organisation of different business activities. - 1.3. Benefits of asset partitioning. - 1.3.1. Rationalisation of the management of business risk. - 1.3.2. Protection of a firm’s going concern value. - 1.3.3. Reduction of the cost of credit. - 1.4. Costs of asset partitioning. - II Separate Pools of Assets - 2.1. The discipline of separate pools of assets (“Patrimoni destinati ad uno specifico affare”). A brief overview. - 2.2. Advantages of creating separate pools of assets. - 2.2.1. Priority of creditors’ claims. - 2.2.2. Reduction of monitoring costs. - 2.2.3. Separate pools of assets and risk-return profiles. - 2.3. Problems arising from the creation of a separate pool of assets. - 2.3.1. Opportunistic behaviour and transparency rules. - 2.3.2. Moral hazard and the “piercing the corporate veil” doctrine. - 2.3.3. Problems related to the existence of different classes of creditors: asymmetry of rights and conflicts of interest. - 2.3.4. Separate pools of assets and insolvency. - III Spin-Offs and Separate Pools of Assets - 3.1. What is a spin-off. - 3.1.1. Advantages of spin-offs. - 3.1.2. Spin-offs and creditor protection. - 3.2. Spin-offs and separate pools of assets. A comparison from a law and economics perspective. - 3.3. Conclusion. - NOTE

I Introduction.

The globalization of capital markets and developing competition between legal systems forced the Italian legislature to reform the national corporate law system in 2003. In such a context, a legal system is only competitive if corporations are provided with a wide range of financial sources from which to raise capital [1]. The Italian reform of corporate law (hereinafter “Reform”) [2] definitely moved in this direction, as it was expressly aimed at favouring the competitiveness of firms by facilitating their access to national and international capital markets [3]. One of the most innovative rules introduced by the Reform concerns the possibility for corporations (more precisely, the form of corporation known as “società per azioni” in the Italian system) [4] to create one or more separate pools of assets (“Patrimoni destinati ad uno specifico affare”) [5] and to allocate them to the accomplishment of one or more specific transactions [6]. A pool of assets can be isolated from the creditors of the corporation (“general creditors”) [7]: that is to say the assets are included in the pool to satisfy only those claims arising from the specific transaction to which the pool of assets is designated. Thus, the creditors of the separate pool of assets (“special creditors”) have an exclusive claim on the assets included in the distinct pool while the general creditors have no claim on them [8]. Conversely the special creditors have no claim, at least as a rule, on assets that are not included in the separate pool [9]. Simply put, a separate pool of assets enjoys limited liability for the obligations arising from a specific transaction and therefore represents an alternative to creating a distinct corporation through a spin-off [10]. The separate pool of assets constitutes a corporation-like entity, or a kind of “corporation within a corporation” [11], or better, a sort of “segregation within segregation” [12], as it is suggested by the fact that an initial form of asset segregation already exists between corporate assets and shareholders’ personal assets [13]. Even the parliamentary interpretative commentary of the delegating law for the Reform (hereinafter “Interpretative commentary”) recognizes that the designation of a separate pool of assets represents an alternative to the creation of a [continua ..]

Diversification and Asset Partitioning

1.1. Multidivisional firms, economies of specialization and the economic rationales for diversification.

Nowadays the market is widely dominated by the existence of multidivisional firms, engaged in different sectors of industry. Currently, the idea of a firm that produces only a single type of product or service may be considered an abstraction of economic theory rather than a reality. Firms tend to increase their size and to grow through a process of diversification, which is the only way to ensure a certain degree of stability in the creation of their value[20]. There are several sound economic reasons for implementing a multidivisional structure in a firm adopting a growth strategy. A traditional justification for diversification is based on the need to split the business risk and to undertake a more balanced range of business activities. A firm can avoid wide fluctuations in its performance by operating in various sectors characterized by different degrees of riskiness: a poor performance in one sector of activity can be compensated by a good performance in another sector thus ensuring a certain degree of income stability[21]. However, the traditional basis for diversification appears now to be outdated. It has been argued that it is quite unlikely that a firm would have the necessary know-how in all its various activities and still enjoy the same comparative advantage in every sector of its operation. It is more likely that embarking on new activities which are unfamiliar would increase rather than reduce the risk of the undertaking. Besides, the increase of riskiness seems to be coherent with the increase of the total expected profits of a diversification strategy[22]. It is not by chance that in the last thirty or forty years concentric diversification has prevailed completely over conglomerate diversification. Many growth strategies are now carried out by adding new goods and services which are closely related to the goods and services already produced and distributed by the firm: the introduction of products unrelated to the existing core business of the firm would only increase the riskiness of the diversification strategy. The primary economic rationales for diversification are different: efficient allocation of corporate resources and achievement of economies of scale and scope. It is well-known that, under certain conditions, it is more efficient to organise production within a firm rather than carrying out transactions on the market. In his renowned article “The Nature of the Firm”, Ronald Coase explains that the transaction [continua ..]

