W I T N E S S E T H:

Why is Delaware so dominant in corporate law?

Why is Delaware so dominant in corporate law? The traditional story among most practicing corporate lawyers is that Delaware's superior corporate law, judiciary, and responsiveness allowed it to win an interstate competition for corporate charters. According to this perspective, Delaware is "just better." But as many, many academic papers have argued, however, the true reason for Delaware's continued dominance is likely much more complex.

In my recent paper, The Delaware Trap: An Empirical Study of Incorporation Decisions, I attempt to provide some new information to help explain the drivers of incorporation decisions. Using a large dataset of corporate finance filings, I find that one of the strongest predictors of a company's choice of incorporation state is its choice of law firm. In other words, the data suggest that many companies are not choosing Delaware over other states because of the quality of its law or because of the companies' individual needs, but rather companies choose the type of law firm, and the type of law firm largely dictates the state of incorporation. These results suggest that we may need to rethink much of the research on state competition in corporate law.

Here is the abstract:

One of the most enduring debates in corporate law centers on why Delaware has become the dominant state in the market for corporate charters. Traditionally, two perspectives dominated the debate, the “race to the top” perspective that sees competition among states as driving legal rules toward efficiency and the “race to the bottom” perspective that sees competition among states as driving legal rules toward the interests of corporate managers. The two dominant perspectives have struggled to explain why approximately half of companies incorporate in Delaware, while the other half incorporate in their home states. Whether the choices are attributable to the quality of state law or to characteristics of the companies themselves or both has given rise to a large, but inconclusive empirical literature.

This Article uses a large dataset of corporate financings to shed new light on this mystery and uncovers strong evidence that some of the strongest factors in incorporation choice are factors unrelated to either the quality of state law or the characteristics of individual companies. Instead, the data strongly suggest that demographic markers of sophistication, such as choice of law firm and headquarters location, predict the jurisdictional choice about as well as state law or the business attributes of companies. Companies with more demographic markers of sophistication tend to choose Delaware incorporation, and companies with fewer demographic markers of sophistication tend to choose home-state incorporation. The finding persists even when other attributes of the company are controlled for, such as its industry classification, the amount of money raised, or whether the company is public or private. Indeed, the sophistication factors arguably predict Delaware incorporation as well or better than any factors documented in the vast literature on state competition for corporate charters.

The findings have important implications for the state “race-to-the-top” debate in corporate law. At a minimum the results in this Article make it clear that the choice of legal representation is an important missing variable in models of incorporation decisions. The fact that the choice of law firms drives the jurisdictional choice has far broader implications. If law firms drive the jurisdictional choice they may steer companies toward states that serve the law firms’ own interests without regard to the quality of legal rules or the needs of the client. When the state chosen is Delaware, as it often is, there are few alternative jurisdictions that shareholders and managers can agree on. As a result, companies inadvertently fall into a “governance trap” from which reincorporation out of state is nearly impossible. This interpretation would suggest that Delaware’s carefully calibrated positioning in the charter market has largely eliminated meaningful competition among the states for the quality of corporate law.

My paper is available on SSRN here. 

Long and short of corporate governance from Marty Lipton, again

Marty Lipton is again railing against "short-termism" in corporate governance, while confusing operational horizon short-termism (maximizing profits in the accounting sense in the short-term, which nobody advocates) with investment horizon short-termism (maximizing the stock price in the short-term, which is a plausible objective). The facile assumption that investment horizon short-termism leads to operational short-termism is seductive but largely incorrect, I argued in The Long and Short of Corporate Governance. Many thoughtful commentators disagree with my perspective that short (or long) investment horizon does not dictate short (or long) operational horizon, but to not even acknowledge the role of the market in the "long-and-short" debate isn't intellectually honest.

SEC Roundtable on Proxy Voting Announced

Yesterday the Securities and Exchange Commission announced a roundtable on proxy voting to take place on February 19. The roundtable is to focus on two key questions: (1) whether to facilitate use of universal proxies, and (2) increasing retail shareholder participation in the proxy process.

The universal proxy idea would be a useful reform, depending on how any proposal would be implemented. The current "short slate" exceptions to the "bona fide nominee" rule are unnecessarily cumbersome for those attempting to seat a few nominees on a board and invite excessive strategic manipulation. A simple proxy form with all the names of nominees clearly indicated would give shareholders the best opportunity to select the mix of nominees they prefer.

The issue of promoting retail proxy participation is an interesting one. Presumably, by "retail" shareholder the SEC means non-institutional shareholders. These shareholders have much lower rates of participation in the process than do institutional shareholders, in part because of the rational apathy that derives from holding an infinitesimal stake in the company.

Any initiative to increase retail shareholder participation in the proxy process needs to confront the basic fact of rational apathy head on, rather than taking the approach that more investor "education" is necessary. Retail shareholders don't have the economic incentives to research individual companies' nominees to determine whether or not to support them, and that's true no matter how educated or "civic-minded" the retail shareholders are. Indeed, even if one tried to determine which nominees to support, information is rarely available as to how individual directors (as opposed to the board as a whole) voted on particular matters, so they have to throw the whole slate out or keep all of them.

