Delaware’s success in attracting corporate formations is well known, but explanations for it vary. In a recent paper, I test these explanations as well as the reasons for Delaware’s success in attracting other types of business formation I find evidence consistent with Delaware’s making a credible commitment to creating quality corporate law, particularly through its judiciary, and this commitment extends to LLCs and other organizational forms. These results provide insight into why Delaware leads corporate formations, how that lead expands to related organizational forms, and how the future of state competition for organizational formations might unfold.
The Delaware saga of Gatz Properties v. Auriga Capital Corp. provides the basis for my empirical study. It began as a routine Chancery Court opinion upholding prevailing understandings of default fiduciary duties of managers in LLCs. It then dramatically, and unexpectedly, turned into a Delaware Supreme Court decision that bucked conventional assumptions about default fiduciary duties. The unanimous opinion questioned, but declined to resolve, bedrock principles of whether fiduciary duties applied by default in LLCs as they do in other organizational forms. The legal community’s reaction was swift and negative, with commentators lamenting the court’s creation of legal uncertainty and seeming disregard for the state’s reputation for predictable, top-quality organizational law. Given this unrest, it was only a matter of time before the legislature responded, with the governor signing into law a bill “confirming” the existence of default fiduciary duties in Delaware LLCs.
Only 17 months passed from Chancery Court opinion to the bill’s passage. The business and legal community’s reactions during this period allow me to assess the demand for having cases decided by Delaware’s judiciary and for subjecting businesses to laws enacted by the Delaware legislature. I do so in two ways. First, I study the abnormal returns of publicly traded Delaware LLCs – the group of companies directly affected by the events – during the dates immediately surrounding the Chancery and Supreme Court opinions, as well as during key developments of the ensuing legislative response. The Chancery Court opinion yields no statistically significant abnormal returns, which we might expect if the opinion merely reaffirmed prevailing wisdom. The Supreme Court opinion, however, is associated with statistically significant, sustained declines in Delaware LLC stock prices, which is consistent with a long-run decrease in the Delaware judiciary’s attractiveness to the business community stemming from the opinion. Finally, the legislative response produces no statistically significant abnormal returns; whether that is because the business community does not value Delaware’s legislature or because the legislature’s actions simply affirmed its already favorable reputation, cannot be determined.
The second way I assess demand is to study the response by privately held LLCs. There are far more privately held than publicly traded LLCs, but private companies, of course, lack readily available share prices. I therefore assess private companies’ response by analyzing Delaware’s weekly LLC-to-corporation formation rates relative to competitor states’ rates. As before, I find no significant impact from either the Chancery Court opinion or the legislative response. However, consistent with the earlier analysis, I find a significant decrease in Delaware’s relative LLC-to-corporation formation rates following the Supreme Court opinion.
The results offer several useful insights into organizational law and state competition for organizational formations. The results are consistent with the theory that Delaware’s sustained advantage stems from its ability to commit credibly to producing high quality business law, with a significant portion of this commitment derived from its judiciary. But the results also help explain why Delaware’s success goes beyond attracting public corporations. Key components of the state’s credible commitment to producing quality corporate law, like its renowned judiciary, make forming other entity types comparatively attractive in Delaware, too, showing why Delaware leads a diverse array of non-corporate out-of-state company formations that range from LLCs to nonprofits. Finally, the results shed light on how state competition for organizational law might play out. Network effects driven by existing Delaware corporations make forming in Delaware attractive, but negative shocks to Delaware’s credible commitment quickly affect market participants’ formation choices. Robust competition thus still remains among states for organizational formations, both for corporations as well as for a broader range of entity types with needs that differ from those of publicly traded corporations.
This post comes to us from Professor Peter Molk at the University of Florida’s Levin College of Law. It is based on his recent article, “Delaware’s Dominance and the Future of Organizational Law,” available here.