Why are security interests and legal entities both widely used? The prevailing answer in legal scholarship is that both bodies of law exist to partition assets for the benefit of designated creditors. (1) This view is not merely an academic matter; rather, it is exemplified by many financial products, such as asset securitizations. 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. This entity is not a prototypical business with an active management and going concern value is simply interposed to hold the assets in order to assure creditors of their special claim to the assets. Accordingly, entities’ essential role, just like security interests, is to pledge certain assets to particular creditors. The increasing use of entities as mere asset pools suggests that both bodies of laws are converging.
In a forthcoming Article, we question the notion that entities and security interests are becoming indistinguishable by offering a theory of the distinction between them. We argue that security interest law and business entity law 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 fixedpriority scheme. By floating priority scheme, we mean that the administrator of the assets is generally permitted to pledge them 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.
Thus, creditors can obtain priority under either body of law, but the choice between them is a decision about how much flexibility to leave to the borrower to manage the assets. The tradeoff between security interests and entities is ultimately between the benefits of allowing greater discretion to the administrator of the assets to re-finance them to pursue valuable projects, and the benefits of limiting such discretion in order to reduce the costs to creditors for evaluating the assets, whose value will be less sensitive to managerial decision-making.
We defend this distinction in two main ways. First, we show that 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 it is impracticable to create asset pools with fixed priority using only entities and contract. The basic intuition is that to create either fixed or floating priority, there is a need for a law that binds third parties; otherwise, creditors will not be protected from opportunistic behavior by the manager of the assets. Second, we show that other candidate distinctions are not satisfactory. In particular, we argue that the claim that entities, but not security interests, are protected from the bankruptcy of their owner is not a good distinction because there are in fact transactions, such as whole-business securitizations and covered bonds, where security interests are accorded such protection.
This distinction between fixed and floating priority has several implications. First, it is useful for understanding how entities and security interests are used in different financial structures. 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 to make them ‘“bankruptcy remote”. (2) 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. (3) Mutual fund investors and the insured in captive insurance products seek to have a fixed priority over a pool of assets. Thus, the investors are entitled by law to the net asset value of their investment, and the mutual fund is subject to restrictions on issuing debt securities or taking loans. (4) Likewise, captive insurance regulation typically limits the ability of captive insurance companies to pledge the assets contributed by each insured to raise capital from new creditors or to satisfy the claims of other insureds, thereby, ensuring that every insured has a fixed priority to her insurance reserve.
To be sure, many financial products do use entities to benefit from greater bankruptcy remoteness. However, the underlying demand for these products is a by-product of investor interest in security interests or other laws that provide fixed priority. Thus, the proliferation of entities in financial products is paradoxically driven by an appetite for fixed priority. Accordingly, we discuss a potential reform that affords security interests greater bankruptcy remoteness in specific transactions.
Second, the distinction we propose allows us to better understand the recent evolution of new legal forms, which further blur the distinction between security interests and entities. Interestingly, these legal forms have arisen primarily to serve as vehicles for creating securitization vehicles, mutual funds, and captive insurance companies.
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. A single entity consists of multiple protected cells, each cell securing obligations to different classes of creditors. The cells exhibit some entity-like features (distinct securities, separate collateral pools) without others (no board of directors or charter). We offer the first scholarly discussion of these new legal forms, showing how in most cases these pseudo-entities are better regarded as a form of security interest. Our theory provides guidance to courts called upon to characterize these new legal forms and define their scopes.
Finally, we make the claim that our distinction is enduring.It not only survives the recent evolution of new legal forms, but we predict it will also survive other recent technological innovations. For example, blockchain technology may blur the distinction between contract law and property law, by making contracts more transparent and thus potentially binding on third parties. However, the distinction between fixed and floating priority will remain relevant because they reflect two distinct products that have different economic benefits and risks.
Ofer Eldar is Associate Professor of Law at Duke University School of Law.
Andrew Verstein is Associate Professor of Law at Wake Forest University School of Law.
(1) Henry Hansmann & Reinier Kraakman, The Essential Role of Organizational Law, 110 Yale L.J. 387 (2000); George G. Triantis, Organizations as Internal Capital Markets: The Legal Boundaries of Firms, Collateral, and Trusts in Commercial and Charitable Enterprises, 117 Harv. L. Rev. 1102, 1138 (2004).
(2) That is, placing the assets within a separate entity, typically referred to as a special purpose entity (‘“SPE’”), reduces the possibility that the assets held by the SPE will be affected by the sponsor corporation’s bankruptcy; see Steven L. Schwarcz, The Alchemy of Asset Securitization, 1 Stan. J.L. Buss. & Fin. 133, 135 (1994); Gary Gorton and Andrew Metrick, Securitization, in Handbook of the Economics of Finance: Corporate Finance, Volume 2A, (2013), 1-70.
(3) 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, and health insurance.
(4) The purpose for such limitations is to reduce the costs of evaluating the assets for investors in mutual funds, who are typically passive, and rarely if ever engage in any active monitoring or lawsuits.