competition believe or rather the inefficient L rule will be adopted, as critics contend. The claim that we seek to examine does not assert that competition would produce big inefficiencies but rather that its outcomes would be biased in thei favor. To explore the possibility of such bias, we will assume that the inefficiency costs of the L rule are not too large in a sense to be more precisely defined below 2.3.3. Price A state's strategy will also include the price P>0 that each company incorporated in the state will have to pay. The price consists of the incorporation tax and all other payments to institutions and citizens of the state as a result of the incorporation including court fees, fees paid to members of the local bar, and so forth. Prior literature, which has assumed that maximization of profits from incorporations is synonymous with maximization of the number of incorporations, has implicitly assumed that the revenue to the state from each company is exogenously fixed. A complete analysis of our subject, however, should not take price to be exogenous, and we shall therefore include price as an element of each states strategy. At the same time, we shall allow for the possibility that political forces might impose an exogenous bound on the price.6 2.4 T=2: Incorporation Decisions At T=2, the m companies choose their state of incorporation, making a choice between remaining where they were initially incorporated and reincorporating in another state. The companies move sequentially in a randomly selected order. Let t l,, m denote the rounds within period T=2, in which the m companies choose their state of incorporation(in random order), and let t=0 denote the period before the first company moves At t=0, the companies are assumed to know the strategies chosen by the different states at T=1.7 It is assumed that reincorporation involves no transaction costs. The procedure for reincorporation is assumed to be the one that has been long established under US corporate law. The managers must initiate a reincorporation, making a proposal to the shareholders; if the shareholders approve, the company will move. Thus, 6 Our analysis can be extended, with little change in the results, to the case in which the price cannot go below a certain positive level because, even if the franchise tax is set at zero, the state's lawyers will make some profits from the presence of incorporations. 7 As explained in section 2.5 below, there are two types of companies- those that benefit from a legal infrastructure and from network externalities those that do not derive such benefits it is assumed that at t=0 the companies know their tyl 9
9 competition believe, or rather the inefficient R L rule will be adopted, as critics contend. The claim that we seek to examine does not assert that competition would produce big inefficiencies but rather that its outcomes would be biased in their favor. To explore the possibility of such bias, we will assume that the inefficiency costs of the R L rule are not too large in a sense to be more precisely defined below. 2.3.3. Price A state’s strategy will also include the price P ≥ 0 that each company incorporated in the state will have to pay. The price consists of the incorporation tax and all other payments to institutions and citizens of the state as a result of the incorporation – including court fees, fees paid to members of the local bar, and so forth. Prior literature, which has assumed that maximization of profits from incorporations is synonymous with maximization of the number of incorporations, has implicitly assumed that the revenue to the state from each company is exogenously fixed. A complete analysis of our subject, however, should not take price to be exogenous, and we shall therefore include price as an element of each state’s strategy. At the same time, we shall allow for the possibility that political forces might impose an exogenous bound on the price.6 2.4 T = 2: Incorporation Decisions At T = 2, the m companies choose their state of incorporation, making a choice between remaining where they were initially incorporated and reincorporating in another state. The companies move sequentially in a randomly selected order. Let t = 1,...,m denote the rounds within period T = 2, in which the m companies choose their state of incorporation (in random order), and let t = 0 denote the period before the first company moves. At t = 0, the companies are assumed to know the strategies chosen by the different states at T = 1.7 It is assumed that reincorporation involves no transaction costs. The procedure for reincorporation is assumed to be the one that has been long established under US corporate law. The managers must initiate a reincorporation, making a proposal to the shareholders; if the shareholders approve, the company will move. Thus, 6 Our analysis can be extended, with little change in the results, to the case in which the price cannot go below a certain positive level because, even if the franchise tax is set at zero, the state’s lawyers will make some profits from the presence of incorporations. 7 As explained in section 2.5 below, there are two types of companies – those that benefit from a legal infrastructure and from network externalities and those that do not derive such benefits. It is assumed that at t = 0 the companies know their type
