Tag: Corporate Law

The Enduring Distinction between Business Entities and Security Interests

Ofer Eldar & Andrew Verstein[*]

What are business entities for? What are security interests for? The prevailing answer in legal scholarship is that both bodies of law exist to partition assets for the benefit of designated creditors. But if both bodies of law partition assets, then what distinguishes them? In fact, these bodies of law appear to be converging as increasing flexibility irons out any differences. Indeed, many legal products, such as securitization vehicles, insurance products known as captive insurance, and mutual funds, employ entities to create distinct asset pools. Moreover, recent legal innovations, including “protected cells” (which were created to facilitate such products), further blur the boundaries between security interests and entities, suggesting that convergence has already arrived.

This Article identifies and defends a central distinction between business entities and security interests. We argue that while both bodies of law support asset partitioning, they do so with different priority schemes. Security interests construct asset pools subject to fixed priority, meaning that the debtor is unable to pledge the same collateral to new creditors in a way that changes the existing priority scheme. Conversely, entities are associated with floating priority, whereby the debtor retains the freedom to pledge the same assets to other creditors with the same or even higher priority than existing ones.

The distinction is valuable in understanding financial products such as securitization, captive insurance, and mutual funds. We show that such products are driven by an appetite for assets pools with a fixed priority scheme, and recent legal innovations are primarily designed to meet this need. This distinction is consistent with the intuitive view of entities as managed going concerns and security interests as mere interests in assets. The distinction is also enduring. Despite the apparent convergence of forms, we predict that the distinction we offer will survive legal and technological innovations.

Introduction

The last decades have brought about significant innovation in the use of business entities in financial structures. While entities have long been used to control risk and organize production, business planners gradually began using them primarily as vessels to hold assets. A prime example of such innovation is securitization. In a standard securitization, a sponsor corporation transfers some of its assets to an entity, which borrows money from creditors and passes the money back to the sponsor as consideration for the assets. In many ways, securitization resembles a secured loan directly to the sponsor. However, an entity is interposed to hold the assets in order to assure creditors of their special claim to the assets.[1] The creative use of entities to pool assets is not limited to securitization vehicles,[2] but also includes other products, such as investment funds[3] and insurance.[4] All of these industries have experienced dramatic growth in recent years amounting to many trillions of dollars.[5] A hallmark of each of these important financial innovations is the partitioning of assets into different pools for the benefit of designated creditors, each with different risk profiles, contained within an entity.

The growing use of entities as a mechanism for pledging a pool of assets has been accompanied by a shift in academic thinking about the role of entities. Historically, law and economics scholars viewed entities primarily as a “nexus of contracts” between a fictional entity and investors, customers, and employees[6] and entity law as a type of standard form contract among such disparate groups.[7] However, the dominant view of late has emphasized the function of entities in patterning creditor rights in ways that no bundle of contracts could practicably achieve.[8] This asset partitioning role is a form of property law because it is good against the world and cannot be accomplished through bilateral contracts.[9] As with the concurrent innovation in business practice, this “property” theory defines the essential role of entities as a legal tool for partitioning assets into distinct pools for the benefit of some creditors relative to others.[10]

Both commercial and scholarly treatment of entities have been enriched by the asset partitioning theory. Business planners use entities in alternative forms of secured lending, and scholars rationalize entities as a species of property law. Yet it is not entirely clear why entities are actually necessary in such settings. Security interests also give creditors priority over identified pools of assets and would seem to provide a suitable foundation for asset-backed finance. Why not just use security interests for the same purpose? Conversely, if entities can substitute for security interests, why ever bother with security interests? The literature has long recognized the potential substitutability of entities and security interests; however, scholars have largely left open the question of whether there is any essential distinction between the two legal forms that would make one optimal relative to the other.[11]  A looming possibility is that there is no essential distinction between entities and security interests and that these two legal forms will ultimately converge.[12]

Recent legal innovations may seem to suggest that this moment of convergence is fast approaching. New legal forms are emerging, which blur the distinction between security interests and entities. For example, a “protected cell company” can issue multiple tranches of notes with each issuance secured by a different pool of assets placed within a protected cell.[13] A single entity consists of multiple protected cells, each cell securing obligations to different classes of creditors. The cells exhibit some entity-like features (for example, they can own property and enter into contracts) without others (for example, they have no board of directors or charter). Not surprisingly, “cells,” “series,” “segregated portfolios,” and other forms are used to economize the costs of creating multiple entities in products where entities are used effectively as security interests (for example, securitization vehicles, investment funds, and captive insurance). They are arguably best understood as new forms of security interest, which share many of the features associated with entities. Regardless of whether these new products are “really” entities or security interests, they have made the distinction between entities and security interests largely elusive.

Despite these developments, this Article challenges the notion that entities and security interests are becoming indistinguishable by offering a novel theory of the distinction between them. We adopt the property theory of entities, but we develop it by preventing the collapse it implies between security interests and business entities. We argue that while both security interest law and entity law create asset partitions, they differ with respect to the priority schemes operating on those pools.

Specifically, we argue that the functional difference between security interests and entities is that entities create floating priority over asset pools while security interests opt the parties into a fixed priority scheme.[14] By floating priority scheme, we mean that the administrator of the assets is generally permitted to pledge the same assets to other creditors with the same or even higher priority than existing ones. Conversely, a fixed priority scheme means that it is not possible for the administrator to pledge the assets in a manner that changes the existing priority scheme, which typically affords a prior claim to the secured party over any other creditors.

From a theoretical perspective, the distinction we offer has five main attractive features. First, it fits well with doctrinal law, which insists that security interests, but not entities, establish fixed priority.[15] Second, it is consistent with the intuitive view of entities as managed going concerns and security interests as mere interests in assets. Third, it is functional in that it illuminates the economic benefits and costs of each priority scheme. Fixed priority reduces the creditors’ costs of evaluating assets, but restricts managerial discretion, whereas floating priority decreases the former, but increases the latter.[16] Fourth, the distinction is essential in the sense that it is not possible to create asset pools with floating priority using only security interests and contractual mechanisms, and likewise, it is impracticable to create asset pools with fixed priority using only entities and contract.[17] Fifth, the distinction is enduring. It not only survives the recent evolution of new legal forms, but we predict it will also survive other innovations that will likely blur the distinction between contract law and property law, such as blockchain technology.

In addition to our theoretical contribution, the distinction between fixed and floating priority has several important practical and explanatory implications. First, it is useful for understanding how entities and security interests are used in different financial structures, primarily securitizations, investment funds, and captive insurance. Taking securitization as an example, much of the literature has focused on the use of entities in such structures. This literature emphasizes that entities are necessary in those structures because they are “bankruptcy remote.”[18] Yet the literature on securitizations seems to have underappreciated the necessity of security interests to securitizations. While most securitizations use entities, all use security interests. This is because without fixed priority, the economic rationale for securitizations—particularly reducing the costs of evaluating assets—would largely disappear. More surprisingly, we show that demand for fixed priority explains the structure of other financial products, such as mutual funds and captive insurance.

Second, the distinction we propose allows us to better understand the recent evolution of new legal forms. We show that with few exceptions, these forms are better characterized as security interests, and that their evolution is mainly driven by an appetite for fixed priority schemes. In particular, most jurisdictions limit the use of cells to particular financial products (especially securitizations, investment funds, and captive insurance), and through regulation of such products, the administrator of the assets cannot change the priority scheme of the creditors secured by the cells. In this way, we claim that the evolution of the new form does not undermine the distinction between fixed and floating priority, but rather reinforces it.

Third, our account may inform judicial decisionmaking. With the evolution of innovative financial structures and flexible legal forms, courts are called on to characterize these flexible forms and define their scopes. Are the cells entities? Security interests? Without functional principles for such cases, legal results will be either arbitrary or formalistic.[19] Our analysis can guide courts in adjudicating cases that involve such determinations.

Fourth, our analysis suggests that there may be scope for further flexibility in legal forms, primarily security interests. In particular, we recommend according greater bankruptcy remoteness to security interests, at least for certain financial transactions such as securitizations. Such a reform could introduce greater legal certainty at a lower cost.

Our Article proceeds as follows. Part I explains the functional similarities between entities and security interests as asset partitioning technologies and shows how each can often serve as a substitute for the other. Part II explains our thesis that the feature distinguishing entities and security interests is that the former provides a floating priority scheme and the latter provides a fixed priority scheme. Part III discusses alternative candidate distinctions and explains why they are not satisfactory. Part IV lays out the explanatory implications of our view, showing how it sheds light on existing financial products. Part V discusses the evolution of new legal forms, such as protected cell companies. Part VI presents some policy implications. Part VII expresses our view that the analytical distinction we make will survive legal and technological innovations.

