I am off to Syracuse University to give a couple of talks at their law school. The first is a lunch talk on Delaware's dominance of the market for corporate charters. Why does Delaware dominate the law of corporate governance? And what should we do about that, if anything? For a long-ish answer keep reading. (Note that because this post is a transcript of my oral remarks, it does not contain citations to the literature cited. Sorry!)
In my talk later today on the business judgment rule, I will be focusing on Delaware law. As you’ll remember from your days taking corporation law, Delaware is to corporate law as Michael Jordan is to basketball – the undisputed all-time champ.
The extent to which Delaware dominates the incorporation market is really quite astonishing. Fully 60 percent of Fortune 500 companies are incorporated in Delaware.
As a California lawyer, I’m particularly struck by how poorly California does at retaining local business incorporations: California retains the incorporations of only 22% of businesses located within it. Delaware takes most of the out-of-state incorporations, although Nevada does get a substantial percentage.
What we make of Delaware’s dominance as a policy matter depends in the first instance on why Delaware dominates. This is an old debate, but also one on which new studies continue to shed light. Lest I be accused of hiding the ball, let me acknowledge at the outset that I am a Delaware defender.
The principal explanations of Delaware’s dominance are familiar: they are the competing race to the bottom and race to the top hypotheses. According to the "race to the bottom" hypothesis, states compete in granting corporate charters. After all, the more charters (certificates of incorporation) the state grants, the more franchise and other taxes it collects. Because it is corporate managers who decide on the state of incorporation, states compete by adopting statutes allowing corporate managers to exploit shareholders.
According to the race to the top version of the story, however, investors will not purchase, or at least not pay as much for, securities of firms incorporated in states that cater too excessively to management. 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 recent empirical data suggest that neither story holds true. Granted, Delaware does get an astonishing percentage of state revenues from incorporation fees and franchise taxes. In some years, Delaware's annual revenues from these sources constitute up to 30% of the state's budget – an estimated equivalent of $3,000 for each household of four in the state.
The caricatures one usually sees of both the race to the bottom and the race to the top hypotheses claim that other states are vigorously trying to steal that revenue away from Delaware. The empirical data, however, imply a much less vigorous competition than either story claims. At most, it seems that states compete with Delaware to retain local incorporations. With few exceptions (perhaps Pennsylvania and Nevada), states generally are not competing with Delaware for out-of-state incorporations.
The empirical data only comes as a surprise, however, to those bemused by the popular caricature of the debate. Race to the top theorists like Ralph Winter or Roberta Romano never claimed that a Los Angeles-based lawyer sits down and thumbs through all 50 state statutes before deciding where to incorporate a client.
We all know that lawyers play a big role in the decision of where to incorporate. Lawyers are subject to the same bounded rationality constraints everybody else is, as well as the familiar incentives of agency cost economics. Under such conditions, lawyers naturally will adopt a decisionmaking heuristic; and, home state versus Delaware is far and away the most sensible heuristic.
So the market for corporate charters is better described as a leisurely walk than a race. But so what? Even though Delaware doesn’t face as much competition as the caricature of the debate claims, there is still competition: When a firm is incorporated, the lawyer and client often decide between Delaware and the home state. And, of course, many firms periodically consider whether to change their domicile to Delaware via reincorporation.
Given the importance of franchise taxes and other corporate fees to Delaware’s budget it would be surprising if such competition did not suffice to keep Delaware on its toes. If Delaware isn’t racing, it is at least fast-walking.
But in which direction: towards the top or the bottom?
There are lots of reasons to think that the trend of Delaware corporate law over time is towards the top – towards fair and efficient laws.
The evidence on the race to the top versus race to the bottom dispute is not free from controversy, but I think the weight of the evidence clearly favors the race to the top. Roberta Romano’s event study of corporations changing their domicile by reincorporating in Delaware, for example, found that such firms experienced statistically significant positive cumulative abnormal returns. In other words, reincorporating in Delaware increased shareholder wealth. This finding strongly supports the race to the top hypothesis. If shareholders thought that Delaware was winning a race to the bottom, shareholders should dump the stock of firms that reincorporate in Delaware, driving down the stock price of such firms. As Romano found, and all of the other major event studies confirm, there is a positive stock price effect upon reincorporation in Delaware.
