Diversification and the Legal Organization of the Firm

Abstract

The existing literature on the relationship between strategy and structure tends to ignore the legal dimension of the organization of diversified firms. Yet, there is considerable variation in the legal organization of diversified firms; while some of these firms are organized as simple corporations, many are organized as “corporate groups” in which certain lines of business are organized as separate, subsidiary firms. In this paper we argue that this variation in legal organization is observed because legal organization can significantly affect firm value. In particular, forming subsidiary firms to accommodate new businesses can protect the outstanding stakeholders of a diversified firm from increases in bankruptcy risk and liability exposure. However, forming subsidiary firms also reduces economies of scope. Hence, there are offsetting costs and benefits to adopting different types of legal organization. Changes in these relative costs and benefits over time can also be expected to trigger changes in legal organization, as well as the divestiture of businesses characterized by particular types of economic hazards.

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