Hansmann and Kraakman176 argue that the essential role of organisational law177 is
“to provide for the creation of a pattern of creditors - a form of ‘asset partitioning’ - that could not be practicably established otherwise. One aspect of this asset partitioning is the delimitation of the extent to which creditors of an entity can have recourse against the personal assets of the owners […] of the entity. The truly essential aspect of asset partitioning is, in effect, the reverse of limited liability - namely, the shielding of the assets of the entity from claims of the creditors of the entity’s owners or managers.”178
174 51. “The company attains maturity at its birth. There is no period of minority – no interval of incapacity.”
175 53.
176 Hansmann & Kraakman Organizational Law 390.
177 The law in respect of different legal entities.
178 Hansmann & Kraakman Organizational Law 390.
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Hansmann and Kraakman identify two crucial elements for a firm to serve as a nexus of contracts.179 Firstly it has to have agents to enter into contracts on behalf of the entity and secondly the firm has to have a pool of assets to satisfy claims of creditors against the company.180 The authors refer to this pool of assets as the firm’s “bonding assets.”181
A natural person has these two attributes. Juristic persons also have these attributes but differ from natural persons in that their bonding assets are separate from the assets of the shareholders or directors of the company. Therefore the creditors of the juristic person can in principle only claim from the assets of the juristic person and the creditors of the shareholders and directors of the company can only claim from the personal assets of the shareholders and directors respectively. For Hansmann and Kraakman the last mentioned element is the defining element of a juristic person, i.e. the separation of the bonding assets of the entity and the personal assets of the shareholders and directors of the juristic person.182 Organisational law’s most important role according to the authors is then to establish this separation of assets.183
Asset partitioning has two components. The first is to separate the assets of the juristic entity and the shareholders of the juristic entity. The second component is the
“assignment to creditors of priorities in the distinct pools of assets that result from the formation of a legal entity.”184 This assignment of assets then takes two forms. The first is the claim that the creditors of the company have against the assets of the company which ranks higher and stronger than the claim of the creditors of the shareholders of the company. This the authors call “affirmative asset partitioning.”185 The other form of asset partitioning is called defensive asset partitioning. This term reflects the opposite notion, namely that the personal creditors of the shareholders have a prior claim against the personal assets of the shareholders of a company, which claim is stronger than the claims,
179Cheffins Company Law 32 states that a company is a “network of explicit and implicit bargains, or a nexus of contracts” according to contractual theorists . See chapter three in respect of the nexus of contracts argument.
180 Hansmann & Kraakman Organizational Law 392.
181 Hansmann & Kraakman Organizational Law 392.
182 Hansmann & Kraakman Organizational Law 393.
183 Hansmann & Kraakman Organizational Law 393.
184 Hansmann & Kraakman Organizational Law 393.
185 Hansmann & Kraakman Organizational Law 393.
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if any, of the voluntary creditors of the company.186 Defensive asset partitioning is therefore reflected by the principle of limited liability which precludes the creditors of a company from claiming against the assets of the shareholders of the company.187 Affirmative asset partitioning and defensive asset partitioning form two sides of the same coin, the position of creditors of the company vis-à-vis the shareholders of the company and their personal creditors. Hansmann and Kraakman argue that affirmative asset partitioning reduces the costs of credit for companies since it reduces monitoring costs, it protects against the premature liquidation of assets and it allows for efficient risk allocation.188
Hansmann and Kraakman argue that the costs of defensive asset partitioning are not high from the perspective of the shareholder. The reasons for this is that it allows the shareholders to act opportunistically towards the creditors of the company especially in cases where the asset value of the company is less than the credit which the company requires for its operations. This implies that the company may take excessive risks.189
Hansmann and Kraakman next ask the question whether the law is required to provide for limited liability or whether it can be achieved by means of contract. The authors argue that although there could be high transaction costs involved for the shareholders, the latter approach would not be impossible. They argue that the transaction costs of establishing defensive asset partitioning would still not be as high as the transaction costs involved in creating affirmative asset partitioning.190 Affirmative asset partitioning would be impossible to provide for by means of contract in light of the transaction costs, monitoring costs and moral hazard involved. The reasons for the high costs would be that the creditors of the company would have to rely on the shareholder to enter into a contract with each of his creditors that they would not lay claim to the assets of the company. The shareholder would have to enter into such a contract with every creditor
