ISSN1045-6333 HARVARD John M. Olin Center for Law. Economics and Business THE MARKET FOR CORPORATE LAW Oren Bar-Gill Michal barzuza Lucian bebchuk Discussion Paper No 377 072002, Revised08/2004 Harvard Law School Cambridge MA 02138 This paper can be downloaded without charge from The Harvard John M. Olin Discussion Paper Series http://www.lawharvardedu/programs/olincenter The Social Science Research Network Electronic Paper Collection http://papers.ssrn.com/abstractid=275452
ISSN 1045-6333 HARVARD John M. Olin Center for Law, Economics, and Business THE MARKET FOR CORPORATE LAW Oren Bar-Gill Michal Barzuza Lucian Bebchuk Discussion Paper No. 377 07/2002, Revised 08/2004 Harvard Law School Cambridge, MA 02138 This paper can be downloaded without charge from: The Harvard John M. Olin Discussion Paper Series: http://www.law.harvard.edu/programs/olin_center/ The Social Science Research Network Electronic Paper Collection: http://papers.ssrn.com/abstract_id=275452
Last revision: August 2004 The Market for Corporate Law Oren bar-Gill Michal Barzuza"and Lucian bebchuk Abstract This paper develops a model of the competition among states in providing corporate law rules. The analysis provides a full characterization of the equilibrium in this market Competition among states is shown to produce optimal rules with respect to issues that do not have a substantial effect on managers private benefits but not with respect to issues(such as takeover regulation) that substantially affect these private benefits. We analyze why a Dominant state such as Delaware can emerge, the prices that the dominant state will set and the profits it will make. We also analyze the roles played by legal infrastructure, network externalities, and the rules governing incorporations. The results of the model are consistent with, and can explain, existing empirical evidence they also indicate that the performance of state competition cannot be evaluated on the basis of how incorporation in Delaware in the prevailing market equilibrium affects shareholder wealth JEL classification: G30, G38, H70, K22 Keywords: corporate law, managers, shareholders, regulatory competition, Delaware, private benefits of control, network externalities en bar-Gill Michal Barzuza, and Lucian bebchuk Junior Fellow, The Society of Fellows, Harvard University; Olin Fellow in Law and Economics, Harvard Law school Olin Fellow in Law and Economics Harvard Law School. William J. Friedman Professor of Law, Economics, and Finance and Director of the Corporate Governance Program, Harvard Law School; Research Associate, National Bureau of Economic Research We have benefited from the helpful comments of Bernard Black, John Coates, Denis Gromb Sharon Hannes, Oliver Hart, Bert Huang, Louis Kaplow, Michael Klausner, Leeat Yariv and workshop participants at Harvard, Stanford, Sidley, Austin, Brown Wood, and the annual meeting of the American Law and Economics Association. We wish to thank the John M. Olin Center for Law, Economics, and Business for its financial support
Last revision: August 2004 The Market for Corporate Law Oren Bar-Gill*, Michal Barzuza** and Lucian Bebchuk*** Abstract This paper develops a model of the competition among states in providing corporate law rules. The analysis provides a full characterization of the equilibrium in this market. Competition among states is shown to produce optimal rules with respect to issues that do not have a substantial effect on managers’ private benefits but not with respect to issues (such as takeover regulation) that substantially affect these private benefits. We analyze why a Dominant state such as Delaware can emerge, the prices that the dominant state will set and the profits it will make. We also analyze the roles played by legal infrastructure, network externalities, and the rules governing incorporations. The results of the model are consistent with, and can explain, existing empirical evidence; they also indicate that the performance of state competition cannot be evaluated on the basis of how incorporation in Delaware in the prevailing market equilibrium affects shareholder wealth. JEL classification: G30, G38, H70, K22. Keywords: corporate law, managers, shareholders, regulatory competition, Delaware, private benefits of control, network externalities. © Oren Bar-Gill, Michal Barzuza, and Lucian Bebchuk * Junior Fellow, The Society of Fellows, Harvard University; Olin Fellow in Law and Economics, Harvard Law School. ** Olin Fellow in Law and Economics, Harvard Law School. *** William J. Friedman Professor of Law, Economics, and Finance and Director of the Corporate Governance Program, Harvard Law School; Research Associate, National Bureau of Economic Research. We have benefited from the helpful comments of Bernard Black, John Coates, Denis Gromb, Sharon Hannes, Oliver Hart, Bert Huang, Louis Kaplow, Michael Klausner, Leeat Yariv and workshop participants at Harvard, Stanford, Sidley, Austin, Brown & Wood, and the annual meeting of the American Law and Economics Association. We wish to thank the John M. Olin Center for Law, Economics, and Business for its financial support
