Delaware's Competition

I'm at the Federalist Society to participate in a panel on federalism in corporate governance. My thoughts on this subject have been heavily influenced by Mark Roe's article Delaware's Competition, from which I borrowed some fo the following remarks (if it's okay for Joe Biden, why not me?):

For over 200 years, corporate governance has been a matter for state law. Even the vast expansion of the federal role begun by the New Deal securities regulation laws left the internal affairs and governance of corporations to the states. To be sure, over the years, there have been countless proposals to federalize corporate law. Until quite recently, however, none were successful.

The “Public Company Accounting Reform and Investor Protection Act” of 2002—popularly known as the Sarbanes-Oxley Act—marked a major shift in the allocation of power between the states and the federal government. (The stock exchanges are important players in this dynamic, as well, due their ability to impose corporate governance requirements via their listing standards. The formal and informal powers of Congress and the SEC to influence exchange action in this area, however, justifies treating the exchanges as a de facto branch of the federal government in this area.)

The Obama administration’s various responses to the financial crisis of 2008 and the concomitant recession have included a number of specific new federal corporate governance rules. Collectively, they mark the largest shift in power from the states to the federal government since the New Deal securities regulation statutes.

So far, most of these changes have been restricted to financial institutions and beneficiaries of federal bailouts. Many of them, moreover, are temporary impositions that will disappear when the various bailout regimes come to an end.

Others, however, are likely to become permanent features of the federal regulatory regime for all public corporations. The Securities and Exchange Commission, for example, is moving ahead with a regulatory proposal designed to empower shareholders to nominate directors.

The so-called “Shareholder Bill of Rights” proposed by Senator Charles Schumer contains many provisions that would federalize core corporate governance issues. Schumer’s press release identifies the following specific areas affected by the bill:

“1. It requires that all public companies hold an advisory shareholder vote on executive compensation. By allowing shareholders to have a “say on pay,” companies are far less likely to award compensation packages that are excessively lavish or tied to risk-taking that is not good for the long-term health of the firm.

“2. It instructs the SEC to issue rules allowing shareholders to have access to the proxy form if they want to nominate directors to the board. In order to make a nomination, shareholders will have to have owned at least 1% of a public company’s shares for at least two years. Schumer and Cantwell said it is essential that long-term shareholders have a real voice in selecting the men and women who sit on the boards of the companies they own.

“3. It requires board directors to receive at least 50% of the vote in uncontested elections in order remain on the board. It makes no sense for board members to be re-elected if a majority of shareholders cast their ballots against them.

“4. It requires all board directors to face re-election annually. Schumer and Cantwell said there is no reason that directors at a well-run company should fear facing their shareholders every year. So-called “staggered boards” just serve to insulate board members from the consequences of their decisions.

“5. It requires public companies to split the jobs of CEO and Chairman of the Board, and requires the Chairman to be an independent director. It is vital that the Chairman of the Board, who sets the board’s agenda, should be someone who works closely with the CEO, but also brings a different perspective to the table.

“6. It requires that public companies create a board risk committee. Today, the oversight of how companies manage their risks is most often a responsibility of the audit committee, which has enough responsibilities already without also having to focus on risk. By creating separate risk committees, boards will never again be able to say they did not understand the risks that the firms they oversee were taking.”

Congressman Barney Frank reportedly is likewise considering legislation including many of these ideas. Senator Dodd's financial regulation bill also includes a number of these provisions.

Virtually all U.S. corporations are formed (“incorporated”) under the laws of a single state by filing articles of incorporation with the appropriate state official. (A very few exceptions are formed under federal law.) The state in which the articles of incorporation are filed is known as the “state of incorporation.” Selecting a state of incorporation has important consequences, because of the so-called “internal affairs doctrine”—a conflicts of law rule holding that corporate governance matters are controlled by the law of the state of incorporation. Virtually all U.S. jurisdictions follow the internal affairs doctrine, even if the corporation in question has virtually no ties to the state of incorporation other than the mere fact of incorporation.

The internal affairs doctrine takes on particular transactional significance when considered in conjunction with the constitutional restrictions on a state’s ability to exclude foreign corporations. With rare exceptions, states have always allowed foreign and pseudo-foreign corporations to do business within their borders. As early as 1839, for example, the U.S. Supreme Court held that federal courts should presume a state would recognize foreign corporations in the absence of an express statement to the contrary by the legislature. A subsequent Supreme Court decision implied that states could not exclude foreign corporations from doing business within the state provided that the business constituted interstate commerce under the Commerce Clause of the U.S. Constitution. These decisions effectively created a common market for corporate charters. If Illinois, for example, adopts a restrictive corporation law, its businesses are free to incorporate in a less restrictive state, such as Delaware, while continuing to conduct business within Illinois.

Throughout the nineteenth century state corporation laws gradually moved in the direction of increased liberality, making the incorporation process simpler on the one hand, while at the same time abandoning any effort to regulate the substantive conduct of corporations through the chartering process. In later years, this process became known as the “race to the bottom.” Corporate and social reformers believed that the states competed in granting corporate charters. After all, the more charters (certificates of incorporation) the state grants, the more franchise and other taxes it collects. According to this view, because it is corporate managers who decide on the state of incorporation, states compete by adopting statutes allowing corporate managers to exploit shareholders.

Many legal scholars reject the race to the bottom hypothesis. According to a standard account, investors will not purchase, or at least not pay as much for, securities of firms incorporated in states that cater too excessively to management. Lenders will not make loans to such firms without compensation for the risks posed by management’s lack of accountability. As a result, those firms’ cost of capital will rise, while their earnings will fall. Among other things, such firms thereby become more vulnerable to a hostile takeover and subsequent management purges. Corporate managers therefore have strong incentives to incorporate the business in a state offering rules preferred by investors. Competition for corporate charters thus should deter states from adopting excessively pro-management statutes. The empirical research appears to bear out this view of state competition, suggesting that efficient solutions to corporate law problems win out over time.

Whether state competition is a race to the bottom or the top, there is no question that Delaware is the runaway winner in this competition. More than half of the corporations listed for trading on the New York Stock Exchange and nearly 60% of the Fortune 500 corporations are incorporated in Delaware.

The passage of the Sarbanes-Oxley Act, along with various other developments, suggests that Delaware has new competition. The new competitor is not, however, another state. Instead, it is the federal government.

When a corporate governance issue has national ramifications, the federal government is increasingly willing to nationalize the relevant legal regime or, at least, to threaten to do so in the expectation that Delaware will do the “right thing.” Our job today is to discuss whether this is a good thing.

(BTW, for those of you who are following along at home, I settled on leaving the tie home.)

Comments

[Cornellian]

You'd think Joe Biden would be lobbying to stop this sort of federal takeover. He must know a great deal of Delaware's prosperity depends on its well-deserved reputation for top notch corporate law. The whole Delaware Congressional delegation has normally been pretty good at blocking things that will reduce the state's comparative advantage.