Corporate Law
Bridging the Book-Tax Accounting Gap
115 Yale L.J. 680 (2005) The book-tax accounting gap allows corporations to minimize their earnings for tax purposes while maximizing them in reports to investors, all within the letter of the law. Although the U.S. Treasury has reported the rising divergence between book and taxable income with alarm, scholars and policymakers have yet to consider fundamental reform. This Note proposes eliminating the book-tax divide by moving to a book-conformed system. Implementing this proposal will both cut down on rampant corporate tax sheltering and help restore the integrity of the financial accounting system.
Fixing Freezeouts
115 Yale L.J. 2 (2005) Freezeout transactions, in which a controlling shareholder buys out the minority shareholders, have occurred more frequently since the stock market downturn of 2000 and the Sarbanes-Oxley Act of 2002. While freezeouts were historically executed as statutory mergers, recent Delaware case law facilitates a new mechanism--freezeout via tender offer--by eliminating entire fairness review for these transactions. This Article identifies two social welfare costs of the current doctrinal regime. First, the tender-offer-freezeout mechanism facilitates some inefficient (value-destroying) transactions by allowing the controller to exploit asymmetric information against the minority. Second, the merger-freezeout mechanism deters some efficient (value-increasing) transactions because of the special committee's veto power against the deal. These negative wealth effects are unlikely to be resolved through private contracting between the controller and the minority in the corporate charter. Rather than advocating patchwork reforms to correct these problems, this Article proposes a return to first principles of corporate law in the freezeout context. The result of this re-grounding would be a convergence in judicial standards of review for freezeouts and the elimination of the efficiency loss that is inherent in the existing doctrine.
The Sarbanes-Oxley Act and the Making of Quack Corporate Governance
114 Yale L.J. 1521 (2005) This Article provides an evaluation of the substantive corporate governance mandates of the Sarbanes-Oxley Act (SOX) of 2002 that is informed by the relevant empirical accounting and finance literature, and of the political dynamics that produced the mandates. The empirical literature provides a metric for evaluating whether specific provisions can be most accurately characterized as efficacious reforms or as quack corporate governance. The learning of the literature, much of which was available when Congress was debating the bill, is that SOX's corporate governance provisions were ill conceived. The political environment explains why Congress would enact legislation with such mismatched means and ends. SOX was enacted as emergency legislation amid a free-falling stock market and media frenzy over corporate scandals shortly before midterm congressional elections. The governance provisions, introduced toward the end of the legislative process in the Senate, were not a focus of any considered attention. Their inclusion stemmed from the interaction between election-year politics and the Senate Banking Committee chairman's response to the suggestions of policy entrepreneurs. The scholarly literature at odds with those individuals' recommendations was not brought to Congress's attention (and was ignored on the rare occasions that it was referenced). The pattern of congressional decisionmaking in SOX is not, however, unique. Much of the expansion of federal regulation of financial markets has occurred after significant market turmoil. The Article concludes that SOX's corporate governance provisions should be stripped of their mandatory force and rendered optional. To mitigate future policy blunders on the scale of SOX, it also suggests that emergency or crisis-mode legislation provide for reevaluation at a later date when more deliberative reflection is possible.
Bargaining in the Shadow of Takeover Defenses
113 Yale L.J. 621 (2003) For decades, practitioners and academic commentators who believe that target boards should have broad discretion to resist hostile takeover attempts have put forward the "bargaining power hypothesis" to support their view. This hypothesis states that a target with strong takeover defenses will extract more in a negotiated acquisition than a target with weaker defenses, because the acquirer's no-deal alternative, to make a hostile bid, is less attractive against a strong-defense target. The hypothesis helped usher in the modern era of takeover defenses: In endorsing the poison pill in Moran v. Household International, Inc., the Delaware Chancery Court framed the question as a balance between "the unrestricted right of shareholders to participate in nonmanagement sanctioned tender offers" and "the right of a Board of Directors to increase its bargaining powers." The bargaining power hypothesis has been voiced more frequently over the past few years as other shareholder-focused arguments in favor of takeover defenses, such as protection against "structural coercion" and protection against "substantive coercion," have been rendered less important through federal and state intervention or challenged by recent empirical evidence. Yet despite its venerable heritage and recent revitalization, the bargaining power hypothesis has generally been asserted by defense proponents and conceded by defense opponents, never subjected to a careful theoretical analysis or a comprehensive empirical test. This Essay attempts to fill this gap. I use negotiation-analytic tools to construct a model of bargaining in the "shadow" of takeover defenses. This model identifies the conditions that must exist in order for the bargaining power hypothesis to hold in a particular negotiated acquisition. I demonstrate that the bargaining power hypothesis only applies unambiguously to negotiations in which there is a bilateral monopoly between buyer and seller, no incremental costs to making a hostile bid, symmetric information, and loyal sell-side agents. These conditions suggest that the bargaining power hypothesis is only true in a subset of all deals, contrary to the claim of some defense proponents that the hypothesis applies to all negotiated