Introduction This paper develops a model of the market for corporate incorporations and uses it to study the outcome and performance of this market. A central feature of the US corporate environment is the presence of competition among jurisdictions Companies are free to choose their state of incorporation, and they are subject to the corporate law of the state that they choose. Whether and to what extent this competition works well has been one of the most hotly debated subjects in corporate scholarship in the last quarter of a century. As the European Union has been moving European companies some freedom to choose their country of incorporation this subject has become important there as well The large existing literature on state competition has focused on two questions One question concerns the quality of the incentives produced by competition. According to the dominant view among corporate law scholars, competition generally pushes states, including Delaware, to adopt rules that benefit shareholders (see,e. g, Winter (1977), Easterbrook and Fischel(1991), and Romano(1993a, 1993b) An alternative view holds that state competition pushes states to adopt rules enefiting managers, not shareholders, with respect to an important set of corporate (see, e.g., Cary(1974), Bebchuk(1992) The other subject that has attracted much attention concerns the structure of the incorporations market. The market has been long characterized by one dominant player. Among publicly traded non-financial firms, Delaware is the domicile of 58% of the publicly traded companies 59% of the fortune 500 companies and 67% of the companies that went public during 1996-2000 Bebchuk and Cohen(2003)). In the face of this market structure researchers have discussed what explains the emergence and persistence of a dominant state, and how the desire to maintain and take advantage of such dominance affects the behavior of this dominant state(see, e.g., Romano(1985), Klausner(1995), Kamar(1998), Bebchuk and Hamdani(2002) Kahan and Kamar(2001, 2002))) Although a great deal has been written on state competition in the past three decades, there has been surprisingly little effort to develop a formal framework that would enable a rigorous study of the subject. The present paper seeks to fill this void. It develops a model of the market for corporate law, and it uses this model to study the questions long discussed informally with the discipline provided by a formal model. The model enables us to resolve significant debates in the literature to confirm some informally made claims while rejecting others and to identif issues that have been thus far overlooked
1 1. Introduction This paper develops a model of the market for corporate incorporations and uses it to study the outcome and performance of this market. A central feature of the US corporate environment is the presence of competition among jurisdictions. Companies are free to choose their state of incorporation, and they are subject to the corporate law of the state that they choose. Whether and to what extent this competition works well has been one of the most hotly debated subjects in corporate scholarship in the last quarter of a century. As the European Union has been moving toward giving European companies some freedom to choose their country of incorporation, this subject has become important there as well. The large existing literature on state competition has focused on two questions. One question concerns the quality of the incentives produced by competition. According to the dominant view among corporate law scholars, competition generally pushes states, including Delaware, to adopt rules that benefit shareholders (see, e.g., Winter (1977), Easterbrook and Fischel (1991), and Romano (1993a, 1993b). An alternative view holds that state competition pushes states to adopt rules benefiting managers, not shareholders, with respect to an important set of corporate issues (see, e.g., Cary (1974), Bebchuk (1992)). The other subject that has attracted much attention concerns the structure of the incorporations market. The market has been long characterized by one dominant player. Among publicly traded non-financial firms, Delaware is the domicile of 58% of the publicly traded companies, 59% of the Fortune 500 companies, and 67% of the companies that went public during 1996-2000 (Bebchuk and Cohen (2003)). In the face of this market structure, researchers have discussed what explains the emergence and persistence of a dominant state, and how the desire to maintain and take advantage of such dominance affects the behavior of this dominant state (see, e.g., Romano (1985), Klausner (1995), Kamar (1998), Bebchuk and Hamdani (2002), Kahan and Kamar (2001, 2002))). Although a great deal has been written on state competition in the past three decades, there has been surprisingly little effort to develop a formal framework that would enable a rigorous study of the subject. The present paper seeks to fill this void. It develops a model of the market for corporate law, and it uses this model to study the questions long discussed informally with the discipline provided by a formal model. The model enables us to resolve significant debates in the literature, to confirm some informally made claims while rejecting others, and to identify issues that have been thus far overlooked
In our model, each state chooses its strategy -what rules to offer, whether to invest in creating a legal infrastructure, what prices to charge, and so forth Companies then make incorporation decisions. Clearly, states choose their strategies in anticipation of the reactions to them by other states and by companies. We solve for the equilibrium outcome and study its features Bb. When a company is incorporated in a given state, payoffs to shareholders and managers are determined by (i) the substantive content of the states corporate law rules,(i) the institutional texture of the state s corporate environment, including the existence (or absence) of legal infrastructure(e. g. a specialized judiciary) and the presence(or absence) of beneficial network externalities, and (iii) the price charged by the state -either directly(e. g. franchise taxes) or indirectly ( e. g. fees paid to the local bar) As far as the substantive content of corporate rules is concerned, we shall distinguish between two categories of rules. The first category includes rules that have little or no effect on the ability of managers to extract private benefits of control. With respect