1.2. Diversification and the organisation of different business activities.

A firm engaged in different lines of business has to face the problem of structuring and organising all its activities within the same proprietary sphere. The way the firm is structured and the way its production is organised has a strong influence on the overall value of the firm itself. Basically the firm can choose between two main options: (a) either to carry on its different business activities within the same legal entity (the corporation itself, divided into different strategic business units), or (b) to separate its assets (“asset partitioning”) creating one or more distinct legal entities (subsidiary corporations) or sub-entities (separate pools of assets in the Italian legal system), each one engaged in the production of a different class of product or service. When the first option is chosen, all the administrative costs of creating a separate legal entity (or sub-entity) are saved. On the other hand, several problems and costs might be associated with the management of a multidivisional corporation with different business units. The board of directors must allocate the corporate resources efficiently to maximise the overall value of the firm and to avoid at the same time development of conflicts of interests between different classes of stakeholders. When the second strategy is chosen, the costs of creating distinct legal entities (or sub-entities) are compensated by several efficiency advantages in the organisation of large firms engaged in different lines of business[26]. The example chosen by Hansmann and Kraakman to illustrate how much the choice of the corporate structure can be important is very explicative and it is worth quoting: “Imagine a company that is engaged in two distinct lines of business: ownership and management of a chain of hotels, and ownership and management of oil fields and refineries. Then consider two distinct ways in which these entities could be structured: (1) as a single corporation with two operating divisions, one for the hotel business and one for the oil business; (2) as two distinct corporations, one for the hotel business and one for the oil business, both of which are wholly owned by a single parent holding company that has no separate assets of its own, but simply holds all of the stock of the two subsidiary corporations. In terms of decision-making authority, the two structures are essentially identical: in each, the single board of directors of the parent firm has complete control [continua ..]

1.3. Benefits of asset partitioning.

According to the definition given by Hansmann and Kraakman, asset partitioning consists in the “designation of a separate pool of assets that are associated with the firm” and which are distinct from the general assets of the firm, and is characterised by the “assignment to creditors of priorities in the distinct pool of assets that results from the formation of a legal entity”[28]. To avoid confusion, it is important to distinguish between the concept of “separate pool of assets” in the strict sense of the expression and the use of the same locution in a broader and more generic sense. In this paper the expression is always used in a strict sense, referring to the specific institution of “patrimoni destinati ad uno specifico affare” (asset partitioning without the creation of a new corporation). On the contrary, when Hansmann and Kraakman speak of “separate pool of assets” and “legal entity”, they only refer to the creation of a subsidiary corporation with its own assets that are separated from the assets of the parent holding corporation. Obviously, the authors do not refer to the institution of “patrimoni destinati ad uno specifico affare”, which exists in the Italian legal system and is unknown in the American legal system. In any case all remarks made by Hansmann and Kraakman about asset partitioning and different “legal entities” with reference to the creation of a subsidiary corporation also apply to the specific case of “patrimoni destinati ad uno specifico affare”. The essential function of asset partitioning is to shield the assets of the new entity from the claims of the creditors of the parent entity: depending on the type of asset partitioning, the creditors of the new entity have an exclusive or prior claim on the entity’s assets. The characteristics and functions of asset partitioning as described make it an efficient way of reorganising production capable of improving the allocation of resources of the firm. Asset partitioning ensures a more rational management of business risk thus creating incentives for investment[29], enhances the value of the firm, protects its going concern value and reduces the cost of credit.

1.3.1. Rationalisation of the management of business risk.

A primary benefit associated with asset partitioning is the rationalisation of the management of business risk and the consequent creation of incentives to investment. It is well-known that limited liability fosters optimal investment decisions. According to the most authoritative literature[30], limited liability encourages managers to “maximize investors’ welfare by investing in any project with a positive present value”: the shield of limited liability allows them to “accept high-variance ventures (such as the development of new products) without exposing the investors to ruin”. On the contrary, without the protection of limited liability, managers would reject some projects with positive net present values as being too risky. The cited benefits of limited liability in terms of rationalisation of business risk are generally discussed whenever corporations and partnerships are compared[31]. Yet, it is important to note that the same benefits of limited liability described here, a fortiori apply to every form of corporate asset partitioning. Indeed, asset partitioning is nothing more than a further fragmentation of liability and sharing of risk spreading within the same proprietary scheme. The benefits of limited liability (and asset partitioning) have particular relevance in firms engaged in different lines of business. A multidivisional corporation, which carries on different business activities within the same legal entity, already enjoys the cited benefits of limited liability: the liability of the corporation is limited to its own assets and the management can invest in risky projects. However, the pursuit of certain business objectives could still expose the corporation to very high risks, so the corporation might be willing to face those risks exposing only a fraction of its own assets[32]. Then, the firm might decide to segregate its assets creating one or more separate legal entities, each one engaged in the production of a different product or service: in such a case the benefits offered by limited liability in terms of rational management of business become even stronger. Asset partitioning means fragmentation and specialisation of liability and risk. When managers invest in risky business, they know that the enterprise will be liable only with that part of partitioned assets devoted to that specific sector of activity. On the contrary, the multidivisional firm is always liable with all its assets, no matter [continua ..]

