Is There a Delaware Effect for Controlled Firms?

The effect of Delaware incorporation on firm value is an enduring question in corporate law.  Robert Daines shifted the terms of this debate in Does Delaware Law Improve Firm Value? (2001) by showing that publicly traded Delaware corporations, controlling for a number of other factors, were worth more money.  Daines interpreted this to mean that Delaware’s corporate law increased firm value, particularly as it relates to hostile takeovers.

In my paper, Is There a Delaware Effect for Controlled Firms?, I present new empirical evidence on whether the Delaware premium applies to firms for which takeover law is not relevant: publicly traded firms with a controlling shareholder.  Delaware proponents have argued that Delaware’s expert judiciary, unique political economy, and extensive case law will increase the value of minority shares, in large part through strong protections for minority shareholders against exploitation by the controlling shareholder.  Looking at controlled corporations therefore helps us understand the market value, if any, of Delaware’s skilled judiciary, and comprehensive case law outside the context of board entrenchment and hostile takeovers.  If these institutional advantages have market value, it should show up here.   Publicly traded controlled firms are worth trillions of dollars, and better fiduciary protection could easily add tens of billions of dollars to the value of minority positions in these companies.

Empirically studying the effect of state corporate law on the value of minority shares is complicated by the possibility that ex-ante higher (or lower) quality firms[1] incorporate in Delaware compared with those that decide to incorporate where their headquarters are located.  This gives rise to what economists call “endogenous variation” in the state of incorporation and makes it difficult to disentangle cause and effect.  This endogeneity does not mean that it is impossible to use empirical evidence to help identify the effect of state law on the value of minority shares, but it does require one to have a theory of how those controlled firms choose where to incorporate.

As reflected in the literature, there are good reasons to think that, controlling for observable firm characteristics, ex-ante higher quality controlled firms choose to incorporate in Delaware.  Ronald Gilson, Henry Hansmann, and Mariana Pargendler, for example, have argued that controlling shareholders who are most interested in maximizing share value choose Delaware, while controllers with other interests who might be more likely to exploit the minority choose to incorporate at home.  Likewise, critics of Does Delaware Law Improve Firm Value? have argued that the estimated Delaware premium is too large to be causal, suggesting that ex-ante higher quality firms choose Delaware.

As a result, before looking at the data, one might expect controlled Delaware firms to be worth more than their counterparts incorporated at home both because (1) ex-ante higher quality firms choose Delaware and (2) Delaware’s expert judiciary and comprehensive case law increase firm value.  Observe that if, on average, ex-ante higher quality controlled firms choose Delaware, then the Delaware premium estimated from the data should be a ceiling on the actual average effect of Delaware’s legal institutions on controlled firms.

To estimate the Delaware premium for controlled firms, I merge data on the ownership and other characteristics of 1,500 large corporations with a single class of common stock and a few hundred firms with dual-class shares.  For data reasons, my analysis focuses on 1996-2001.  Following the literature, I look at each firm’s Tobin’s Q, which compares the market value of the firm’s assets to their book value.  I then control for a variety of factors like each firm’s age, size, and industry, as well as market-wide trends in Tobin’s Q.  In some specifications, I also add controls for the firm’s profits, debt, R&D spending, and measures of corporate governance quality.

I find that Delaware controlled firms are worth about 4 percent less than their counterparts incorporated elsewhere, after controlling for firm characteristics.  This is surprising and suggests that either ex-ante higher quality controlled firms on average avoid Delaware or that Delaware’s judiciary and case law have little market value for controlled firms, or perhaps both.[2]

In contrast to controlled firms, all else equal, diffusely held Delaware firms are estimated to be about 3 percent more valuable than similar firms incorporated elsewhere.  While the difference in the estimated Delaware effect across the types of firms is statistically significant in only some of the specifications, the results suggest there are likely some differences in how Delaware incorporation interacts with firm value in diffusely held and controlled firms.

In the paper, I sketch a few possible explanations but focus here on two.  The first implies that Delaware does not in fact create value for controlled firms.  Outside the realm of board entrenchment, Delaware’s institutional advantages over other states may be blunted by features that also increase litigation costs, and these costs disproportionately affect controlled firms.  Delaware’s advantages in preventing board entrenchment may still be real, however, generating value for diffusely owned firms.  Relatedly, I hypothesize that shareholders in diffusely held firms are actually at more risk of suffering from selective changes in corporate law if the firm incorporates in its home state compared with minority owners in controlled firms.  There are numerous examples of managers of diffusely held firms bending home-state corporate law to help entrench themselves, but controlling shareholders may find it more challenging to warp home-state corporate law toward allowing them to “tunnel” assets out of the firm for their own benefit.  This is because the duty of loyalty, which restrains such behavior, rests on a deeply held sense of fairness (at least outside Nevada).

In the second explanation, I observe that if Delaware is in fact more protective of minority interests in controlled firms, this can lead—at least in theory—to ex-ante lower quality controlled firms choosing Delaware.  Intuitively, controlling shareholders without a reputation for protecting minority shareholders might be more likely to choose Delaware to signal they will not tunnel assets out of the firm.  In the argot of agency theory, Delaware incorporation is thus a form of “bonding.”  The firms with controllers who need to endure these bonding costs are likely to be ex-ante lower quality than firms whose controller has an established and clean reputation. These latter higher-quality firms, which do not need bonding, may pick Delaware relatively less often.  Rather, these firms’ incorporation decisions are even more likely to be driven by factors not closely associated with firm quality, like which lawyers the firm picks to handle the IPO process.  Under this second explanation, therefore, low quality controlled firms will disproportionately choose Delaware, but this won’t be true of high quality controlled firms.  This implies that Delaware controlled firms will be ex-ante lower quality on average.  This selection effect can dominate Delaware’s hypothesized creation of value and yield a negative association between Delaware and the value of minority shares in controlled firms observed in the data. 

ENDNOTES

[1] To understand what I mean by “ex-ante higher quality” firms, perform the following thought experiment: Imagine that all the firms actually incorporated in Delaware had instead always incorporated at home and calculate the value of the firms.  If—after controlling for firm-characteristics unrelated to state of incorporation—the Delaware firms would be more valuable if they had incorporated at home than the ones actually incorporated at home, then Delaware firms are “ex-ante higher quality.”

[2] I should note that although the point estimate is that Delaware controlled firms are worth 4 percent less than similarly situated non-Delaware controlled firms, the result is not precisely estimated.  This is frequently the case with estimates based on Tobin’s Q, which is a noisy outcome variable.  Thus, the top of the 95 percent confidence interval is slightly above 0 (2.3 percent).  When compared with control premiums attributable to private benefits taken by the controlling shareholder, which are frequently estimated to exceed 10 percent, even the top end of the 95 percent interval would suggest that Delaware does not protect minority shareholders substantially better than other states do (or that Delaware controlled firms are ex-ante lower quality).

This post comes to us from Edward G. Fox, law and economics fellow at NYU School of Law’s Center for Law & Economics. It is based on his recent paper, “Is There a Delaware Effect for Controlled Firms?,” available here.

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