to these rules - which can be labeled insignificantly redistributive rules- both the managers and the shareholders of existing companies prefer rules that maximize cash flows to shareholders. The second category of rules includes those that might have a significant effect on managers ability to extract private benefits. Rules governing takeovers, self-dealing, and taking of corporate opportunities are examples of such rules. With respect to these rules- which might e called significantly redistributive rules- managers of existing companies might prefer rules that would increase their private benefits even if such rules would not maximize the cash flows to shareholders We allow payoffs to depend not only on the substantive content of legal rules but also on" institutional" factors such as the existence of a legal infrastructure and network externalities. Because Delaware's investment in a specialized judiciary might provide benefits to Delaware companies (see Romano(1985)and Fisch 2000)), we assume that cash flows may increase from the presence of a lega infrastructure. Following the view that companies benefit from having many other companies incorporated in the same state(Klausner(1995), we allow for network externalities. Such externalities include the benefits that a company may enjoy from having more precedents to rely on and from being subject to rules and practices with which capital market participants are well familiar We also allow payoffs to depend on the price charged by the state of incorporation. More importantly, we include the price charged by states as an endogenous element of states strategies. The literature had largely assumed that states can maximize profits from incorporations by maximizing the number of incorporated companies, implicitly assuming that the price paid by companies is
2 In our model, each state chooses its strategy — what rules to offer, whether to invest in creating a legal infrastructure, what prices to charge, and so forth. Companies then make incorporation decisions. Clearly, states choose their strategies in anticipation of the reactions to them by other states and by companies. We solve for the equilibrium outcome and study its features. When a company is incorporated in a given state, payoffs to shareholders and managers are determined by (i) the substantive content of the state’s corporate law rules, (ii) the institutional texture of the state’s corporate environment, including the existence (or absence) of legal infrastructure (e.g. a specialized judiciary) and the presence (or absence) of beneficial network externalities, and (iii) the price charged by the state – either directly (e.g. franchise taxes) or indirectly (e.g. fees paid to the local bar). As far as the substantive content of corporate rules is concerned, we shall distinguish between two categories of rules. The first category includes rules that have little or no effect on the ability of managers to extract private benefits of control. With respect to these rules – which can be labeled insignificantly redistributive rules – both the managers and the shareholders of existing companies prefer rules that maximize cash flows to shareholders. The second category of rules includes those that might have a significant effect on managers’ ability to extract private benefits. Rules governing takeovers, self-dealing, and taking of corporate opportunities are examples of such rules. With respect to these rules – which might be called significantly redistributive rules – managers of existing companies might prefer rules that would increase their private benefits even if such rules would not maximize the cash flows to shareholders. We allow payoffs to depend not only on the substantive content of legal rules but also on “institutional” factors such as the existence of a legal infrastructure and network externalities. Because Delaware’s investment in a specialized judiciary might provide benefits to Delaware companies (see Romano (1985) and Fisch (2000)), we assume that cash flows may increase from the presence of a legal infrastructure. Following the view that companies benefit from having many other companies incorporated in the same state (Klausner (1995)), we allow for network externalities. Such externalities include the benefits that a company may enjoy from having more precedents to rely on and from being subject to rules and practices with which capital market participants are well familiar. We also allow payoffs to depend on the price charged by the state of incorporation. More importantly, we include the price charged by states as an endogenous element of states’ strategies. The literature had largely assumed that states can maximize profits from incorporations by maximizing the number of incorporated companies, implicitly assuming that the price paid by companies is
exogenously fixed. As Kahan and Kamar(2001)pointed out, however, Delaware also makes choices with respect to the prices it charges. 1 In our model, in setting the prices charged, the dominant state takes into account the effects of the price it sets both on delawares revenues and on the incentives of other states to mount a challenge to delawares dominance We will focus in the first part of our analysis on the(re)incorporation decisions f existing publicly traded companies. We then extend our analysis to allow for IPOs. We show that our results largely apply to the case in which the stock of publicy traded firms is increased in any given period by new IPOs as long as the number of such IPOs is not too large relative to the existing stock of non-Delaware companies. When analyzing reincorporation decisions, we take as given the long- company requires board initiation followed by a vote of shareholder approval Gi standing rules of US corporate law, under which reincorporation of an existing As to the payoffs of states, we shall assume that some (if not all) states seek to maximize revenues. 