1.3.2. Protection of a firm’s going concern value.

Another important function of asset partitioning is the protection of a firm’s going concern value. Asset partitioning not only assigns to the creditors of the separate entity a prior or exclusive claim on the partitioned assets, but also provides that, if the parental legal entity becomes insolvent[33], the parental legal entity’s creditors are not allowed to force liquidation of the separate assets to satisfy their claims[34]. To use the words of Hansmann and Kraakman, the creditors of the separate pool of assets enjoy “priority with liquidation protection”[35]. In the absence of liquidation protection, the creditors of the separate entity might force liquidation of some or all of the assets of the parental entity, destroying the going concern value of the latter. If the going concern value of the firm is greater than its liquidation value, then the liquidation is inefficient. The liquidation protection offered by entity shielding eliminates the risk of inefficient liquidation of the firm and makes asset partitioning an effective instrument to preserve going concern value.

1.3.3. Reduction of the cost of credit.

Asset partitioning reduces the cost of credit because it decreases the monitoring costs borne by creditors. It may be reasonably supposed that, when dealing with a firm, every potential creditor wants to assess the firm’s creditworthiness. The ability of the firm to meet its debt obligations is evaluated on the basis of the following principal factors: the capacity of corporate assets and the way the firm is managed and carries on its business. The resources spent by creditors on evaluating these factors are called monitoring costs. To better understand how asset partitioning can reduce monitoring costs, let’s recall the example of the firm engaged in the hotel business and in the oil business[36]. Let us imagine that a supplier of linen to the hotel business is interested in dealing with the firm in question and, therefore, wishes to judge the financial viability of the firm in the hotel industry[37]. The supplier, who is used to dealing with other hotel chains, is certainly acquainted with the overall financial and economic performance of the hotel industry. Moreover, after dealing regularly with the particular hotel chain in question, the supplier is likely to acquire a lot of information that will enable him to estimate whether the firm is financially healthy and whether it is well managed or not. In other words, the supplier can use his knowledge about the hotel industry in order to assess the creditworthiness of the firm. However, the supplier to the hotel industry is not likely to know very much about the oil industry in general and about the oil business carried on by the firm in question in particular. At this point there are two possible scenarios: either the hotel business and the oil business are run by separate corporations[38], or both the hotel and oil business are operated in separate divisions within the same conglomerate corporation. In the first case, the hotel business is operated by a separate legal entity, with its own separate assets and management. Therefore, the supplier does not need to be concerned about the prospects of the oil business. The hotel corporation is not liable for the obligations arising from the oil business and so, even in case of insolvency of the firm’s oil business, the ability of the firm to satisfy the claims of the hotel business is not affected. Hence, the supplier does not need to monitor the oil business but only the hotel business. This is not true when both the hotel and the oil [continua ..]

1.4. Costs of asset partitioning.

The benefits of asset partitioning have been described. Asset partitioning constitutes a very efficient way of organising production in a firm engaged in various sectors of activity and offers a solution to those problems related to the coexistence of different business units within the same firm. The most typical form of asset partitioning[40] for firms engaged in different lines of business is the creation of one or more subsidiary corporations through a spin-off. As already mentioned[41], in 2003 the Italian legislature introduced a new, alternative method of asset partitioning, by allowing corporations to designate a separate pool of assets (“patrimoni destinati”) for the accomplishment of a specific transaction without the necessity of forming a spin-off and thus creating a new juridical person. The efficiency advantages of asset partitioning discussed in this paragraph apply both to spin-offs and to the Italian separate pool of assets. Nevertheless, as Hansmann and Kraakman warn, “asset partitioning will reduce the overall costs of credit only when its benefits outweigh [its] disadvantages”[42]. The costs of asset partitioning come, basically, from the increased risk of opportunistic behaviour by the debtor and the related problem of creditor protection. Hence the need to find a set of rules that best governs creditor protection and reduces the typical costs of asset partitioning[43]. Different forms of asset partitioning might be regulated under different rules and the wrong rules might compromise the effectiveness of the benefits deriving from asset partitioning. The selection of the most appropriate organisational and structural legal framework is crucial for the implementation of a diversification strategy. The choice of corporate structure and the organisation of corporate assets and resources should be largely influenced by the applicable legal framework. The firm should identify which set of rules allows the most efficient organisation of corporate assets, with special regard to the interests involved and starting with the creditors’ interests. In the following section the Italian discipline of separate pool of assets will be examined in order to establish whether Italian law is able to solve problems related to that form of asset partitioning and to strike an efficient balance between the interests of creditors and the interests of the firm. This kind of analysis will be fundamental to understanding whether [continua ..]

