A new approach to corporate choice of law.

AuthorDammann, Jens

ABSTRACT

The state of incorporation doctrine, which now applies both in the United States and in the European Community, allows corporations to choose the state law governing their internal affairs by incorporating in the appropriate state. Most scholars believe that this freedom to choose benefits both shareholders and society as a whole. Against this background, an obvious question is whether the state of incorporation doctrine is really the most efficient way of granting corporations the right to choose. In this Article, the Author argues that while there are sound reasons for retaining the state of incorporation doctrine as one mechanism for allowing corporations to choose the applicable corporate law, it should not be the only such mechanism because the state of incorporation doctrine does not allow corporations to choose the applicable corporate law in isolation, but forces them to accept certain "side effects," such as exposure to litigation in the state of incorporation. These side effects appear to be largely responsible for the general unwillingness of European firms to incorporate in the United States. Therefore, federal law in both Europe and the United States should ensure that corporations can choose the applicable corporate law in their articles of incorporation.

TABLE OF CONTENTS I. INTRODUCTION II. WHAT IS WRONG WITH THE STATE OF INCORPORATION DOCTRINE? A. Exposure to Litigation in the State of Incorporation 1. The Legal Rules Governing Exposure to Third-Party Suits 2. The Need to Litigate Internal Affairs in the State of Incorporation 3. The Practical Relevance of Having to Litigate in the State of Incorporation B. Securities Regulation 1. The U.S. Charter Market 2. The European Charter Market 3. The Transatlantic Charter Market a. The Securities Act of b. The Securities Exchange Act of 1934 C. Double Taxation 1. The U.S. Charter Market 2. The European Charter Market 3. The Transatlantic Charter Market III. THE STATUTORY APPROACH TO FREE CHOICE A. Franchise Fees B. Changing the Selected State IV. THE PRACTICAL RELEVANCE OF THE STATUTORY APPROACH A. The Real Seat Doctrine B. The Inability to Reincorporate C. The Demand for U.S. Corporate Law V. POTENTIAL JUSTIFICATIONS FOR THE PRESENT SYSTEM A. Transparency B. Slippery Slope C. The Need for a Constitutional Basis VI. WHY DID WE END UP WITH THE STATE OF INCORPORATION DOCTRINE AS THE ONLY MECHANISM FOR EXERCISING FREE CHOICE IN CORPORATE LAW? A. Why Have Lawmakers Failed to Adopt the Approach Discussed in this Article? B. Why Have Courts Failed to Adopt the Approach Discussed in this Article? 1. The European Community 2. The United States VII. CONCLUSION I. INTRODUCTION

U.S. corporations can freely choose the state law governing their internal affairs, (1) a concept that can be referred to as free choice. (2) As a technical matter, free choice is granted by means of a choice-of-law rule. Under the so-called state of incorporation doctrine, it is the law of the state of incorporation, rather than the law of the state in which the corporation's headquarters is located, that governs the corporation's internal affairs. (3)

The question of whether free choice benefits shareholders has long occupied a central place in the corporate law literature. Some scholars argue that free choice harms shareholders because states, driven by the desire to collect franchise taxes, try to attract corporate charters by promulgating rules that favor managers at the expense of shareholders. (4) In contrast, a majority of scholars now seem to hold the opposite view. According to this group, state competition in corporate law benefits shareholders, at least on balance, because capital markets discipline managers sufficiently to ensure that corporations prefer states with efficient corporate law. (5) This Article does not seek to resolve this debate. Rather, the assumption here is that free choice is at least on the whole beneficial. (6)

In obvious contrast to the attention lavished on the race-to-the-top/race-to-the-bottom debate, comparatively little thought has been devoted to the issue of how free choice can be organized most efficiently. (7) In particular, existing scholarship completely ignores the question of whether it is truly efficient for federal law to use the state of incorporation doctrine as the exclusive mechanism for guaranteeing free choice in corporate law.