2 A state's revenue(or payoff) is the product of the price it charges incorporated companies multiplied by the number of such companies. Also, for any given level of revenues, we assume that a state prefers more incorporation to less. In making its decisions, each state will take into account how companies as well as other states will react to it the dominant state will also consider whether its decisions will create an incentive for other states to expend resources to challenge its dominar Using the above building blocks, we derive the equilibrium in the state competition game. We show that state competition works differently for rules that do and do not have a significant effect on managers' private benefits of control When a corporate issue does not have a significant effect on managers private benefits of control, state competition will push states to adopt rules that would best serve shareholders. However, with respect to rules that have a substantial effect on managers private benefits of control, such as rules governing corporate takeovers or managerial conflicts of interests, states might adopt rules that make shareholders worse off. In particular, the dominant state will have to do so in order to attract reincorporation from other states and in order to prevent other states from being able to beat it in attracting companies willing to leave their"home" state 1 Kahan and Kamar (2001) focus on the possibility that, facing heterogeneous companies that differ in the benefits they derive from the advantages offered by Delaware, Delaware will seek to charge different prices to different companies. In contrast, we focus on a strategic role that the setting of price has regardless of whether such heterogeneity is present. e also allow for the possibility that some states are not interested in revenues from incorporations (Kahan and Kamar(2002))
3 exogenously fixed. As Kahan and Kamar (2001) pointed out, however, Delaware also makes choices with respect to the prices it charges.1 In our model, in setting the prices charged, the dominant state takes into account the effects of the price it sets both on Delaware’s revenues and on the incentives of other states to mount a challenge to Delaware’s dominance. We will focus in the first part of our analysis on the (re)incorporation decisions of existing publicly traded companies. We then extend our analysis to allow for IPOs. We show that our results largely apply to the case in which the stock of publicy traded firms is increased in any given period by new IPOs as long as the number of such IPOs is not too large relative to the existing stock of non-Delaware companies. When analyzing reincorporation decisions, we take as given the longstanding rules of US corporate law, under which reincorporation of an existing company requires board initiation followed by a vote of shareholder approval. As to the payoffs of states, we shall assume that some (if not all) states seek to maximize revenues.2 A state’s revenue (or payoff) is the product of the price it charges incorporated companies multiplied by the number of such companies. Also, for any given level of revenues, we assume that a state prefers more incorporation to less. In making its decisions, each state will take into account how companies as well as other states will react to it. The dominant state will also consider whether its decisions will create an incentive for other states to expend resources to challenge its dominance. Using the above building blocks, we derive the equilibrium in the state competition game. We show that state competition works differently for rules that do and do not have a significant effect on managers’ private benefits of control. When a corporate issue does not have a significant effect on managers’ private benefits of control, state competition will push states to adopt rules that would best serve shareholders. However, with respect to rules that have a substantial effect on managers’ private benefits of control, such as rules governing corporate takeovers or managerial conflicts of interests, states might adopt rules that make shareholders worse off. In particular, the dominant state will have to do so in order to attract reincorporations from other states and in order to prevent other states from being able to beat it in attracting companies willing to leave their “home” state. 1 Kahan and Kamar (2001) focus on the possibility that, facing heterogeneous companies that differ in the benefits they derive from the advantages offered by Delaware, Delaware will seek to charge different prices to different companies. In contrast, we focus on a strategic role that the setting of price has regardless of whether such heterogeneity is present. 2 We also allow for the possibility that some states are not interested in revenues from incorporations (Kahan and Kamar (2002))
