Although states stand to earn significant revenue from developing a system of corporate law and encouraging companies to incorporate under it, most tend not to make the necessary investments. That may be perfectly rational. After all, a state may not capture much value from creating superior corporate laws because other states can simply amend their statutes to include the same sorts of provisions.
Many of the debates over controversial corporate law provisions proceed with both sides arguing that particular provisions will increase or diminish shareholder welfare. Take Delaware’s debate over fee-shifting bylaws and charter provisions as an example. Opponents argued that fee-shifting provisions, which essentially require the losers of lawsuits to pay the winners’ legal fees, would hurt shareholders because management would use them to insulate themselves from being sued. A fee-shifting provision would chill meritorious litigation because few shareholders would voluntarily expose themselves to liability for staggering corporate litigation fees. Presumably, corporations with such provisions would be worth less to shareholders, because the shareholders would have less freedom to challenge management and a greater expectation that management might steal. Moreover, rational shareholders holding these views would sell on the news that a corporation adopted a fee-shifting provision. Supporters, on the other hand, argued that the provisions responded to value-destroying shareholder litigation, benefiting shareholders by reducing litigation costs and making more money available for investment or dividends. In theory, rational investors concerned about excessive-litigation costs would prefer to buy shares in a company likely to have lower litigation expenses.
Delaware ultimately decided against allowing its corporations to adopt fee-shifting provisions. Oklahoma took a different approach and made fee-shifting mandatory for its corporations. Although Nevada recently introduced legislation that, if passed, would have authorized fee-shifting and required the secretary of state to study its effects, most other states have remained completely passive.
Whether certain corporate law provisions help or harm shareholders is a question that need not go unanswered. A state could pass legislation designed to attract companies to incorporate there and simultaneously gather information useful for further amending and promoting its corporate law. Access to favored governance innovations may draw public corporations to reincorporate or adopt fee-shifting or other provisions, opening the door for market responses that provide useful information about the provisions’ impact. If the stock of companies that adopted certain of these provisions tended to fall in price, a state might conclude that the provisions destroyed wealth and harmed shareholders. This evidence would support following Delaware and banning the provisions. On the other hand, if stocks reliably rose when corporations announced that they had adopted or intended to adopt the provisions, that would indicate that the state’s law generated wealth for shareholders. A state might gain market share by endorsing fee-shifting provisions that seemed to make a corporation more valuable.
Importantly, stock-price reactions are only one factor for states to consider when evaluating corporate law provisions. Just because particular corporate law provisions lead to higher stock prices doesn’t mean that they strike the right balance between society’s interests and shareholder interests. A state might decide that its long-term interest in developing case law outweighs creating benefits for shareholders.
Putting the fee-shifting policy question to the side, states may want to consider designing future corporate law changes in ways that help generate information about how the provisions actually perform in practice. Despite the possible benefits from a different approach, states may not be well-positioned to use market reactions to test corporate law provisions. Many legislatures lack corporate law expertise, and the process would require a sustained legislative commitment and willingness to use market reactions to help guide corporate law. At the least, it’s unlikely to be a campaign issue. Elected officials run for office by taking positions and telling voters their views on issues. It’s less inspiring to campaign on a plan to use markets to help you figure out what to do after you get elected. Many legislators and policymakers might also balk at this because review might produce evidence that a legislator’s bill did more harm than good. Initiating a project like this would likely require delegating significant authority to some rule-making agency somewhat insulated from political pressure.
This post comes to us from Professor Benjamin Edwards at the University of Nevada’s William S. Boyd School of law. It is based on his recent article, “Crafting Fee-Shifting Policy,” available here.