Asset Partitioning, Debt-Equity Agency Conflicts, and Choice of Organizational Form

Abstract

Jensen & Meckling's agency theory represented the predominant analytical tool in scrutinizing the institutions of corporate governance during the last decades. While most of the literature focused on the corporate form, far less attention has been paid to the agency conflicts predetermining the governance structure of partnerships. The typical unity of ownership and control draws attention to the cardinal conflict between partners and creditors (broadly understood as all agents engaging in deferred exchanges with the partnership). The law of partnership across jurisdictions facilitates the separation of asset pools and consequently allows for partner opportunism vis-a-vis the firm's creditors. Joint and several liability which marks a common feature of the law of partnership in major legal systems constitutes a transaction cost reducing mechanism to contain partner opportunism. It internalizes the costs of asset diversion, claim dilution and risk enhancement. Its main function is to incentives equity holders accurately (not to insure creditors fully). Yet, under certain preconditions, the coarse tool of unattenuated personal liability renders the partnership form unattractive. This paper delineates the relative benefits and costs that figure in determining the efficiency of using either partnership or corporate law as standard contracts in firm organization. Historical and current data indicates that the divide does not necessarily equal the small firm/large firm distinction but flows from the firms' ownership structure and financing needs. It is also endogenously determined by the costs of incorporation that vary across jurisdictions.