Our analysis highlights the importance of the established procedure for witching from state to state for the equilibrium in the market for corporate law Under this procedure, managers have a veto power over reincorporation Moreover, whereas the shareholders also have a veto power managers must initiate the vote on reincorporation, which essentially gives them the power to make a take- it-or-leave-it offer to the shareholders regarding reincorporation. Thus, if a move from a company s home state to either one of two states would benefit shareholders, the managers would be able to determine the state to which the company would move. Faced with a choice between remaining in their home state and reincorporating to whichever one of the two states managers favor, shareholders can be expected to approve the reincorporation. This feature of the situation strengthens the incentives of the dominant state to choose certain rules that are favored by managers but not shareholders Our model explains how a state that has moved first to invest in legal infrastructure will be able to obtain, and subsequently maintain, a dominant position. The initial advantage that the state might have due to its legal infrastructure will be reinforced by network externalities, as companies will (correctly) anticipate that other companies also will be drawn to the dominant state Furthermore, the dominant will set its rules and prices in such a way as to provide no incentive for states to make similar investments in infrastructure Finally, our model explains how the dominant state will be able to make profits from the incorporation business but will not be able to capture the full benefits to companies incorporated in the dominant state from the legal infrastructure and network externalities they enjoy by incorporating in this state. The model thus can explain the phenomenon recently highlighted by Kahan and Kamar(2001)-that Delaware seems to make a high return on its investments but that it does not raise its prices to the highest level that companies would likely be willing to pay for Delaware incorporation. Indeed, Delaware obtains tax revenues from the incorporations business on the order of $3, 000 for each family of four(Bebchuk and Hamdani(2002). We show that the advantage that a dominant state has can enable it to make positive profits without inducing a rival to challenge its dominance. To 3 Thus, our model may explain why Delaware's franchise tax seems low compared with reasonable estimate of the value generated by Delaware's legal infrastructure and the netw externalities it provides to large publicly traded companies. While the value of the median company in Delaware is approximately $237 million Daines(2001), Delawares franchise tax does not exceed $150 thousand a year. This is the maximum tax even for companies whose stock market capitalization is in the dozens of billions of dollars
4 Our analysis highlights the importance of the established procedure for “switching” from state to state for the equilibrium in the market for corporate law. Under this procedure, managers have a veto power over reincorporations. Moreover, whereas the shareholders also have a veto power, managers must initiate the vote on reincorporation, which essentially gives them the power to make a takeit-or-leave-it offer to the shareholders regarding reincorporation. Thus, if a move from a company’s home state to either one of two states would benefit shareholders, the managers would be able to determine the state to which the company would move. Faced with a choice between remaining in their home state and reincorporating to whichever one of the two states managers favor, shareholders can be expected to approve the reincorporation. This feature of the situation strengthens the incentives of the dominant state to choose certain rules that are favored by managers but not shareholders. Our model explains how a state that has moved first to invest in legal infrastructure will be able to obtain, and subsequently maintain, a dominant position. The initial advantage that the state might have due to its legal infrastructure will be reinforced by network externalities, as companies will (correctly) anticipate that other companies also will be drawn to the dominant state. Furthermore, the dominant state will set its rules and prices in such a way as to provide no incentive for other states to make similar investments in legal infrastructure. Finally, our model explains how the dominant state will be able to make profits from the incorporation business but will not be able to capture the full benefits to companies incorporated in the dominant state from the legal infrastructure and network externalities they enjoy by incorporating in this state.3 The model thus can explain the phenomenon recently highlighted by Kahan and Kamar (2001) — that Delaware seems to make a high return on its investments but that it does not raise its prices to the highest level that companies would likely be willing to pay for Delaware incorporation. Indeed, Delaware obtains tax revenues from the incorporations business on the order of $3,000 for each family of four (Bebchuk and Hamdani (2002)). We show that the advantage that a dominant state has can enable it to make positive profits without inducing a rival to challenge its dominance. To 3 Thus, our model may explain why Delaware’s franchise tax seems low compared with any reasonable estimate of the value generated by Delaware’s legal infrastructure and the network externalities it provides to large publicly traded companies. While the value of the median company in Delaware is approximately $237 million (Daines (2001)), Delaware’s franchise tax does not exceed $150 thousand a year. This is the maximum tax even for companies whose stock market capitalization is in the dozens of billions of dollars
prevent such a challenge, however, the dominant state will not raise its prices to fully capture the benefits companies would gain from incorporating in it The remainder of the paper is organized as follows. Section 2 presents the framework of the analysis. Section 3 solves the model and presents the resulting equilibrium in the market for corporate law. Section 4 studies several extensions to the basic model. Section 5 offers concluding remarks on the positive and normative implications of our analysis 2. Framework of analysis 2.1. Sequence of events The sequence of events in the model is as follows T=0: There is a set of states N=(1,.) where n 22, including a dominant state, named Delaware, and other states; and a (large) number of companies, m>>n, whose initial incorporations are distributed among the n states T=1: The states choose their strategies, which include: whether they invest in creating a legal infrastructure; which legal rules they adopt; and what price they will charge companies incorporated in the state T=2: Companies choose where to(re)incorporate T=3: All payoffs-to shareholders, managers and states-are realized Companies The initial States choose choose where to Payoffs are situation strategies (re)incorporate realized Fig. 1: Sequence of Events The assumptions about each of the stages are described in detail below