acquisitions. I confirm the features of this model with evidence from practitioner interviews. It is interesting to note that while the bargaining power hypothesis lies squarely at the intersection of law and business--namely, legal rules on takeover defenses influencing the business issue of price--to my knowledge the businesspeople who actually negotiate price have been silent on this question. In order to better understand practitioner views, I interviewed the head or co-head of mergers and acquisitions at ten major New York City investment banks. Collectively these firms represented either the acquirer or the seller, or both, in seventy-two percent of negotiated acquisitions by number, and ninety-six percent by size, during the 1990s deal wave. The evidence compiled from these practitioner interviews is consistent with the theoretical model presented here. I then test the bargaining power hypothesis against a database of negotiated acquisitions of U.S. public company targets between 1990 and 2002 (n = 1692). If the hypothesis is correct, then premiums should be higher in states that authorize the most potent pills (Georgia, Maryland, Pennsylvania, and Virginia), and lower in the state that provides the least statutory validation for pills (California), relative to Delaware, which takes a middle ground on the pill question. Consistent with the predictions of my model, however, I find no evidence that premiums are statistically different across these states, either overall or in those subsamples in which bargaining power is most likely to manifest itself. I further test for intrastate differences using the Maryland Unsolicited Takeovers Act of 1999 as the basis for a natural experiment, and also find no empirical support for the bargaining power hypothesis. These findings have implications for the current antimanagerial, pro-takeover trajectory of Delaware's corporate law jurisprudence in the aftermath of Enron. Proponents of the status quo warn that such doctrinal movements will weaken targets' bargaining power in negotiated acquisitions, which will in turn reduce overall returns for target shareholders. But by unpacking the "black box" of negotiated acquisitions and examining the microlevel underpinnings of the bargaining process, this Essay suggests that a return to the original promise of intermediate scrutiny articulated in Unocal Corp. v. Mesa Petroleum Co. is unlikely to yield significant negative wealth consequences for target shareholders. Rather, as I and others have argued, a controlled revitalization of the hostile takeover marketplace can help to improve overall corporate governance, an objective that has become only more important in the post-Enron era. The remainder of this Essay proceeds as follows. Part II provides relevant background, including the origins of the bargaining power hypothesis and the evidence put forward to support it. Part III constructs a theoretical model of bargaining power in the negotiated acquisition context, beginning with a baseline case in which the bargaining power hypothesis clearly holds, and then adding real-world complexities that make it less plausible in many negotiated acquisitions. In addition, Part III uses evidence from practitioner interviews to illustrate the features of the model. Part IV provides new econometric evidence on the validity of the bargaining power hypothesis. Part V discusses implications of these findings. Part VI concludes.
How To Fix Wall Street: A Voucher Financing Proposal for Securities Intermediaries
113 Yale L.J. 269 (2003) Securities market intermediaries reduce the collective action problem facing investors in the capital markets. Analysts provide securities research. Proxy advisory firms assist investors in determining how to vote their shares. Even shareholders bringing proxy contests can be viewed as providing a collective benefit to the extent the contests are motivated by a desire to increase share value. Despite the services they provide to investors, many intermediaries face financing problems due to pervasive free riding on the part of dispersed shareholders. This can result in underfunding of valuable intermediary services or, alternatively, excessive or duplicative funding of wasteful services. One regulatory response is mandatory financing of intermediaries. Regulators are poorly suited, however, to determine optimal funding levels and to make appropriate allocation decisions. Alternatively issuers, through their managers, can subsidize intermediary services. Issuers may subsidize analysts, for example, through the investment banking fees they pay to brokerage firms. Manager control over allocation of issuer-based funding can, however, corrupt the intermediaries in favor of the managers. Understanding the problem of intermediary corruption as an outgrowth of the financing problem cautions against simply imposing regulatory prohibitions on voluntary issuer subsidies. Instead, this Article proposes a voucher financing mechanism to separate the source of subsidization from the allocation. Under the proposal, regulators determine a subsidy amount funded through levies on publicly traded firms, roughly equal to the present amount of subsidies that flow from issuers to intermediaries. Shareholders are then given the ability to direct the subsidy dollars to their preferred intermediaries, using vouchers in proportion to their shares. Voucher financing offers a market-based mechanism to finance intermediaries, resulting in greater flexibility and responsiveness in the provision of intermediary financing. Shareholders may aggregate vouchers from several companies in their portfolios and direct them across different intermediaries to their highest-value use. By providing a common funding mechanism for a range of intermediaries, voucher financing enables shareholders to address problems of both excessive and inadequate intermediary funding. Similarly, shareholder allocation reduces the potential for intermediary corruption. Although voucher financing is subject to problems, including information problems, coordination problems, and shareholder apathy, the Article identifies potential solutions to these problems and argues that voucher financing reflects a substantial improvement over the existing regulation and funding of intermediaries.
