Ann Lipton spotted an Elon Musk tweet that threatens "to threaten to preempt Delaware law with federal corporate governance standards, if the Delaware Supreme Court does not restore his Tesla pay package":
Delaware corporate law is not perfect. It's not even close to perfect. Nothing created by humans ever is. But the corporation is the foundation of our economy and Delaware corporate law is the engine that makes it run. I firmly believe that federal preemption of corporate law is a terrible idea.
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. The state-based system of regulating corporate governance is one of the main strengths of the U.S. capital markets. Indeed, as Professor Roberta Romano famously claimed, state regulation and the resulting regulatory competition between jurisdictions it is the “genius of American corporate law.”
No one seriously doubts that Congress has the power under the Commerce Clause, especially as it is interpreted these days, to create a federal law of corporations if it chooses. The question of who gets to regulate public corporations thus is not one of constitutional law but rather of prudence and federalism.
Until the New Deal, corporate law was exclusively a matter for the states. Around the beginning of the last century, however, economic progressives began arguing for federal preemption—frequently in response to various corporate scandals of the day. After the Great Crash of 1929, serious consideration in fact was given to creating a federal law of corporations. Throughout the 1930s there were repeated proposals to federalize corporate law. All failed.
Legislative inaction is inherently ambiguous. All that can be said with certainty is that Congress chose not to act. Yet, the Supreme Court nevertheless has routinely rejected regulatory efforts to preempt state law and create a de facto federal law of corporations. Because it believes that “state regulation of corporate governance is regulation of entities whose very existence and attributes are a product of state law,” CTS Corp. v. Dynamics Corp., 481 U.S. 69, 89 (1987), the court has consistently reaffirmed that: “It ... is an accepted part of the business landscape in this country for states to create corporations, to prescribe their powers, and to define the rights that are acquired by purchasing their shares.” Id. at 91. Indeed, the Supreme Court opines that “[n]o principle of corporation law and practice is more firmly established than a State’s authority to regulate domestic corporations.” Id. at 89.
It is state law, for example, that determines the rights of shareholders, “including ... the voting rights of shareholders.” Id. State law thus determines such questions as which matters may be authorized by the board of directors acting alone and which must be authorized by the shareholders. State law typically requires, for example, that certain control transactions, such as mergers or sales of substantially all corporate assets, be approved in advance by the shareholders and establishes the vote required (often a supermajority) for shareholder approval of such matters. State law likewise regulates the conduct of shareholder meetings, specifies who may call such meetings and prescribes whether, and the procedures by which, actions may be taken without a shareholder meeting.
The Supreme Court also has consistently recognized that state law governs the rights and duties of corporate directors: “As we have said in the past, the first place one must look to determine the powers of corporate directors is in the relevant State’s corporation law. ‘Corporations are creatures of state law’ and it is state law which is the font of corporate directors’ powers.” Burks v. Lasker, 441 U.S. 471, 478 (1979) (citations omitted). State law defines the directors’ powers over the corporation, for example. State law establishes the vote required to elect directors. State law determines whether shareholders have the right to cumulative voting in the election of directors, whether the corporation’s directors may have staggered terms of office, and whether shareholders have the right to remove directors prior to the expiration of their term of office.
Does the Supreme Court’s defense of what might be called “corporate federalism” make policy sense?
The basic case for federalizing corporate law rests on the so-called “race to the bottom” hypothesis. States compete in granting corporate charters. After all, the more charters the state grants, the more franchise and other taxes it collects. According to the race to the bottom theory, because it is corporate managers who decide on the state of incorporation, states compete by adopting statutes allowing corporate managers to exploit shareholders. As the clear winner in this state competition, Delaware is usually the poster-child for bad corporate governance.
Basic economic common sense tells us that 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 lend 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.
Even if that were not the case, one should still be reluctant to embrace federal preemption. Those who favor preemption betray a complete lack of sympathy for—and perhaps even awareness of—the vital relationship between federalism and liberty. In other words, even if one could prove that state competition is a race to the bottom, basic federalism principles would still counsel against federal preemption of corporate law. The corporation is a creature of the state, “whose very existence and attributes are a product of state law.” States have an interest in overseeing the firms they create. States also have an interest in protecting the shareholders of their corporations. Finally, a state has a legitimate “interest in promoting stable relationships among parties involved in the corporations it charters, as well as in ensuring that investors in such corporations have an effective voice in corporate affairs.” CTS Corp. v. Dynamics Corp., 481 U.S. 69, 91 (1987). In other words, state regulation not only protects shareholders, but also protects investor and entrepreneurial confidence in the fairness and effectiveness of the state corporation law.
According to the Supreme Court’s CTS decision, the country as a whole benefits from state regulation in this area, as well. As Justice Powell explained in that case, the markets that facilitate national and international participation in ownership of corporations are essential for providing capital not only for new enterprises but also for established companies that need to expand their businesses. This beneficial free market system depends at its core upon the fact that corporations generally are organized under, and governed by, the law of the state of their incorporation. This is so in large part because ousting the states from their traditional role as the primary regulators of corporate governance would eliminate a valuable opportunity for experimentation with alternative solutions to the many difficult regulatory problems that arise in corporate law. 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.” New State Ice Co. v. Liebmann, 285 U.S. 262, 311 (1932) (Brandeis, J., dissenting). 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 that would result from federal preemption 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.
The point is not merely to restate the race to the top argument. Competitive federalism promotes liberty as well as shareholder wealth. When firms may freely select among multiple competing regulators, oppressive regulation becomes impractical. if one regulator overreaches, firms will exit its jurisdiction and move to one that is more laissez-faire. In contrast, when there is but a single regulator, such that exit by the regulated is no longer an option, an essential check on excessive regulation is lost.
In other words, by promoting the economic freedom to pursue wealth, competitive federalism does more than just expand the economic pie. A legal system that pursues wealth maximization necessarily must allow individuals freedom to pursue the accumulation of wealth. Economic liberty, in turn, is a necessary concomitant of personal liberty—the two have almost always marched hand in hand. The pursuit of wealth has been a major factor in destroying arbitrary class distinctions, moreover, by enhancing personal and social mobility. At the same time, the manifest failure of socialist systems to deliver reasonable standards of living has undermined their viability as an alternative to democratic capitalist societies in which wealth maximization is a paramount societal goal. Accordingly, it seems fair to argue that the economic liberty to pursue wealth is an effective means for achieving a variety of moral ends.
In turn, the modern public corporation has turned out to be a powerful engine for focusing the efforts of individuals to maintain the requisite sphere of economic liberty. Those whose livelihood depends on corporate enterprise cannot be neutral about political systems. Only democratic capitalist societies permit voluntary formation of private corporations and allot them a sphere of economic liberty within which to function, which gives those who value such enterprises a powerful incentive to resist both statism and socialism. As Michael Novak observes, private property and freedom of contract were “indispensable if private business corporations were to come into existence.” Michael Novak, Toward a Theology of the Corporation 45 (2d ed. 1990). In turn, the corporation gives “liberty economic substance over and against the state.” Id.
In sum, Donald Trump should not start his presidency by blowing up the bedrock of our corporate economy just because Elon Musk is throwing a hissy fit.
