CLS Blue Sky Blog

The Delaware Delusion

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.

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