Organizations as internal capital markets: The legal boundaries of firms, collateral, and trusts in commercial and charitable enterprises

This Article explains an important yet unexplored function of the legal boundaries of various organizations, such as corporations, security interests, and trusts. These boundaries define internal capital markets within which capital may be redeployed over time by fiat and across 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, if agents have little private information, or if agency costs are high, the principal should constrain the ability of the agent to reallocate capital. The principal may accomplish this task by shrinking the legal boundaries of the relevant internal capital market - that is, by segregating projects into separate legal organizations. For example, a number of rules in corporate, securities, tax, and debtor-creditor law make switching capital allocations among affiliate corporations significantly more costly than switching such allocations 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. This Article also examines internal capital markets in the charitable sector: the prevailing information conditions and tax rules in this sector differ in important respects from those in the commercial sector, thus raising interesting internal capital market issues. Capital budgeting flexibility in charities is also constrained by charitable trust law principles. In both commercial and charitable sectors, intermediaries offer an attractive alternative solution to the agency tradeoff problem.