Editor's Note: The following post comes to us from Martijn Cremers, Professor of Finance at the University of Notre Dame, and Simone Sepe of the College of Law at the University of Arizona. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

For at least 40 years, a large body of literature has debated the effects of state competition for corporate charters and the value of state corporate laws. The common assumption of these studies is that interstate competition affects the way state corporate laws respond to managerial moral hazard, i.e., the agency problem arising between shareholders and managers out of the separation of ownership from control (Jensen and Meckling, 1976). Nevertheless, scholars have been sharply divided about the importance of interstate competition, and particularly whether interstate competition fosters a “race to the top” that maximizes firm value (Winter, 1977; Easterbrook and Fischel, 1991; Romano, 1985, 1993) or a “race to the bottom” that pushes states to cater to managers at the expense of shareholders (Cary, 1974; Bebchuk, 1992; Bebchuk and Ferrell, 1999, 2001).

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Limited Commitment and the Financial Value of Corporate Law

The following post comes to us from Martijn Cremers, Professor of Finance at the University of Notre Dame, and Simone Sepe of the College of Law at the University of Arizona. This post is part of the Delaware law series, which is cosponsored by the Forum and Corporation Service Company; links to other posts in the series are available here.

For at least 40 years, a large body of literature has debated the effects of state competition for corporate charters and the value of state corporate laws. The common assumption of these studies is that interstate competition affects the way state corporate laws respond to managerial moral hazard, i.e., the agency problem arising between shareholders and managers out of the separation of ownership from control (Jensen and Meckling, 1976). Nevertheless, scholars have been sharply divided about the importance of interstate competition, and particularly whether interstate competition fosters a “race to the top” that maximizes firm value (Winter, 1977; Easterbrook and Fischel, 1991; Romano, 1985, 1993) or a “race to the bottom” that pushes states to cater to managers at the expense of shareholders (Cary, 1974; Bebchuk, 1992; Bebchuk and Ferrell, 1999, 2001).

Delaware has long been at the core of this debate—as the state firmly holding the dominant share of the (re)incorporation market—especially starting from the early 1980s, due to event studies documenting that financial value is higher for Delaware firms than for firms incorporated elsewhere (Dodd and Leftwich, 1980; Romano, 1985; Peterson, 1988; Netter and Poulsen, 1989; Wang, 1996; Heron and Lewellen, 1998). Consistent with these studies, Robert Daines finds that financial value as measured through Tobin’s Q is higher for Delaware firms than for firms incorporated elsewhere in the cross-section of firms (Daines, 2001). Supporters of the race to the bottom view, however, have argued that both sets of studies fail to provide conclusive evidence on the higher financial value of Delaware law, due to both methodological and endogeneity concerns (Bebchuk and Ferrell, 2001; Gompers, Ishii, and Metrick, 2003; Subramanian, 2002; Bebchuk, Cohen, and Ferrell, 2002).

In our paper, Whither Delaware? Limited Commitment and the Financial Value of Corporate Law, which was recently made publicly available on SSRN, we provide novel evidence concerning the association between firm value (as measured by Tobin’s Q) and (re)incorporation, both in and out of Delaware and other U.S. states. Using a panel of over 10,000 U.S. firms for the period 1994-2012 and over 80,000 firm-year observations—hence employing a database with historical incorporation information for all publicly traded firms in the U.S.—we first document that the cross-sectional Delaware incorporation effect is positive only in the 1990s (associated with 8% higher Q, confirming the result in Daines, 2001), negative in the 2000s (associated with 4% lower Q), and statistically insignificant during the full 1994-2012 period.

Our next main new finding is that in the time series the Delaware reincorporation effect has a negative association with financial value, at economically and statistically significant levels, while reincorporation in managerial-friendly legislations (i.e., “Managerial States”) has a substantial economically and statistically significant positive association with firm value. This comparison group of 19 “Managerial States” consists of jurisdictions whose state law can be distinguished from Delaware law based on the adoption of more restrictions on shareholder rights and the market for corporate control, typically in the form of more stringent antitakeover statutes.

These time series results are identified from 560 firms reincorporating into or out of Delaware versus any of the Managerial States. Using pooled panel Tobin’s Q regressions with firm fixed effects, reincorporation into Delaware is associated with a decrease in Tobin’s Q of 26% (t-statistic of 4.85), while reincorporation into a Managerial State is associated with an increase in Tobin’s Q of 25% (t-statistic of 4.06). Regressions using changes in Tobin’s Q on changes in the state of incorporation give similar results.

We then attempt to reconcile the insignificant cross-sectional Delaware incorporation result in the full sample with the negative time series Delaware reincorporation result. We do so by showing that firm value is partly endogenous to both incorporation (i.e., at the IPO stage) and reincorporation (i.e., after the IPO stage) decisions, indicating that already valuable firms are more likely to (re)incorporate into Delaware rather than Delaware law causing firms to have a higher financial value.

