Professors Jens Dammann and Matthias Schündeln on incorporation choices of privately held corporations
Corporate law varies between states in the US. Some people think this is great, in that it leads to competition for the most efficient corporate laws. Other people think this is bad, in that it leads to competition to create laws that help management at the expense of shareholders. In other words, some see a potential for a "race to the top", and others for a "race to the bottom." The question of which model is (more) correct has inspired a lot of analysis but, so far, no definitive conclusions.
This debate requires, however, that the variations in corporate law among states actually make a difference to companies. If firms don't really care, there isn't much of a "race" at all. For publicly traded companies, it is clear that these variations do matter. It is well known that many of them choose to incorporate somewhere other than their primary place of business - above all in Delaware, which is viewed as having favorable substantive law and high-quality courts. It has long been assumed, on the contrary, that private corporations (or, slightly more broadly, closely held corporations) nearly always incorporate in their home state - that for them, there really is no "race". Is this right? The answer matters - private companies contribute more than half of corporate output nationwide.
As it turns out, nobody seems to have challenged this assumption empirically. In a forthcoming paper "The Incorporation Choices of Privately Held Corporations", presented at this week's Works in Progress (WiP) talk, Professors Jens Dammann (visiting Chicago from the University of Texas School of Law) and Matthias Schündeln (Harvard) analyze the issue.
Their paper shows two important things: first, the vast majority - about 93% - of private corporations do incorporate in their primary place of business. This confirms the existing intuition, as far as it goes. Their second observation from the data is that things get more complicated as firms get larger. The bigger a private company is, the more likely it is to incorporate out-of-state, and the biggest private firms behave something like the way public companies do - they incorporate out of state at high rates, and the vast majority of those who do so incorporate in Delaware. What's going on here?
Profs. Dammann and Schündeln look into the data more deeply in the paper, and show that the likelihood of private corporations incorporating out-of-state is linked to specific identifiable features of states' corporate legal systems. With respect to substantive law, states are more likely to "lose" local private corporations to other states if the risk of corporate "veil piercing" is high (that is, if corporate directors are at greater risk of being personally liable), if states have adopted "exculpation" statutes (that allow firms to protect directors in their bylaws), or if states have generous levels of minority shareholder protection. Further, firms are more likely to incorporate elsewhere if their state is percieved to have a lower-quality judiciary. These results hold true across all sizes of private firms.
This seems to show both that states' corporate law does matter for privately held companies - many of them are voting with their corporate feet, so to speak (though not at the rates of publicly traded companies). They also seem to care more the bigger they are. Profs. Dammann and Schündeln speculate that this increasing importance of law as companies grow could be due to any of a number of factors. Larger companies might consider themselves possible takeover targets or be preparing for an IPO (even if relatively few of them actually ever have one), and might therefore be more likely to worry about the same issues that public firms do. Bigger firms might also be getting different (maybe better) legal advice, have more access to information, or be less burdened by the possibility of being sued in another state.
Neither the results of Profs. Dammann and Schündeln's analysis nor their hypothetical explanations do much to directly address the "race to the bottom"/"race to the top" debate, but they do provide significant data that was missing from this debate. A further implication is that states really should worry about the efficiency of their corporate law, and not assume that they have simply outsourced it to Delaware. The large majority of private corporations and their owners are bound by this local law since they incorporate locally, and its contents are therefore quite important to companies and shareholders.
Commenters noted some interesting wrinkles in the data that may need further explanation. First, Delaware itself is not an outlier - one might expect an abnormally high percentage of Delaware firms to incorporate locally, but this does not seem to be the case. A nontrivial number of Delaware firms are incorporating in other states. A further suggestion was that the two key state-level indicators - the rate at which local firms incorporated out of state, and the rate at which out-of-state firms chose to incorporate in the state in question - might in principle be used to evaluate and rank the perceived quality (from the point of view of private corporations) of states' corporate law. This turns out not to work all that well, however, since the states that do well on one indicator do not necessarily do well on the other. These observations indicate, possibly, that factors other than law are driving some of the out-of-state incorporation trends.
Another commenter noted that there are really two different kinds of out-of-state incorporation - that in which a company incorporates in its primary place of business, but later moves, and that in which a company "shops" for the best state of incorporation (either initially or as a later switch). The two different scenarios might have different explanations or implications, though their existence does not affect the correlations that the authors show in their analysis.
Another commenter cautioned that correlation between corporate law and incorporation states should not be taken as causation. For example, the fact that states with well-regarded court systems are more likely to be the site of incorporation for out of state firms could mean either of two things: either the state's good judiciary attracts out-of-state corporations, or the presence of more out-of-state corporations (due originally to some other factors) might result in a more experienced and effective judiciary. The paper does not answer these types of questions about the direction of causality.
These concerns, however, go to questions about interpretation of the data Profs. Dammann and Schündeln present in their paper. Since the primary purpose of their paper is to contribute new information to the debates on competition in corporate regulation, the concerns are best viewed as evidence that the paper is successful - people are talking about the data and what it means. While it is unlikely that this or any single piece of data will resolve the larger debates in this area, it will be interesting to see what effects this new information has on them.