The State of State Competition for Incorporations

Marcel Kahan is the George T. Lowy Professor of Law at the New York University School of Law.

The competition by states for incorporations has long been the subject of extensive scholarship. Views of this competition differ radically. While some commentators regard it as “The Genius of American Corporate Law,” others believe it leads to a “Race to the Bottom” and yet others have taken the position that it barely exists. Despite this lack of consensus among corporate law scholars, scholars in other fields have treated state competition for incorporations as a paradigm case of regulatory competition.

I try to deconstruct the state competition debates by showing that, in fact, scholars are engaged in three separate debates that are only loosely connected to each other. The first, “directional” debate concerns whether firms, if given a choice, will chose corporate law rules that maximize shareholder value, maximize managerial benefits, something in between, or something else entirely. Resolution of this question is relevant regardless of whether states “compete.” All it takes to make this question important is for firms to have a meaningful choice among legal rules. Such choice can exist, even in the absence of state competition, as long as states offer different legal rules or even when a single legal regime offers firms flexibility in devising their governance rules.

The second, “competition” debate concerns whether, how, and which states compete for incorporations. Depending on what is meant by “competition”, competition can exist even in a regime where firms have no choice over where they incorporate and may not exist in a regime where firms have free choice. Depending on how many states compete, what competitive strategy should Delaware—the one state that clearly tries to attract incorporations—pursue and what forces shape the laws of non-competing states?

The third, “federalism” debate concerns the desirability of federal corporate law as an alternative to the present regime, where many corporate law rules are determined by the law of the firm’s state of incorporation. How such a law would stack up in absolute terms along various dimensions—pro-shareholder versus pro-manager, concern for other constituents such as creditors and employees, speed of adopting innovations, and so on—is a question that is entirely separate from the earlier two debates.

In pursuing their arguments, partisans of the “race to the top” and “race to the bottom” schools have often failed to distinguish between various settings in which firms chose governance rules and treated evidence that is relevant to one of the three debates as bearing on a different debate. As a result, both the theoretical underpinnings of the various positions in the debates and their empirical support are not always made clear. In fact, neither the theoretical arguments nor the empirical evidence on the most debated issue—whether and to what extent a mandatory federal regime should replace enabling state laws—are even close to conclusive.

Absent clear evidence that federal law would be superior to the current system, one may be inclined not to advocate any major changes. For one, the devil we know may be better than the devil we don’t know. The legal regime chosen by most firms—Delaware law—works at least tolerably well. So why take a chance and replace it with some unknown federal rules. Moreover, the current system has at least the feature that, if the political process for some reason produces a deficient law, companies can opt into a different regime.

This suggests that commentators should focus on how to improve the present regime that permits a substantial degree of firm choice, rather than on how to replace it. To the extent that firm choice has features that cause firms to choose sub-optimal law, how can one change these features? To the extent that more competition among states would be desirable, how can one induce states to compete? To the extent that matters of corporate law are regulated by federal rules, how can one improve the structure of these rules?

The full article is available for download here.

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