5 prevent such a challenge, however, the dominant state will not raise its prices to fully capture the benefits companies would gain from incorporating in it. The remainder of the paper is organized as follows. Section 2 presents the framework of the analysis. Section 3 solves the model and presents the resulting equilibrium in the market for corporate law. Section 4 studies several extensions to the basic model. Section 5 offers concluding remarks on the positive and normative implications of our analysis. 2. Framework of Analysis 2.1. Sequence of events The sequence of events in the model is as follows: T = 0: There is a set of states N = {1,..., n} where n ≥ 2, including a dominant state, named “Delaware,” and other states; and a (large) number of companies, m >> n , whose initial incorporations are distributed among the n states. T = 1: The states choose their strategies, which include: whether they invest in creating a legal infrastructure; which legal rules they adopt; and what price they will charge companies incorporated in the state. T = 2: Companies choose where to (re)incorporate. T = 3: All payoffs—to shareholders, managers and states—are realized. The assumptions about each of the stages are described in detail below. T 0 1 2 3 The initial situation States choose strategies Payoffs are realized Companies choose where to (re)incorporate Fig. 1: Sequence of Events
2.2 T=0: The Initial situation We assume that at t=0, one state-which we call delaware-has a legal infrastructure that may improve cash flows for companies incorporated in that state The said infrastructure can be thought of as a specialized judiciary. As will be shown later on, network externalities will complement and reinforce Delawares initial infrastructure advantage We assume that each one of the m companies has a home" state i.e. the state in which the companys headquarters is located. At T=0, each company is assumed to be incorporated either in its" home"state or in Delaware. (In the case of companies located in Delaware, the"home"state and Delaware will be of course the same. )In particular, among the local companies of any given state, some(at least one) are incorporated at home" and some (at least one) are incorporated in Delaware. We assume that at T-0 Delaware already enjoys a significant number of incorporations Note that reincorporation does not affect the location of a company's headquarters or its place of operation -but only the corporate law system to which the company will be subject. We initially assume that all of the companies have gone public prior to T=0. This assumption will be relaxed in Section 4.2. Each company is assumed to have dispersed ownership, with managers holding only a small fraction a of the company' s shares 2.3 T=1: States Choose their Strategies At this stage, states choose, and make public, strategies consisting of three elements: (1)whether they make a special investment in legal infrastructure(of course, since Delaware already has such an infrastructure, this choice is relevant only for the other states),(2) which rules they adopt, and 3) what price they will charge incorporated companies The states select and announce their strategies sequentially, with Delaware moving first and the order in which the remaining states move being chosen randomly. a state announcing its strategy cannot amend its strategy later on; but, of 4 It is further assumed that, even though Delaware starts with a significant number of incorporations, there is at T=0 a significant number of companies incorporated outside Delaware The fraction of companies that are initially out-of-state is assumed to be sufficiently large to make Delaware interested in luring companies from their"home" states rather than pursuing a strategy focusing solely on companies that are already incorporated in Delaware. Footnote 28 in Appendix A further elaborates on the analytical underpinnings of this condition. It also describes the equilibrium in the case in which Delaware focuses solely on the companies which it has at T=0; this case is of lesser importance, of course, in understanding the existing state competition in the US
6 2.2 T = 0: The Initial Situation We assume that, at T = 0, one state—which we call Delaware—has a legal infrastructure that may improve cash flows for companies incorporated in that state. The said infrastructure can be thought of as a specialized judiciary. As will be shown later on, network externalities will complement and reinforce Delaware’s initial infrastructure advantage. We assume that each one of the m companies has a “home” state, i.e. the state in which the company’s headquarters is located. At T = 0, each company is assumed to be incorporated either in its “home” state or in Delaware. (In the case of companies located in Delaware, the “home” state and Delaware will be of course the same.) In particular, among the local companies of any given state, some (at least one) are incorporated “at home” and some (at least one) are incorporated in Delaware. We assume that at T = 0 Delaware already enjoys a significant number of incorporations.4 Note that reincorporation does not affect the location of a company’s headquarters or its place of operation—but only the corporate law system to which the company will be subject. We initially assume that all of the companies have gone public prior to T = 0. This assumption will be relaxed in Section 4.2. Each company is assumed to have dispersed ownership, with managers holding only a small fraction α of the company’s shares. 