Delaware Law As Lingua Franca: Theory And Evidence

Brian J. Broughman

Indiana University Maurer School of Law

Jesse M. Fried

Harvard Law School; European Corporate Governance Institute (ECGI)

Darian M. Ibrahim

William & Mary Law School

July 8, 2014

57 Journal of Law and Economics 865-895 (2014)

Abstract:

Why would a firm incorporate in Delaware rather than in its home state? Prior explanations have focused on the inherent features of Delaware corporate law, as well as the positive network externalities created by so many other firms domiciling in Delaware. We offer an additional explanation: a firm may choose Delaware simply because its law is nationally known and thus can serve as a “lingua franca” for in-state and out-of-state investors. Analyzing the incorporation decisions of 1,850 VC-backed startups, we find evidence consistent with this lingua-franca explanation. Indeed, the lingua-franca effect appears to be more important than other factors that have been shown to influence corporate domicile, such as corporate-law flexibility and the quality of a state’s judiciary. Our study contributes to the literature on the market for corporate charters by providing evidence that Delaware’s continued dominance is in part due to investors’ familiarity with its corporate law.

Delaware Law As Lingua Franca: Theory And Evidence

Delaware dominates the corporate chartering market in the U.S-it is the only state that attracts a significant number of out-of-state incorporations.1 As a result, incorporation decisions are “bimodal:” public and private firms typically choose between home-state and Delaware incorporation, with most public firms and large private firms going to Delaware (Bebchuk and Hamdani, 2002; Daines, 2002; Bebchuk and Cohen, 2003; Dammann and Schündeln, 2011).

Why would a firm today incorporate in Delaware rather than in its home state? Traditional accounts focus on the inherent quality of Delaware’s corporate-law rules. Under the “race-to-the-top” view, firms choose Delaware because its law maximizes firm value for shareholders (Winter, 1977; Romano 1985). Under the “race-to-the-bottom” view, firms choose Delaware because it offers corporate law that favors insiders at other parties’ expense (Cary, 1974; Bebchuk, 1992; Bar-Gill, Barzuza, and Bebchuk, 2006).

More recent explanations for why a firm might choose Delaware turn not on the inherent quality of its law but rather on the number of other firms incorporated in Delaware. Drawing on the network-effects literature, Klausner (1995) argues that a firm (Firm X) committing to a long-term domicile (such as an IPO firm that cannot easily change domicile after going public) may choose Delaware even if its corporate law is not optimal because a large number of other firms will be domiciled in Delaware in the future. This large, continuing network of Delaware firms ensures that Firm X will have access to more caselaw and better legal services in the future than if Firm X domiciles in its home state, where the firm network is smaller.

Relatedly, Kahan and Klausner (1997) argue that contractual terms (in loan agreements, charters, etc.) may persist not because of their quality but simply because of the “learning benefits” (such as drafting efficiencies and a reduction in uncertainty) that arise from these terms having already been widely used. Their analysis suggests that a firm may choose Delaware simply because of the learning benefits generated by so many other firms having chosen Delaware domicile in the past.

We put forward and test a new explanation for why a firm today would go to Delaware rather than stay home: that Delaware law can serve as a lingua franca for investors around the country, both in-state and out-of-state. The lingua-franca explanation builds on the fact that, after decades of Delaware’s dominance, business parties throughout the U.S.—including investors and their lawyers—are generally familiar only with Delaware law and the law of their home state (Daines, 2002; Klausner, 1995; Kahan and Klausner, 1997). As Daines (2002, pg. 1581) puts it:

Focusing on one national standard allows [corporate lawyers] to economize on the need to keep up to date with developments in multiple jurisdictions. Delaware is thus much like a common language and such lawyers are “bi-lingual,” speaking Delaware law plus the local dialect.

Thus, a firm wishing to attract investors from around the country may choose Delaware merely to provide a law that can be “spoken” by all of its investors.

Delaware law

Delaware law

Delaware law

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