Vigorous race or leisurely walk: reconsidering the competition over corporate charters.

• Author: Bebchuk, Lucian Arye

1. INTRODUCTION

   Docs American corporate law work effectively to enhance shareholder value? The recent corporate governance crisis makes this time as good as any for reexamining the basic structure of this body of law. This Essay provides such a reconsideration of a defining feature of U.S. corporate law--the existence of regulatory competition among states.

   In the United States, most corporate law issues are left for state law, and corporations are free to choose where to incorporate and thus which state's corporate law system will govern their affairs. The dominant state in attracting the incorporations of publicly traded companies is, and for a long time has been, the small state of Delaware. (1) Although Delaware is home to less than one-third of a percent of the U.S. population, (2) it is the incorporation jurisdiction of half of the publicly traded companies in the United States and of an even greater fraction of the larger publicly traded companies. (3) Delaware thus plays a central role in setting corporate governance rules for the nation's publicly traded companies.

   Why should this small state play such a critical role in the governance of the nation's corporate sector? At first glance, Delaware's existing dominant role might be viewed as inefficient or even illegitimate. (4) The widely accepted justification for the existing state of affairs, however, is that Delaware's dominant role is a product of its winning a competition among states for providing desirable corporate law rules.

   Indeed, the dominant view in corporate law scholarship is that allowing Delaware to dominate national corporate law is not a problematic feature, but rather an important virtue, indeed the "genius," of American corporate law. (5) According to the prevailing view among corporate scholars, competition provides powerful incentives for adoption and development of value-enhancing corporate rules. (6) Delaware has won its leading place by offering the best rules, and the competitive pressure it faces can be relied on to ensure that Delaware will continue to provide companies with whatever rules turn out to be best in our dynamic and changing business world.

   The view that state competition works well rests on two propositions: (i) that states actively and vigorously compete for incorporations, and (ii) that the ensuing competitive threat provides the dominant state of Delaware, as well as other states, with powerful incentives to provide value-enhancing rules. Those skeptical of state competition have mainly focused on questioning the second proposition. Accepting that states actively compete for incorporations, such critics have argued that the competitive threat might push states in undesirable directions with respect to some important corporate issues. (7)

   In contrast, this Essay challenges the standard case for state competition by questioning the claim of the first proposition that states vigorously compete for incorporations. The alleged vigorous race among states wing for incorporations, we argue, simply does not exist. We present evidence that Delaware's dominant position is far stronger, and thus that the competitive threat that it faces is far weaker, than has been previously recognized. We also explain the underlying reasons for the weakness of competition in the market for incorporations. Furthermore, we show that the weakness of competition has major implications for both assessing the performance of state competition and determining the desirable role of federal law in this area.

   Part II of this paper discusses the conventional premise that states compete actively for incorporations. We highlight the key role that this premise plays in the views of supporters of state competition. We also discuss how, at least for the purpose of the debate, critics of state competition have often accepted this premise.

   Part III then discusses evidence indicating the absence of active competition among states for corporate charters. We pay close attention in this Part to the patterns of incorporations among states that have been documented in a recent empirical study by Alma Cohen and one of us. (8) Although half of the publicly traded companies are incorporated outside Delaware, Delaware does not face any significant competitors in the business of attracting and serving out-of-state incorporations. The vast majority of non-Delaware corporations do not incorporate in a state that competes with Delaware over the hearts (or pockets) of firms incorporating out-of-state; rather, these firms simply remain incorporated in the state where they are headquartered.

   In assessing the competitive threat facing Delaware, it is important to consider Delaware's position in the market for out-of-state incorporations. Among firms that do "shop" for out-of-state incorporations, Delaware captures approximately 85% of all incorporations. (9) Delaware is thus a virtual monopoly in the out-of-state incorporations market, and no other state holds a significant position in this market. For example, whereas Delaware captures 216 out-of-state incorporations of Fortune 500 companies, no other state captures even 10 such incorporations, and the five states that follow Delaware's lead capture a total of 27 such out-of-state incorporations. (10) Similarly, whereas Delaware captures about 3744 out-of-state incorporations of publicly traded companies, each other state attracts fewer than 180 such incorporations. (11) Furthermore, Delaware's longstanding dominance of the out-of-state incorporation market, and the larger incorporation market, has been growing. Indeed, examination of recent trends indicates that Delaware's dominance can be expected to keep growing even further in the near future. (12)

   Its dominant position enables Delaware to make substantial supracompetitive profits. While Delaware's expenses on providing corporate law rules to the nation's firms are exceedingly small, it captures large franchise tax revenues--which on a per capita basis amount to $3000 for each household of four--that constitute a large fraction of the state's budget. (13) Still, notwithstanding these supracompetitive returns, other states have not been making any visible efforts to mount a serious challenge to Delaware's dominance. No state, as it were, has been giving Delaware a run for its money.

   What explains Delaware's powerful and unchallenged dominance? Some states, especially large states for which such profits would not be significant, might well be simply indifferent to the prospect of making profits from the incorporation business. There are, however, enough small states in the United States for which profits such as those Delaware has been making would be quite attractive; such states would have had strong motivation to mount a challenge to Delaware's dominance if such a challenge could have been expected to succeed in enabling them to capture a significant fraction of these profits. That this has not been happening, notwithstanding Delaware's persistent supracompetitive returns, indicates in our view that mounting a challenge to Delaware has not been viewed as likely to be profitable.

   Part IV analyzes the reasons for the absence of active competition. Drawing on the theory of industrial organization, we identify a number of structural features of the incorporation market that can explain why a challenge to Delaware's dominance by some other small state is unlikely to be profitable. The "product" currently offered by Delaware should be viewed as including not only its rules but also its institutional infrastructure, including Delaware's specialized chancery court, and the network benefits currently enjoyed by Delaware corporations. As a result, a state that would offer the same rules, but charge lower incorporation taxes and fees, would not be able to attract many out-of-state incorporations. Although its current incorporation taxes are in the aggregate meaningful for Delaware, such taxes never exceed $150,000 for any given firm, and reductions in such expenditures are unlikely to lead firms incorporating out-of-state to forgo the benefits from the institutional infrastructure and network externalities provided by Delaware. Similarly, a state that merely offers the same rules as Delaware with some marginal improvements cannot hope that such marginal improvements would by themselves attract many out-of-state incorporations.

   The existing rules governing reincorporations further constrain the ability of a challenger to attract quickly a significant number of out-of-state incorporations. Reincorporations must be initiated by the board before being brought to a shareholder vote. Therefore, even if a rival state could identify a set of rules that could make shareholders substantially better off, this state would be unable to attract quickly many out-of-state incorporations unless the rules are also preferable for managers. This significantly narrows, of course, the scope of improvements in substantive rules on which a potential challenge could be based.

   Finally, even if a rival were to identify some substantial set of changes that could significantly benefit both shareholders and management, and even if the rival were willing to invest up-front in institutional infrastructure, the profitability of a challenge could be undermined by the inability of the rival to launch a swirl hit-and-run challenge. The substantial amount of time that would be required for the challenger to adopt changes and for firms to respond to them would provide Delaware with ample opportunity to react. Delaware could "match" by adopting the challenger's improved rules; Delaware's out-of-state incorporators might then stick with Delaware due to its initial network benefits, and the challenger would merely serve as a stalking horse pulling Delaware to improve its rules. Furthermore, even if the challenger were somehow able to capture a significant fraction of the out-of-state incorporation...