2.3 T=1: States Choose their Strategies At this stage, states choose, and make public, strategies consisting of three elements: (1) whether they make a special investment in legal infrastructure (of course, since Delaware already has such an infrastructure, this choice is relevant only for the other states), (2) which rules they adopt, and (3) what price they will charge incorporated companies. The states select and announce their strategies sequentially, with Delaware moving first and the order in which the remaining states move being chosen randomly. A state announcing its strategy cannot amend its strategy later on; but, of 4 It is further assumed that, even though Delaware starts with a significant number of incorporations, there is at T=0 a significant number of companies incorporated outside Delaware. The fraction of companies that are initially out-of-state is assumed to be sufficiently large to make Delaware interested in luring companies from their “home” states rather than pursuing a strategy focusing solely on companies that are already incorporated in Delaware. Footnote 28 in Appendix A further elaborates on the analytical underpinnings of this condition. It also describes the equilibrium in the case in which Delaware focuses solely on the companies which it has at T=0; this case is of lesser importance, of course, in understanding the existing state competition in the US
course, states will choose their strategy in anticipation of what other states will do We next specify the assumptions about each of the three elements of the strategy each state chooses 2.3.1 Legal Infrastructure We assume that, by investing K, a state can establish a legal infrastructure similar to Delaware's infrastructure-that would operate to improve cash flows for companies incorporated in the state. Formally, each state, other than Delaware, chooses its investment in infrastructure, k, from the set 0, K). The infrastructure can be thought of as including a specialized judiciary and the various other services and institutions needed to have an experienced, smooth, and fast system for litigating cases 2.3. 2. Rules Each state must choose its rules with respect to each corporate issue. We characterize a legal rule by its effects on(1)the company's cash flows, Y, and (2 )the level of private benefits that managers can extract from the company, B. Issues can be divided into two categories: (i) issues that do not have a significant effect on private benefits, which are labeled "insignificantly redistributive issues, and (ii) issues that have such a significant effect, which are labeled"redistributive issues Whereas shareholders and managers have overlapping interests and preferences with respect to issues of type (i), their interests and preferences diverge with respect to issues of type(ii) (1) Insignificantly redistributive issues: We assume that there is one issue, denoted NR, which belongs to this category. With respect to this issue, states must choose between the lk rule and the hr rule we normalize the effect of the lnk rule on cash flows to zero, and denote the effect of the hk rule on cash flows by y x>0 Hence, shareholders will be better off under h k than under L. the choice between the two rules will have no or little effect on managers private benefits and managers thus also prefer H R over LNR Our results generally carry over to the case in which the choice between the two rules has an effect on managers private benefits but this effect is small enough that managers prefer h because of its positive effect on cash flows. 5 The main 5 Specifically, suppose that, compared with H R, LR increases managers private issue as shareholders and will also prefer H over LM have the same preferences regarding this B>0. As long as ar-B>0, managers will I
7 course, states will choose their strategy in anticipation of what other states will do. We next specify the assumptions about each of the three elements of the strategy each state chooses. 2.3.1 Legal Infrastructure We assume that, by investing K, a state can establish a legal infrastructure— similar to Delaware’s infrastructure—that would operate to improve cash flows for companies incorporated in the state. Formally, each state, other than Delaware, chooses its investment in infrastructure, k, from the set {0,K}. The infrastructure can be thought of as including a specialized judiciary and the various other services and institutions needed to have an experienced, smooth, and fast system for litigating cases. 2.3.2. Rules Each state must choose its rules with respect to each corporate issue. We characterize a legal rule by its effects on (1) the company’s cash flows, Y, and (2) the level of private benefits that managers can extract from the company, B. Issues can be divided into two categories: (i) issues that do not have a significant effect on private benefits, which are labeled “insignificantly redistributive issues,” and (ii) issues that have such a significant effect, which are labeled “redistributive issues.” Whereas shareholders and managers have overlapping interests and preferences with respect to issues of type (i), their interests and preferences diverge with respect to issues of type (ii). (i) Insignificantly redistributive issues: We assume that there is one issue, denoted NR, which belongs to this category. With respect to this issue, states must choose between the NR L rule and the NR H rule. We normalize the effect of the NR L rule on cash flows to zero, and denote the effect of the NR H rule on cash flows by > 0 NR Y . Hence, shareholders will be better off under NR H than under NR L . The choice between the two rules will have no or little effect on managers’ private benefits, and managers thus also prefer NR H over NR L . Our results generally carry over to the case in which the choice between the two rules has an effect on managers’ private benefits but this effect is small enough that managers prefer NR H because of its positive effect on cash flows.5 The main 5 Specifically, suppose that, compared with NR H , NR L increases managers’ private benefits by > 0 NR B . As long as ⋅ − > 0 NR NR α Y B , managers will have the same preferences regarding this issue as shareholders and will also prefer NR H over NR L
