Study Questions Competition in Corporate Charters

Thursday, January 2, 2003 — 10:30 a.m.

A study by two Harvard Law School researchers provides evidence that the vigorous competition among states over corporate charters–the engine that many believe pushes toward rules that benefit shareholders–is largely a myth. This evidence leads the researchers to call for federal law to provide a federal incorporation option, as well as to enable shareholders to initiate and vote to approve corporate reincorporation to a different jurisdiction. The study, “Vigorous Race or Leisurely Walk: Reconsidering the Competition over Corporate Charters,” by Professor Lucian Bebchuk and Olin Fellow Assaf Hamdani, will soon appear in the Yale Law Journal.

The dominant state in attracting the incorporations of publicly traded companies is, and has long been, the small state of Delaware. Although Delaware is home to less than one-third of one percent of the U.S. population, it plays a central role in setting corporate governance rules for the nation’s publicly traded companies.

“The widely accepted justification for the existing state of affairs is that Delaware’s dominant role is a product of its winning a competition among states for providing desirable corporate law rules,” says Professor Bebchuk. “Harnessing competition among states racing to attract incorporations with rules that benefit shareholders–the perceived ‘race to the top’–has been even termed the ‘genius’ of American corporate law by one prominent supporter.”

Challenging the conventional wisdom, the new study questions the widely held belief that states vigorously compete for incorporations. Although roughly half of the publicly traded companies are incorporated outside Delaware, the study documents that Delaware does not face any significant competitors in the business of attracting and serving out-of-state incorporations. The vast majority of corporations that do not incorporate in Delaware do not go to any other player in the out-of-state incorporation market but simply remain incorporated in the state where they are headquartered.

In assessing the competitive threat facing Delaware, the researchers argue, it is important to consider Delaware’s position in the market for out-of-state incorporations. They document that Delaware is a virtual monopoly in this market, with 85 percent of all out-of-state incorporations, and that no other state holds a significant position in this market. For example, among non-financial firms, Delaware attracts 216 out-of-state incorporations of Fortune financial 500 companies, while no other state captures even 10 such incorporations; in fact, the five states that follow Delaware’s lead collectively only capture a total of 27 out-of-state incorporations. Similarly, whereas Delaware captures 3,744 out-of-state incorporations of publicly trade companies, no other state attracts more than 180 such incorporations.

The evidence also indicates that Delaware’s dominant position enables it 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 the researchers estimate to be $3,000 for each Delaware household of four–that constitute a large fraction of the state’s budget. Still, despite 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.

Bebchuk and Hamdani argue that, given the weakness of existing competition, state competition could in all likelihood be improved by using “choice-enhancing” federal intervention. In particular, they argue, it would be desirable for federal law to provide a federal incorporation option, as Canada’s federal law does. It also would be advantageous to enable shareholders to initiate and approve via a vote reincorporation to another state. Such federal intervention, they conclude, could introduce substantial and healthy competition in this market to the benefit of investors.