I.  Entities and Security Interests as Property Law

Before embarking on the task of articulating a distinction, it is important to highlight the functional similarities of entities and security interests as property law. By property law, we mean that these bodies of law create entitlements that are binding against the world rather than just against those who agree to them. Property law is essential to facilitating asset partitioning, which means shielding a pool of assets from the claims of creditors of other pools of assets.[20]

To illustrate the idea of asset partitioning, it is useful to have in mind a simple example.[21] Consider an individual (“the owner”) who wishes to finance several shopping malls. For example, A1 (for “Asset 1”) might be a large outdoor luxury shopping mall in Hawaii, geared to high-end tourists.[22] A2 might be a small, local indoor mall in Oklahoma, which attracts local residents and students at a nearby university.[23] The owner’s financiers are C1 (for “Creditor 1”), C2, C3, and so forth.[24] The simplest arrangement for financing these malls is for the owner to personally own the assets and borrow from the creditors. This arrangement is depicted visually in Figure 1.

Figure 1.  No Partition

Figure 2.  Entity Partitioning

This asset partitioning through the use of entities reduces the costs of appraising the credit risk of the owner and monitoring her.[25] No individual creditor need invest in the capacity to appraise and monitor the debtor’s whole corpus of operations. Instead, each creditor can specialize in one pool of assets, disregarding the others.[26] C1 can specialize in high-end malls in Hawaii, whereas C2 can focus on the local Oklahoma shops.

Security interests can achieve similar asset partitioning to that of entities, with comparable benefits.[27] Imagine that instead of using any entities, the owner borrows and owns the assets personally—but grants security interests in her assets to particular creditors. She grants C1 a security interest in A1, the Hawaiian shopping mall, and she grants C2 a security interest in A2, the Oklahoma shopping mall.

Figure 3.  Security Interest Partitioning

This asset partitioning function of both entities and security interests is a species of property law because it cannot be practically accomplished through contracts alone. The reason is that contractual promises are bilateral and, unlike property law, do not bind third parties.

Without using security interests or entities, C2 might demand from the owner that C1 (and any future creditors) have no recourse to the Oklahoma mall. But even if the owner agrees to such a contractual term, she may rationally breach it to C2’s detriment. She can get a cheaper interest rate from C1 by offering recourse to all of her assets, including the Oklahoma mall. The owner can also shift assets from one business to another. For instance, the owner could sell a valuable Waikiki property and plow the proceeds into an expansion of the Oklahoma shopping mall, exposing C1 to risk that he did not bargain for. C2 can sue owner for these breaches, but he cannot invalidate C1’s claim to all of the owner’s assets, including the Oklahoma mall, or undo the sale of the Hawaii mall. Any deal between C2 and the owner was a contractual deal, and contracts bind only on those who have notice of them.

C1 would fare better if the owner granted him a security interest or placed the mall in a separate entity.[30] Efforts to move assets across asset partitions, or otherwise shift the assets away from their intended purposes, are constrained by various remedies against wrongful shifting, primarily fraudulent conveyance laws in the case of entities, and encumbrance on the property in the case of security interests.[31] Property law thus solves a multi-lateral commitment problem that contracts alone cannot.

II.  Our Proposed Distinction: Fixed versus Floating Priority

In this Part we identify and defend the respective functions served by entities and security interests that cannot be practicably reproduced by the other form. We argue that although both bodies of law can partition assets, they do so with different rules for updating priority over those assets.

When entities are used to partition assets, they do so without fixing the priority of creditors to the assets. If the pool lacks the resources to fully repay all the creditors, they share ratably in their recovery. The parties can initially agree to a payment hierarchy, so that one creditor gets higher priority than another, but the credit hierarchy is floating because the owner can always update it to undermine the priority of existing creditors by pledging the assets to additional creditors. In contrast, security interests fix priority against later efforts by the owner to grant equal (or higher) priority to other creditors. The typical fixed priority pattern is to prioritize the first perfected secured interest over other claims in the assets.[32]

The fixedness of priority is a ubiquitous feature of security interests. Not only can security interests create priority schemes over a pool of assets, but they always grant fixed priority.[33] Security interests and entities coexist in the world and in particular structures because they offer different and irreplaceable priority schemes for creditors.

In order to show that security interests and entities are truly distinct, we need to show that their functions are distinct, in that each performs an essential role that no other body of law can perform. In Section II.A, we show that one cannot create floating priority asset pools without entity law, and in Section II.B, we explain that it is impossible to create fixed priority that binds third parties without security interests.

Section II.C describes what is at stake in choosing one priority scheme over another. The distinction between fixed and floating priority is economically functional, conferring differing costs and benefits to the parties who use them. We explain the tradeoffs inherent in deploying one body of law or the other.

A.  Only Security Interests Allow Fixed Priority over an Asset Pool

We first argue that security interests, but not entities, can create fixed priority. To draw again on the shopping mall example, we claim that if C2 wishes to have first priority over the Oklahoma mall, only security interests make this possible. If the owner instead partitions her assets by placing the Oklahoma mall in a separate entity, but does not give C2 a security interest over the mall, C2 would not be able to achieve fixed priority over it. We examine four possible techniques to create fixed priority without security interests, none of which succeed.

1.  Covenants

A plainly insufficient strategy is simply to have the owner promise not to take on new creditors as peers to C2. The trouble is that these promises are binding only on the owner, and not any other creditor (such as C3) who lends to the owner. What C2 would like to do, and what contract law does not allow, is to cite the owner’s promise in litigation against C3 to undermine C3’s claim on the assets. C2 may monitor the owner to make sure that her priority is respected, but such monitoring is likely to be very costly, and unrealistic for all but the largest creditors.

2.  Structural Priority

It may be argued that perhaps structural priority, the stacking of entities into nested tiers, can fix the priorities among creditors.[34] Imagine that owner wishes to finance the Oklahoma mall, with a $10 senior loan from C2 and a $10 junior loan from C3. The owner can achieve this result by forming Entity 3, of which she is the sole shareholder, and which owns nothing but shares of Entity 2. Entity 2 is then made the owner of the business assets. In principle, C2 will be repaid if the assets produce $10 because the money is generated by an entity that owes no one except for C2. Only if Entity 2 makes enough money to cover its debts to C2, can it pay dividends up to Entity 3—which can use that money to pay C3. As depicted in Figure 4, this structure creates a payment hierarchy.[35]

Figure 4.  Structural Priority

3.  Charter Provision

Some scholars have argued that an entity’s charter should be able to affect creditor relations. For example, a corporation’s charter might be amended to specify that it can no longer borrow, or can borrow only junior terms, and to award recovery rights against third parties who frustrate these objectives.[36] C2 could then sue to invalidate as ultra vires any transaction at odds with a priority-fixing charter provision, such as a loan from C3. Unfortunately for C2, courts do not invalidate ultra vires transactions.[37] C3’s interest would remain valid even if it violated a charter provision.[38] Moreover, a charter provision limiting the firm’s ability to borrow is generally not enforceable.[39]

4.  Creditor Control

Another idea would be for C2 to take control of Entity 2, so that C2’s approval would be required for any new borrowing. C2 could then decline to authorize any credit that would undermine C2’s senior priority. C2 could take this control in a number of ways, but one of them would be for the owner to assign her ownership interest in Entity 2 to C2. As controlling shareholder, C2 could select a trusted board that will cater to his or her interests.

However, control is not a practical solution. First, it is at best a solution for just one creditor; it is not feasible for every creditor in the hierarchy to take an absolute assignment and install a board of directors. Second, the controlling creditor exposes itself to liability.[40] Third, creditor control is likely to be inefficient. Usually, the owner has the best incentives and expertise to select and discipline managers of the assets.