II Separate Pools of Assets

2.1. The discipline of separate pools of assets (“Patrimoni destinati ad uno specifico affare”). A brief overview.

Before going into a more specific analysis of the costs and benefits related to the designation of a separate pool of assets, it is convenient to present an overview of the discipline of “Patrimoni destinati ad uno specifico affare”. A general awareness of the discipline could be useful for a better understanding of the analysis of the issues concerning creditor protection[44]. According to article 4, par. 4, letter b) of the Delegating law, the Reform should (i) allow the corporations (società per azioni) to separate pools of assets, (ii) establish the conditions to perform this kind of operation and (iii) provide a specific legal regime of accountability, mandatory disclosure and liability for claims arising from the specific transaction to which the pool is designated. The provisions of the Delegating law have been implemented introducing into the Italian Civil Code a new section entirely devoted to separate pools of assets[45]. After the introduction of the new section, the discipline of separate pools of assets is now provided under article 2447-bis et seq. of the Italian Civil Code. Article 2447-bis, paragraph 1, letter a), allows corporations to designate one or more separate pools of assets in order to allocate each of them to the accomplishment of one specific transaction[46]. The resolution to designate one or more separate pools of assets is taken by the board of directors. When a corporation separates its assets under article 2447-bis, the amount of assets available to satisfy general creditors is reduced, because a part of corporate assets is included in a separate pool in order to satisfy exclusively the claims of the special creditors. Hence, it has been necessary to provide a series of disclosure and transparency rules aimed to protect the rights of general creditors and to prevent and settle all the potential conflicts among different classes of creditors. A first rule prohibits the creation of a separate pool of assets which exceeds 10% of the net worth of the whole corporation[47]. The aim of this rule is to avoid that the amount of assets available to satisfy the claims of general creditors might be reduced too much and that the corporation might abuse the possibility of fragmenting its liability and engage in excessively risky activities, harming the interests of general creditors. Another important rule is provided under article 2447-ter. It is a transparency rule which prescribes that the resolution of the [continua ..]

2.2. Advantages of creating separate pools of assets.

The general efficiency advantages of asset partitioning for the corporation has been examined in the first section. It is now time to focus our attention on the specific benefits of the creation of a separate pool of assets as a particular form of asset partitioning. The description of the discipline of “Patrimoni destinati” should provide us with the tools needed to better understand why the designation of a separate pool of assets could bring certain kinds of economic and financial benefits. As already mentioned[58], by allowing corporations to create a separate pool of assets the Italian legislator pursued the goal of increasing the competitiveness of Italian firms through the introduction of an innovative financial tool which is supposed to reduce the cost of credit and to create incentives to investment. How can the creation of a separate pool of assets produce a reduction of the cost of raising debt capital for corporations? The explanation lies in the fact that the establishment of a separate pool of assets determines a larger propensity for third parties to extend a loan for the reasons described in the following paragraphs.

2.2.1. Priority of creditors’ claims.

First of all, the potential dealers and loaners of the firm know that, as creditors of a separate pool of assets, they would have an exclusive claim on the segregated assets (art. 2447-quinquies) and priority over the general creditors of the firm in insolvency proceedings[59]. Therefore, the choice of organising corporate production creating separate pools of assets should attract more investors and, as a result, reduce the cost of credit. This assumption can be confirmed by the reverse application of the Modigliani-Miller Theorem[60]. The Modigliani-Miller Theorem states that, in a perfect market, without taxes, information asymmetries, contractual incompleteness, agency costs and transaction costs, the cost of equity and the cost of debt are equal and it does not matter if the capital of the firm is raised by issuing stocks or selling debt. Therefore, the value of the firm is unaffected by its financial structure[61]. Applying the Theorem to the separate pool of assets, the following conclusions can be reached: in a perfect debt capital market, characterised by the existence of the full perception of risk and the perfect adjustment of contractual terms, the advantage for special creditors to be preferred in the separate pool of assets is exactly counterbalanced by the related disadvantage for the general creditors[62]. As a consequence, the reduction of the cost of debt capital obtained from one side (creditors of the separate pool of assets) is neutralised by the increase of the cost of debt capital raised from the other side (general creditors of the whole firm). If this were true, the choice between separating or not separating assets for the accomplishment of a specific business activity would not be relevant for a firm. However, by turning the Modigliani-Miller Theorem upside down and applying it to separate pools of assets, different conclusions may be reached[63]: the choice of designating or not designating a separate pool of assets does affect the value of the firm in an imperfect market characterised by different levels of risk propensity, asymmetric information, incomplete contracts and a non-neutral tax treatment. Because the existence of a perfect market is purely theoretical, it can be affirmed that the choice of implementing a financial structure characterised by the fragmentation of corporate assets into separate pools for the accomplishment of specific transactions does affect the value of the firm, because it is unlikely that the [continua ..]