Our new time series results challenge the view that Delaware law improves firm value, while at the same time raising the question of how one could interpret the positive association between firm value and reincorporation in Managerial States. We propose and test the hypothesis that the corporate laws of Managerial States provide a better response to two agency problems—namely the limited commitment problem and the moral hazard problem—and the tradeoff between them. These twin agency problems both arise from the separation of ownership and control in the context of asymmetric information and incomplete contracts. Whereas the moral hazard problem focuses on potential conflicts of interest between managers and shareholders, the limited commitment problem concerns potential conflicts of interests between public shareholders and other stakeholder groups such as directors and top management, employees, bondholders, preferred equity holders, and customers (see Mayer, 2013, for a book-length survey and discussion).

The limited commitment of the shareholders in publicly traded companies comes from their ability to sell their shares whenever this benefits them, resulting in a change in control and/or investment policy and, hence, making their commitment to longer-term investment horizons not credible to other stakeholders (Agrawal and Knoeber, 1996; Cremers, Litov, and Sepe, 2014). For example, shareholders may accept an LBO or a significant takeover premium, which may result in a significant loss to bondholders and other stakeholders (Billet, King, and Mauer, 2004; Cremers, Nair, and Wei, 2007; Warga and Welch, 1993). As another example, shareholders may have limited incentives to be fully informed or evaluate the performance of top management over longer time periods, endangering the corporation’s ability to engage in long-term research and development (Stein, 1988, 1989; Mizik and Jacobson, 2007; Edmans, 2009; Bushee, 1998).

The potential exit of shareholders in the short-term complicates the longer-term commitments that corporations need to sustain with other stakeholder groups. Indeed, in response to the limited commitment from the shareholders, other stakeholders are likely to increase the cost of their involvement and/or reduce the level of their investment (Francis, Hasan, John, and Waisman, 2010), resulting in lower firm value. Viewed through this lens, Managerial States that reduce shareholder rights and further remove directors from takeover pressure—and hence reduce the likelihood that shareholder exit may result in a change in control and investment policy—might be better equipped to constrain a firm’s commitment problem than jurisdictions like Delaware, which has less restrictive anti-takeover laws and which allows wider discretion for shareholders to pressure management and the board (Daines, 2001; Coates, 2001; Romano, 2001).

On the other hand, stronger shareholder rights and greater exposure to the market for corporate control reduce managerial entrenchment and thus lessen the moral hazard problem. The ensuing trade-off between these twin agency problems suggests that incorporation in a Managerial State could involve higher agency costs from increased managerial moral hazard due to the board’s greater insulation from disciplining market forces. Nevertheless, the positive effect on firm value we document in the time series for firms reincorporating into a Managerial State seems to indicate that such an increase in moral hazard is more than compensated by the benefits accruing from more strongly committing all stakeholders to the corporation, which thus empirically emerges as the dominant corporate agency problem.

We test our hypothesis about the implications of the twin agency problems using a variety of firm-level proxies for the respective importance of each problem and the tradeoff between them. As we do not have exogenous variation in reincorporation decisions, our main identification in our empirical tests rests on identifying those firms where the limited commitment problem vis-à-vis the moral hazard problem seems especially relevant. In addition, we try to further mitigate endogeneity concerns by focusing on industry-level proxies or proxies for firm-level characteristics that are less at the discretion of management.

Empirically, we find strong evidence that the increased financial value for firms reincorporating into Managerial States and/or reincorporating out of Delaware is driven by firms where the limited commitment problem seems most relevant. In particular, the increase in Tobin’s Q after such reincorporations is considerably higher for firms engaged in R&D, for firms with a large customer, for firms in industries requiring relationship-specific investments, and for firms in relationship industries.

Further, our analysis of the tradeoff between the twin agency problems seems to confirm that the limited commitment problem dominates the moral hazard problem. First, while the negative (positive) association of reincorporation in Delaware (Managerial States) is lower in periods of significant M&A activity, the economic effect is limited and the overall effect still remains negative (positive) at economically and statistically significant levels. This result suggests that while Delaware firms might benefit more (relative to Managerial States firms) from reduced managerial moral hazard upon increases in M&A activity, moral hazard remains an economically minor problem with a second order economic association relative to the limited commitment problem. Second, the value of firms with an institutional block owner declines (increases) more after that firm reincorporates into Delaware (a Managerial State) than firms without such block owner. Again, this result supports our hypothesis that the limited commitment problem is the primary channel through which state corporate law influences firm value. Board insulation also seems unrelated to a board’s propensity to replace the CEO after poor performance, as we document that incorporation in a Managerial State does not decrease the likelihood and performance sensitivity of either voluntary or forced CEO turnover relative to incorporation in Delaware.

In conclusion, our analysis suggests that state corporate law only matters to a firm’s financial value when the limited commitment problem is relevant, implying that governance features that promote substantial board insulation should significantly reduce (or, potentially, eliminate) the negative Delaware effect we document. In support of this, the negative Delaware effect is substantially lower for firms with weaker shareholder rights (i.e., more antitakeover defenses as proxied by the G-Index) and disappears for firms with a controlling shareholder (as proxied by the issuance of dual class stock).

The full paper is available for download here.

 

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