Fourth, creditor control sets in motion a problem of debt liquidity. C2 knows better than anyone else whether she has been effective in enforcing the priority scheme. Perhaps C2 has allowed a senior or peer claim to arise, out of error or in exchange for side-payment. When C2 wishes to sell her interest to a new investor, that new investor will not know whether C2 truly has the senior priority she claims to have.[41] The new investor will discount C2’s interest accordingly, in a way that would not occur if C2’s priority was public knowledge.[42]

B.  Only Entities Allow Floating Priority over an Asset Pool

We have argued that entities cannot create fixed priority, and we now show that the complementary limitation applies to security interests, such that floating priority over asset pools would be impracticable without entities. Thus, the only way for the owner to create floating priority as to the Oklahoma mall is for her to place it within an entity, as in Figure 2. Figure 5 demonstrates that, in principle, security interests (sans entity) can achieve asset partitioning. However, security interests necessarily deny the owner the power to raise additional funds by pledging the collateral to later creditors (C3, C4, and so forth). To prove our claim, we consider three non-entity techniques for creating floating priority over asset pools. All three fail.

Figure 5.  Security Interest Partion with Multiple Creditors

The owner could freely add creditors to Asset 2 if the existing creditors always agree to subordinate themselves when the owner wishes to pledge the same asset to a new creditor (C4). Then the Oklahoma mall will serve as ratable collateral to C2, C3, and C4, all of whom will recover ahead of C1. Yet securing creditor-by-creditor consent is impractical for large ventures with millions of creditors (including all customers, suppliers, and investors). Each new creditor would necessitate unique subordination agreements from the entire existing network. Moreover, it is unrealistic to assume that creditors will assent to subordination. Some might like to freeride on other creditors, retaining their priority even as other creditors accept subordination. Others might simply hold out, demanding payment in exchange for consent. As many creditors make these types of strategic calculations, the costs of obtaining ex post consent will likely be preclusive.

Transaction costs continue to mount since each new creditor will have to expend resources verifying that subordination of all previous creditors has been accomplished. If the owner fails to secure a valid subordination from C2, then C2 will retain higher priority over C4. To actually protect her interest, C4 would have to vet each purported subordination agreement to make sure that it is valid and effective, and she would have to check whether any creditors’ subordination agreements are missing from the stack. Thus, ex post consent creates a staggering due diligence burden for later creditors.

2.  Ex Ante Consent

The owner may bargain with a potential creditor for the right of the owner to add new peer creditors that will share with him equal priority to the assets. For example, imagine that at the time of contracting, C2 agreed to subordinate herself to any other creditor who met certain specified conditions. Among those conditions would be acceptance of an identical subordination agreement. Thus, C2 would hold the first lien on the Oklahoma mall, but would be a peer to C3 if C3 agreed to subordinate herself to all similarly agreeing creditors. When C4 arrives, she will have an incentive to adopt a similar clause. If she does so, then C2 and C3 will automatically relinquish their higher priority. If she fails to adopt such an agreement, the prior subordination agreements will not apply to her, and she will therefore fall behind C2 and C3. If all of them comply, the result is that each creditor would share ratably in the Oklahoma mall.

Yet this solution also falls apart in light of the same problems that plagued the ex post solution. It is possible that C4 will not want to join the consortium. Failing to do so will place her lower in priority than C2 and C3—but it will preserve her status against all later creditors.[43] The fact that some creditors could rationally opt out of the arrangement resuscitates diligence problems, as later creditors demand assurances that all earlier creditors have opted in to the equality scheme.

3.  Single Creditor

Another more complicated ex ante technique would be to try to run all of a project’s financing through a single creditor (C2).[44] C2 takes a first lien over the Oklahoma mall to secure all present and all future claims by C2, even claims acquired by assignment from subsequent creditors nominated by the owner. When the owner borrows from C3, she nominates C3’s claim as eligible for assignment. C3 assigns the claim to C2 (in exchange for a non-recourse claim against C2 secured by the very claim assigned to C2). The new loan now stands as equal priority to C2’s original claim because the security interest covers all claims held by C2. This seems to create floating priority because the owner has the power to change the priority of the creditors by assigning new claims to C2. Figure 6 depicts this arrangement.[45]

Nevertheless, this clever maneuvering is unlikely to be a good substitute for floating priority. The apparent ratable priority disappears whenever the later creditors want to make a claim. Recall that the claims against the owner are equal priority only when in C2’s hands. Suppose C2 ceases to pay C3 or C4, for example, if the owner does not pay C2 with respect to their respective claims. In this case, recovery by C3 and C4 is limited to the claims (against the owner) that they transferred to C2. Upon repossessing them, they drop back into the lower priority earned by their order of perfection. Thus, fixed priority in reinstated whenever priority ends up mattering.

Figure 6.  Security Interest Partition with Lead Creditor

However, the Fifth Circuit held that notwithstanding the security agreements, the subsidiaries could not benefit from the parent’s prioritized security interest.[48] The court held that Article 9 does not permit “‘floating secured parties,’ that is, an open-ended class of creditors with unsecured and unperfected interests who . . . can assign their claims to a more senior lienor and magically secure and perfect their interests under an omnibus security agreement and financing statement.”[49] The court reasoned that allowing such conduct “would disrupt commercial transactions to an unwarranted and unnecessary degree[,]”[50] presumably because it would undermine the fixed scheme created by security interests.

C.  The Relative Benefits (and Costs) of Floating and Fixed Priority

In this Section, we elaborate on the key benefits and costs associated with fixed and floating priorities. Ultimately, the optimal priority scheme depends on a trade-off between reducing the costs of evaluation through fixed priority and the benefits of maintaining managerial discretion to finance the business.

As discussed above, reducing creditors’ costs of evaluating assets is probably the most often cited benefit of asset-partitioning.[51] Fixed priority reduces these costs even further. Using again our simplified example, suppose the Oklahoma shopping mall is placed within Entity 2 owned by the owner, and C2 lends to Entity 2, as in Figure 2. Compare this with a situation whereby C2 lends to the owner and gets a security interest in the shopping mall (A2), as in Figure 3. In both cases, C2 will have priority over C1. However, in the first case, C2’s claim to the shopping mall in the event of default will be diluted by the claims of any other creditors to Entity 2, say C3, C4, and so forth. On the other hand, if C2 has a security interest, she can generally collect on the shopping mall, without worrying about any other creditors, who will have to claim against the other assets of the owner or whatever value is left in A2 once C2 is satisfied. As a result, C2 does not need to spend as much resources on evaluating the creditworthiness of the owner and the owner’s management of the business. In contrast, if the owner can borrow from other creditors through Entity 2, C2 must expend the costs of assessing ex ante the quality of the management by the owner and monitor the business to make sure that the owner doesn’t excessively leverage Entity 2. C2 must also check whether the owner uses the proceeds of all loans (not just the loan from C2) for productive purposes. If C2 fails to do so, the value of her claim against Entity 2 will be diluted.

Against the savings in evaluation costs, parties must trade–off the value of managerial discretion. Under floating priority, the owners retain the right to take on new creditors with the same priority. Fixed priority imposes constraints on the owner’s subsequent borrowings. Subsequent lenders will be more hesitant to lend if they stand lower in priority than earlier secured creditors, or will demand higher interest rates. This can be inefficient if it hampers a firm’s ability to raise funds for productive activity.

For many operating companies, the managers (on behalf of the owner) need flexibility to respond to changing circumstances—adjusting the company’s assets and liabilities accordingly. It could be very costly for the business to give up this flexibility in terms of future borrowing. The creditors in this case are effectively lending against the going–concern value of the company, and such value is a function of managerial discretion. In fact, even the creditors would be harmed by unduly impairing the ability of managers to obtain more financing, because such financing could be essential for enhancing the going–concern value of the business.

As one extreme example, consider the value of flexibility for a leveraged buyout (“LBO”). In an LBO, the stock of the company is sold to a new buyer, typically a private equity firm, which obtains financing from a creditor using as security all the assets of the business. Thus, an LBO involves a comprehensive updating of the priority of all existing creditors by subordinating them to a single creditor. If all priorities were fixed, it would be difficult to effect an LBO. Creditors would be reluctant to finance these risky transactions if they stood last in line behind all existing creditors. Yet LBOs have historically yielded significant profits for shareholders and increased efficiency of firms.[52] Floating priority reserves for managers the option to undertake an LBO, which may be a valuable option for some companies.

