An important feature of U.S. corporate law is regulatory competition among various states. Unlike firms in other industrialized countries, American corporations can choose to incorporate in any state, even if they do not do business there. A large body of academic literature has studied the merits and weaknesses of this approach to regulating corporations, focusing primarily on the value of state corporate laws. This debate has focused on two competing hypotheses. In the first, interstate competition in corporate laws promotes a “race to the top” by motivating states to enact laws that are optimal for shareholders and that minimize managerial moral hazard and agency costs. In the second hypothesis, interstate competition in corporate law results in a “race to the bottom” because states, motivated by the desire to maximize corporate tax revenue and other benefits, enact laws that tend to favor managerial discretion and entrenchment (more than do the laws that protect the investors), because managers ultimately decide where to incorporate.
Delaware is in the crossfire of this debate because it has virtually won the competition, with a large number of U.S. publicly traded companies continuing to choose Delaware as their state of incorporation or reincorporation. Delaware’s unique Court of Chancery, a 110-year-old specialty court that only hears cases involving business entities, has a reputation for striking a fair balance in resolving complex disputes between shareholders and boards – particularly with its “business judgment rule,” which presumes that directors of a corporation act with adequate information and in good faith and in the best interests of the company. However, there are more than two sides to the debate. A third view advocates federal intervention, attributing Delaware’s dominance to weak competition (or even lack of competition) from other states. This view argues that Delaware holds a monopoly that the federal government should break for the benefit of the shareholders.
We explore these arguments in the context of U.S. state chartering competition to examine whether Delaware incorporation continues to provide additional value for shareholders as popularly believed, and as earlier (pre-Sarbanes Oxley) studies have contended.. Though its registration fees and taxes are relatively high, Delaware has many advantages over other states. A big one is its Court of Chancery, which is known for expertise in issues involving mergers and acquisitions, management and its duties to shareholders, and other areas of corporate law. Backed by comprehensive statutes, the court is considered adept at protecting the rights of boards of directors and shareholders. Additionally, incorporating in Delaware brings a degree of prestige, given that over 60 percent of Fortune 500 firms are incorporated in Delaware, as are more than half of all companies whose securities trade on the NYSE, NASDAQ, and other exchanges.
However, over the last few years, several states have begun to compete. For example, Nevada and Wyoming have sought to attract more companies with management-friendly corporate laws and low fees and taxes. Their state websites make comparisons with other states based on factors like: 1 ) whether stockholders must reveal their identities to the state, 2 ) whether companies must issue an annual report before the anniversary of their incorporation date, 3) whether they must disclose the identity of their officers or members, 4) whether unlimited stock is allowed, of any par value, 5) whether nominee shareholders are allowed, and 6) whether a statute requires that the company indemnify officers, directors, employees, and agents. These hot-button governance issues are often marketed as indicators of whether a state favors stockholders or management, complementing academic debates about legal variations between Delaware and other states that affect the extent of agency problems.
Prior studies have explored some of these arguments, but we contend that it is time to re-visit the Delaware Effect for several reasons. First, since the abundance of Delaware studies in the early and late 1990’s, there have been many changes in the corporate laws of various states including Delaware as well as at the federal level. For example, in 2006, Section 141(d) of the Delaware General Corporation Law (“DGCL”) was rewritten to allow directors to confer greater or lesser voting powers on one or more directors (whether or not such directors are separately elected by the holders of any class or series of stock) so long as a corporation’s certificate of incorporation allowed the directors to do so. In 2015, a new DGCL Section 102(f) and an amended section 109(b) prohibited fee-shifting provisions, in a corporation’s certificate of incorporation or its bylaws, that would make shareholders liable for all attorneys’ fees and expenses in connection with an internal corporate claim. In 2016, DGCL Section 251(h) was broadened to allow the consummation of certain acquisitions (employing a two-step structure), under specific conditions, without shareholder approval. At the federal level, in 2002, the Sarbanes-Oxley Act created some of the most significant corporate governance reforms since the 1930s. They included requirements for greater board independence, increased audit committee responsibilities, codes of ethics covering company e financial officers, CEO certification of financial statements, an independent audit of a company’s system of internal control over financial reporting, and more instances in which in-house counsel would have to report material violations to the SEC.
Second, in the wake of the global financial crisis, the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010 was enacted. Its requirements included shareholder say-on-pay votes on executive compensation, more independence for compensation committee directors, increased oversight of executive compensation consultants, enhanced executive compensation disclosure (i.e., pay ratio rule), claw backs of incentive compensation in certain circumstances, access to company proxy ballots for certain shareholders under certain conditions, and disclosure of the justifications for having one person serves as both board chair and the CEO..
Third, technology and globalization of the financial markets have made it unnecessary for a corporation to list its securities on a domestic exchange. Many corporations list on foreign exchanges for reasons that include being able to differentiate themselves in the capital markets by “renting the corporate laws” of the foreign jurisdiction. In essence, these changes are facilitating a market for corporate charters.
Finally, there has been a recent increase in the popularity of corporate inversions, whereby U.S. publicly traded companies incorporate outside of the United States to save taxes. Foreign-chartered corporations pay U.S. tax only on their domestic profits while U.S.-chartered corporations also pay taxes on their overseas profits (with credit for taxes paid overseas). This practice has implications for corporate governance, where strong U.S. state corporate laws and governance are bundled with taxation policies. In sum, the contested nature of state chartering competition suggests that there is much work to be done in understanding how and why U.S. firms select where to incorporate, and the value that decision provides shareholders.
With data that extends over a 16-year period and a sample of all firms that file Form 10-K with the SEC, including foreign firms, we find that Delaware incorporated firms appear to have less debt and a higher value, as measure by Tobin’s Q, than firms incorporated elsewhere, suggesting that they are managed to create high shareholder returns and thus support race-to-the-top arguments. However, when taking into account fixed effects, and expanding the sample to include companies that are publicly traded in the U.S. but incorporated overseas, the effect of Delaware incorporation is negative on shareholder wealth. Foreign incorporated firms provide significantly more value for shareholders over longer periods than do Delaware corporations. We suggest that this may be attributable to increasing shareholder lawsuits and associated legal costs in Delaware, as well as higher taxes and reporting requirements that lower firm value. Our results also suggest that the popularity of Delaware incorporation can be attributed in part to the state’s management-friendly laws and courts.
Incorporating in Delaware may afford directors the autonomy and discretion needed to balance demands from multiple stakeholders, supported by the state’s unique Chancery Court system. Our findings also suggest that it is time to move beyond “race to the bottom” and “race to the top arguments” that may be negligible in the wake of new regulation and opportunities for businesses to differentiate themselves through corporate charters.
This post comes to us from Professor Anne Anderson at Lehigh University, Professor Jill Brown at Bentley University, and Professor Parveen Gupta at Lehigh University. It is based on their recent article, “Jurisdictional Competition for Corporate Charters and Firm Value: A Reexamination of the Delaware Effect,” available here.