Regulatory Competition And The Market For Corporate Law

Ofer Eldar

Yale School of Management – Finance Department; Yale Law School

Lorenzo Magnolfi

Yale University, Department of Economics, Students

November 14, 2015

Yale Law & Economics Research Paper No. 528


This paper develops an empirical model of firms’ choice of corporate laws under inertia. Delaware dominates the incorporation market, though recently Nevada, a state whose laws are highly protective of managers, has acquired a sizable market share. Using a novel database of incorporation decisions from 1995-2013, we show that most firms dislike protectionist laws, such as anti-takeover statutes, and that Nevada’s rise is due to the preferences of small firms. Our estimates indicate that, although it is impossible for states to compete with Delaware by copying its laws, Delaware would lose market share and revenues if it adopted protectionist laws.

Regulatory Competition And The Market For Corporate Law – Introduction

There is a longstanding debate in corporate law and governance over the merit of competition for corporate laws. U.S. firms may choose to incorporate in any state, and each state’s corporate laws may embed a different set of corporate governance rules. The debate has traditionally been divided between those who believe competition for charters produces efficient corporate laws that maximize firm value (e.g., Winter, 1977; Romano, 1985; Easterbrook & Fischel, 1991; Romano, 1993a), and others who argue that legal regimes produced by state competition benefit managers at the expense of shareholders’ interests (e.g., Cary, 1974; Bebchuk, 1992; Bebchuk & Ferrell, 1999; Bar-Gill, et al., 2006; Barzuza, 2012). Delaware famously dominates the market for incorporations (with more than 60 percent of total incorporations). Proponents of regulatory competition emphasize that Delaware, a state that  offers laws that facilitate takeover activity and has a specialized judiciary known for its corporate law expertise, is the winner of this race. Critics on the other hand emphasize that many states manage to retain large domestic corporations by offering anti-takeover laws that protect managers, and point to the recent rise in the market share of Nevada, a state that offers very protectionist laws that exempt managers from liability for breach of fiduciary duties.

However, despite these developments, Delaware’s market power has remained mostly unchallenged. Thus, a growing camp of scholars argues that there is no significant competition in this market in any direction (Klausner, 1995; Kamar, 1998; Kahan & Kamar, 2002; Bebchuk & Hamdani, 2002; Roe, 2003; Broughman et al., 2014). Decisions regarding where to incorporate tend to be sticky, as relatively few firms reincorporate into other states. Moreover, firms prefer to be governed under the same corporate laws, namely Delaware’s, in order to benefit from network externalities, learning benefits and familiarity with the law. On this view, the quality or content of the law does not matter much for firm incorporation decisions.

This project has two goals. The first is to estimate whether demand for corporate laws is elastic, or alternatively whether firms care little about the substance of corporate laws. The second is to evaluate the extent to which firms prefer to be governed by laws that are relatively shareholder-friendly as opposed to laws that primarily protect managers’ interests. The two questions are inherently related. If demand for corporate law is inelastic, then firms care little about whether corporate laws facilitate takeovers or entrench managers, and such laws have a limited effect on firms’ incorporation decisions. On the other hand, if firms do express preferences for a particular set of laws, then the question is how strong these preferences are, and whether they can generate market shifts despite the presence of inertia. For example, if firms strongly prefer protectionist laws, there is a concern that managers will incorporate in states that offer laws that advance managers’ interests at the expense of shareholder welfare. A related concern is that states could attract market share by offering more protection for managers. By contrast, if firms manifest preferences for incorporating under less protectionist laws, then this is evidence that Delaware is subject to pressure on the demand side to provide laws that facilitate takeovers and stricter monitoring of management, and thus regulatory competition generates laws that promote shareholders’ welfare.

In order to address these questions, we develop an empirical model of firms’ incorporation decisions under inertia. We estimate the model using newly formed data of public firms and reincorporations between 1995-2013 parsed from SEC filings. To our knowledge, our data is the only available database that identifies the accurate state of incorporation for every firm year. In our model, heterogeneous firms choose states of incorporation over time based on the characteristics of the laws. Unlike past studies, we focus not only on anti-takeover laws, but also add measures of liability protection for directors and officers to account for changes to Nevada law that seem to have triggered the recent increase in Nevada’s market share. The main feature of the model is that, contrary to standard multinomial logit models, each firm makes a conscious choice of its state of incorporation with only some probability. We estimate this probability from the data; the idea is to capture the inertia in firms’
decisions. 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 to them based on their characteristics and economic conditions.

Corporate Law

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