Minorities, Shareholder and Otherwise
113 Yale L.J. 119 (2003) "[M]en are described as I think they are," Adolf Berle writes of his work, "rather than as they think they are." He continues: "Some will be shocked. The businessman will find that he is a politician and a commissar--perhaps even a revolutionary one. The liberal finds himself a traditionalist." My juxtaposition of the corporate lawyer and the progressive activist may strike both as surprising and even uncomfortable. But corporate law has long been described as the constitutional law for the economic state. Both corporate law and constitutional law seek to order relations between heterogeneous persons who hold stakes in a shared enterprise. Yet the parallels between the two have rarely been fully drawn. In this paper, I have begun to sketch the unexplored but immanent connections in the two domains. That the word "minority" is critical in both constitutional law and corporate law is not mere lexical coincidence. Much of life is affected by one's minority or non-minority status. On my reinterpretation, corporate law offers the same insight as critical scholarship: Law must take into account relations of domination and subordination. Corporate law already does this. Equal protection jurisprudence, at least as currently promulgated by the Supreme Court, denies it. But if there is to be a kind of grand unifying theory of corporate and constitutional law, it will turn on this insight about power.
The Politics of Corporate Governance Regulation
112 Yale L.J. 1829 (2003) Why do corporate governance systems differ quite substantially around the world? The American model supervises managers through a board representing a diffuse mass of external shareholders whose rights are defended by a variety of institutional rules (such as those governing insider trading, antitrust, and an open market for corporate control) and by watchdog "reputational intermediaries" (such as accountants, securities analysts, and bond-rating agencies). The claims of employers, suppliers, and buyers are subordinated to shareholder rights. The German model, in contrast, supervises managers by concentrating ownership in blockholders, permitting insider relationships, allowing substantial horizontal coordination among producers, and accepting a variety of "stakeholder" claims on the firm besides those of the shareholders. Japan, as well as Sweden, Austria, and other continental European countries, resembles the German model to varying degrees, while the United Kingdom, Canada, Australia, Ireland, and New Zealand bear closer resemblance to the American system. Just why these differences exist has been the object of vigorous debate both in the legal academy and across many other fields. Mark Roe's new book, Political Determinants of Corporate Governance, vigorously presents the "politics school," of which he is the pioneer and an important leader. Political forces, he argues, account for the difference in choice of corporate governance models among advanced industrial countries. Researchers ask: What are the "legal and institutional preconditions for strong securities markets"? Roe adds politics to the list and puts it in first place. Corporate governance arrangements inside the firm, Roe argues, interact deeply with a nation's politics. Political forces--party systems, political institutions, political orientations of governments and coalitions, ideologies, and interest groups--are the primary determinants of the degree of shareholder diffusion and the relationships among managers, owners, workers, and other stakeholders of the firm. Whatever the formal specifications of corporate law, politics shapes daily the calculations made by all players. Roe argues that where social democracy is strong, shareholder rights are weak, and shareholder diffusion is low. Social democracy gives voice to claims on the firm in addition to those of the shareholders: employee job security, income distribution, regional or national development, social welfare and social stability, and nationalism, to name a few. To counter these competing claims, blockholders resist diffusion of shares in order to maintain leverage in the boardroom, and investors shy away from a system in which they lack protection or dominance. To test this theory, Roe first correlates the degree of shareholder concentration with various indicators of social democratic power, such as partisan composition of governments, employee protection in labor law, and income equality. He finds strong evidence that weak labor correlates with strong diffusion. He then provides qualitative process-tracings (country case studies of the historical evolution of governance patterns) that show how strong labor power inhibits diffusion, and examines the impact of other economic variables--the degree of economic competition and monopoly power--on the degree of shareholder diffusion. Finally, Roe uses his political argument to confront directly a very influential alternative interpretation--the Quality of Corporate Law (QCL) argument, developed by Rafael La Porta, Florencio López-de-Silanes, Andrei Shleifer, and Robert Vishny (LLS&V). Countries with similar levels of QCL, Roe observes, differ in the degree of shareholder diffusion. Therefore, other variables must be in play. The critical one is politics. He demonstrates that for his sample of countries, the political account correlates more strongly than QCL with shareholder diffusion. Advanced industrial countries with high QCL vary considerably in the degree of shareholder diffusion; thus, something else must be at work. That something is the degree of social democratic influence. Roe tests LLS&V's impressive data collection with his own substantial data on political variables, and concludes, in my view convincingly, that politics does better than QCL. QCL can matter, Roe argues, when politics enables it to matter--that is, when property rights are assured, when enforcement and independent judges are allowed to work, and when the political balance in society gives it a place. Even then, the consequences for corporate governance of any given set of laws are driven by politics. Roe's is the only account in the law-and-economics tradition that makes politics explicitly central to an explanation of corporate governance in a comparative and international perspective. For him, political forces not only define the law--they also determine how the law actually operates. In stressing politics, Roe directly challenges other leading interpretations that stress the primacy, and autonomy, of economics, law, and private processes of reputational bonding. Roe's book provides an important opportunity to examine the status of politics in the conflicting interpretations of corporate governance. No one really doubts that politics has something to do with corporate governance, but theorists vary considerably in the status they give to politics in a causal model. Roe is unique among major authors in seeing politics as continuous, ongoing, and primary. For other theorists, politics operates in the distant past, or indirectly, or