Fixed priority is more valuable in two main circumstances. The first is when the value of managerial discretion is limited. The simplest example is a home mortgage. Creditors could finance individual homes by placing the house in an entity without a security interest and extending the loan to the entity. However, they do not use this alternative form of asset partitioning. Instead, mortgages (that is, security interests) are ubiquitous in residential finance transactions. The reason is in part that managerial discretion is a bug, not a feature, in these consumer transactions. The owner of an entity would be able to pledge the house to other creditors, a decision unlikely to be valuable for the bank-creditor. Homeowners are unlikely to be skilled business people. To the contrary, a homebuyer is more likely to engage in undue risk or personal consumption. The costs to the creditor of monitoring the other loans of the homeowner would be extremely high. Without security interests, debtors would be tempted to take on negative expected value projects, pledging existing collateral for increasingly risky ventures.[53]

The second circumstance is when debt liquidity is critical. If debt can be sold in the secondary market, the owner can obtain better credit terms. Debt is more liquid when its priority is fixed. The reason is that if buyers had to undertake expensive appraisal and monitoring of the creditworthiness of the owner, the transaction costs of buying the debt would be higher. Consider a creditor that buys a home mortgage from the original lender (or more likely, buys many home mortgages from many lenders). The home mortgage would be difficult to assign if the buyer in the secondary market needs to accrue substantial costs in monitoring the homeowner.

Secondary sales are subject to an adverse selection problem, which is the risk that the sellers are only selling the worst debt and keeping the best for themselves. For example, buyers may be concerned that the owner has pledged the house to additional creditors. If the priorities to the underlying assets cannot be undermined by the owner, then buyers need not investigate whether the owner has taken such an action. At least one study confirms that that security interests improve liquidity, by showing that secured bonds have higher liquidity than unsecured bonds, controlling for various bond characteristics, even including the rating of the bonds.[54]

III.  Other Potential Distinctions and Why They Do Not Work

We showed in Part II that the distinction between fixed and floating priority may serve as the distinction between entities and security interests. An essential distinction must provide a meaningful economic function that cannot be accomplished by a creative use of the other legal form and other bodies of laws, primarily contract and agency law. In this Part we show that other potential distinctions do not satisfy these criteria. Nevertheless, we briefly explain why such characteristics are more likely to follow from or accompany legal pools with fixed or floating priority, as applicable: many familiar features of both bodies of law work to support the essential distinction. Thus, these other potential distinctions are often complements to our fixed/floating distinction.

A.  Fixed Pools of Assets

Security interests typically attach to identified assets, such as a home or a shopping mall. This is reflected in the U.C.C., which prohibits a blanket pledge of all the assets of any description and requires a more specific description of the particular assets which are covered by the security agreement.[55]

However, it is unlikely that specificity of the pool of assets is the distinguishing feature of security interests. For one thing, security interests allow floating asset pools. The U.C.C. does allow floating liens over assets that cover both present and future (“after–acquired”) assets.[56] Creditors also commonly take interests in the proceeds of the assets, meaning the cash for which items are sold and whatever that cash is spent on.[57] Moreover, other jurisdictions go even further by allowing security interests to float over the whole business.[58] On the other hand, some entity-based transactions such as securitizations are designed to restrict any change in the pool of assets.[59]

It is not surprising, though, that security interests are associated with more specific or clearly defined sets of assets. Creditors who seek fixed priority are taking steps to support specialized monitoring and facilitate valuation in a secondary market. Generally, if the pool of assets is subject to drastic changes, the monitoring efficiencies associated with fixed priority may be lost.

B.  Filings by Creditors

Adding secured creditors may be cumbersome. For example, Article 9 typically requires filing a new financing statement that lists the new creditor by name.[60] Entity-based pools can take on new creditors without filing. However, filing obligations are unlikely to be material.[61] Scholars have noted that, in practice, the cost of filing affects the decision of whether to secure a loan “only in very rare cases.”[62] Further, as information technology improves, recording and verification costs are likely to decrease.[63] Moreover, even entities must make frequent filings.[64]

Although filing cannot serve as a principled distinction between the two bodies of law, requiring it makes sense for security interests, but not entities.[65] Filing through a registry gives notice to creditors about those who have fixed priority to the relevant asset pool. This information is likely relatively stable. Conversely, information about the identity of unsecured creditors who have floating priority is likely to be unhelpful to other creditors because the manager of the assets can change their identity at any time.

C.  In Rem Rights Against Third Parties

Security interest law gives secured parties a remedy against third parties.[66] When a lien attaches to an asset, that lien follows the asset even if it is sold. If the debtor defaults, the creditor can foreclose on the asset,[67] even if it is in the hands of new, potentially innocent owners.[68] Both discourage unauthorized shifting of encumbered assets and protect the creditor if such shifting occurs.[69] This type of right against third parties is typically referred to as the “in rem” quality of property law, as opposed to “in personam” rights. The latter are created by contract law and are binding only on the contracting parties and, sometimes, those on notice of the contracts.

Yet the advantages of security interests in this respect are relative rather than absolute. Entity law can also give an asset pool’s creditors a claim against third parties, so it is also in rem. When assets are owned by an entity, efforts to sell or pledge them are subject to fraudulent conveyance law, which invalidates transfers that are intended to frustrate creditors.[70] It also invalidates transfers for less than reasonable value when the debtor becomes insolvent.[71] True, rights granted by fraudulent conveyance law may be less intrusive to third parties than those granted by security interest law because they only disrupt bad-faith transfers or too-good-to-be true transactions. But this is only a difference in degree rather than a unique function of either entities or security interests.

To the degree that security interests provide creditors a more dependable claim against third parties who come to possess the collateral, this is best thought of as a detail of our account rather than a competitor to it. Security interests create fixed priority schemes, in which managers are not permitted to lower the relative status of a creditor as to certain collateral. Just as managers may not impair the rights of a secured creditor by promising another creditor higher priority, managers may not impair them by selling the assets free of liens and encumbrances. The fact that security interests “follow” property into the hands of third parties is an entailment of fixed priority. A rule fixing creditor priority against subsequent creditors fixes it against purchasers, a fortiori.

Likewise, it is not surprising that the remedy against shifting assets in entities is usually less exacting than that for security interests. When the manager has discretion to update the pool of creditors, it is harder to define the scope of the assets, and therefore it is more difficult to determine which asset transfers are detrimental to creditors. Conversely, when the assets are well defined (as is more likely when creditors have fixed priority), it is efficient to give the secured creditors a direct claim to the assets without a legal process that examines the motivation behind the transfer of those assets.

D.  Governance Structure

Entities typically require the appointment of dedicated decisionmakers and prescribe the duties and powers of such decisionmakers.[72] For example, corporations must appoint a board, and the board has fiduciary duties to the owners. Nonetheless, it is fairly easy to opt out of these rules, even in a standard corporation.[73] Moreover, entities, such as the general partnership and the member-managed Limited Liability Company (“LLC”), do not even have default centralized management or detailed governance provisions.[74] Many financial structures exist in which entities are used as shells without any meaningful governance structure, and the management of assets within the entity is outsourced to an outside manager, for example, a mutual fund manager or a servicer of securitized loans.[75] Moreover, a security agreement could contractually provide for the appointment of a manager for the secured assets and specify the manager’s duties and responsibilities. Accordingly, governance provisions can be constructed without an entity.

That said, governance structure is understandably more likely in entities. Asset pools with floating priority require management with discretion to update the priority of the creditors. It makes sense to impose on those managers some default set of duties to play their part in good faith. Detailed governance rules are less important for administering assets whose creditors have fixed priority because no updating is required.

E.  Limited Liability

Limited liability protects owners from the contract and tort claimants of the enterprise.[76] It is the most commonly cited benefit conferred by the use of legal entities.[77] In contrast, secured creditors typically have recourse to the unsecured assets of the owner.[78]

Nevertheless, limited liability is an imperfect distinction. First, an owner can obtain most forms of limited liability by simply bargaining for a waiver or non-recourse provision from creditors.[79] Second, limited liability is far from universal in entities. General partnerships (and general partners of limited partnerships) lack it altogether. Guarantees by individual owners or parent corporations, which effectively nullify limited liability, are pervasive across industries.[80] Moreover, limited liability does not apply to owners who personally control the business or when the entity’s personnel act on the owner’s behalf.[81] Some entities have some advantage in limiting liability to involuntary creditors who have no contractual relationship with the owner.[82] However, firms that have very few tort creditors (such as financial firms) nonetheless make extensive use of subsidiaries.[83] Even in industrial companies where torts could matter,[84] companies operated for hundreds of years without limited liability.[85]

Though the functional distinction of entities relative to security interests cannot boil down to limited liability, our theory nevertheless helps explain why entities often provide limited liability and security interests do not. Security interest-defined pools typically do not have managers; an owner actively managing the assets of such a pool is unlikely to be shielded by limited liability. Moreover, owners of an entity benefit more from limited liability because they would otherwise be liable for some unauthorized actions taken by the separate managers of the assets, who due to floating priority, have discretion to undertake a wide range of potentially risky transactions.

