Regulatory Competition and the Market for Corporate Law

Ofer Eldar is a doctoral candidate at the Yale School of Management. This post is based on an article authored by Mr. Eldar and Lorenzo Magnolfi, a doctoral candidate at Yale Economics Department. This post is part of the Delaware law series; links to other posts in the series are available here.

There is a longstanding debate in corporate law and governance over the merit of competition for corporate laws. “Race to the top” scholars point to the fact that Delaware, the state where most public firms are incorporated, has laws that are highly responsive to business and has been a laggard in enacting anti-takeover statutes. Proponents of the “race to the bottom” have shown that firms are more likely to incorporate in their home state when that state has adopted more anti-takeover statutes. More recently, they have highlighted the recent rise of firm incorporations in Nevada, following a 2001 Nevada law, which exempts managers from liability for breaching their fiduciary duties. Finally, skeptics of competition argue that it is impossible for states to compete with Delaware by simply replicating its laws, and that relatively few firms reincorporate from one state to another.

In our paper, Regulatory Competition and the Market for Corporate Law, which was recently made publicly available on SSRN, we weigh in on this debate by directly estimating whether firms prefer to be governed by laws that are relatively shareholder-friendly or laws that primarily protect managers’ interests. More importantly, we evaluate whether these preferences are strong enough to generate market shifts when states change their corporate laws. These questions are critical for assessing the direction and intensity of regulatory competition, especially in light of the recent rise of Nevada.

In order to address these questions, we develop a structural model of firms’ incorporation decisions over time, and estimate it using newly formed panel data on public firms’ state of incorporation from 1995-2013. The essence of our model is that heterogeneous firms may choose to incorporate in one of 51 states each year, and states’ laws are treated as bundles of characteristics, such as anti-takeover statutes and laws that protect managers from liability.

There are two main advantages to using a structural choice model (instead of standard reduced form regressions). First, it allows firm heterogeneity in size and institutional shareholding to be reflected in firm preferences. Second, it enables us to consider counterfactuals, particularly where firms would decide to incorporate following changes in states’ laws.

A key feature of the model is that firms’ decisions may be subject to inertia. Given that most firms tend to stay incorporated in the same state, it is unrealistic to treat every firm year observation as a new decision. Thus, we assume that each firm makes an incorporation decision in the first year in which it appears in the data; this year often corresponds to the year in which the firm goes public, when firms often make reincorporation decisions. In the following years, each firm makes a conscious choice regarding its state of incorporation with only some probability. We estimate this probability of choosing from the data. More specifically, firms are subject to “rational” inertia in the sense that the probability of choosing increases (and inertia decreases) when firms face alternative laws that are particularly attractive based on their characteristics and economic conditions. By adding the inertia element, we identify firms’ preferences primarily from those firm year observations in which firms make conscious incorporation decisions, rather than staying in the same state.

Our data is novel in two main respects. First, most existing databases do not include accurate historical information on firms’ states of incorporation. We address this issue by parsing public disclosure documents (10-Ks, 8-Ks and 10Qs) on the SEC website to retrieve accurate historical information on all public firms for which we have financial data. Our final database consists of approximately 80,000 firm year observations and 8,700 firms.

Second, unlike past studies, we focus not only on anti-takeover laws, but also add indices to capture the level of liability protection for directors and officers under each state’s laws. These indices measure the extent to which firms are permitted to exempt and indemnify managers for violating their fiduciary duties. The main motivation for constructing these indices is to assess recent accounts that Nevada has attracted firms by exempting directors and officers from the duty of loyalty.

The main finding of the paper is that inertia in decision-making camouflages the extent to which firms may prefer particular corporate governance provisions. Firms of average size and institutional ownership show strong dislike for protectionist laws, such as anti-takeover statutes, and laws that protect officers from liability. Aversion for these laws is particularly strong for large firms with high institutional shareholding, and it increases when the takeover activity in the relevant industry increases. More importantly, demand for these laws is sufficiently elastic to generate market shifts. Our counterfactual analysis indicates that if Delaware changed its laws to adopt stronger anti-takeover protections, it could lose about 11 percent of its market share and between $35-$70 million in franchise tax per year.

Moreover, we find that the recent shift of firms to Nevada is mainly due to small firms with low institutional shareholding, which prefer strong liability protections for officers. Therefore, Nevada does not seem to create pressure on Delaware to cater to managerial interests, as Delaware’s revenues derive primarily from larger firms that pay higher franchise fees.

To be sure, we do find that there are several factors that make the market for corporate laws relatively static and reduce the likelihood of reincorporations and market shifts. In particular, Delaware derives much of its market power from unobservable benefits, presumably the quality of its courts and network benefits, which we estimate as time-invariant fixed effects. Thus, we show in counterfactuals that states cannot compete with Delaware by copying its statutory code, as many skeptics of competition predict. In fact, we even predict that Nevada would lose market share if it adopted Delaware’s shareholder-friendly laws. Moreover, we find that firm incorporation decisions are subject to significant inertia, and firms have a strong tendency to incorporate in the state where they are located, presumably to benefit from local influence. However, despite these factors, which may make competition somewhat imperfect, our results indicate that there is a significant competitive pressure on Delaware to provide adequate protection to shareholders.

The results further support the view that regulatory competition promotes regulatory diversity by allowing heterogeneous firms to self-select into different corporate governance regimes. While the average firm favors market-oriented laws that give relatively strong protection to shareholders, a segment of small firms have stronger preferences for laws that cater to managerial interests. Although we do not examine in this paper whether firms’ decisions enhance shareholder value, other studies suggest that these decisions are value enhancing for these types of firms. [1]

Finally, our findings cast doubt on policy proposals for adopting a federal corporate law that imposes a uniform standard for all public corporations. These proposals are often based on an empirical assumption that firms prefer laws that favor managerial interests, and that Delaware’s pro-shareholder approach is only due to fear of federal intervention. In contrast, our findings show that Delaware law is in large part shaped by the demand of public firms for good corporate governance laws. This finding is consistent with hypothesis that firms must commit to such laws in order to attract capital.

The full paper is available for download here.


[1] Such studies include: event studies of firm reincorporation that show a positive stock price effect on firm reincorporation (Romano, 1985), the relationship between Delaware incorporation and higher Tobin’s Q (Daines, 2001), and a recent study by one of us that shows that Nevada law does not harm and may actually benefit small firms that self-select into Nevada (Eldar, 2015).
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