barely at all. Specifically, Roe's book allows us to examine a contest between his political theory and LLS&V's version of QCL. Although the essays contained in Political Determinants of Corporate Governance are not intended to confront QCL directly--Roe's concern with politics, dating back to the late 1980s, precedes the LLS&V publications that emerged in the late 1990s--they in fact do so. In LLS&V's argumentation, the difference between governance systems arises from the effects of common- versus civil-law legal traditions; politics exists only in the initial choice of legal system in a given jurisdiction. LLS&V then focus on the consequence of this initial act upon the development of corporate governance systems and shareholder diffusion. Yet what a country does with its legal tradition and system turns on politics: the rules that determine the extent of economic competition within and between countries; the laws and decrees that structure banking, corporate finance, and the securities industry; the rules that shape the markets for capital and labor; and the degree of state involvement in the economy. LLS&V make allusions to politics in their analyses of QCL, referring to rule of law, judicial efficiency, and corruption. But politics has no distinct causal status in their argument and, after the initial choice of systems, no longer plays a role in shaping the actual content or use of law. Roe's political theory and the QCL theory are themselves criticisms of an important literature in economics that argues that the efficacy of the market makes regulation unnecessary and renders variation among governance forms unimportant or nonexistent. Competition in product and capital markets forces firms to adopt "rules, including corporate governance mechanisms," that minimize costs in the drive to efficiency. In situations of vigorous competition, the remaining details of corporate governance are irrelevant. The logic of risk diversification will lead to shareholder diffusion. Securities regulation is unnecessary and possibly harmful. An open world economy will lead to convergence. Observed variance in systems among countries would reflect differences in economic competition, shaped by objective characteristics such as size or factor endowments. The empirical critique of this approach, made by Roe and LLS&V, notes that despite increasing international competition, the Berle-Means separation of owners from managers by no means has become universal, and thus other forces must be at work. Another interpretation of diffusion, developed by Brian Cheffins and John Coffee, argues for the private capacity of markets to develop mechanisms of reputation without state intervention, thus implicitly without politics. John Coffee groups Roe with LLS&V and Lucian Bebchuk as sharing the view that "[o]wnership and control cannot easily [be] separate[d] when managerial agency costs are high." Although they disagree "about the causes of high agency costs--i.e., weak legal standards versus political pressures that cause firms sometimes to subordinate the interests of shareholders--they implicitly concur that the emergence of deep, liquid markets requires that the agency cost problem first be adequately resolved by state action." In disagreement, Coffee quite persuasively argues that the Berle-Means model emerged from the behavior of private actors in the United States--bankers such as J.P. Morgan seeking to reassure foreign investors and the leaders of the New York Stock Exchange seeking to attract a particular kind of listing--and out of a particular situation in which state authority was absent. The legal protections came afterward, as shareholders created a constituency seeking the aid of state authority. It is not the law that causes corporate governance, but the reverse. I read Coffee as agreeing that there was a managerial agency problem--investors sought protections--but believing that state regulation was not required to solve it. Coffee rejects Roe's version of a political account, but politics does appear in his analyses in two ways. First, the shareholders lobby for regulation after diffusion has occurred, working through politics to generate QCL. Second, politics is central to Coffee's key variable--the presence or absence of state involvement in economic life--in shaping whether the private mechanisms of investor assurance develop. Arguments using norms and culture generally discount politics. Amir Licht makes an argument stressing culture, path dependence, and norms, while Coffee and Roe have both explored the role of norms in shaping behavior, holding law constant. It is not clear what these arguments make of politics: Does politics shape norms by altering the law and its enforcement in what is acceptable convention, or do norms shape politics and the law? Analyses of social movements and of corporate networks by sociologists and legal scholars explore linkages to politics and public policy. Another important body of literature on corporate governance examines competition among securities regulation and markets. The disagreement between Roberta Romano and Bebchuk on convergence for or against shareholders turns substantially on assumptions about the utility function of politicians: Do they actually seek to attract incorporation, or are they responding to other political calculi, pressures, and interests? That literature recognizes that politics matters, but does not appear to have a substantive theory of politics. The issues about the consequences of U.S. federalism reappear in analyses of the potential for "functional convergence" in international competition among securities markets. Roe's political theory of corporate governance directly confronts these alternative explanations. Whereas his first book explores the U.S. case, the new book combines, integrates, and extends into a comprehensive statement a series of articles, stretching back a decade, that sets the American experience in a comparative framework with other advanced industrial democracies. Roe's argument has become the foundation of the "political theory" of corporate law. Articles that refer to political explanations generally refer to Roe. His particular account is quite powerful, and he has advanced our understanding in developing it. The chapter on what constitutes a political interpretation, however, is by no means closed: There is not one political interpretation, but several. In this regard, Roe opens wider the door for exploration of political influences on corporate law and behavior. A careful reading of Roe's book helps us to evaluate the status of politics in interpretations of corporate governance and to examine the different meanings that can be given to political explanations. There are, thus, two steps to such a discussion. First, how does politics compare to other arguments? Second, which among several political arguments is the most convincing? Roe's admirable account is, in my view, very powerful, indeed superior, in taking the first step: Politics dominates explanations about corporate governance. In taking the second