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E-MailPeter Molk is associate professor of law at the University of Florida Levin College of Law. This post is based on a recent paper by Professor Molk, forthcoming in the Iowa Law Review.
Delaware’s dominance in the race for publicly traded company incorporations is well known. Its success in attracting other types of entities, however, is less understood but no less important. In my paper Where Nonprofits Incorporate and Why It Matters, I study the incorporation behavior of nonprofits, a trillion dollar industry that employs twelve million people and includes some of the most well-known organizations in the world. I find evidence that nonprofits, like publicly traded firms, engage in intentional and strategic incorporation decisions, although at a lower rate. I also find that nonprofits’ incorporation decisions are more consistent with choosing states that maximize nonprofits’ agency costs, rather than minimize them, representing a potential “stroll to the bottom” among nonprofit corporations. The findings raise policy issues about the state of nonprofit law and regulation that I address with attainable, evidence-based solutions.
My paper has three goals. First, I develop the theoretical case for strategic nonprofit incorporations. Just as the state of incorporation can affect publicly traded firms’ cost of capital and therefore their competitive advantage, so too can it affect nonprofits’ operations. Like with traditional corporations, nonprofits’ incorporation state determines the law that governs internal disputes and the courts that often decide those disputes. This can affect nonprofits’ capital costs; although nonprofits lack investors, they often rely as a substitute on capital donations from external donors. If a state’s law and courts offer donors strong protections—such as by imposing efficient fiduciary duties on management, providing donor standing to sue, or requiring company policies on conflicted transactions and whistleblower complaints—then nonprofits that incorporate in that state could achieve lower capital costs through higher donations. The incorporation state also determines which state attorneys general have oversight responsibility for the nonprofit’s operations, which can also impact nonprofit operations. State attorneys general are charged with primary responsibility for policing nonprofits’ operations, so incorporating in a state with strong oversight could enhance donors’, employees’, customers’, and suppliers’ trust in the nonprofit, increasing the firm’s market advantage. As a matter of organizational theory, therefore, nonprofits should prefer to incorporate in some states over others, just as with publicly traded corporations.
Next, I empirically examine nonprofits’ incorporation decisions to gauge how theory corresponds to actual behavior. I analyze the incorporation choices of 300,000 charitable nonprofits from 2010 through 2019 (the entirety of nonprofits filing IRS Form 990 during this time), resulting in 1.6 million firm-year observations. Over this period, most nonprofits incorporate in their headquarters state, with only 5% incorporating in another state. This number is, of course, much smaller than the rate for publicly traded corporations, although it still represents a meaningful swath of nonprofit activity. When I restrict the analysis to nonprofits that incorporate out-of-state, several noteworthy findings emerge. First, like with publicly traded firms, Delaware is the most popular choice with a 17% share of these incorporations, but other jurisdictions including Washington, D.C., California, and New York are not far behind. Next, the likelihood of incorporating out-of-state increases with factors that signal higher potential agency costs (firm size) and decreases with factors that signal lower potential agency costs (more internal and external monitors). Finally, incorporating out-of-state is associated more with increasing agency costs, rather than with controlling them. When firms change their incorporation state, two of four measures of nonprofit agency costs increase, while only one decreases. And, after New York’s 2014 statutory amendments increased oversight, firms were more likely to reincorporate out of New York than other states, and those firms’ agency costs increased after reincorporating.
The two principal empirical findings of my paper—that the rate of strategic nonprofit incorporations is low, and that incorporating out-of-state is more consistent with increasing agency costs than diminishing them—present a need for policy responses. Theory suggests potentially significant welfare gains if more nonprofits factored the implications of incorporation choice into their decision-making, and if nonprofits chose incorporation states to minimize agency costs. These twin goals can be achieved in several ways.
For instance, nonprofit rating agencies like GuideStar and Charity Navigator could integrate incorporation choice into their ratings decisions. This solution is particularly effective if nonprofits and stakeholders suffer from low awareness about the incorporation decision’s importance. Or, monitoring state attorneys general could account for the incorporation state when deciding how to allocate their oversight resources, paying more attention to nonprofits that incorporate in states that facilitate higher agency costs. These and other solutions could incentivize nonprofits, like publicly traded firms, to appreciate and internalize the incorporation state’s significance for their operations, resulting in more intentional incorporation decisions that reduce agency costs and improving nonprofit governance and operations across the industry.
The complete paper is available for download here.
