May 8, 2017 | By Kylie Larkin — Professor Robert Anderson‘s forthcoming article, “The Delaware Trap: An Empirical Study of Incorporation Decisions,” (SSRN) is featured in today’s Wall Street Journal, “A ‘Delaware Trap’ for Companies: Where firms incorporate, says a study, might not be based on what’s best for shareholders.”
Excerpt of “A ‘Delaware Trap’ for Companies” — The Wall Street Journal:
What incorporates in Delaware stays in Delaware.
More than half of publicly traded U.S. companies incorporate in the small state, regardless of their headquarters location, and once there they rarely leave. That is generally because once incorporated, it is difficult to get shareholders and management to agree on a new state of incorporation, says Robert Anderson IV, an associate professor of law at Pepperdine University School of Law.
In a new study, Dr. Anderson examines why so many companies land in what he dubs “the Delaware Trap.”
There have long been two competing theories on what motivates companies’ incorporation decisions. The “race to the bottom” theory holds that states compete by making rules that favor company insiders at the expense of corporations and their shareholders.
The “race to the top” theory, in contrast, suggests that market constraints prevent such favoritism, and that states instead compete to provide efficient legal rules that enhance shareholder value.
But Dr. Anderson examined regulatory filings related to raising private capital, and concluded that it is all about the company’s choice of law firm near the time of founding.
The complete article may be found at www.wsj.com (subscription required)
Abstract of “The Delaware Trap: An Empirical Study of Incorporation Decisions”:
One of the most enduring debates in corporate law centers on why Delaware has become the dominant state in the market for corporate charters. Traditionally, two perspectives dominated the debate, the “race to the top” perspective that sees competition among states as driving legal rules toward efficiency and the “race to the bottom” perspective that sees competition among states as driving legal rules toward the interests of corporate managers. The two dominant perspectives have struggled to explain why approximately half of companies incorporate in Delaware, while the other half incorporate in their home states. Whether the choices are attributable to the quality of state law or to characteristics of the companies themselves or both has given rise to a large, but inconclusive empirical literature.
This Article uses a large dataset of corporate financings to shed new light on this mystery and uncovers strong evidence that some of the strongest factors in incorporation choice are factors unrelated to either the quality of state law or the characteristics of individual companies. Instead, the data strongly suggest that demographic markers of sophistication, such as choice of law firm and headquarters location, predict the jurisdictional choice about as well as state law or the business attributes of companies. Companies with more demographic markers of sophistication tend to choose Delaware incorporation, and companies with fewer demographic markers of sophistication tend to choose home-state incorporation. The finding persists even when other attributes of the company are controlled for, such as its industry classification, the amount of money raised, or whether the company is public or private. Indeed, the sophistication factors arguably predict Delaware incorporation as well or better than any factors documented in the vast literature on state competition for corporate charters.
The findings have important implications for the state “race-to-the-top” debate in corporate law. At a minimum the results in this Article make it clear that the choice of legal representation is an important missing variable in models of incorporation decisions. The fact that the choice of law firms drives the jurisdictional choice has far broader implications. If law firms drive the jurisdictional choice they may steer companies toward states that serve the law firms’ own interests without regard to the quality of legal rules or the needs of the client. When the state chosen is Delaware, as it often is, there are few alternative jurisdictions that shareholders and managers can agree on. As a result, companies inadvertently fall into a “governance trap” from which reincorporation out of state is nearly impossible. This interpretation would suggest that Delaware’s carefully calibrated positioning in the charter market has largely eliminated meaningful competition among the states for the quality of corporate law.