step, however, Roe's position, while still strong, is neither completely convincing nor exhaustive of the political forces at work. Roe's political account is incomplete. He does not consider two significant alternative political analyses. The first is an alternative political preferences and interest group model. Roe stresses the relative power of left versus right, and labor versus capital. But he does not consider issues and interest groups--stressed by Raghuram Rajan and Luigi Zingales --that cut across the class divide, such as industrial sectors, agriculture, religion, and constitutional disputes. The second alternative political model looks at political institutions: Divergence in outcomes reflects differences not in preferences but in the mechanisms of preference aggregation, such as electoral laws, federalism, legislative-executive relations, and party systems. Corporate governance outcomes may reflect, as Marco Pagano and Paolo Volpin argue, the degree to which institutions favor specific coalition formation. Roe simplifies for the purpose of research. His argument is parsimonious. His account of specific country cases, as opposed to the statistical tests, is quite nuanced, subtle, complex, and astute. In fact, in his work I can find passages that demonstrate his complete awareness of most of my objections. He does not, however, consider how these nuances could be integrated into alternative political variables that need examination on their own terms. As a political scientist, my criticisms focus on the political account. This seems appropriate, as politics is the center of his argument. A law professor or economist might pay more attention to Roe's presentation of those arguments. I choose only to summarize his interpretations of the legal and economic issues, and instead focus my comments on his particular version of the political argument. Part I of this Review lays out Roe's political argument and his empirical test of it. Part II explores the contest between Roe's political argument and LLS&V's QCL. Part III situates Roe's political argument in relationship to other political interpretations. Part IV probes the implications of Roe's argument for public policy issues. Part V categorizes the various meanings given to politics in arguments about corporate governance.
Coase's Penguin, or, Linux and The Nature of the Firm
112 Yale L.J. 369 (2002) For decades our common understanding of the organization of economic production has been that individuals order their productive activities in one of two ways: either as employees in firms, following the directions of managers, or as individuals in markets, following price signals. This dichotomy was first identified in the early work of Ronald Coase and was developed most explicitly in the work of institutional economist Oliver Williamson. Recently, public attention has focused on a fifteen-year-old phenomenon called free software or open source software. This phenomenon involves thousands, or even tens of thousands, of computer programmers who collaborate on large- and small-scale projects without traditional firm-based or market-based ownership of the resulting product. This Article explains why free software is only one example of a much broader social-economic phenomenon emerging in the digitally networked environment, a third mode of production that the author calls "commons-based peer production." The Article begins by demonstrating the widespread use of commons-based peer production on the Internet through a number of detailed examples, such as Wikipedia, Slashdot, the Open Directory Project, and Google. The Article uses these examples to reveal fundamental characteristics of commons-based peer production that distinguish it from the property- and contract-based modes of firms and markets. The central distinguishing characteristic is that groups of individuals successfully collaborate on large-scale projects following a diverse cluster of motivational drives and social signals rather than market prices or managerial commands. The Article then explains why this mode has systematic advantages over markets and managerial hierarchies in the digitally networked environment when the object of production is information or culture. First, peer production has an advantage in what the author calls "information opportunity cost," because it loses less information about who might be the best person for a given job. Second, there are substantial increasing allocation gains to be captured from allowing large clusters of potential contributors to interact with large clusters of information resources in search of new projects and opportunities for collaboration. The Article concludes with an overview of how these models use a variety of technological, social, and formal strategies to overcome the collective action problems usually solved in managerial and market-based systems by property, contract, and managerial commands.
Vigorous Race or Leisurely Walk: Reconsidering the Competition over Corporate Charters
112 Yale L.J. 553 (2002) Does American corporate law work effectively to enhance shareholder value? The recent corporate governance crisis makes this time as good as any for reexamining the basic structure of this body of law. This Essay provides such a reconsideration of a defining feature of U.S. corporate law--the existence of regulatory competition among states. In the United States, most corporate law issues are left for state law, and corporations are free to choose where to incorporate and thus which state's corporate law system will govern their affairs. The dominant state in attracting the incorporations of publicly traded companies is, and for a long time has been, the small state of Delaware. Although Delaware is home to less than one-third of a percent of the U.S. population, it is the incorporation jurisdiction of half of the publicly traded companies in the United States and of an even greater fraction of the larger publicly traded companies. Delaware thus plays a central role in setting corporate governance rules for the nation's publicly traded companies. Why should this small state play such a critical role in the governance of the nation's corporate sector? At first glance, Delaware's existing dominant role might be viewed as inefficient or even illegitimate. The widely accepted justification for the existing state of affairs, however, is that Delaware's dominant role is a product of its winning a competition among states for providing desirable corporate law rules. Indeed, the dominant view in corporate law scholarship is that allowing Delaware to dominate national corporate law is not a problematic feature, but rather an important virtue, indeed the "genius," of American corporate law. According to the prevailing view among corporate scholars, competition provides powerful incentives for adoption and development of value-enhancing corporate rules. Delaware has won its leading place by offering the best rules, and the competitive pressure it faces can be relied on to ensure that Delaware will continue to provide companies with