186 Hansmann & Kraakman Organizational Law 393.
187 Hansmann & Kraakman Organizational Law 394.
188 Hansmann & Kraakman Organizational Law 398–405. Compare also Easterbrook & Fischel Economic structure para 2.3 51.
189 Hansmann & Kraakman Organizational Law 423.
190 Hansmann & Kraakman Organizational Law 429. In respect of affirmative asset partitioning by means of contract and the difficulties and resulting transaction costs see 406-410.
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which would be time consuming and expensive. The monitoring costs for the creditors of the company would be excessive. They would have to monitor the shareholder to ensure that he enters into these contracts with every personal creditor. Since this will be difficult, this could lead to opportunistic behaviour by the shareholder by not contracting with all of his personal shareholders. This leads to moral hazard.191 With defensive asset partitioning the company, in the absence of limited liability, would include a standard waiver in every contract with a creditor in terms of which the creditor waives his right to claim from the personal estates of the shareholders. Hansman and Kraakman argue that these costs would not be as expensive as with affirmative asset partitioning since there would be no need to amend the contract in respect of every creditor (only one standard form waiver is required) and the chances for moral hazard would not be present.192
In respect of involuntary creditors193 the authors argue that limited liability would appear to be a “historical accident.”194 They base this opinion on the circumstances which existed during the formative years of companies in the late nineteenth century where delictual liability was sufficient to cause the downfall of a company. The authors further argue that although limited liability makes sense in respect of the law of contract, it does not make sense in respect of delictual liability. A victim of a delict, after all, has no influence over who injures him. They therefore argue that “to make the amount recovered by a tort victim depend upon the legal form of the organization responsible for the tort is to permit the externalization of accident costs, and indeed to invite the choice of legal entity to be governed in important part by the desire to seek such externalization.”195
The problem with the abovementioned views of Hansmann and Kraakman, in respect of voluntary creditors, is that they do not necessarily make sense within the context of the reality of a group of companies. The authors argue that asset partitioning benefits the creditors of the owners or managers of a company because the creditors of the owner
191 Hansmann & Kraakman Organizational Law 406-410. Where there is a number of shareholders the costs would increase exponentially.
192 Hansmann & Kraakman Organizational Law 429.
193 An involuntary creditor is a creditor who involuntarily becomes a creditor of a company, for example, a delictual victim. A contractual creditor will therefore be a voluntary creditor.
194 Hansmann & Kraakman Organizational Law 431.
195 Hansmann & Kraakman Organizational Law 431.
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enjoy protection for their claims against the owner in light of the fact that the creditors of the company cannot enforce claims against the owner. The problem with this argument where a holding company is the owner is that the owner does not have “personal creditors” and is even less in need of protection than the creditors of its subsidiary company in the light of the domination and control that the holding company enjoys. The holding company’s power to give directions to the subsidiary, divert corporate opportunities from the subsidiary to the holding company and deprive it of its funds ensures that the holding company runs less risk of insolvency than the subsidiary company. The creditors of the holding company are therefore shielded and were the holding company to be liquidated they have a claim against the assets of the holding company, which assets include its shares in the subsidiary company. The pool from which the creditors of the holding company can draw is in theory much bigger than the pool available to the creditors of the subsidiary and asset partitioning works in favour of the creditors of the holding company as well as the owners of the holding company.
Should these owners be natural persons the ultimate benefits of the subsidiary company accrue to them and their creditors ultimately enjoy the benefits of limited liability and asset partitioning.
In chapter six it will be shown that other writers also doubt the historical basis for limited liability in respect of the field of the law of delict.196