Optimal Holding Company Organization and Capital Structure Under Constitutional Governance

Abstract

This paper considers an economy in which a not-for-profit government seeks to minimize the cost to taxpayers of maintaining a constitutionally mandated free trading market economy while letting firms maximize market values. By free trading, I mean that the government does not (a) force merger among firms, (b) inject new taxpayer funds to firms, and (c) buy assets at fictitious prices from firms. Both the parent and subsidiaries of holding companies (HCs) can be financially leveraged in this economy. The subsidiaries may be simply bankruptcy-remote firewalled entities, created legally on paper and reported as off-balance sheet items, like Master Trusts and Conduits. Milti-tier HC capital structures have led to failures of many mega corporations like Enron and MCI-WorldCom. Major banks are now facing crises due to badly leveraged bankruptcy-remote entities. This paper shows how HCs should optimally determine their multi-tier financial leverage based on a novel debt-holders’ option to walk out (DOW) of bankruptcy proceedings should their out-of-pocket expenses exceed the value of recovery. We show that (a) DOW is too costly for many HCs to seek full diversification, for example, by mergers, and (b) DOW can optimally determine the number of tiers and the capital structure of a holding company.