whatever rules turn out to be best in our dynamic and changing business world. The view that state competition works well rests on two propositions: (i) that states actively and vigorously compete for incorporations, and (ii) that the ensuing competitive threat provides the dominant state of Delaware, as well as other states, with powerful incentives to provide value-enhancing rules. Those skeptical of state competition have mainly focused on questioning the second proposition. Accepting that states actively compete for incorporations, such critics have argued that the competitive threat might push states in undesirable directions with respect to some important corporate issues. In contrast, this Essay challenges the standard case for state competition by questioning the claim of the first proposition that states vigorously compete for incorporations. The alleged vigorous race among states vying for incorporations, we argue, simply does not exist. We present evidence that Delaware's dominant position is far stronger, and thus that the competitive threat that it faces is far weaker, than has been previously recognized. We also explain the underlying reasons for the weakness of competition in the market for incorporations. Furthermore, we show that the weakness of competition has major implications for both assessing the performance of state competition and determining the desirable role of federal law in this area. Part II of this paper discusses the conventional premise that states compete actively for incorporations. We highlight the key role that this premise plays in the views of supporters of state competition. We also discuss how, at least for the purpose of the debate, critics of state competition have often accepted this premise. Part III then discusses evidence indicating the absence of active competition among states for corporate charters. We pay close attention in this Part to the patterns of incorporations among states that have been documented in a recent empirical study by Alma Cohen and one of us. Although half of the publicly traded companies are incorporated outside Delaware, Delaware does not face any significant competitors in the business of attracting and serving out-of-state incorporations. The vast majority of non-Delaware corporations do not incorporate in a state that competes with Delaware over the hearts (or pockets) of firms incorporating out-of-state; rather, these firms simply remain incorporated in the state where they are headquartered. In assessing the competitive threat facing Delaware, it is important to consider Delaware's position in the market for out-of-state incorporations. Among firms that do "shop" for out-of-state incorporations, Delaware captures approximately 85% of all incorporations. Delaware is thus a virtual monopoly in the out-of-state incorporations market, and no other state holds a significant position in this market. For example, whereas Delaware captures 216 out-of-state incorporations of Fortune 500 companies, no other state captures even 10 such incorporations, and the five states that follow Delaware's lead capture a total of 27 such out-of-state incorporations. Similarly, whereas Delaware captures about 3744 out-of-state incorporations of publicly traded companies, each other state attracts fewer than 180 such incorporations. Furthermore, Delaware's longstanding dominance of the out-of-state incorporation market, and the larger incorporation market, has been growing. Indeed, examination of recent trends indicates that Delaware's dominance can be expected to keep growing even further in the near future. Its dominant position enables Delaware to make substantial supracompetitive profits. While Delaware's expenses on providing corporate law rules to the nation's firms are exceedingly small, it captures large franchise tax revenues--which on a per capita basis amount to $3000 for each household of four--that constitute a large fraction of the state's budget. Still, notwithstanding these supracompetitive returns, other states have not been making any visible efforts to mount a serious challenge to Delaware's dominance. No state, as it were, has been giving Delaware a run for its money. What explains Delaware's powerful and unchallenged dominance? Some states, especially large states for which such profits would not be significant, might well be simply indifferent to the prospect of making profits from the incorporation business. There are, however, enough small states in the United States for which profits such as those Delaware has been making would be quite attractive; such states would have had strong motivation to mount a challenge to Delaware's dominance if such a challenge could have been expected to succeed in enabling them to capture a significant fraction of these profits. That this has not been happening, notwithstanding Delaware's persistent supracompetitive returns, indicates in our view that mounting a challenge to Delaware has not been viewed as likely to be profitable. Part IV analyzes the reasons for the absence of active competition. Drawing on the theory of industrial organization, we identify a number of structural features of the incorporation market that can explain why a challenge to Delaware's dominance by some other small state is unlikely to be profitable. The "product" currently offered by Delaware should be viewed as including not only its rules but also its institutional infrastructure, including Delaware's specialized chancery court, and the network benefits currently enjoyed by Delaware corporations. As a result, a state that would offer the same rules, but charge lower incorporation taxes and fees, would not be able to attract many out-of-state incorporations. Although its current incorporation taxes are in the aggregate meaningful for Delaware, such taxes never exceed $150,000 for any given firm, and reductions in such expenditures are unlikely to lead firms incorporating out-of-state to forgo the benefits from the institutional infrastructure and network externalities provided by Delaware. Similarly, a state that merely offers the same rules as Delaware with some marginal improvements cannot hope that such marginal improvements would by themselves attract many out-of-state incorporations. The existing rules governing reincorporations further constrain the ability of a challenger to attract quickly a significant number of out-of-state incorporations. Reincorporations must be initiated by the board before being brought to a shareholder vote. Therefore, even if a rival state could identify a set of rules that could make shareholders substantially better off, this state would be unable to attract quickly many out-of-state incorporations unless the rules are also preferable for managers. This significantly narrows, of course, the scope of improvements in substantive rules on which a potential challenge could be based. Finally, even if a rival were to identify some substantial set of changes that could significantly benefit both shareholders and management, and even if the rival were willing to invest up-front in institutional