reincorporation will occur if and only if both managers and shareholders wish reincorporate. Furthermore managers have the power to make take-it-or-leave-it offers to the shareholders. as a result, if reincorporation in either one of two states is superior to the present incorporation, the managers can direct reincorporation to the state that the managers prefer We make several tie-breaking assumptions. When managers are indifferent between incorporating in the companys home state and another state, they will prefer the home state. If managers are indifferent between reincorporating in two states none of which is the companys home state, they will choose each one of the two states with a probability of fifty percent. Finally, we assume that, if shareholders are indifferent between accepting and rejecting a proposal by management, they will accept it 2.5 T=3: Payoffs At this stage, all players will receive their payoffs. The cash flows of a company that chooses to incorporate in state i will be Y=X+·E(k,m)+xA+YF-P where Yo represents the element of a companys cash flows that is independent of the legal system; Y and y represent the effects of the non-distributive and the distributive rules, respectively; P represents the franchise tax and other charges, and E(k, m,) represents the benefits flowing from the state's legal infrastructure and network externalities Companies do not benefit equally from a legal infrastructure or from network externalities. In particular to some companies the benefit of remaining incorporated in their"home"states may outweigh the increased cash flows generated by another states legal infrastructure and network externalities. For simplicity, we capture this effect by assuming that a company j is characterized by a parameter 8, eo, 1),which determines whether or not the company benefits from infrastructure and network externalities. It is assumed that the share 8 of companies that do not benefit from infrastructure and networks, i.e. companies with 8=0, is smaller than 0.5
10 reincorporation will occur if and only if both managers and shareholders wish to reincorporate. Furthermore, managers have the power to make take-it-or-leave-it offers to the shareholders. As a result, if reincorporation in either one of two states is superior to the present incorporation, the managers can direct reincorporation to the state that the managers prefer. We make several tie-breaking assumptions. When managers are indifferent between incorporating in the company’s home state and another state, they will prefer the home state. If managers are indifferent between reincorporating in two states none of which is the company’s home state, they will choose each one of the two states with a probability of fifty percent. Finally, we assume that, if shareholders are indifferent between accepting and rejecting a proposal by management, they will accept it. 2.5 T=3: Payoffs At this stage, all players will receive their payoffs. The cash flows of a company that chooses to incorporate in state i will be: i R i NR Yi = Y0 + δ j ⋅ E(ki ,mi) + Yi + Y − P , where Y0 represents the element of a company’s cash flows that is independent of the legal system; NR Yi and R Yi represent the effects of the non-distributive and the distributive rules, respectively; Pi represents the franchise tax and other charges; and ( , ) i mi E k represents the benefits flowing from the state’s legal infrastructure and network externalities. Companies do not benefit equally from a legal infrastructure or from network externalities. In particular, to some companies, the benefit of remaining incorporated in their “home” states may outweigh the increased cash flows generated by another state’s legal infrastructure and network externalities. For simplicity, we capture this effect by assuming that a company j is characterized by a parameter δ j ∈{ } 0,1 , which determines whether or not the company benefits from infrastructure and network externalities. It is assumed that the share δ of companies that do not benefit from infrastructure and networks, i.e. companies with δ j = 0 , is smaller than 0.5
Legal infrastructure increases the cash flows of 8 =1 companies incorporated aE(k in a state with such an infrastructure. Hence, 1>0.8 The effect of the legal k environment in Delaware is denoted E(K, mp), even though Delawares investment in establishing an infrastructure is considered sunk in the present framework. However, potentially more important than the legal infrastructure are network externalities, which arise when many companies choose to incorporate in one specific state. These positive externalities include familiarity of the legal community and the participants in capital markets with the rules of that state as well as the generation of a larger body of precedents, both of which can operate to increase the value of the companys securities to investors(see Klausner(1995)and Kahan and Klausner(1997). Formally, we assume that the network externalities effect in state i is increasing in the number of companies, which are incorporated in state i, m,,i.e dE(K,, m,) 212>0.9 Finally, let E=E(K, (1-5).m) denote the maximal level of benefits from a legal infrastructure and network externalities--i. e, the level that would be enjoyed by companies that benefit from such institutional advantages if all such companies were incorporated in the same state(which, as we shall see is what would happen in equilibrium). Given our interest in exploring the possibility of the adoption of rules somewhat (rather than hugely) tilted in favor of managers, we will assume that E outweighs the potential inefficiency on the r rule dimension, Y The shareholders will receive their fraction of the companys cash flows, (1-a).Y. The manager will receive the private benefits of control in addition to their fraction of the cash flows, and they will thus get a Y+ B Each state will receive the revenues if any from the incorporations it will ha at the final T=3 stage. The state will get the price it set for incorporated companies, P, multiplied by the number of companies which end up incorporated in the state at the end of the T= 2 stage of (re)incorporation decisions 8 We assume that a legal infrastructure is efficient to establish, i.e. the per-company value of an infrastructure exceeds the per-company cost of establishing an infrastructure(at least if all of the 8 =1 companies benefit from the infrastructure): E(K, (1-8).m)-E(0, (1-8).m)>K 9 We assume that the number of 8,=0 companies incorporated in any non-Delaware state at T=0 is insufficient to produce a positive level of network externalities
