The Firm as a Legal Entity : What Distinguishes Wholly Owned Subsidiaries from Internal Divisions in Japan?

We argue that the legal boundaries of the firm have more substantial effects on the Japanese multi-business organization than on its U.S. counterpart. The standard economic, management, or legal view is that distinguishing between an in-house division and a subsidiary, in particular, a wholly owned subsidiary, does not make sense: Although it is the subsidiary who owns its assets, and the parent firm only owns the subsidiary as a legal thing, the parent firm, as the dominant shareholder, can hire or fire the subsidiary's managers at will, or even dissolve the subsidiary and sell off all the assets. However, subsidiary companies appear to have very different roles in the U.S. and Japan. Although the traditional approach to diversification in the U.S. is to organize businesses as divisions, most large Japanese firms maintain a network of affiliated firms many of which are subsidiaries, and the core firms actively separate activities from the main body, in part for the purpose of diversifying and developing new businesses. What then distinguishes a subsidiary from an in-house division? We argue that separating a business as a subsidiary has an economic impact on the firm that attempts to make a commitment in delegation of authority to some of the divisions but fails because of the 'multilateral' nature of relationships between the head office of the firm and the in-house divisions. Although the ultimate control right resides with the head office of the firm, it may attain delegation of authority by making a credible promise to rubber-stamp the decisions made by the divisions in repeated relationships. Whether this 'informal delegation' is sustained as an equilibrium depends on the strategies of the relevant parties. We argue that in the stylized Japanese firm, the managers identify themselves with the firm rather than the divisions they belong to, and hence everyone expects that deviation from informal delegation at a specific division will be met with punishment from all the divisions. If such a multilateral arrangement is well established and prevails in the Japanese firm, it faces difficulties in differentiating its internal units: either informal delegation granted to all the units or delegation to neither unit is sustainable as an equilibrium. This inflexibility makes room for a role of legal boundaries. Even if separating a unit as a subsidiary only changes its 'label', it enables the Japanese firm which cannot sustain partial informal delegation to distinguish among the businesses and attain informal delegation to those outside the boundaries while maintaining centralization internally