The Delaware Trap: An Empirical Study of Incorporation Decisions

One of the most enduring debates in corporate law is whether the United States system of corporate law federalism leads to a “race to the bottom” or a “race to the top.” [1] Race to the bottom theorists argue that because insiders of companies must initiate incorporation decisions, jurisdictions compete to provide legal rules that favor insiders, allowing them to extract private benefits at the expense of the corporation or its shareholders. Race to the top theorists argue that market constraints prevent insiders from favoring such jurisdictions, and that jurisdictions actually compete to provide efficient legal rules that enhance shareholder value. Although the dichotomous framing as a “race” to the “top” or “bottom” is a bit of an oversimplification of a more nuanced debate, that version of the debate has dominated discussions of corporate law for decades.

The standard explanation from race-to-the-top theorists, which largely coincides with the views of large-firm lawyers, is that the substantive quality of Delaware’s law, corporate bar, and judiciary accounts for its dominance. This “conventional wisdom” explanation has been the subject of many scholarly analyses, attempting to analyze the dominance of Delaware in two complementary ways. The first approach looks at the results of the “race,” asking whether Delaware law is better or worse than the law of other states. The idea is that if Delaware law is better, then one could plausibly argue that companies are choosing the more efficient law and that the race is to the top. The second approach has analyzed the jurisdictional choice question by studying the factors that influence how companies make incorporation choices. In other words, what characteristics of companies predict the decisions they will make? The idea is that once one knows what influences corporate choices, one has a good idea of the incentives of competing states. This topic has given rise to an extensive empirical and theoretical literature, but the leading scholarly studies remain largely inconclusive on how companies decide where to incorporate or even whether Delaware law has value relative to the law of other states.

There is another hypothesis that has hovered in the background of many existing studies without receiving direct scholarly attention from most analyses—the role of law firms in incorporation decisions. There is reason to believe that lawyers play a lead role in the jurisdictional choice decision. Lawyers themselves appear to believe they play such a role, and several studies that examining other factors in the incorporation decision have suspected that lawyer identity may be an omitted variable. In particular, several articles have suggested that the local versus national scope of law firms may play a role in the decision to incorporate in Delaware or in the company’s home state. Indeed, the role of lawyers was specifically identified in the context of IPO decisions, where Professor Daines suggested that local firms versus national firms was an important driving factor. [2]

In my paper, The Delaware Trap: An Empirical Study of Incorporation, I attempt to untangle these factors by developing and exploiting a very large dataset containing a diverse mixture of over 60,000 public and private companies over several years. The data is drawn from Securities and Exchange Commission filings relating to Regulation D financing transactions by the companies. Each data point consists of a financing transaction by a company, and includes important information about the company involved, its location and state of incorporation, the type of transaction, the amount of money raised, and certain tell-tale clues about the sophistication of legal counsel involved in the financing, together with dozens of additional data points. These financings provide new variables that have not previously been examined that help to explain the organizational choices of businesses.

The empirical analysis in the paper uncovers a set of demographic variables that may be the strongest predictors of businesses’ jurisdictional choices ever documented in the scholarly literature. In particular, the demographic markers of sophistication of the companies, especially legal sophistication, predict the incorporation decision as well or better than leading predictors identified in existing studies. Companies with more demographic markers of sophistication tend to incorporate in Delaware, while companies with fewer demographic markers of sophistication tend to incorporate in their home states. The data strongly suggest that the sophistication variable is primarily related to the sophistication of legal counsel representing the companies, which means that the choice of the company’s law firm, rather than the legal needs of the company itself, may drive the jurisdictional choice. The result is robust to a wide variety of control variables, suggesting that an important omitted variable has lurked behind the scenes in the state incorporation debate. This analysis provides strong support for the conclusions of Robert Daines in his important work on initial public offerings from fifteen years ago.

The data lend themselves to two potentially divergent interpretations. One is that companies choose sophisticated or unsophisticated legal counsel, and then sophisticated legal counsel choose Delaware and unsophisticated counsel choose local incorporation. This interpretation would indicate that law firms are the key mediators of the choice of jurisdiction. The second is that sophisticated companies choose sophisticated counsel and the sophisticated companies also choose Delaware, independently of the counsel. The data are also consistent with a causal mechanism where sophisticated companies choose sophisticated counsel who then choose Delaware incorporation.

Either interpretation has important implications for analyzing the federal system of corporate law. The first interpretation would lead to an agency cost interpretation of choice of jurisdiction. If the law firms are in control of the incorporation choice, then the ability of law firms to effectively serve clients may be undermined by entrenched patterns of practice that conflict with clients’ needs. The second interpretation would suggest that Delaware companies themselves are different from the companies in other states, making empirical inferences about the value of Delaware law unreliable. If the clients are in control of the incorporation choice, then empirical studies on the value of Delaware law must grapple with the fact that Delaware companies are just “different” from other companies in ways that bias empirical studies of the value of Delaware corporate law.

In either case, the fact that selection of counsel appears to drive the incorporation choice means that the system has a built-in inertia in favor of Delaware that may make state competition illusory. This is because when the initial state chosen at the company’s inception 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.

The full paper is available for download here.

Endnotes

1The classic articles that launched the debate were William L. Cary, Federalism and Corporate Law: Reflections upon Delaware, 83 Yale L.J. 663,663-68 (1974) (arguing that state competition produces a race to the bottom) and Ralph K. Winter, Jr., State Law, Shareholder Protection, and the Theory of the Corporation, 6 J. Legal Stud. 251, 254- 66 (1977) (arguing that state competition produces a race to the top).(go back)

2Robert Daines, The Incorporation Choices of IPO Firms, 77 N.Y.U. L. Rev. 1559 (2002).(go back)