The event study findings are buttressed by a well-known study by Robert Daines in which he compared the Tobin’s Q of Delaware and non-Delaware corporations. (Tobin’s Q is the ratio of a firm’s market value to its book value and is a widely accepted measure of firm value.) Daines found that Delaware corporations in the period 1981-1996 had a higher Tobin’s Q than those of non-Delaware corporations, suggesting that Delaware law increases shareholder wealth. Although subsequent research suggests that this effect may not hold for all periods, Daines’ study remains an important confirmation of the event study data.
Additional support for the event study findings is provided by takeover regulation. Compared to most states, which have adopted multiple anti-takeover statutes of ever-increasing ferocity, Delaware’s single takeover statute is relatively friendly to hostile bidders. An empirical study of state corporation codes by John Coates confirms that the Delaware statute is the least restrictive and imposes the least delay on a hostile bidder. Given the clear evidence that hostile takeovers increase shareholder wealth, this finding is especially striking. The supposed poster child of bad corporate governance, Delaware, turns out to be quite takeover-friendly and, by implication, equally shareholder-friendly.
This interpretation is supported by Lucian Bebchuk and Alma Cohen’s recent findings that "the fraction of local firms that each state retains is correlated with the number of antitakeover statutes that the state has" and "that offering a stronger antitakeover protection is also helpful in attracting out-of-state incorporations."
A recent news headline sums it up pretty well: "Beware Delaware." The article went on to argue that " the Delaware Supreme Court has [recently] issued at least five decisions of great concern to the corporate bar. Each was remarkable not only because it found against directors and in favor of shareholders, but also because it reversed a lower court ruling that went the other way."
State competition, it would seem, thus drives Delaware law towards a more fair and efficient outcome than the law of other states.
Even if the quality of Delaware law were low, however, incorporating in Delaware would still be advantageous given the sheer quantity of Delaware law. When Coors recently reincorporated in Delaware, among the reasons it cited for doing so were: (1) Delaware offers a comprehensive, widely used, and extensively interpreted corporate law. (2) Delaware has a special court, the Court of Chancery, that handles all corporate legal cases. Most states don't have such a business-oriented court.
Proponents of the race to the bottom thesis reject this line of reasoning. Instead, they have embraced USC law professor Ehud Kamar's claim that Delaware law is indeterminate. I have never bought his argument. Granted, Delaware corporate law consists mainly of standards rather than rules, but it is still highly predictable.
In most jurisdictions the base of precedents applying the local statute is quite thin. In California, for example, it is still unclear whether poison pills are valid – almost 20 years after Delaware courts said they were. As that example suggests, Delaware's great strength is a body of precedents that are both broad and deep.
Using standard common law tools counsel faced with a Delaware corporate law problem can readily develop an opinion in which he or she can repose considerable confidence. The idea that Delaware law is radically indeterminate thus, to put it bluntly, is radically wrong.
Delaware thus wins – whether the standard is quality or quantity.
Let us assume, however, that the race to the bottom proponents are right. What is to be done? The standard answer is to replace state corporate law with a federal system of incorporation. This strikes me as a very bad idea. As Justice Brandeis pointed out many years ago, “It is one of the happy incidents of the federal system that a single courageous State may, if its citizens choose, serve as a laboratory; and try novel social and economic experiments without risk to the rest of country.” So long as state legislation is limited to regulation of firms incorporated within the state, as it generally is, there is no risk of conflicting rules applying to the same corporation. Experimentation thus does not result in confusion, but instead may lead to more efficient corporate law rules.
In contrast, the uniformity imposed by a national federal corporate law would preclude experimentation with differing modes of regulation. As such, there will be no opportunity for new and better regulatory ideas to be developed—no “laboratory” of federalism. Instead, we will be stuck with rules that may well be wrong from the outset and, in any case, may quickly become obsolete.
Recently, however, Bebchuk and Cohen modified the standard move by suggesting that a federal incorporation option should be provided to invigorate competition. A mandatory switching rule under which shareholders would be able to initiate and approve, even over the objection of management, a reincorporation under federal law also would be provided.
As a good contractarian, how can I argue against giving people more choices? Suffice it to say that the content of corporate law matters, at least at the margins. As such, I doubt whether a federal incorporation option would keep Delaware up nights. Anybody who watched Congress make a hash out of Sarbanes-Oxley or the SEC muck up shareholder access and still thinks the federal government can do a better job than Delaware is beyond my powers to help.