2.2.2. Reduction of monitoring costs.

As already mentioned in the first section, every form of asset partitioning involves the specialisation of the liability and the fragmentation of third parties’ claims. As a consequence, the existence of different classes of creditors allows the firm to exploit comparative advantages (related to the reduction of monitoring costs)[64]. The segregation of assets overcomes the inefficiencies of over-monitoring. In a multidivisional firm, where assets are not separated, all the creditors have to assess the capacity of the whole corporation’s assets and have to monitor the performance of all the businesses run by corporation, even when they themselves are interested only in one specific business. On the contrary, the fragmentation of assets allows special creditors to assess only the capacity of the separate pool of assets and to monitor only the performance of the specific transaction to which the pool of assets is designated. The reduction of credit evaluation costs and credit monitoring costs allows a better allocation of credit. The more the assets and the business are fragmented and specialised, the more the corporation potentially gains in terms of efficient reduction of the cost of credit. Indeed, if creditors are not put in a position to have enough information and incentives to assess business risk correctly or to monitor the actions of the debtor, they tend to charge the firm a very high risk premium and, as a result, the cost of credit raises[65].

2.2.3. Separate pools of assets and risk-return profiles.

In the previous paragraphs it has been explained how the cost of raising debt capital can be reduced by creating a separate pool of assets because of the greater propensity for the potential special creditors to invest in one specific transaction and because of the reduction of monitoring costs. However, the possibility that the corporation might create separate pools of assets for the accomplishment of very risky transactions has not yet been considered. Would this event have consequences on the cost of credit? Would it affect creditors’ risk-return profiles with tangible consequences on their propensity to invest? Usually the creation of separate pools of assets is highly recommendable for a firm interested in carrying on a very innovative and risky business without exposing all its assets to the risk of failure. In particular, when the technologies used are not very well known and when the success of the innovation is not certain, fragmentation of the assets avoids that the increase in the average riskiness of the firm might increase the claims of potential creditors[66]. Obviously all the creditors will have different risk-return profiles depending on whether they finance the business activity of the firm as a whole or only the specific business activity of the separate pool of assets. Nevertheless, the possible increase of the average risk borne by the whole firm by running the new transaction to which the separate pool of assets is designated does not increase the cost of raising debt capital. The reason is that the creation of a separate pool of assets shifts the risk to a better risk bearer (the less risk-averse creditors, i.e. the special creditors) and at the same time reduces the risk borne by more risk-averse creditors (the general creditors)[67].

2.3. Problems arising from the creation of a separate pool of assets.

As already mentioned in the first section[68], one of the key remarks made by Hansmann and Kraakman about asset partitioning is that every form of “asset partitioning will reduce the overall costs of credit only when its benefits outweigh [its] disadvantages”[69]. With regard to the benefits, it has been noted that the effectiveness of the benefits offered by separate pool of assets are strictly linked to the specificity of the business activity to which the pool is designated: the nature, the riskiness and the viability of the specific transaction should be distinct and dissimilar from the remaining general business of the corporation, otherwise the creation of a separate pool of assets is not efficient[70]. With regard to the costs, it is important to stress that the separation of assets and the specialisation of liability require the provision of adequate rules aimed at limiting all the typical costs of asset partitioning, principally represented by the problems related to creditor protection. It is therefore essential to examine whether the legislation of the Italian Civil Code provides efficient solutions to the typical problems which arise from the creation of a separate pool of assets. The outcome of the analysis done in the following paragraphs will reveal whether the potential benefits of separate pools of assets exceed their potential costs or not.

2.3.1. Opportunistic behaviour and transparency rules.

Corporate creditors face different forms of debtor misbehaviour. It has been stressed that “limited liability exacerbates [two different] risks. Ex ante, it assists shareholders in misrepresenting the value of corporate assets by falsely claiming that the firm holds title to assets that shareholders control but that actually belong to other entities […]. Ex post, shareholders can siphon assets out of corporate solution directly, or do so indirectly by pursuing risky projects knowing that creditors will bear the costs if these projects fail”[71]. Similar and additional problems occur when a separate pool of assets is created. The designation of a separate pool of assets involves a fragmentation of liability and therefore tends to exacerbate all the typical problems of limited liability. Ex ante, the corporation might misrepresent the value of the assets that are included in the separate pool to satisfy the claims of the special creditors and that are separated from the remaining assets available to satisfy the general creditors of the firm (or different classes of special creditors). Also, the corporation might blur the separation between the assets of the separate pool and the remaining assets. Ex post, the corporation might engage in hazardous business, exposing creditors to excessive risks[72]. Increased creditor protection is therefore needed when a separate pool of assets is created. Both creditors and the corporation may benefit from stricter creditor protection, because it “reduces the costs of raising debt capital through the corporate form”[73]. The legislation of the Italian Civil Code guarantees a certain degree of transparency and allows creditors to get detailed information about the real capacity of the assets and the actual performance of the various business activities of the firm: strict disclosure and accounting rules are provided[74]. Article 2447-ter prescribes that the written resolution of the board of directors must specify a series of elements that should allow the potential creditors to identify the nature and the riskiness of the business activity of the separate pool and the nature and the value of the segregated assets. The content of the written resolution is disclosed in the Register of enterprises (article 2447-quater). Separate accountability for the business activity of the separate pool of assets is required and a professional auditor is appointed (art. 2447-ter, 2447-sexies and [continua ..]

