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. -B<0, so that managers prefer L" over H. The main point is that, with respect to the significantly redistributive rules, there is a conflict of interests between shareholders and managers. While shareholders prefer H over L, managers prefer L over H We further assume that while a.yR-BR<0, yR-B>0- 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 α Y B , so that managers prefer R L over R H . The main point is that, with respect to the significantly redistributive rules, there is a conflict of interests between shareholders and managers. While shareholders prefer R H over R L , managers prefer R L over R H . We further assume that while ⋅ − < 0 R R α Y B , − > 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