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.