2.3.2. Moral hazard and the “piercing the corporate veil” doctrine.

It is well known that, because limited liability increases the probability that there will be insufficient assets to pay creditor’s claims, the corporation enjoys all the benefits of risky activities without bearing all of the costs, since the risk of the undertaking is partially shifted to creditors. The “incentive created by limited liability to transfer the cost of risky activities to creditors” is called moral hazard[77]. The externalization of risk onto creditors is undesirable because it imposes social costs: limited liability firms “undertake projects with an inefficiently high level of risk”[78]. Yet, it is important to note that the consequences of moral hazard are different for voluntary creditors and involuntary creditors. It has been demonstrated that “there is no externality with respect to voluntary creditors”, since the compensation they demand is always a function of the risk they decided to face[79]. The main risks faced by creditors are represented by the possibility that the corporation will not pay all its debts because of limited liability and that the corporation will take increased risks after the contractual conditions are set. Now, “as long as these risks are known, the firm pays for the freedom to engage in risky activities”; therefore there is no externality for voluntary creditors, who “receive compensation in advance for the risk that the firm will be unable to meet its obligations”[80]. In particular, the voluntary creditors get an ex ante remuneration for the possibility of bearing increased risks ex post. For this reason, they must be put in a position to know and assess ex ante the risk of not being paid by the corporation. If they are deceived because of the misrepresentation of risk by the corporation, they will not demand adequate ex ante remuneration and the corporation will take excessive risks, because part of the costs of these risks will be externalized onto creditors. In other terms, if the creditors are made to believe that the risk is lower than it actually is, they will not ask for appropriate compensation. On the contrary, involuntary creditors do not get any ex ante remuneration for the externalization of risk. By definition, involuntary creditors do not have the possibility of choosing the debtor on the basis of an ex ante assessment of their creditworthiness. Therefore, involuntary creditors are much more vulnerable to the opportunistic [continua ..]

2.3.3. Problems related to the existence of different classes of creditors: asymmetry of rights and conflicts of interest.

Two different classes of creditors must be considered when a separate pool of assets is created: the general creditors of the corporation and the special creditors of the separate pool [89]. The existence of different classes of creditors, each one with different interests and different rights, raises various problems. As already mentioned, the default rule of article 2447-quinquies provides that the corporation is held liable only with the separate assets for the obligations arising from the specific transaction of the separate pool: as a rule, the remaining assets of the corporation cannot be used to satisfy the claims of special creditors. However, as already mentioned [90], the Italian Civil Code allows three exceptions to the default rule. In greater detail, these state that the corporation is held liable with all its assets (including those that do not belong to the separate pool) for: (a) the obligations arising out of a tort caused through the activity of a separate pool of assets (art. 2447-quinquies, paragraph 3); (b) when the resolution of the board of directors provides that the corporation will be held liable with all its general assets even for the obligations arising from the specific transaction of the separate pool (art. 2447-quinquies, paragraph 3) [91]; (c) in case of misrepresentation (art. 2447-quinquies, paragraph 4). Because of these exception to the default rule, some scholars talk about a “quasi-perfect” separation of assets [92], referring to the fact that the creation of a separate pool of assets not always guarantees a perfect entity shield. Serious doubts have been raised about the solution chosen by the Italian lawmakers. It has been argued that a system of perfect separation of assets and liability with no exceptions would have been much more efficient from a law and economics perspective [93]. The efficiency problems are not so much related to the application of the piercing the corporate veil doctrine [94], but to the possibility of choosing arbitrarily the liability rule (perfect or imperfect separation) for those obligations arising from the specific transaction of the separate pool of assets [95]. The same market could be characterised by the coexistence of corporations which choose to apply only the default rule and other corporations which choose a regime of imperfect separation. In addition, the same corporation might create different separate pools of assets, [continua ..]