point is that, with respect to the insignificantly redistributive rules, there is no conflict of interests, and both shareholders and managers prefer H over L'. For simplicity of exposition, and without loss of generality, we assume that both the L rule and the h rule have an identical effect on managers' private benefits, and we normalize this effect to zero An example of an insignificantly redistributive rule is the rule requiring directors to attend board meetings. Although the rule imposes some small private cost on managers, this cost might be sufficiently small (relative to the cash flow enefits of having directors attend board meetings)that managers would not favor absenteeism ii) Redistributive issues: This category includes rules with respect to which the interests of shareholders and managers diverge, because the rule that would increase cash flows would also significantly reduce private benefits, thus making it disfavored by managers. For example, shareholders might favor a takeover rule that managers would disfavor because of its effect on the managers private benefits, or shareholders might prefer a rule concerning conflict of interests that managers would disfavor. We do not claim, of course, that any reduction in managers private enefits would benefit shareholders. Some provision of private benefits is desirable in many cases. But once the optimal level of private benefits is reached, there is still commonly a choice between a rule that establishes this level and a rule that would go beyond it to provide managers with higher benefits. It is this choice that we focus Specifically, we assume that there is one issue that belongs to this category, R, and states can choose with respect to this issue R between the L rule and the H rule. We normalize the effect of the l rule on cash flows to zero and denote the effect of the H rule on cash flows by y>0. Hence, shareholders prefer Hover L. Similarly, we normalize the effect of the H rule on managers private benefits to zero, and denote managers private benefits under the l rule by b>0 Ne also assume, contrary to the assumption in the category of insignificantly redistributive rules, that a. -B0- namely the L rule is inefficient. Managers still prefer the inefficient LR rule, since they capture the increase in private benefits produced by the rule but bear only a small fraction a of the reduction in cash flows created by it. The interesting question is whether state competition will result in the adoption of the efficient H rule, as supporters of state 8
8 point is that, with respect to the insignificantly redistributive rules, there is no conflict of interests, and both shareholders and managers prefer NR H over NR L . For simplicity of exposition, and without loss of generality, we assume that both the NR L rule and the NR H rule have an identical effect on managers’ private benefits, and we normalize this effect to zero. An example of an insignificantly redistributive rule is the rule requiring directors to attend board meetings. Although the rule imposes some small private cost on managers, this cost might be sufficiently small (relative to the cash flow benefits of having directors attend board meetings) that managers would not favor absenteeism. (ii) Redistributive issues: This category includes rules with respect to which the interests of shareholders and managers diverge, because the rule that would increase cash flows would also significantly reduce private benefits, thus making it disfavored by managers. For example, shareholders might favor a takeover rule that managers would disfavor because of its effect on the managers’ private benefits, or shareholders might prefer a rule concerning conflict of interests that managers would disfavor. We do not claim, of course, that any reduction in managers’ private benefits would benefit shareholders. Some provision of private benefits is desirable in many cases. But once the optimal level of private benefits is reached, there is still commonly a choice between a rule that establishes this level and a rule that would go beyond it to provide managers with higher benefits. It is this choice that we focus on. Specifically, we assume that there is one issue that belongs to this category, R, and states can choose with respect to this issue R between the R L rule and the R H rule. We normalize the effect of the R L rule on cash flows to zero, and denote the effect of the R H rule on cash flows by > 0 R Y . Hence, shareholders prefer R H over R L . Similarly, we normalize the effect of the R H rule on managers’ private benefits to zero, and denote managers’ private benefits under the R L rule by > 0 R B . We also assume, contrary to the assumption in the category of insignificantly redistributive rules, that ⋅ − 0 R R Y B -- namely, the R L rule is inefficient. Managers still prefer the inefficient R L rule, since they capture the increase in private benefits produced by the rule but bear only a small fraction α of the reduction in cash flows created by it. The interesting question is whether state competition will result in the adoption of the efficient R H rule, as supporters of state