Corporate Charter Competition

In an article to be published in the Minnesota Law Review, I use systems-strategic analysis to explore the role of charter competition in corporate law. A systems-strategic analysis begins by identifying a law-related system for study, then describes how the system functions, and finally infers from that function what goals the system is pursuing. The system analyzed in this article is the system by which American corporate law is produced, adopted, and enforced—the corporate charter competition. Although charter competition extends to private corporations and other types of entities, I limited my analysis to the public company context because the competition is most pronounced in that context and nearly all of the empirical studies necessary to conduct a systems analysis have been confined to that context.

Three principles structure the charter competition. First, a corporation is entitled to incorporate in any state. Second, regardless of the state a corporation chooses, the corporation will be allowed to do business in all states. Third, regardless of where the corporation does business, the law of the state of incorporation governs its “internal affairs.” Those affairs include substantially the entire scope of corporate law. The result is a system composed of three subsystems. In the first, corporations choose states of incorporation. In the second, states decide what packages of regulation to offer. In the third, courts that states and parties have chosen in a variety of ways interpret and apply the incorporation state’s law to regulate the corporation.

My analysis concludes that the system’s principal effects have been to deregulate corporations and shield them from the democratic re-imposition of regulation. The system accomplishes the former through a reiterative process in which corporations choose the states that regulate them least and the states reduce their regulations to increase their appeal. A few states compete for incorporations to gain filing fee and franchise tax revenues from foreign corporations, but most compete as one element in a broad effort to attract business activity by demonstrating the state’s business-friendliness.

Despite considerable empirical evidence to the contrary, most scholars consider the charter competition to be a race to the top. The standard account is that Delaware won the race by developing corporate law expertise and striking the most efficient balance between the rights of managers and shareholders. Delaware alone provided a specialized court that could respond quickly and expertly to corporate needs and Delaware alone was able to credibly commit to continue serving the interests of corporations. Delaware’s lead is so great and the network effects so strong that no other state actively competes against it. If some other state adopted a rule or practice that provided it with an advantage in the competition, Delaware could and would nullify the advantage by copying the rule or practice.

The systems-strategic analysis suggests that this account should be revised in essentially five respects:

First, corporate charter competition is neither dormant nor merely a competition between Delaware and the corporations’ home states. Other states not only compete, but have captured 19 percent of the public company charter market—more than double most prior reports.

Second, courts function as the delivery system for corporation law. Delaware’s highly specialized courts are not merely a benefit that only Delaware can offer. They are the key element of a unique competitive strategy. Delaware has deliberately made its corporation statute almost entirely indeterminate. Delaware uses its courts to make corporate law at the point of delivery and tailor that law to the needs of both Delaware and its corporate customers.

Third, Delaware’s dominance of corporate charter competition is at high risk because its judicial strategy is failing. Delaware is losing cases for a variety of reasons discussed in a burgeoning literature. The shift to arbitration of shareholder litigation that is already underway may leave Delaware with too little litigation to continue its judicial strategy and no alternative advantage on which to fall back.

Fourth, charter competition should be modeled not as an attempt to strike the right balance between managers and shareholders, but as a delegation of power to managers who then strike that balance through implicit contracting. That reconceptualization leads to the insight that states do not need corporate law expertise to compete for incorporations.

Fifth, regardless of what happens to Delaware, corporate charter competition is beyond democratic control. That is, neither the citizens of Delaware, the competition-losing states, the United States, nor their elected representatives can impose meaningful regulation on corporations without first completing the near-impossible political task of eliminating the competition.

Corporate charter competition as a system is neither a race to the top or the bottom. The competition is a system capable of generating only one result: deregulation. What remains of corporate law is not regulation, but mere obfuscation. Regardless of what happens to Delaware, for the foreseeable future charter competition will remain a highly stable system that is effectively beyond democratic control.

This post comes to us from Lynn M. LoPucki, the Security Pacific Bank Distinguished Professor of Law at UCLA School of Law. It is based on his recent article, “Corporate Charter Competition,” available here.