Columbia Law School
Sky Blog
Delaware dominates the incorporation market, with approximately 60% of publicly traded companies in the United States incorporated there, including 63% of the Fortune 500 companies. Over 90% of companies that incorporate outside of their principal state of operations make Delaware their state of incorporation. The unresolved question is why corporate lawyers and their clients are drawn to Delaware when most companies have little more than a P.O. Box based in the state.
In The Delaware Delusion, we set out to empirically assess whether there is an economic basis for Delaware’s appeal in the market for company incorporations. We set out to test empirically the two leading schools of thought which hold that Delaware’s appeal lies either in its superior legal regime that enhances shareholder value better than other states or in Delaware’s protectionist appeal in adding “managerial value” by entrenching corporate managers at shareholders’ expense. We apply an innovative technique to show empirically that both the “race to the top” and “race to the bottom” schools of thought are based on false assumptions because Delaware law neither adds nor subtracts value compared to other states—the applicable law simply does not seem to matter to capital markets
We test these hypotheses using a novel “merger reincorporation” approach, which leverages the fact that each inter-state merger is effectively a reincorporation of the target company business into the state of incorporation of the acquiring company. This fact creates the opportunity to gauge the market’s assessment of the value of Delaware law relative to that of other states by comparing the pre- and post-acquisition value of acquirers and targets in a cross-section of intra- and inter-state mergers.
We analyzed an eleven-year data set of mergers (from 2001 to 2011) and found that financial markets place no economically consequential value on Delaware law relative to that of other states, which contradicts both of the leading schools of thought. This result suggests that lawyers are engaging in default decision-making based on Delaware’s past preeminence, rather than actively weighing the value-added Delaware and other states offer to their clients. Lawyers appear to turn to Delaware because it is the law they are most familiar with; they assume markets value Delaware law; and they regard Delaware as a safe default that does not trigger pushback from corporate managers. These reasons make it understandable why risk-averse lawyers steer their clients to Delaware. But the problem is that decisions to incorporate in Delaware appear based on faith and path dependency, rather than on any
empirical basis. This constitutes a disservice to corporate clients as well as to the market as a whole.
To break up herding effects among lawyers and spur lawyers to assess this opportunity to add value to transactions, we argue for the consideration of “shareholder say” on the state of incorporation. Empowering shareholders to have a say on the state of incorporation could be accomplished easily through private ordering, a statutory change, a Securities and Exchange Commission regulatory mandate for public companies, or through stock-exchange listing rules. Empowering shareholders to vote on retaining or changing the state of incorporation would subject this decision to greater scrutiny and give shareholders the opportunity to address this principal-agent failure. This strategy would incentivize proxy advisory firms to analyze the merits of states of incorporation and to recommend to shareholders to retain or change the state of incorporation. This approach would also turn on the market test of institutional investors’ weighing the benefits and costs of investing their energies in changing the state of incorporation.
The need to justify incorporation decisions to shareholders would force lawyers to actively assess the value-added by Delaware law and the law of other states. Creating incentives for lawyers to acquire legal fluency in multiple corporate governance jurisdictions, rather than to rely solely on their knowledge of the law of Delaware, would make it more likely that corporate lawyers will spearhead change in a proactive way to extract value for companies. This heightened scrutiny will create market pressures for Delaware and other states to compete to assess and enhance the quality of their corporate governance law. While Delaware’s hegemony would not change overnight, over time this approach would dampen Delaware-centric herding and foster constructive state competition.
The preceding post comes to us from Robert Anderson IV, Associate Professor of Law at Pepperdine University School of Law, and Jeffrey Manns, Associate Professor of Law at George Washington University Law School. It is based on their article, which is entitled “The Delaware Delusion” and available here.
There is no doubt that Delaware has the most complete and most responsive legal regime for corporate entities, whether publicly traded or not. Thus, when the decision is made to incorporate or reincorporate, the lawyer faces the real world question – where is the most, complete, most responsive, least ambiguous set of rules for this entity? That question does not relate to either “race to the bottom” or “race to the top.” Delaware is the rational choice.
Bruce, you have accurately narrated the standard mental process corporate lawyers go through in deciding where to incorporate. We don’t disagree that Delaware is an acceptable answer to that “real world question,” which is why Delaware is so dominant. We agree that it is *a* rational choice to incorporate in Delaware, because it makes no difference, and most lawyers are familiar with Delaware. But it is not *the* rational choice to incorporate in Delaware, again because it makes no difference. If it did, the capital markets would penalize the opposite choice, and we find no evidence that they do.
If markets don’t care where the company is incorporated, then why would it be a disservice for lawyers to suggest incorporation in the jurisdiction with which they are the most familiar? If the lawyers choose another jurisdiction, they would presumably run higher legal bills to spend the time necessary to acquaint themselves with its rules. Why not choose a state they know well and that they know is responsive and sophisticated, instead of taking a risk for a lesser known state that has less of a stake in its reputation as a corporate law capital? You said it yourself – the markets don’t really care about Delaware over somewhere else.
I also suspect if your proposal to let shareholders decide the state of incorporation actually went through, Delaware would still maintain its preeminence, perhaps even increase it.
Thanks for your comments, Associate. When we say this constitutes a disservice to clients, we mean this in the macro sense, rather than in the micro sense. As you point out, because the markets don’t care about the corporate law, it makes little difference where the company is incorporated in the micro sense. Thus, lawyers are not really harming individual clients by choosing Delaware. But these (admittedly defensible) micro-level decisions lead to an overall dysfunction that harms all businesses, and indeed society as a whole by undermining competition. This is what I mean by a disservice in the macro sense.
Delaware is a natural choice of domicile for lawyers to recommend because the unique body of precedent and the expert Court of Chancery make it possible for lawyers to counsel their clients more effectively; questions that have clear answers in Delaware law are often met with the response from lawyers in other states that “there is no authority in [state] but our courts generally look to Delaware on questions such as this.” Add to that a bar and legislature that view continual improvement of the Delaware General Corporation Law as an important responsibility (e.g., the recently enacted amendment to Section 141(f) (board consents in advance) and Section 251(h) (mergers without stockholder votes following tender offers)) and it’s a clear choice from the perspective of a corporate lawyer.
We don’t necessarily disagree with any of this. Indeed, I teach this standard textbook account of Delaware’s dominance in my Corporations class almost every year. But even if these things are true, our analysis shows that the market doesn’t value them very much, if at all. Delaware’s advantages may have held value in the past (as prior studies have found), but that value appears to have disappeared. Perhaps recent innovations such as the ones you cite will make a difference, but I doubt it. The conventional wisdom that Delaware incorporation is superior in an economically consequential way appears to be outdated.