F.  Legal Personality

Entity law confers separate legal personality on asset pools, which can then own assets in their own name, sue, and be sued. However, legal personality on its own does not serve a meaningful economic function. For example, legal personality allows Entity 1 to sue individuals who damage the Hawaii mall, but that same suit could have been brought by the owner if she owned the mall in her individual capacity (as in Figure 3).

Another variant of that argument is that the bankruptcy process cannot attach to asset pools without legal personality.[86] Bankruptcy is arguably unique in that it collectively settles the claims of all creditors of the entity.[87] However, there is an equivalent process that can be applied to security interests: receivership. A receiver appointed following a motion by secured creditors may take control of some or all of a debtor’s assets.[88] The priority of claims in a receivership proceeding is similar to that applied in bankruptcy.[89] Although unsecured creditors generally do not take an active role in the receivership, they may be parties to receiverships,[90] and the receiver must protect their interests.[91] Thus, the law provides security-based pools a functionally similar process to that which is based on legal personality.

While legal personhood cannot serve as the functional distinction, it nevertheless makes sense for entities to have personhood because personhood is often useful for asset pools with a dedicated management. It makes less sense to sue an asset pool in its own name if the manager is also the owner of that pool, as in a typical security interest partition. Likewise, there is little gained by letting an asset pool sue in its own name if it is managed by an owner who is already able to sue in her own name. On the other hand, it likely most efficient to allocate the power to sue in the name of assets to entities, as they typically have dedicated management that is best positioned to deploy and protect the assets.

G.  Bankruptcy Protection

Although entities and security interests perform the same asset partitioning role, it may be argued that entities have the additional advantage of bankruptcy protection.[92] If an entity’s owner becomes insolvent, the owner’s personal creditors cannot usually force bankruptcy or liquidation of the entity’s assets; at best, they can take the owner’s ownership interests over the entity. In entity structures like those in Figure 2, C2’s collateral is unaffected if the Hawaii mall goes bust. In contrast, the unsecured creditors of an owner can drag the secured assets into liquidation by filing for the bankruptcy of the owner. In Figure 3, C1 could force the owner into bankruptcy along with all her assets, such as the Oklahoma mall. So C2 must evaluate the financial health of the owner and the viability of the Hawaii mall, rather than just the Oklahoma mall.

Nonetheless, we believe that bankruptcy protection cannot serve as the distinction between security interests and entities. First, we believe that it is not accurate to say that entities provide bankruptcy protection.[93] Rather they provide what practitioners call “bankruptcy remoteness.”[94] Entities may make the risk more remote, but there are many circumstances under which one entity is drawn into another’s bankruptcy. For instance, the sale of the receivables might be recharacterized as a loan or a security interest, in which case the assets would not be protected from bankruptcy.[95] The bankruptcy process can be extended to include a set of entities that operate as a group under the doctrine of substantive consolidation.[96] In fact, most public corporations run their various businesses in a way that makes consolidation almost inevitable.[97] Even in a securitization, there is a risk that solvent entities will be impaired by a bankrupt owner. Indeed, this is what happened in the highly publicized In re General Growth Properties Inc. case,[98] on which our figures throughout the paper are based.[99] In that case, the court drew solvent entities (each owning different shopping malls) into the bankruptcy proceedings of their owner (a real estate investment company).[100] General Growth filed for bankruptcy along with a number of its special purpose entities (“SPEs”), some of which were still performing.[101]

Just as entities’ bankruptcy protection is not absolute, security interests’ protection is not trivial,[102] especially for financial transactions that can be structured to take advantage of foreign law.[103] Under English law before 2002, and even after 2002 for certain transactions, holders of a specific type of security interest called the floating charge have the right to effectively block the bankruptcy (called the “administration” in the U.K.) of a company.[104] Instead, the senior creditor may appoint an administrative receivership, under which the security is protected and payments continue even as junior creditors’ claims are addressed. These expansive rights protect one pool from liquidation despite the owners’ financial difficulties.

Covered bonds—another instrument widely used in Europe—provide significant bankruptcy protection without meaningful use of an entity.[105] Covered bonds are similar to secured bonds, granting the creditors priority over obligations that remain on the balance sheet of the issuer. However, covered bonds also enjoy bankruptcy remoteness from the issuer.[106] The other creditors of the issuing entity do not get to interrupt payments to the covered bond in the event of insolvency. Covered bonds achieve this bankruptcy remoteness by way of enabling statutes, rather than by relying primarily on entities.

Moreover, bankruptcy protection is material only when the bankruptcy process disrupts the pre-existing priorities to the asset pools. The bankruptcy process does not necessarily harm the interests of secured creditors. Typically, secured creditors must be paid in full before any unsecured creditors may be paid anything at all,[107] they may be compensated for disruptions due to the bankruptcy process,[108] and senior creditors exercise significant control over the bankruptcy process.[109] To the degree that bankruptcy is disruptive to asset partitioning, this may be a contingent feature of recent American law,[110] rather than an enduring feature.[111] Indeed, it is possible that what partly motivated the emergence of securitization transactions in the 1980s, as an alternative to standard secured lending, is the contraction of the rights of secured creditors in bankruptcy following the 1978 Act to the benefit of unsecured creditors.[112]

Finally, it is worth noting that not all entities offer bankruptcy protection, so the defining feature of an entity cannot be bankruptcy protection. Creditors of a bankrupt partner in a partnership have the power to force liquidation and winding-up (which is equivalent to a bankruptcy) of the partnership by foreclosing on the partner’s interest in the partnership.[113]

While bankruptcy protection does not prove an adequate basis to distinguish these bodies of law, it is somewhat easier to obtain it with entities than security interests. Why? Unlike the other candidate distinctions above, we believe that the policy reasons behind this are questionable.[114] We address this issue below in Part V.

IV.  Explaining the Structure of Financial Products

With the growth in financial innovation, segregating asset pools is a common objective of many financial products. We focus on three areas of financial innovation that have experienced substantial growth in recent decades: securitization, captive insurance, and mutual funds. The basic choice business planers face in creating these asset pools is whether to place them in separate entities or simply give creditors a security interest over these assets. These two options are depicted in Figures 7 and 8.

Figure 7.  Entity Partitioning

Figure 8.  Security Interest Partitioning

These areas all involve the use of numerous entities, largely as a form of security interest. The proliferation of entities in these products thus might seem to lend support to the view that entities serve the same function as security interests, and the two forms are functional substitutes.

However, as we show below, in all these financial products, the key structural element is actually a security interest or other law that essentially fixes the priority of the creditors. Without fixed priority, these products would not be viable. The main reason entities are typically used in these structures is because in the United States, security interests are not bankruptcy remote; much recent financial innovation reflects a frustration with this feature. In Part V, we will discuss how even more recent innovations such as protected cell regimes attempt to address this deficiency in security interests.

A.  Securitization

In a securitization, the sponsor corporation sets aside a pool of assets.[115] The company sells those assets to a newly formed special purpose entity (“SPE”).[116] The SPE raises the purchase money by issuing bonds commonly known as asset-backed securities (ABS, or MBS when the asset is a mortgage). Many companies use securitization as their principal mode of financing. We return here to the notable example of General Growth Properties. General Growth owned numerous SPEs, which held shopping malls financed by loans and bonds. Each SPE owned one shopping mall (or a group of them), and the parent entity essentially acted as a management company that specialized in securitizing the assets. The structure was described in Part I, Figure 2, and it is essentially the same structure depicted in Figure 7, except that the SPEs are not necessarily owned by the originator of the assets, but may be independent of it.[117]

The economic rationale for securitization is that the notes are supposed to be informationally insensitive, or safe,[118] so that the noteholders’ costs of evaluating and monitoring the assets are low. This is reflected in the nature of the assets, which are supposed to have predictable cash flows and homogenous risk. There is limited value in managerial discretion at the SPE level, as the SPE is not an operating company.