11 Legal infrastructure increases the cash flows of δ j = 1 companies incorporated in a state with such an infrastructure. Hence, 0 ( , ) > ∂ ∂ i i i k E k m .8 The effect of the legal environment in Delaware is denoted ( , ) E K mD , even though Delaware’s investment in establishing an infrastructure is considered sunk in the present framework. However, potentially more important than the legal infrastructure are network externalities, which arise when many companies choose to incorporate in one specific state. These positive externalities include familiarity of the legal community and the participants in capital markets with the rules of that state, as well as the generation of a larger body of precedents, both of which can operate to increase the value of the company’s securities to investors (see Klausner (1995) and Kahan and Klausner (1997)). Formally, we assume that the network externalities effect in state i is increasing in the number of companies, which are incorporated in state i, mi , i.e. 0 ( , ) > ∂ ∂ i i i m E k m .9 Finally, let E = E(K,(1− δ )⋅ m) denote the maximal level of benefits from a legal infrastructure and network externalities -- i.e., the level that would be enjoyed by companies that benefit from such institutional advantages if all such companies were incorporated in the same state (which, as we shall see, is what would happen in equilibrium). Given our interest in exploring the possibility of the adoption of rules somewhat (rather than hugely) tilted in favor of managers, we will assume that E outweighs the potential inefficiency on the R rule dimension, R Y . The shareholders will receive their fraction of the company’s cash flows, ( ) Yi 1−α ⋅ . The manager will receive the private benefits of control in addition to their fraction of the cash flows, and they will thus get R Yi + Bi α ⋅ . Each state will receive the revenues, if any, from the incorporations it will have at the final T=3 stage. The state will get the price it set for incorporated companies, P, multiplied by the number of companies which end up incorporated in the state at the end of the T = 2 stage of (re)incorporation decisions. 8 We assume that a legal infrastructure is efficient to establish, i.e. the per-company value of an infrastructure exceeds the per-company cost of establishing an infrastructure (at least if all of the δ j = 1 companies benefit from the infrastructure): ( )( ) m K E K m E m − ⋅ − ⋅ − − ⋅ > (1 ) ,(1 ) 0,(1 ) δ δ δ . 9 We assume that the number of δ j = 0 companies incorporated in any non-Delaware state at T=0 is insufficient to produce a positive level of network externalities
2.6 States'objectives With respect to the decision whether to establish a legal infrastructure, as well as with respect to the pricing strategy, states are assumed to seek to maximize their T=3 revenues. Also, as a tie-breaking assumption, we assume that between two outcomes that provide the state with the same revenues, the state will prefer to have an outcome in which more companies are incorporated in that state With respect to the legal rules states will also be assumed to maximize revenues(and, as a tie-breaker, maximize the number of incorporations). However, we shall also explore below the possibility that some states are not interested in revenues from incorporations(Bebchuk and Hamdani(2002), Kahan and Kamar (2002). In order to capture this potential heterogeneity, we will allow for states that deviate from the equilibrium revenue maximizing r rule( there is no reason to expect heterogeneity in the Nr category). Specifically, we assume that if such deviations occur they are adopted by at least two(non-Delaware)states. We refer to such states as "deviating states". Even when we permit for such deviations, we shall assume that Delaware does seek to maximize revenues from incorporations 3. The market Equilibrium This section presents our results concerning the equilibrium outcome in the market for corporate law and the intuition underlying these results. The following proposition describes the equilibrium in the market Proposition 1: The market for corporate law has a unique equilibriun that has the following atures (1) All of the states choose the rule favored by shareholders with respect to the insignificantly redistributive issue(NR)--H 2)The dominant state of Delaware chooses the inefficient L rule with respect to th significantly redistributive issue(R) (3)With respect to the significantly redistributive issue(R), any state other than delaware that chooses rules in order to attract incorporations chooses the inefficient LK rule.(By assumption, if there are deviating states that do not choose legal rules this way, these states will choose the efficient H rule)
