Do Corporations Worldwide Still Prefer Delaware?

Hardly a day goes by without a headline about the brewing tension between the United States and China. But even as the Trump administration mulled de-listing Chinese firms traded in American securities markets, and Nasdaq reportedly planned to tighten its listing rules for Chinese IPOs, Chinese grocery delivery company Dada made its debut on the Nasdaq on June 5, 2020, with a valuation of $3.5 billion. Dada, along with mega-Chinese firms like Alibaba and Baidu, are now a hot topic on Wall Street. This burst of activity raises the question of whether Delaware is still the preferred state of incorporation for foreign firms.

I answer that question in my forthcoming paper, Delaware’s Global Competitiveness, principally by studying the corporate law preferences of foreign firms listed in the United States. Equipped with a sophisticated judicial infrastructure and a robust body of case law, Delaware is the juridical home to over 66 percent of Fortune 500 companies, and roughly half of all publicly traded companies in the United States. But we know relatively little about whether Delaware maintains its competitive edge globally.

Delaware popularity has, in fact, fallen dramatically among foreign corporations listed in American stock markets. Its share of foreign firms listed in the United States has declined from 29.5 percent in 1985 to 11.7 percent in 2016. The trend is particularly striking among corporations based in China, which have largely abandoned Delaware in favor of offshore jurisdictions in the Caribbean. As documented in my paper, the Cayman Islands is now home to over 50 percent of Chinese companies listed on American stock markets, compared with Delaware’s 4.8 percent. In recent years, companies like Sohu.com and China Biologic Products have spent millions of dollars hiring elite American law firms to change their legal domiciles from Delaware to the Cayman Islands.

There is a pressing need to examine Delaware’s lack of popularity among foreign firms. The potential pool of foreign corporations that are eligible to shop for Delaware law has expanded because a number of major nations have relaxed requirements that corporations to be bound by local corporate law. Delaware’s unpopularity among foreign firms listed in the United States also reveals a paradox. If foreign firms choose to be bound by federal securities law to raise capital from American investors, why wouldn’t they also choose to be bound by Delaware corporate law? After all, American investors are most familiar with Delaware corporate law, and a robust body of empirical work indicates that incorporating in Delaware enhances firm value.

Using Chinese companies listed in the United States as a case study, I explain how local regulations and market infrastructures affect the corporate law preferences of firms. In short, Delaware’s elaborate legal regime policing “self-dealing” transactions clashes with China’s contemporary industrial organization, where firms typically operate in corporate groups that routinely engage in related party transactions. Chinese corporate groups share some features of their counterparts in South Korea (Chaebol) and Japan (Keiretsu) but often are vertically integrated, preferring to transact with affiliated companies rather than rely on the open market. These firms would have reason to avoid Delaware, where related party transactions would open the floodgate to costly shareholder litigation. Indeed, according to my survey of SEC filings, over 95 percent of Chinese firms listed in the United States but incorporated in the Cayman Islands engage in related party transactions. It is telling that three of the most popular jurisdictions for Chinese corporations listed in American stock markets—the Cayman Islands, the British Virgin Islands, and Nevada—practically immunize self-dealing transactions from challenge. Of course, the merits of self-dealing transactions are murky. But transactions between affiliated companies within corporate groups can be economically advantageous for firms operating within weak legal systems and less developed capital markets.

The factors that make Delaware law popular in the United States may, in fact, make it unattractive to foreign corporations. The state’s legal regime is costly, and its rules developed and applied in the American context may not be ideal for corporations operating abroad in  vastly different market conditions. This is particularly true because the United States is fairly unusual for its lack of self-dealing transactions and corporate groups. For Delaware, of course, it is an open question whether the state would want to attract Chinese firms. On the one hand, firms incorporated in Delaware—domestic or foreign—can generate up to $200,000 per company annually for the state’s coffers. On the other hand, there is no question that at least some Chinese companies are on the verge of scandals similar to the one involving Luckin Coffee, whose chief operating officer was accused of fabricating much of its reported sales in 2019.

My paper suggests that, although there are undoubtedly Chinese firms that go offshore because it makes it easier to defraud American investors, there are legitimate business reasons why a typical Chinese firm listed in the United States would avoid Delaware. Institutional investors in the United States thus far have not (successfully) demanded that Chinese firms incorporate in Delaware. They also have not lobbied these firms to safeguard shareholder rights in corporate charters or bylaws—suggesting that the popularity of the Cayman Islands and the British Virgin Islands as jurisdictions of incorporation has more to do with corporate governance rules that comport with local market conditions than with facilitating fraud.

This post comes to us from Professor William J. Moon at the University of Maryland School of Law. It is based on his recent article, “Delaware’s Global Competitiveness,” forthcoming in the Iowa Law Review and available here.