Securitization practitioners take many steps to ensure low evaluation costs and low managerial discretion. The SPE’s organizational documents and the terms of the notes limit the SPE’s activities to holding the assets and making payments on the notes; managers are not permitted to incur any other debt or pledge the assets to secure the debt of another firm.[119] In the case of General Growth, for example, each SPE held a shopping mall, but the SPE’s board had no discretion to buy more assets, or issue debt at its own discretion; rather, management is outsourced to a management company that simply collects the income and rents out the shops.[120]

However, as discussed above, these contractual provisions, including those set in the SPE’s organizational documents, are insufficient because they are not binding on third parties.[121] Thus, it is crucial for the bondholders to have a security interest in the receivables and, without exception, bondholders in all securitizations do receive a security interest in the assets. The security interest is typically held by an indenture trustee on behalf of the bondholders.[122] This ensures that the bondholders have a fixed priority to the assets. If the SPE issues more debt, that debt will be automatically subordinated to the claims of the original noteholders. If the bondholders had only floating priority with respect to the assets, the SPE would be able to add more creditors with equal priority to the noteholders.

If fixed priority is the goal, why use a special entity? It is not as though the entity is doing “real” work; the entire structure is intended to strip all operational control from the SPEs managers. Nor is it costless to use entities. Each entity has to satisfy the relevant securities regulations, including the filing of a separate prospectus.[123] Parties are willing to bear these costs because entities are “bankruptcy remote.”[124] Bankruptcy remoteness, like fixed priority, is important for creating informationally insensitive notes, and empirical evidence suggests that it is priced into the value of the notes on the market.[125] When the same company manages many different securitization vehicles, the bondholders in one issuance (represented by C1 in Figure 7 and Figure 8) must ensure that the bondholders in the other issuances (i.e. C2) will not be able to drag the pledged assets (i.e. A1) into the bankruptcy of the management company. Because each pool of assets is held by a separate entity, there is less likelihood that it will be included in the bankruptcy of the management company.[126]

If security interests in the United States were bankruptcy remote, there would be no reason to use entities in this process.[127] In this case, the informational efficiencies could be achieved with mere security interests, as in Figure 8. In fact, a type of securitization called whole business securitizations, which is common in England, achieves bankruptcy remoteness without meaningful use of an entity. Rather, it relies on a form of security interest known as the floating charge, which enjoys bankruptcy protection.[128] In this type of securitization, the securitized assets are not transferred to a bankruptcy-remote SPE, but stay with the company.[129] The bondholders are protected from the bankruptcy of the sponsor corporation because due to the floating charge, they indirectly have the right to appoint an administrative receiver and take control of the assets if an unsecured creditor or the company applies for administration (the English equivalent for bankruptcy).[130] The administrative receivership procedure is designed to ensure that the securitized assets continue to operate for the benefit of the creditors, even if the business becomes bankrupt.

There are other examples of security interests thriving with bankruptcy protection, even without an essential link to entities. “Covered bonds” have been much touted as a safer alternative to securitization.[131] Covered bonds are widespread in Europe,[132] and they amount to secured bonds except that they possess appreciable protection from the bankruptcy of the issuer.[133] For financial institutions, this protection is granted by legislative fiat.[134] With this protection, entities are not crucial to the asset partitioning effort. However, statutory covered bonds are usually only issued by financial institutions. When issued by other companies, they face the same obstacles as we described in Part II and make use of entities for the same reasons.

This demonstrates that a security interest that has fixed priority and bankruptcy remoteness could in theory obviate the need for entity-based asset partitioning in securitizations. The fact that entities are substantially absent when security interests suffice further supports the claim that entities are being used only incidentally, as part of a strategy to ensure that fixed priority is maintained in the event of a bankruptcy.

B.  Captive Insurance

Captive insurance is a form of self-insurance, whereby a firm sets aside reserves in order to pre-fund a specific risk, such as product liability, professional liability, or health insurance.[135] Self-insurance is typically used when a firm has homogeneous risk exposures, such that its aggregate, expected losses are reasonably stable and predictable. It is generally cheaper than standard insurance, mainly because the insurance can be better tailored to the needs of the insured, as opposed to standard insurance that reflects industry risk.[136]

In theory, firms can self-insure simply by saving up a reserve fund, but without creating a separate pool of assets. However, when the funds remain under the discretion of the insureds, potential claimants and regulators will not view the reserve as being credibly committed to funding the identified risk.[137] One way to improve the credibility of self-insurance is to form captive insurance companies. The insured firm will set up a separate entity-subsidiary (a “captive”) with capital from the insured. This capital, along with the insurance premium, is used to satisfy potential claims.[138] The management of the subsidiary-entity is contracted out to an insurance management company, which manages many of these entities on behalf of the insureds.

This structure is basically the same as that depicted in Figure 7, in that the assets pledged to the creditors—that is, the insureds—are placed in separate entities. Similar to securitizations, the assets that the management company manages are partitioned such that each creditor—that is, the insured—has a priority in his reserve funds over other creditors of the insurance management company.

But, as in securitizations, the use of entities just to partition the assets is not sufficient. One problem with a purely entity-based approach is that entities create floating priority, but insurance customers need fixed priority. There is little value here to managerial discretion since the insured just wants the money safely held for a rainy day, rather than deployed to seek business opportunities. Nor do captive insurance creditors wish to incur any costs in monitoring the use of the assets by the captive insurance company.

To create this fixed priority, the insured needs to have a security interest in the assets of the captive insurance entity, which gives the insured priority over those assets.[139] Moreover, each of the captive entities must be a licensed insurance company, which is typically subject to numerous regulatory restrictions on its ability to incur any indebtedness. For example, under Delaware captive insurance regulation, the captive company is not permitted to incur material debts, make material loans or extensions of credit without regulatory approval, or enter into major transactions without regulatory approval.[140] These limitations, together with a security interest, would appear to fix the priority of the insured to the assets of the captive entity.

But again, if security interests and regulatory restrictions already achieve fixed priority, why do we need entities? For example, the insurance management company could simply own each reserve account on behalf of the insureds and each insured would have a security interest in its account (see Figure 8). In fact, some captive insurance companies have used this structure in order to avoid obtaining a separate insurance license for each entity.

However, without entities, the captive might not be adequately protected from the bankruptcy of the insurance management company. In particular, there would be a risk that claims by other insureds could render the management company insolvent and effect the liquidation of all the captives.[141] The fact that the management company promised C1 priority recourse against A1 (the contents of its cell) is not necessarily binding on C2, or any other creditors of the management company.

Insurance management companies have tried to avoid the costs of setting up separate entities to save the fees for insurance licenses while overcoming the limitations on a security interest approach by creating “rental captives.”[142] In rental captives, the management company issues each insured non-voting preference shares, and the proceeds of the issue are allocated to a specific account, which is also known as a “contractual cell.” Under the insurance policy, the insured is limited to claiming only from the segregated funds in the relevant account. The insured also has a security interest over his account.[143] Moreover, the insured as a preference shareholder in the insurance company enters into a shareholder agreement that (1) specifically limits claims to its respective fund, (2) states that the insured will have no recourse to any other company assets or the funds of other insureds, and (3) provides that such limitations also apply in the liquidation of the captive insurance company.[144]

Through this contractual arrangement, insurance management companies effectively tried to create bankruptcy remoteness without entities. However, this structure faces the same challenges we described in Part II. It essentially requires monitoring by each insured to make sure that the insurance company enters into similar arrangements with all other insureds—otherwise the other insureds could potentially file for the bankruptcy of the company or make claims to assets outside their segregated accounts. Moreover, there remains uncertainty whether in a bankruptcy of the insurance company, the bankruptcy court would respect the security interests of each insured and the relevant contractual limitations.

As in the case of securitizations, security interests with bankruptcy remoteness would make entities redundant in this structure. In fact, as we discuss in Part V, the contractual cells served as the basis for protected cell legislation, which largely addressed the deficiencies of the contractual approach, and provided effective bankruptcy remoteness to the cells.