12 2.6 States’ Objectives With respect to the decision whether to establish a legal infrastructure, as well as with respect to the pricing strategy, states are assumed to seek to maximize their T = 3 revenues. Also, as a tie-breaking assumption, we assume that between two outcomes that provide the state with the same revenues, the state will prefer to have an outcome in which more companies are incorporated in that state. With respect to the legal rules, states will also be assumed to maximize revenues (and, as a tie-breaker, maximize the number of incorporations). However, we shall also explore below the possibility that some states are not interested in revenues from incorporations (Bebchuk and Hamdani (2002), Kahan and Kamar (2002)). In order to capture this potential heterogeneity, we will allow for states that deviate from the equilibrium revenue maximizing R rule (there is no reason to expect heterogeneity in the NR category). Specifically, we assume that if such deviations occur they are adopted by at least two (non-Delaware) states. We refer to such states as “deviating states”. Even when we permit for such deviations, we shall assume that Delaware does seek to maximize revenues from incorporations. 3. The Market Equilibrium This section presents our results concerning the equilibrium outcome in the market for corporate law and the intuition underlying these results. The following proposition describes the equilibrium in the market: Proposition 1: The market for corporate law has a unique equilibrium that has the following features: (1) All of the states choose the rule favored by shareholders with respect to the insignificantly redistributive issue (NR)-- NR H . (2) The dominant state of Delaware chooses the inefficient R L rule with respect to the significantly redistributive issue (R). (3) With respect to the significantly redistributive issue (R), any state other than Delaware that chooses rules in order to attract incorporations chooses the inefficient R L rule. (By assumption, if there are deviating states that do not choose legal rules this way, these states will choose the efficient R H rule)
(4) The dominant state of Delaware sets the highest possible price that (i) preempts a potential rival from entering and establishing a competing legal infrastructure, (ii) makes reincorporation to it still profitable for all the companies that benefit from a legal infrastructure and from network externalities (i.e. commpanies with 8 =1), and (ii) does not exceed the politically imposed price cap P. Formally K PD mIn E-y. P (5) Delaware makes a positive profit from its incorporation business (6)Delaware does not capture the full value of the benefits it confers on companies incorporated in it () States that at t=0 do not have a legal infrastructure, i.e. all states other than delaware do not invest in establishing a legal infrastructure, i.e. kiaD =0 (8)All states, other than Delaware, set a price of zero, i.e. Pi2D =0 (9)All of the commpanies that benefit from a legal infrastructure and network externalities will be incorporated in delaware (10) The companies that reincorporate in Delaware enjoy an increase in their share value (11) Among non-Delawoare states, if there are deviating states, then the states that choose the rule favored by managers with respect to the significantly redistributive issue(R),L, will enjoy more incorporations than the deviating states that choose the rule favored by shareholders with respect to the significantly redistributive issue(R), H The results stated in proposition 1 are proved in appendix A. Below we describe the underlying intuition for each of the eleven features of the identified equilibrium and discuss the implications of the results 3.1 Efficient Choice of Rules concerning Insignificantly Redistributive Issues Since both managers and shareholders prefer h over L, a state that sets L will have no company incorporated in it at T=3. Consider two states that differ only on the nr dimension with the first state setting L and the second state
13 (4) The dominant state of Delaware sets the highest possible price that (i) preempts a potential rival from entering and establishing a competing legal infrastructure, (ii) makes reincorporation to it still profitable for all the companies that benefit from a legal infrastructure and from network externalities (i.e. companies with δ j = 1), and (iii) does not exceed the politically imposed price cap, P . Formally: − − ⋅ = E Y P m K P R D , , (1 ) min δ . (5) Delaware makes a positive profit from its incorporation business. (6) Delaware does not capture the full value of the benefits it confers on companies incorporated in it. (7) States that at T=0 do not have a legal infrastructure, i.e. all states other than Delaware, do not invest in establishing a legal infrastructure, i.e. ki≠D = 0 . (8) All states, other than Delaware, set a price of zero, i.e. Pi≠D = 0. (9) All of the companies that benefit from a legal infrastructure and network externalities will be incorporated in Delaware. (10) The companies that reincorporate in Delaware enjoy an increase in their share value. (11) Among non-Delaware states, if there are deviating states, then the states that choose the rule favored by managers with respect to the significantly redistributive issue (R), R L , will enjoy more incorporations than the deviating states that choose the rule favored by shareholders with respect to the significantly redistributive issue (R), R H . The results stated in proposition 1 are proved in appendix A. Below we describe the underlying intuition for each of the eleven features of the identified equilibrium and discuss the implications of the results. 3.1 Efficient Choice of Rules concerning Insignificantly Redistributive Issues Since both managers and shareholders prefer NR H over NR L , a state that sets NR L will have no company incorporated in it at T = 3. Consider two states that differ only on the NR dimension with the first state setting NR L and the second state