Organizations as Internal Capital Markets: The Legal Boundaries of Firms, Collateral and Trusts in Commercial and Charitable Enterprises

Abstract

This paper explains a function of the legal boundaries of various organizations (such as corporations, security interests and trusts): they define internal capital markets within which capital may be redeployed over time by fiat and over which it may be moved only at greater cost and with greater difficulty. The option to switch capital allocations among available projects is valuable and its value can be enhanced when management of the option is delegated to an informed and loyal agent. However, if the switching option has low value, agents have little private information or agency costs are severe, the principal should constrain the ability of her agent to reallocate capital. She may accomplish this by shrinking the legal boundaries of the relevant internal capital markets: that is, by segregating projects into separate legal organizations. For example, a number of corporate, securities, tax and debtor-creditor law rules make switching between affiliate corporations significantly more costly than within a firm. Security interests and trusts also constrain capital budgeting flexibility. Indeed, the law provides a menu of instruments that, to varying degrees, remove from agents the discretion to adjust capital allocations among projects over time. The paper also examines the charitable sector: the prevailing information conditions and tax rules differ in important respects from those in the commercial sector and they raise interesting internal capital market issues. Capital budgeting flexibility in charities is constrained by charitable trust law principles. In both commercial and charitable sectors, intermediaries offer an attractive alternative solution to the agency tradeoff.