infrastructure, the profitability of a challenge could be undermined by the inability of the rival to launch a swift hit-and-run challenge. The substantial amount of time that would be required for the challenger to adopt changes and for firms to respond to them would provide Delaware with ample opportunity to react. Delaware could "match" by adopting the challenger's improved rules; Delaware's out-of-state incorporators might then stick with Delaware due to its initial network benefits, and the challenger would merely serve as a stalking horse pulling Delaware to improve its rules. Furthermore, even if the challenger were somehow able to capture a significant fraction of the out-of-state incorporation market, price competition between the challenger and Delaware would likely bring down prices; in this case, the challenger would bring down Delaware's current profits without being able to capture a substantial fraction of them. Part V turns to exploring the implications of the weak-competition account we develop for assessing the performance of state competition in corporate law. Our analysis indicates that the incentives of Delaware and of other states are likely to be quite different. Delaware is in the business of attracting and profiting from out-of-state incorporation. Its interests would be best served by policies that maintain its monopoly and undermine possible threats to it, and that increase the profits it makes from its position. In contrast, other states cannot, and do not expect to, obtain such a position in the out-of-state incorporation market, and maximizing revenues from such incorporations is thus irrelevant for such states. Accordingly, we examine separately the implications of our analysis for both Delaware law and the corporate law of other states. Among other things, we show that our account of state competition undermines the view that rules produced by state competition should be regarded as presumptively efficient. Neither Delaware nor other states face the type of competitive situation in which a limited slack could gravely hurt a player's interests. We also explain how our account leads to the conclusion that states would tend to provide rules that, with respect to some issues, such as takeover protections, are more favorable to managers than would be optimal for shareholders. Our weak-competition account suggests that the greatest threat confronting Delaware is not competition from other states but the possibility that the federal government will intervene in a way that would undermine Delaware's position. We discuss in Part V how, in light of this threat, Delaware's interests might be best served by providing a body of law that is largely judge-made and relies on open-ended and flexible standards. Furthermore, to the extent that Delaware is moved to act in shareholders' interests by the fear of triggering a federal intervention, this fear can provide a check only against rather large deviations from shareholder interests, and whatever benefits come from it should be attributed to the disciplinary role not of state competition but of federal fiat. Finally, Part VI discusses the implications of the weak-competition account we put forward for the desirable role of federal law in this realm. The absence of strong competition undermines the basis for the view that Delaware's dominance is the product of its winning a vigorous competition. Thus, the analysis implies that the case for preferring state competition to mandatory federal rules is much weaker than supporters of state competition have assumed. Furthermore, we argue that, given the weakness of existing competition, state competition, as currently structured, could in all likelihood be improved by using "choice-enhancing" federal intervention. This type of intervention, which has been put forward by Allen Ferrell and one of us in earlier work, could invigorate state competition. In particular, it would be desirable for federal law to provide a federal incorporation option, as Canada's federal law does, as well as to enable shareholders to initiate and approve via a vote reincorporation to another state. Such federal intervention could introduce substantial and healthy competition in this market to the benefit of investors. Although much of the work on state competition has taken as given the presence of active competition, there has been some prior work, upon which we build, discussing why Delaware has a dominant position. Among other things, earlier work has highlighted the significance of network externalities and legal infrastructure, which are important elements of our analysis. In a contemporaneous work, Marcel Kahan and Ehud Kamar also challenge the vigorous competition account of state competition, offering an analysis that complements ours. Kahan and Kamar persuasively document that states other than Delaware have not made a determined effort to attract and profit from out-of-state incorporations; this evidence complements the evidence on which we focus concerning the patterns of incorporation among states. In explaining the absence of vigorous competition, Kahan and Kamar take a different approach from ours, arguing that states other than Delaware do not compete because state decisionmakers pursue political goals rather than profits. In contrast, we suggest that such a "political" story cannot adequately explain why other small states would not eagerly seek to capture Delaware's profits if they could do so; instead, we focus on "economic" explanations as to why they cannot do so, i.e., why attempts to capture these profits can be expected to fail. Our work differs from earlier and contemporaneous work by others in several important respects. First, we show that the patterns of incorporations indicate that Delaware's dominant position in the incorporations market is far stronger and more secure than has been previously recognized. Second, we provide a comprehensive analysis of the structural features of the market for corporate law--the "industrial organization" of this market--that make it unprofitable for other small states to challenge Delaware's position. Third, other works that have discussed imperfect competition in the incorporation market, including the contemporaneous work by Kahan and Kamar, have largely remained agnostic or even doubtful about the merits of federal intervention. In contrast, we show that the lack of meaningful competition in the incorporation market undermines the case for the existing system and provides an important basis for supporting a federal role. Some of the points discussed in this Essay are more fully or rigorously developed in two companion pieces. An empirical study by Alma Cohen and one of us provides a comprehensive study of the patterns of incorporations, and we draw on it in Part III. A theoretical work by Oren Bar-Gill, Michal Barzuza, and one of us develops the first formal model of state competition over incorporations; this model pays close attention to the industrial organization features of the incorporation market, and we build on its insights in Part IV.