2.3.4. Separate pools of assets and insolvency.

The regulation of separate pools of assets provided by the Civil Code (art. 2447-bis et seq.) is supplemented by the rules provided under Italian bankruptcy law (“legge fallimentare”) [103]. Two possible events are regulated by bankruptcy law: (i) the corporation as a whole goes bankrupt but the separate pool of assets is not insolvent (art. 155); (ii) the corporation as a whole goes bankrupt and the separate pool of assets is insolvent (art. 156). When the corporation goes bankrupt, the court-appointed receiver shall ascertain whether the separate pool of assets is insolvent or not. If the separate pool of assets is not insolvent, the creditors cannot force its liquidation and the receiver shall try to sell it to any interested purchaser. In the case that no interested purchaser can be found, the separated assets are liquidated separately from the remaining assets of the corporation. More precisely, the separated assets flow into the general assets of the firm only after the special creditors have been fully satisfied; this means the special creditors have a prior claim on the separated pool of assets and the general creditors can only be satisfied with what remains. However, the special creditors bear the economic risk of a premature liquidation of the separate pool of assets [104], which event might occur even when the specific business of the separate pool is performing well [105]. As a consequence, special creditors are forced to monitor the performance of the business activity of the whole corporation and not only the specific transaction to which the separate pool of assets is designated. This situation is highly undesirable, because the increase of monitoring costs leads to the increase of the cost of raising debt capital. When the corporation goes bankrupt and the receiver ascertains that the separate pool of assets is insolvent, the latter is liquidated separately from the assets of the whole firm. The special creditors that are not fully satisfied after the liquidation of the separate pool of assets cannot begin a bankruptcy claim unless or provided that the corporation is held liable with all its assets for the obligations arising from the specific transaction of the separate pool, or unless the credit derives from a tort. This rule seems to be inefficient: if the special creditors were always allowed to discharge the debt from the remaining assets of the corporation, one of the basic economic rationales for asset [continua ..]

III Spin-Offs and Separate Pools of Assets

3.1. What is a spin-off.

The economic analysis of the Italian discipline of the separate pools of assets in the previous section has shown the costs and the benefits offered by this particular form of asset partitioning, a form only found in the Italian legal system. As already mentioned, the purpose of this paper is to discover whether the creation of a separate pool of assets really does represent an efficient alternative to spin-offs[110]. Thus, it is now time to introduce spin-offs and compare them with separate pools of assets from a law and economics perspective. After a brief overview of the nature of spin-offs and the economic advantages of creating spin-offs, they will be compared to separate pools of assets. The corporate spin-off has been defined as a “type of corporate restructuring which […] involves the separation of a particular business from a company by listing it as a separate entity on a stock exchange [and] results in the creation of two listed companies, each with its own set of shareholders”[111]. In a few words, a spin-off splits the corporation into two distinct legal entities: the parent firm and the subsidiary firm. As a rule, this kind of restructuring involves a pro-rata distribution of the parent firm’s ownership in another firm subsidiary to the parent’s shareholders[112]. Therefore, when a spin-off is created no new capital is raised nor are the firm’s assets revalued[113]. In other terms, spin-offs “do not involve ownership or capital changes”[114]: after a spin-off the shareholders of the parent corporation hold shares in both the parent and the subsidiary. The subsidiary – an already existing division or a newly created subsidiary of the parent company – is fully divested from the parent company and becomes a separate stand-alone legal entity with its own separate board of directors[115]. It has been correctly remarked that, before the spin-off, “the subsidiary is unable to issue equity and relies on the parent to finance its capital investments. The subsidiary therefore has little if any debt and does not manage its capital structure. At the time of the divestiture, the firm divides the assets of the firm and chooses a capital structure for the new firm. Thus, the choice of leverage for the subsidiary is revealed”[116].

3.1.1. Advantages of spin-offs.

Many scholars argue that usually diversification destroys the firm’s value, because conglomerate firms with broad scope “tend to reduce value either through inefficient investment policies due to agency conflicts at the divisional level or due to other issues such as managerial focus and lack of expertise in multiple areas”[117]. Put simply, according to this theory “the conglomerate structure is not value maximizing”[118]. It has also been noted that when a firm with a conglomerate structure spins off a division, the separation of the parent and the subsidiary increases the combined firm value[119]. For this reason the firms that are more likely to engage in spinning-off are those having a broader scope and less efficient investment. Many experts on the matter agree that the principal economic rationale for creating a spin-off is to “unlock the hidden value” of the firm. However, different explanations have been given for this phenomenon. According to the economic literature, there are two main reasons for believing that a spin-off would “unlock hidden value”. First, when the corporation is correctly valued, it might take advantage from flagging a specific business activity which is performing particularly well and by isolating it from its other activities. Second, when the corporation is undervalued because of information asymmetry, a spin-off may be an efficient way to overcome the problem. It has been observed that a spin-off unlocks hidden value because it attracts new investors who were previously unable or unwilling to invest in separate divisions: the corporation “could attain a higher valuation by making the underlying business more visible to the investors” through the spin-off, which performs a flagging function[120]. The spin-off, more than any other type of corporate restructuring, divides the corporation into clearly distinct business groups with different characteristics which attract investors with differing investment preferences[121]. Many authors have also focused their attention on the relationship between spin-offs and the information asymmetry problem. The capacity of spin-offs to remove or, at least, to reduce information asymmetries has long been considered one of the main reasons for creating a spin-off[122]. It has been highlighted that “a spin-off enhances value because separating the divisions of a firm into individually operated and traded entities [continua ..]