C.  Mutual Funds

Mutual funds are pools of investment securities that issue only redeemable common stock, which is sold widely to the public and is composed entirely of debt or minority equity holdings in many companies. A unique feature of mutual funds is that the shareholders in these funds cannot sell their shares, but they can always redeem their shares for cash equal to their pro rata share of the net asset value of the fund.[145] Mutual funds must register with the SEC and are regulated by the Investment Companies Act of 1940 (“ICA”).[146] We will focus on open-ended funds, the most common type of mutual funds. The typical structure is for each fund to be formed as an entity, as in Figure 8. The management of all these entities is outsourced to a separate fund management company that manages the investments made by many funds, as with securitizations and captive insurance.[147]

Previous literature has emphasized the use of entities for creating mutual funds.[148] However, the organization and regulation of mutual funds effectively creates fixed priority. The ICA prescribes that such funds can only issue common shares and not senior debt securities, and that they can only take out loans from banks if the ratio of net assets to bank-loan principal is equal to or exceeds 3:1.[149] Thus, although mutual funds can take on some debt, the only true creditors of the funds are essentially its equity investors, and they are for the most part the only claimants on the fund’s assets. These investors have the same priority—that is, they each have a claim on their pro rata share. The fund cannot issue any other shares that rank higher to them. In fact, the fund cannot issue shares that rank equally to the current investors in their pro rata share. If the fund issues new shares, the new investor has to contribute additional funds, as each investor maintains his or her claim to his or her share of the net asset value of the fund.[150]

The explanation for creating this fixed priority is essentially to lower the evaluation costs for the investors.[151] As is well known, most households now hold a substantial portion of their assets in mutual funds. These investors tend to be very passive and rarely, if ever, engage in any active monitoring or lawsuits.[152] If the fund is underperforming, these investors often just exit by redeeming their shares and possibly buy shares in another fund. If mutual funds had floating priority by allowing the managers to freely issue debt instruments, the investors would need to monitor more carefully, because such issuances would have priority over common equity, and shareholders would be at a risk of losing their pro rata share of the net asset value.

If investors want fixed priority, then why conjure up an entity for each investment fund? The management company could in principle hold all the securities in the name of a single entity, give the investors in each fund a security interest,[153] and require investors to enter into a contract that segregates the assets of each fund.[154] This structure, which is essentially the one depicted in Figure 8, would have the benefit of saving the transaction costs of setting up new entities, including duplication and expense resulting from multiple boards, contracts with service providers, and regulatory filings.[155]

The main purpose for using entities to form funds is bankruptcy remoteness.[156] Each fund’s investors need to be assured that their fund will not be affected by the claims of other funds’ investors and other creditors of the fund managers. As with captive insurance, it may in theory be possible to require the investors to enter into a multi-lateral contract, whereby each agrees to limit the liability of the management company to the assets in the relevant fund account. But again, there is no guarantee that the security interest and contract would be respected in a bankruptcy of the management company. Furthermore, the investors in each fund would always need to be alert to the creation of additional funds by the manager and get assurance that the new funds are subject to the same limitations on liability. Accordingly, without security interests that have bankruptcy remoteness, it is much easier to use entities to create mutual funds.

V.  The Evolution of New Legal Forms

The purpose of many financial products is effectively to give fixed priority to a group of creditors. Security interests provide fixed priority, but they must be alloyed with entities because security interests do not adequately protect pools from the owner’s bankruptcy. If security interests developed to allow bankruptcy remoteness, they could supplant the role that entities play in these structures. In fact, recent legal innovations appear to be specifically designed to address this void.

Although there has been significant academic focus on the evolution of entity law,[157] the evolution of novel security interests has been largely overlooked. These forms evolved primarily from the late 1990s in off-shore jurisdictions, but they have also been adopted in many U.S. states, including Delaware.[158] The key feature of these forms is that they allow certain entities to subdivide their assets, pledging individual pools of assets to individual creditors. These forms first appeared as a solution to the high costs of setting up entities for captive insurance purposes, which also include the fees for insurance licenses for each captive entity.[159] But they have been increasingly used to set up mutual funds, securitization products, and even real estate firms.

These entities are often called protected cell companies and the individual pools are often called cells or protected cells, although some jurisdictions use other names, such as segregated portfolio companies and segregated portfolios, respectively.[160] In the US, business planners may also use the series trust and series LLC, which allow these entities to form separate asset pools called series. Figure 9 shows the structure of entities that have the power to create these instruments. The entity itself may be a protected cell company or a series LLC. The assets are placed in the cells or the series, and they are pledged for the benefit of specific creditors, just like in the case of entities and security interests. For convenience, we will refer to all types of such asset pools as cells, but our claims will also apply to other types, such as the series or segregated portfolios.

Figure 9.  Protected Cell Partitioning

Nonetheless, most of these legal forms are better viewed as security interests, because managers for most of these legal forms lack the ability to update creditor priority within each cell, and hence the cells exhibit fixed priority. Many of these forms are limited to specific uses for either captive insurance, investment funds, or securitizations. As such, they are subject to legal mandates, including industry-specific regulations that limit managerial discretion to alter creditor priority. These regulations also provide cells with a much greater degree of bankruptcy remoteness than standard security interests, because the creditors of the cells usually have no recourse to any others cells, including in the event that the company as a whole becomes bankrupt. In this way, they address the deficiencies associated with security interests that make them inadequate for the key financial products described above.

We describe three examples, one for each of the three financial products discussed in Part IV. Consider first the protected cells regimes, of which Delaware’s can serve as an example. Its cell regime is limited to captive insurance companies.[161] The law clearly provides that “[t]he assets of a protected cell shall not be chargeable with liabilities of any other protected cell or . . . of the sponsored captive insurance company generally[,]” unless stipulated in the participation agreement.[162] The priority of creditors of each cell is also fixed. The reason is that protected cell companies are not permitted to incur material debts, and the cells are subject to the same restrictions on indebtedness as the captive insurance companies themselves.[163] Furthermore, the liability of each participant insured by a captive insurance company is limited to its share in the assets of a protected cell,[164] and participants may not be added without permission from the regulator.[165] Moreover, the captive insurance company is not permitted to transfer any assets of a protected cell without the participants’ consent or regulatory approvals.[166]

In this way, the law effectively makes the cells bankruptcy remote. To be sure, there is formally no bankruptcy protection in the sense that if the company itself is liquidated or rehabilitated, presumably the cells will be as well. However, captive insurance companies have largely no material creditors, and each of the insured as creditors of cells only have recourse to the cells themselves.[167] Thus, it is difficult to envisage a situation where the default of one cell could lead to the default of the company and the other cells. Moreover, protected cells may be subject to their own liquidation proceedings without impairing the other cells.[168] Finally, if the protected cell company itself is in default and is being liquidated, “[t]he assets of a protected cell may not be used to pay any expenses or claims other than those attributable to such protected cell.”[169] Accordingly, even if the company is liquidated, the cells are protected from the liabilities of the protected cell company, and thus the rights of each cells’ creditors are unlikely to be jeopardized.

Protected cells are increasingly used to structure investment funds as umbrella funds.[170] In the U.K. version of umbrella fund legislation, protected cells are specifically designed to form open-ended mutual funds under the Open–Ended Investment Companies Regulations. Each cell may constitute a separate sub-fund, and the sub-funds are subject to the same regulations as funds.[171] Under the regulations, “the assets of a sub-fund belong exclusively to that sub-fund and shall not be used to discharge the liabilities of or claims against the umbrella company or any other person or body, or any other sub-fund, and shall not be available for any such purpose . . . .”[172] The regulation further mandates that the liabilities of a particular sub-fund can be paid only out of the assets of that sub-fund[173] and declares all contrary provisions void.[174]

The priority of each cell is again fixed under the regulations, which subject each fund and sub-fund to restrictions on indebtedness and prescribe the rights of investors to the fund’s assets. Specifically, the funds may only borrow on a “temporary basis” (defined generally as under three months),[175] and such borrowing may never exceed 10 percent of the value of the fund’s property.[176] Moreover, fund investors are entitled to a proportionate share of the net asset value of the underlying assets when they decide to redeem their shares.[177]

As mentioned above, the cells enjoy substantial bankruptcy remoteness. Given the strict limitation on liabilities, it is hard to envision a realistic situation in which the creditors of each cell could file for the winding-up of the company, because their claims are limited to the cell and the non-cellular assets are subject to substantial limitations on indebtedness. Moreover, each sub-fund can be wound up without impacting the umbrella company.[178]

Lastly, Luxembourg as well as other jurisdictions has established a regime for the formation of securitization funds managed by a management company.[179] Each securitization fund is supposed to serve as a vehicle for securitizing separate pools of assets. The rules for such funds, including those regarding the rights and obligations of the management, must be laid out in the management regulations of the fund,[180] and these management regulations must be filed with the trade and company registry.[181] The securitization fund is liable only for obligations imposed or contracted for under its management regulations.[182] The fund is not liable for the obligations of the management company or its investors.[183] Securitization funds may further be subdivided into separate pools called compartments, and separate management regulations may apply to each compartment.[184] Neither creditors of the management company nor the investors have rights of recourse against assets in the securitization fund.[185] The statute further requires that funds write into their management regulations “the circumstances in which the fund or one of its compartments will be in, or may be put into, liquidation.”[186] This makes it possible to provide for the separate liquidation of each securitization fund without risking the liquidation of the management company,[187] and in fact, regulators have treated this structure as if it guarantees the bankruptcy remoteness of the funds.[188]

Although the above forms are essentially security interests with greater bankruptcy remoteness, we do not believe that all new forms should be understood the same way. Others appear to be new forms of entities. An important example is the series LLC, which is an LLC that can partition its assets and liabilities among distinct series.[189]

Unlike the forms described above, the series LLC is not limited to specific purposes, such as captive insurance and securitizations. The LLC operating agreement may provide classes of members and managers with different rights and duties.[190] Each series may have a different business purpose and different rights, powers, and duties with respect to the assets held in each series.[191] The assets of each series appear to be segregated in much the same way as those in protected cells,[192] and they likewise seem to be bankruptcy remote.[193] In particular, the series in principle have floating priority because the manager of the LLC has discretion to update the priority of the creditors of each series.