A Dilution Mechanism for Valuing Corporations in Bankruptcy
111 Yale L.J. 83 (2001) This Article proposes a new mechanism for valuing firms in bankruptcy. Under the "senior dilution" mechanism, a court would dilute the reorganized stock issued to senior claimants by issuing additional shares to junior claimants until there was no excess demand for the stock at a price that would implement absolute priority. A "junior diluation" mechanism could also be implemented to provide a market test for proposed reorganization plans of junior claimants by having a court issue additional debt to senior claimants until there was no excess supply of the debt at a price that would implement absolute priority. We show that these mechanisms harnass the private information of the claimants and of third parties to produce distributions consistent with absolute priority. Dilution mechanisms can be superior to other information-harnassing devices (such as an option or auction approach) because they (1) are less susceptible to the problem of junior illiquidity than an option approach proposed by Lucian Bebchuk, (2) are less susceptible to the problem of market manipulation and may better allocate control premia than a partial float proposal by Mark Roe; and (3) may produce fewer transaction costs than a full auction approach proposed by Douglas Baird. Moreover, as a response to the Supreme Court's recent admonition in LaSalle that bankruptcy courts employ market tests more often when creditors dissent to a reorganization plan, the junior dilution mechanism provides a uniquely workable solution within the current statutory framework.
The Rise of Dispersed Ownership The Roles of Law and the State in the Separation of Ownership and Control
111 Yale L.J. 1 (2001) Deep and liquid securities markets appear to be an exception to a worldwide pattern in which concentrated ownership dominates dispersed ownership. Recent commentary has argued that a dispersed shareholder base is unlikely to develop in civil-law countries and transitional economies for a variety of reasons, including (1) the absence of adequate legal protections for minority shareholders, (2) the inability of dispersed shareholders to hold control when the private benefits of control are high, and (3) the political vulnerability of dispersed shareholder ownership in left-leaning social democracies. Nonetheless, this Article finds that significant movement in the direction of dispersed ownership has occurred and is accelerating across Europe. What, then, are the legal and political precondiitons to the emergence of strong securities markets? Examining the origins of dispersed ownership in both the United States and the United Kingdom during the late nineteenth and early twentieth centuries and contrasting their experiences with the contemporaneous failure of securities markets to develop in Continental Europe, this Article finds little evidence that the existence of strong legal protections for minority shareholders is the explanatory variable that best accounts for the divergent evolution of common-law versus civil-law economies. During this era, particularly in the United States, the private benefits of control were high, controlling shareholders regularly exploited minority shareholders and manipulated markets, and political corruption undercut the effectiveness of those legal remedies that existed. Yet, ownership and control gradually separated in the largest U.S. corporations. The critical factors explaining early market development in the United States appear to have been the private efforts of investment bankers to develop credible bonding mechanisms plus enlightened self-regulation of the New York Stock Exchange. In this light, the decisive difference between the common-law countries, in which securities markets developed, and the civil-law countries, in which they did not, appears to have been less their divergent legal rules than the early emergence of a relatively autonomous and decentralized private sector in the former countries, in which competition could flourish and self-regulation was encouraged. In contrast, market development was impeded in Continental Europe by pervasive state intervention and a view of the securities market as an appendage of the state. Ultimately, the correlation between strong securities markets and strong legal standards seems real, but the causal sequence may be the reverse of that suggested by recent commentators. Rather than strong legal protections engendering strong markets, securities markets appear to develop first through private initiatives and then create political constituencies that demand stronger legal proetections. "Crash then law" is a recurring cycle. Hence, although law contributes to market growth and particularly market stability, it appears more to follow than precede economic development.
The Essential Role of Organizational Law
110 Yale L.J. 387 (2000) In every developed market economy, the law provides for a set of standard-form legal entities. In the United States, these entities include, among others, the business corporation, the cooperative corporation, the nonprofit corporation, the municipal corporation, the limited liability company, the general partnership, the limited partnership, the private trust, the charitable trust, and marriage. To an important degree, these legal entities are simply standard-form contracts that provide convenient default terms for contractual relationships among the owners, managers, and creditors who participate in an enterprise. In this Article, we ask whether organizational law serves, in addition, some more essential role. The answer we offer is that organizational law goes beyond contract law in one critical aspect, permitting the creation of patterns of creditors' rights that otherwise could not practicably be established. In part, these patterns involve limits on the extent to which creditors of an organization can have recourse to the personal assets of the organization's owners or other beneficiaries--a function we term "defensive asset partitioning." But this aspect of organizational law, which includes the limited liability that is a familiar characteristic of most corporate entities, is of distinctly secondary importance. The truly essential function of organizational law is, rather, "affirmative asset partitioning." In effect, this is the reverse of limited liability: It involves shielding the assets of the entity from the creditors of the entity's owners or managers. Affirmative asset partitioning offers efficiencies in bonding and monitoring that are of signal importance in constructing the large-scale organizations that characterize modern economies. Surprisingly, this crucial function of organizational law--which is essentially a property-law-type function--has largely escaped notice, much less analysis, in both the legal and the economics literature.