Delaware dominates the corporate charter business. About 60% of Fortune 500 firms incorporate in Delaware as has been well documented. And Delaware’s dominance is not limited to large, blue-chip companies; most entrepreneurial ventures that secure professional outside financing are incorporated in Delaware as well. Over the years, Delaware’s incorporation monopoly has been challenged by several other states, but they have had only modest success.
The newest entrant in the “race” among the states is North Dakota, which enacted its Publicly Traded Corporations Act in 2007 in an attempt to offer a “shareholder-friendly” alternative to Delaware. The Act received a fair amount of attention from noted scholars and stimulated a flurry of shareholder proposals to reincorporate there in the 2009 proxy season. But as Stephen Bainbridge predicted and then reiterated, the initiative failed to attract a significant number of companies from Delaware. Even the shareholder proposals seem to have dried up, with no proposals in the 2011 proxy season.
Why did the North Dakota experiment fail? Bainbridge predicted companies would not reincorporate in North Dakota for three primary reasons (loosely paraphrased): (1) Delaware’s case law and courts allow “legal questions to be answered with confidence,” something that would take North Dakota years to achieve, (2) management has no reason to reincorporate there if the race is to the bottom, and (3) nobody has in incentive to reincorporate there if the race is to the top.
I agree with Bainbridge’s basic reasons for why North Dakota’s law failed but disagree about the inevitability of Delaware’s dominance. North Dakota failed because its approach failed to offer a Pareto superior alternative to the Delaware status quo. The problem with a state merely offering a “shareholder friendly” alternative is that shareholders do not have the power to initiate a reincorporation. This means, as Lucian Bebchuk has pointed out (p. 862), it is very difficult to change when managers favor the status quo—Delaware. If a state is to seriously challenge Delaware (absent federal intervention), it will need to offer an advantage that appeals to management as well as shareholders—in other words, a Pareto superior alternative to Delaware.
I believe there is exactly such a Pareto superior opportunity that has gone unnoticed by challenging states like Nevada and North Dakota. There is one thing that both mangers and shareholders want that Delaware does not provide—ex ante certainty about basic corporate law questions. Although Delaware is often praised for its predictable corporate law, it turns out that innumerable basic, foundational corporate law questions are still completely uncertain in Delaware. To illustrate this, I performed a search in Delaware corporate cases decided since 2005 for issues described as being “of first impression” by the court itself and found (among others) these:
- Do officers have the same fiduciary duties as directors? Gantler v. Stephens (2009).
- Does the Delaware statute of frauds apply to LLC operating agreements? Olson v. Halvorsen (2009).
- Can preferred stock be created with no right to receive dividends? Shintom v. Audiovox (2005).
- What happens when a fiduciary fails to observe its duty of full disclosure? Berger v. Pubco (2009).
- What is a promoter's liability in connection with a preincorporation agreement? Re: GS Petroleum, Inc. v. R and S Fuel (2009).
- Are employment contracts containing restrictive covenants are assignable in a sale of the business? Great American Opportunities v. Cherrydale Fundraising (2010).
These are not obscure interstitial details or rapidly-evolving, cutting edge issues. These are basic questions in stable, even hoary areas of law that should have been resolved clearly and definitively decades ago. I do not mean to suggest that other states do a better job that Delaware at clarifying corporate law rules; they don’t. Other states have all of these types of enduring and perplexing uncertainties, and more. The point is that the law is unclear everywhere because of the maddeningly inefficient tradition of making corporate law decisions through judge-made law. But is that inevitable?
The answer is “no,” because there is an obvious alternative no state has tried. A state like North Dakota could provide more certainty than Delaware simply by taking the monopoly on answers away from the litigators and opening it up to planners. A rival state should create a system for providing reliable answers in advance of litigation—indeed, in advance of corporate action—by allowing its companies to simply ask for authoritative answers to basic questions such as whether preferred stock must pay dividends, by asking in advance of taking action, rather than by litigating after taking action. This is the type of guidance that is common in tax, bank regulation, securities regulation, and other areas that require advance planning, but is strangely absent in corporate law. Whether the ex ante guidance took the form of advisory opinions from a court or interpretive guidance from an administrative agency, the state that established such a mechanism to provide managers with authoritative answers ahead of time about uncertain questions of law would lure managers away from Delaware, shareholder friendly or not.
In this approach, a state would set up an authoritative body, which could consist of a business court or an administrative agency, that would receive and act upon confidential requests for interpretive guidance. Instead of paying Delaware counsel hundreds of thousands of dollars for uncertain predictions about the inclination of their friends on the Court of Chancery, a North Dakota agency could answer the question definitively, with certainty, and most importantly, before a decision had to be made. Other states would have to yield to North Dakota’s interpretation of its own corporate law under the Supreme Court’s interpretation of the internal affairs doctrine, which means that companies would be completely protected by such an interpretation. Thus, managers could proceed with routine transactions without the nagging uncertainty of litigation, and shareholders would be immunized from the destructive activity of nuisance plaintiffs.
Suppose a state implemented this suggestion and was successful in attracting companies away from Delaware. Why wouldn’t Delaware just adopt the innovation and outcompete the upstart state? That is the essence of Bainbridge’s final argument, “if investors valued the provisions of the North Dakota Act, Delaware would have gotten there first.” Yet Delaware could not follow where North Dakota could lead, and this is the key to the understanding why this proposal would work.
Delaware has no incentive to provide ex ante answers to legal problems, either as a first-mover or in response to another state. Why? Because Delaware’s advantage in the corporate charter business is also its vulnerability. The Delaware bar’s entrenched interest depends on the ex post revelation of corporate law answers through constant litigation and adjudication. The demand for members of the Delaware bar is driven by the uncertainty, ambiguity, and confusion created by the reliance on judge-made law. Only Delaware lawyers are able to provide companies the best advice based on off-the record conversations with their friends on the bench. Delaware’s wealth is in its human capital: its bench and its bar. But these informal networks of influence and social advantages are no longer valuable when authoritative answers can be had in advance from another state.
In future posts, I plan to build out this proposal for how a small state could make a big impact on corporate law in the United States. In the mean time, I'll wait for a call from North Dakota.