The myth of state competition in corporate law.

• Author: Kahan, Marcel

INTRODUCTION

That states compete for incorporations of public companies has long been a dominant paradigm in corporate legal scholarship. (1) According to this paradigm, states derive substantial benefits from having corporations domicile in them and accordingly engage in significant efforts to attract incorporations. Since a company can incorporate in any state regardless of where it conducts its operations, the legal domicile affects how corporate disputes between directors and shareholders are resolved--and nothing else. State competition for incorporations is thus viewed as a textbook example of regulatory competition.

The competition paradigm has spawned a long debate about the desirability of federalism in corporate law. (2) Race-to-the-bottom scholars argue that managers control incorporation decisions and that states therefore compete by offering laws that cater to managers' personal interests at the expense of shareholders. (3) Race-to-the-top scholars argue that companies incorporate where their value is the highest and that states accordingly compete by offering laws that afford optimal shareholder protection. (4)

The stakes of the debate are high. Empirical evidence suggests that domicile choices affect the value of companies by several percentage points. (5) With market capitalization of public corporations in the United States in the range of $16 trillion, (6) the dynamics that shape the laws states offer to govern the internal affairs of companies are of substantial importance.

But the significance of the competition paradigm extends beyond corporate law. Competition theorists in other legal fields regularly derive lessons from the putative competition for incorporations, draw parallels to it, or distinguish between it and competition in other areas. (7) Thus, for example, the proposal to repeal federal securities law and devolve responsibility for regulation on the states is explicitly based on the view that state competition for incorporations is effective and beneficial. (8) Similarly, the debate over how financial institutions should be regulated parallels the debate over state competition for incorporations. (9) By contrast, the premise for the proposal that states should have greater authority over the design of environmental protection is that the competitive dynamics in this area differ from those in corporate law. (10) Other fields drawing on the notion that states compete for incorporations include bankruptcy law, (11) state tax law, (12) limited liability company law, (13) blue sky law, (14) secured transactions law, (15) corporate law in the European Union, (16) antitrust law, (17) computer law, (18) welfare law, (19) choice of law, (20) trust law, (21) campaign finance law, (22) and legal ethics. (23) In short, the state competition paradigm has profoundly influenced the scholarship on corporate law and several other legal areas.

The thesis of this Article is that the very notion that states compete for incorporations is a myth. Other than Delaware, no state is engaged in significant efforts to attract incorporations of public companies. (24) Modern state competition scholars have misconstrued the incentives of states to attract incorporations, misinterpreted their actions, misunderstood the economic and political barriers that states face, and arrived at mistaken conclusions about the market for incorporations.

This is not to say that active competition for incorporations never existed; that none of the participants in state legislation cares about incorporations; that states do nothing that could attract incorporations; or that active competition for incorporations could not develop in the future. As we will discuss, competition may well have existed in the distant past; (25) some local lawyers may profit from incorporations; (26) states may adopt laws that make them more attractive as corporate domiciles; (27) and more serious competition could develop in the future. (28) Rather than make sweeping generalizations, we recognize the incorporation market for what it is. The picture we portray is one where states other than Delaware stand to derive only small benefits from attracting incorporations, and take at most half-hearted steps to that end.

Two contemporaneous works complement our analysis. In one study, Robert Daines presents evidence suggesting that the personal interest of lawyers advising companies, and not only the merits of state corporate laws, determines domicile choices. (29) These findings imply that one needs to reconsider not just the supply side of the incorporation market, but also its demand side. In another study, Lucian Bebchuk and Assaf Hamdani argue that states do not vigorously compete for incorporations. (30) Although Bebchuk and Hamdani attribute this lack of competition to different causes and draw from it different normative implications than we do, their view that states do little today to compete accords with ours.

Our discussion proceeds as follows. Part I analyzes how much states stand to gain by competing. The most commonly alleged benefit that states derive from incorporations is tax revenues. We show, however, that no state other than Delaware structures its taxes to earn revenues from incorporations. The conventional wisdom that states compete to gain such revenues is just wrong. We also examine whether states would profit from attracting legal business associated with incorporations. We argue that any such profits would be rather modest.

Part II considers whether states engage in activities that reflect an effort to attract incorporations. We address three areas for action: the design of statutory law, the design of judge-made law, and the design of the court system. With respect to both the design of judge-made law and the design of the court system, we find no meaningful state activities. With respect to statutory law, we conclude that the activities of states are not principally directed to the goal of attracting incorporations.

Part III examines why the substantial profits that Delaware reaps from incorporations have not induced any other state to revamp its franchise tax structure and compete. Part of the answer, we argue, lies in the existence of economic entry barriers that protect Delaware. Another part is that Delaware's potential competitors are state bureaucracies that pursue political goals and operate under political constraints.

Part IV explores the implications of our analysis for the present structure of corporate law, for the desirability of federal intervention, and for regulatory competition theory in general. Because political factors shape legislation in noncompeting states, the laws of these states favor managers more than they would if states pursued incorporations. And because Delaware needs to respond to these laws in its own pursuit of incorporations, its law protects shareholders less than it would if other states competed, though more than the laws of noncompeting states. The lack of competition also affects other quality dimensions of corporate law. Among other things, it causes the laws of noncompeting states to be less predictable and less innovative, and Delaware law to be less predictable but more innovative, than each would be in the presence of competition. While politics would likely shape a federalized corporate law as well, the political dynamics on the federal level could differ from the dynamics in noncompeting states. It is therefore unclear whether a federal corporate law would offer more or less shareholder protection than current Delaware law. A federal corporate law, however, would likely be less innovative, and judge-made federal corporate law would likely be less predictable, than Delaware law.

1. WHAT CAN STATES GAIN FROM COMPETING?

   The most important component of the theory of state competition for incorporations is the claim that states derive significant benefits from attracting incorporations. According to conventional wisdom, these benefits emanate primarily from franchise taxes assessed on incorporated firms, and secondarily from legal business generated by incorporations. Alas, the conventional wisdom is wrong. Other than Delaware, no state structures its taxes to gain from incorporations or stands to reap substantial benefits from legal business by attracting incorporations. In Part I.A, we examine the tax structures that states employ. In Part I.B, we estimate the gains that states can expect to derive from legal business if they attract incorporations. In Part I.C, we address potential challenges to our analysis.

   1. Taxes

      Commentators regularly assert that franchise tax revenues drive states to compete for incorporations. (31) In all states other than Delaware, however, franchise taxes are not structured to raise substantial revenues from incorporations, even if a state succeeded in attracting a substantial fraction of publicly traded companies. (32) The choice that state lawmakers have made in this regard indicates that they do not try to attract incorporations in order to boost tax revenues.

      1. Annual franchise taxes.

         Consider first annual franchise taxes, which provide the bulk of states' franchise tax revenues. Forty-five states, including the states viewed as Delaware's leading competitors, charge companies that are incorporated in them a low flat tax, a tax based on the amount of business conducted in the state, or both. (33) The former can generate only trivial revenues, even if a state attracted a large portion of the 10,000 to 12,000 companies with publicly traded shares. (34) The tax based on business conducted in the state does not generate any revenues from incorporations because a company incorporated in the state pays the same amount of tax as it would if it were incorporated elsewhere. (35) The remaining six states employ a tax structure that can result in higher taxes for domestically incorporated firms than for foreign firms. (36) With the exception of...