The series LLC is therefore much like an entity. Although one might think that the series LLC may be popular as a way to economize the costs of forming many LLCs, it does not appear to be widely used.[194] The reason is likely that investors have little appetite for yet another enterprise with floating priority. As we explained in Section II.C, floating priority entails high costs of investigation and monitoring, which likely outweigh the costs of forming a new entity. Thus, the series has little advantage over the parent entity (that is, the LLC) that created the series. By contrast, cellular structures with fixed priority are widely used in securitization, captive insurance, and investment funds, suggesting great appetite for innovation based on the core element of a security interest.

The forgoing has attempted to shed light on the purpose and nature of novel business forms, without dwelling on the nature of legal personality. Although it is tempting to deduce that a legal form is an entity because it has legal personality (or that it is not an entity because it lacks personality), such inferences are not helpful in illuminating the function of legal forms. This is in part because legal personality is not consistently and rationally organized in the statutes creating novel forms. For example, most laws state that such cells do not have legal personality, but others do, and some are silent on the point.[195] Legislatures’ decisions about whether to allocate legal personality to each pool of assets seem to be largely arbitrary and unrelated to the specific attributes of the legal form. This further reinforces the claim we made in Section III.F that legal personality cannot serve as a distinguishing principle between entities and security interests. It also highlights the importance of functional analysis for legal policy, as we discuss in the following Part.

VI.  Policy Implications

A.  Judicial Treatment of the New Legal Forms

Courts are increasingly confronted with complicated questions involving novel business forms. Without functional criteria to guide them, judicial decisions are likely to be formalistic or arbitrary. Early cases tended to fixate on the legal personality, rather than the economic objectives of the legal forms chosen by the parties who set up the relevant enterprise. In particular, courts have undermined the asset partitioning of cell structures based on the notion that they lack legal personality. In doing so, they frustrate the very purpose of these forms, which is to establish fixed priority combined with bankruptcy remoteness. By recognizing fixed and floating priority as the critical choices parties make, our account can help guide courts with these difficult determinations.

Consider one of the only American cases addressing the treatment of cells.[196] Pac Re, a Protected Cell Company (“PCC”), agreed on behalf of one of its cells (5-AT) to reinsure AmTrust. When an insurance claim was made, Pac Re argued that only the relevant cell was liable. AmTrust disagreed and compelled arbitration for recourse to all of Pac Re’s assets.[197] “The result of the arbitration is that Pac Re, not just its 5-AT captive cell, must pay AmTrust a whole lot of money.”[198] Why?

AmTrust’s victory was not compelled by clear statutory language: the insurance statute was unclear about whether creditors of a protected cell could proceed against the PCC,[199] though it was explicit that individual cells were not liable for the debts of the PCC or other cells.[200] The contract was likewise unclear about whether the cell’s debts could be satisfied from the PCC’s assets.[201] Ultimately, a federal district court concluded that the PCC was not liable for the debts of its cell.[202] However, the court still sent Pac Re to arbitration because the contract compelled arbitration for some person, and Pac Re was the only legal person around; the cell had no legal personality separate from the PCC.[203] Once Pac Re was before the tribunal, the arbitrators reinstated liability and required it to pay out almost $8 million on behalf of Cell 5-AT.[204]

It seems unlikely that this result is what commercial parties would have wanted. Parties use cells in order to isolate a pool of assets from all other debts and assets. Historically, parties did this by forming a separate entity but moved to cells in order to economize on the administrative and regulatory costs of forming entities. Pac Re seemingly gives cell-based captives less effective asset partitioning than entity-based captives. In the aftermath of the decision, credit rating agency Fitch noted that full recourse “could potentially cause disruption or financial stress for the protected cells in that PCC”[205] because the creditworthiness of all cells within the PCC became central to the status of the cell.

The business model of captive insurance is based on the fixed priority each insured has to each cell. Each insurance customer seeks to avoid the risk that new claimants might arise as peer or superior in status.[206] If the creditors of one cell can potentially levy on the assets of other cells in the group, then the customers of other cells must worry about the promises the insurance management company makes.

Pac Re potentially converts other cells’ fixed priority to floating priority by rejecting Pac Re’s statutory and functionalist argument. The court instead waxed jurisprudential about the nature of legal personhood and found that Pac Re rather than Cell 5-AT was the appropriate defendant in the lawsuit.[207] More troublingly, however, the court appears to suggest that legal personhood is dispositive of whether the segregation of the cells’ assets should be respected: “[T]hat a protected cell should be segregated and isolated from the core and any other protected cells in the PCC misses the mark in this lawsuit because a protected cell is not a separate legal person.”[208]

Legal personality is an inadequate lynchpin for this kind of decision in a world in which entity-like functions are frequently exercised by forms whose personhood is unclear.[209] The question of who should be named in a lawsuit—an assets pool’s owner, its manager, or the pool itself—is analytically separate from the question of what assets are available to satisfy claims. Courts must be mindful of parties’ asset partitioning choices and the priority structures they adopt. Determining the permeability of these partitions on the basis of legal personality or other beside-the-point criteria is misguided.

B.  Bankruptcy Remoteness for Security Interests

We have shown that there is substantial appetite for fixed priorities with bankruptcy remoteness. The law has long permitted this arrangement, but it has generally required the use of two instruments: a security interest and an entity. This is reflected in the structure of the financial products we discussed in Part IV. With more respect for the security interests the entities would be superfluous in such structures.

The law would be improved if it respected the bankruptcy remoteness of security interests in such contexts without requiring the interposition of an entity. Any time that parties are capable of establishing fixed priority and bankruptcy remoteness, there should be an option for them to achieve that effect without actually forming an entity. As long as all creditors have proper notice of the asset partitions, there is little need to require parties to form a separate entity.[210] Specifically, this means that non-recourse secured claims on assets would be respected in bankruptcy to the same degree that non-recourse claims on a subsidiary (or a SPE) that contains the asset would be respected.[211]

At minimum, this reform would have the modest effect of saving the transaction costs of creating new entities. These costs are not trivial when business planners pledge numerous asset pools to numerous creditors, in circumstances where creditors seek safe assets that are easy to evaluate, and the value of managerial discretion is low. It is also possible that such a reform would have more wide-reaching beneficial effects. In particular, a growing number of businesses consist of numerous entities.[212] Thus, our proposal could in principle reduce organizational complexity by making entities redundant for some financial products.[213] It is also possible that pooling assets within security interests would further mitigate wrongful asset-shifting.[214]

How should this reform be effected? One way to do this is by identifying specific structures or transactions which would benefit from the combination of fixed priority and bankruptcy remoteness. This is essentially the approach of specialized legislation for captives, mutual funds, and securitizations. Another option is to create a set of general conditions, potentially applicable to any security interest. For example, a statutory safe harbor could be introduced for any non-recourse security interests;[215] qualifying secured claims would enjoy substantial protections—such as release from bankruptcy’s automatic stay[216] and exemption from the collection efforts of unsecured creditors[217]—which would have arisen through entity-based financing.

The latter proposal raises the concern that permitting secured parties to opt for greater bankruptcy protection would transfer wealth away from non-adjusting creditors, such as tort victims, and accordingly drive firms to create and externalize too much risk. There is a rich debate on the costs and benefits of a regime that privileges one group of creditors above another, and we do not intend to settle it in this paper.[218] However, our proposal is limited to contexts where entity-based bankruptcy remoteness is already feasible. Whether such protections are efficient or not, it is of little importance whether the means is a security interest or an entity.