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))