3.1.2. Spin-offs and creditor protection.

As shown in the previous paragraph, the economic literature has identified and described several economic rationales for a spin-off policy. However, not enough attention has been devoted to the analysis of one of the main reasons for doing a spin-off: risk sharing and the minimisation of liability[129]. A spin-off involves the creation of two or more distinct legal entities with limited liability (the parent and the subsidiaries) out of a single legal person. Therefore, spin-offs can be used to “minimise liability and to insulate assets of one part of the business from claims arising from the activities of another part. […] Unsuccessful companies can be left to fail with only the loss of the original investment in its share capital and without any further liability to the creditors of those concerns”[130]. Indeed, after a spin-off the creditors of the subsidiary must be satisfied with only the assets of the subsidiary and have no claim on the assets of the parent. In addition, it is commonly recognized that creditors of the members of corporate groups are more exposed to opportunistic and negligent behaviour (by the parent firm) than the creditors of independent corporations[131]. In particular, the interests of the creditors of a group member could be harmed in two different ways. First, a group structure reduces transparency “by blurring divisions between the assets of group members, and by suggesting – often wrongly – that the entire group stands behind each member’s debts”[132]. Second, in a group structure it is quite easy to redistribute value among the group members, either through intra-group transaction with the unique purpose of extracting value from the creditors of a group member, or by shifting assets from one member to another arbitrarily[133]. The risk of opportunistic behaviour is particularly high in the case of a spin-off, since the spin-off gives rise to a group structure characterised by the existence of a spun-off entity (which is entirely owned by the parent corporation)[134]. This makes it much easier for the parent corporation to manipulate assets and other resources of the corporate group in order to minimise liability and thus to the detriment of creditors. Hence, it may be asserted that, similarly to separate pools of assets, spin-offs also raise serious problems of creditor protection. In the next paragraph, spin-offs and separate pools of assets will be compared in the light [continua ..]

3.2. Spin-offs and separate pools of assets. A comparison from a law and economics perspective.

Spin-offs and separate pools of assets constitute two different ways of dealing with the same problem. The problem is represented by the trade-off existing between two fundamental objectives typically pursued by corporations: rationalisation and efficient management of business risk on the one side and increased propensity for third parties to finance the firm on the other. Generally these objectives are incompatible, because an efficient management of business risk is usually achieved by segregating the assets, whilst the propensity of third parties to extend a loan depends on the creditworthiness of the firm and, therefore, inter alia, on the capacity of the firm’s assets. Both the spin-off and the separate pool of assets try to solve this trade-off by rationalising the business risk and, at the same time, by creating incentives for third parties to invest in the corporation. However, both the spin-off and the separate pool of assets also entail problems of creditor protection. However, the kind of problems related to creditor protection are slightly different in the case of the creation of a separate pool of assets as compared to the implementation of a spin-off strategy. When a separate pool of assets is created, the main concern is to protect the pre-existing general creditors of the corporation and the new special creditors of the separate pool. On the one hand, the pre-existing general creditors could be potentially harmed because following the segregation of assets they lose their rights over the assets which have been reallocated to the separate pool. On the other hand, the special creditors need precise, clear and unequivocal identification of: (a) the assets included in the separate pool and isolated from the general creditors of the firm, and (b) of the transactions and the activities related to the accomplishment of the specific business of the separate pool. These particular kind of problems do not arise when asset partitioning is realized through a spin-off. First, even though in a spin-off no new capital is raised and the incorporation of the subsidiary involves a transfer of assets from the parent to the subsidiary, there is no need to protect the pre-existing creditors of the parent. Indeed, as already mentioned[135], the spin-off entails a distribution of the shares of the subsidiary to the shareholders of the original corporation. This means that, unlike the case of the creation of a separate pool of assets, the spin-off does [continua ..]

3.3. Conclusion.

The respective costs and benefits of creating a separate pool of assets and creating a spin-off have been discussed. It is now possible to answer the question posed in the introduction to this paper: does the creation of a separate pool of assets represent an efficient alternative to a spin-off? The cost-benefit analysis made in this paper suggests not. Both separate pools of assets and spin-offs offer the typical benefits of asset partitioning: they ensure a rationalisation of business risk and, at the same time, attract new investors by isolating and flagging specific business activities of the firm. In other terms, they both suit the basic organizational and financial needs of a firm engaged in different lines of business. In particular, they represent a better option than operating different business within one multidivisional conglomerate firm. However, even though the separate pools of assets offer unquestionable advantages in terms of coordination and allocation of resources between separate entities within the same proprietary sphere, spin-offs seem to be preferable for a series of reasons. First, the impossibility of creating separate pools of assets which exceed 10% of the net worth of the entire corporation drastically reduces the possibility of choosing this form of asset partitioning, thus making spin-offs more convenient, especially for medium and small-sized corporations. Second, the imposition of a series of cumbersome disclosure and transparency rules constitutes a significant additional cost in operating a business through a separate pool of assets rather than through a spun-off subsidiary. Third, the provision that the corporation shall be liable with all its assets for torts and misrepresentation, even when the liability is exclusively linked to the specific transaction of the separate pool, represents a strong incentive to choose a spin-off strategy. Fourth the insolvency regulation of separate pool of assets does not seem to be particularly efficient.

NOTE