The only solution that would allow retail shareholders to have a meaningful participation would be to have "political parties" for corporate directors. This is the reason voters are able to make up their minds on obscure political races. Each party has a set of principles that nominees (more or less) support, enabling voters to cast ballots in political races without detailed research on each individual.

Likewise, directors could disclose which "platform" they identified most with, whether it's the ISS approach (pro-shareholder), the Business Roundtable (pro-management), or one of the employee pension funds (mixed and complicated). At least with this information retail shareholders would have an opportunity to meaningfully evaluate candidates. Without an approach like this, it seems that trying to increase retail participation in the proxy process is a lost cause.

Forum Selection Bylaws Appeal Dropped

Exclusive forum bylaws are enforceable in Delaware, at least for now. That's because, as Fish & Richardson's Litigation Blog reported, the plaintiffs have apparently dismissed their appeal of the Chancery Court case that validated the bylaws, Boilermakers Local 154 Retirement Fund, et al. v. Chevron Corp. 

This is important news for Delaware companies because exclusive forum selection bylaws can help reduce the risk of simultaneous litigation in multiple forums and adoption of the bylaws doesn't require a shareholder vote. This means that a board can adopt the bylaws at a regular meeting, and there seems to be little reason not to do so. As a result, many, many companies are adopting these bylaws each week, and those Boards who haven't examined them yet should consider doing so at their next meeting.

You can find a blog post about Exemplify's standard forum selection bylaws here. Interestingly, although most companies have adopted bylaws very close to the Chevron or FedEx ones validated in the Boilermakers decision, Exemplify analysis suggests that the standard version is evolving. In particular most firms have not inadvertently copied the misspelled word Exemplify identified in the original Chevron bylaws, although about 10% have. 

SEC Proposes Pay Ratio Disclosure

On September 18 the Securities and Exchange Commission proposed rules to implement the "pay ratio disclosure" called for by the Dodd-Frank Act. The rules require publicly traded companies to identify (1) the median annual total compensation of all employees and (2) the median annual total compensation of Chief Executive Officer, and (3) for the benefit of those who haven't mastered the arcane art of division, the ratio of the two numbers. The rules, which are  pursuant to Section 953(b) of the Dodd-Frank Act of 2010, are implemented through an amendment to Item 402 of Regulation S-K.

The pay ratio disclosure rule is controversial. Prior to even proposing the rule, the SEC apparently had received over 22,000 comment letters plus a huge number of form letters. The proposed rule itself passed by only a 3-2 vote at the Commission level and totaled 162 pages of text. Yes, it took the Commission staff 162 pages to describe a ratio of two numbers.

Part of the reason the proposal is so lengthy is that the Commission staff is trying to be flexible on how companies implement it. The proposal would exempt "emerging growth companies," "smaller reporting companies," and foreign private issuers, and would allow statistical sampling and other methodological flexibility in making the median employee determination.

The likely reason the staff is trying to be flexible is that they themselves realize that the pay ratio disclosure wIll be costly for businesses and has little to do with investor protection. As Commissioner Michael Piwowar correctly noted, the proposal "unambiguously harms investors" and has no benefits that are within the SEC's mission. And Commissioner Daniel Gallagher pointed out that the SEC staff themselves were unable to identify any benefits from the proposed rule.

So who is in favor of the proposal? Commissioner Luis Aguilar argued that the disclosure of the pay ratio is necessary because "investors are asking if such a high level of CEO-pay multiples is in the interest of corporations and their shareholders." But of course investors as investors are asking no such question. Investors may well believe executive compensation is too high, but that information is already disclosed in excruciating detail under existing rules. The only new piece of information is the determination of the "median" employee, and this is the most costly and irrelevant aspect of the rule. Imagine a large corporation with many subisidiaries, each with its own mix of part-time, seasonal, offshore, and other employees making such a calculation. How is a large company supposed to make that calculation at reasonable cost, and who cares? The most likely scenario is that companies will waste large sums of money attempting to comply with the requirement and investors will pay no attention to the disclosure. 

Aguilar cites only three agenda-driven social activist funds who are purportedly "asking" for the disclosure, along with the AFL-CIO (see footnote 3). Indeed, the most vocal supporter of the rules seems to be Richard Trumka, the head of the AFL-CIO. I think it's beyond question that the AFL-CIO may have overriding objectives other than investor protection.

The pay ratio disclosure may, somewhat ironically, work against the labor interests that pressed it so strongly. The disclosure will not reveal anything about overpaid executives (as that is already disclosed), but it may reveal something about overpaid rank-and-file employees. If employees are being overcompensated, one might actually see hostile bidders and activist hedge funds using this information to agitate for a takeover and mass layoffs. So the labor push to calculate this information could actually work against employee interests.

In a sense, the SEC had little choice but to issue pay-ratio rules because Dodd-Frank required this disclosure. However, the SEC has authority to create safe harbors from disclosure rules, and the SEC should do everything possible to minimize the impact on the economy. In particular, the best solution would be for the SEC to create a safe harbor for companies that estimate the pay gap between CEO and median employee on the high side or within a range. That would serve the objectives of the Dodd-Frank Act that assume is that a large gap is a bad thing, while not requiring companies to calculate the exact numbers. Or, alternatively, the Commission could only require disclosure of the ratio only if material to investors, but I won't hold my breath for that.