This Article suggests that the answer to that question should be no. To be sure, there are sound reasons for retaining the state of incorporation doctrine as one mechanism for granting free choice. But it should not be the only such mechanism. Rather, a federal statute should complement the state of incorporation doctrine by allowing corporations to choose the applicable state law in their articles of incorporation. Corporations could thus determine freely which corporate law regime should govern their internal affairs. The law of the state of incorporation should only govern by default, if the articles of incorporation do not contain any choice-of-law clause.

While the analysis in this Article is not without relevance for charter competition in the United States, its purpose goes beyond the context of the U.S. legal system. In fact, the primary goal is to gain an understanding of how any federal or international legal system can organize free choice most efficiently. The importance of that question is easily explained. Free choice in corporate law is no longer a concept confined to the United States alone. (8) Rather, as is explained in more detail elsewhere, (9) the state of incorporation doctrine--and with it the concept of free choice--recently entered the European stage. In the past, the European Community (10) (hereinafter, "Community") allowed its Member States to adopt a choice-of-law system that prevented free choice. Most Member States of the Community adhered to the so-called real seat doctrine, which dictates that the internal affairs of a corporation are governed not by the law of the state of incorporation but by the law of the state in which the corporation's headquarters is located. (11) As a result, corporations could not choose the law of another Member State unless they were willing to move their headquarters. (12) Because the costs of such a move usually outweighed the advantages connected with a more efficient corporate law, (13) the real seat doctrine effectively prevented free choice.

Recently, however, this situation has changed. Three decisions by the European Court of Justice--Centros, (14) Uberseering, (15) and Inspire Art (16)--have made it clear that the real seat rule, as traditionally applied by most Member States, is incompatible with the Freedom of Establishment guaranteed by the Treaty Establishing the European Community (TEC). (17) To be sure, the legal landscape in the Community is still a far cry from its U.S. counterpart. In particular, European corporations, while free to choose where to incorporate in the first place, may find it difficult to reincorporate later without suffering adverse tax consequences. (18) Nevertheless, the concept of free choice is no longer confined to the United States. Rather, it has also become the basic tenet underlying Community law.

It is also important to note that Centros, Uberseering, and Inspire Art may well have set the stage for transatlantic charter competition. At first glance, that suggestion may seem somewhat counterintuitive. After all, the Freedom of Establishment underlying these judgments does not extend to U.S. corporations. (19) Nevertheless, Centros, Uberseering, and Inspire Art are of essential importance to the existence or non-existence of a transatlantic market for corporate charters. The reason can be summed up as follows: As long as the Member States of the Community managed to prevent an intra-European market for corporate charters via the real seat rule, they could hardly be expected to eliminate the various obstacles that prevent European businesses from incorporating in the United States. Nor could the United States be expected to address the various obstacles to transatlantic charter competition existing on the U.S. side, (20) given that the prevalence of the real seat rule in Europe seemed to prevent transatlantic charter competition. (21)

With the abolition of the real seat rule, however, that situation has changed considerably. For those Member States of the Community whose businesses predominantly choose to incorporate elsewhere, it may be in the States' best interests to make it easier for local firms to incorporate in the United States. After all, such a course of action may benefit local businesses by giving them access to more efficient corporate law. At the same time, a real seat state may not care whether pseudo-foreign corporations avoid local corporate law by incorporating in another Member State or whether they do so by incorporating in Delaware. Needless to say, the United States, too, has every incentive to facilitate transatlantic charter competition. Given that the outcome of such competition would likely favor the more flexible U.S. law, states such as Delaware and Nevada would profit from additional revenue. In sum, Centros, Uberseering, and Inspire Art are not only a boon to the intra-Community market for corporate charters, but they may also herald an era of transatlantic charter competition.

Against this background, it seems high time to focus not only on the general desirability of free choice in corporate law, but also on the question of how free choice should best be granted, be it in the U.S., the European, or the transatlantic arena.

Part II of this Article describes the main drawbacks of using the state of incorporation doctrine as the sole mechanism for guaranteeing free choice in corporate law. Part III suggests an alternative to the state of incorporation doctrine--namely, a statutory regime allowing corporations to choose the applicable law in their articles...

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