Comparative Economic Analysis of Regulatory Competition in Corporate Law in Europe and the United States

Content

A. Introduction

B. Literature Overview
1. Race to the Bottom
2. Race to the Top
3. Race to somewhere in between
4. No Race at all
5. Race with the federal legislator
6. The European Debate
7. Summary and Empirical Evidence
a. The American Case
b. The European Case

C. Theoretical Foundations of Regulatory Competition
1. Jurisdictions as Monopolies or Competitors
2. The Market for Regulations
3. Interjurisdictional Competition
4. Forms of Regulatory Competition
5. The Object of Corporate Law: the Firm
a. Necessity of Corporate Law
b. Agency Problems in Corporate Law

D. Functioning of Regulatory Competition in Corporate Law
1. Conditions of Regulatory Competition
a. Sufficient Number of Regulators
b. Mobility of Citizens or Product Factors
2. Advantages of Regulatory Competition
a. Legitimacy
b. Limitation of Power
c. Less Rent-Seeking Activities
d. Satisfaction of Heterogeneous Preferences
e. Learning, Innovation and flexibility
f. Comparative Regulatory Advantages
g. Faster Adjustment to Beneficial Ownership Patterns
3. Problems of Regulatory Competition
a. Interstate and Network Externalities
b. Path Dependencies
c. Lacking Incentives for States
d. Information Problems
aa. Uncertainty of Conflict of Laws Rules
bb. Bounded Rationality
e. Conclusive Summary
4. Possible Solution: “Modulization” and Conflict of Laws facilitation

E. Conclusion

A. Introduction

The legal background of my paper is determined by the decisions of the European Court of Justice (ECJ) from Centros to Inspire Art that obliges EU Member States to recognize each other’s corporate charters. Incorporators can now choose the most suitable corporate charter among all the ones offered by EU Member States, independently of the main location of business transactions. This allows for a regulatory competition between EU Member States in corporate law. Whether a process that leads to an efficient corporate law will take place (positive part), or if not, what alternatives and possibilities for reforms there are to reach that outcome (normative part) is the scope of this analysis.

The situation in the EU is to be compared to the one in the USA, where in a development over the past decades the Delaware corporate law emerged as the one which offers now the preferred charters for an overwhelming majority of US companies. The vast literature on the question whether this outcome of the regulatory competition in the USA is an efficient one, is divided. I will review it to make it fruitful for the European outlook. under the hypothesis that the legal environment for the decision of where (in which state) to incorporate differs very much between both continents. The legal environment includes not only the sector of corporate charters, which provides solutions to the main agency problems (shareholders-managers, minority-majority shareholders, shareholders-third parties) with ex-ante (mandatory) and/or ex-post (liability) rules, but a whole set of legal areas such as e.g. bankruptcy and securities laws. These sectors are federal laws in the US but more decentralized in the EU. If and how this fact might make a difference for the regulatory competition for corporate charters (more “vertical” competition between states and the federal lawmakers in the US, more complexity and legal uncertainty in the EU) in the sense that it has an impact on all participating subjects’ incentives will be assessed.

Generally, the European and American “markets for corporate charters” is to be analyzed from different perspectives:

1. the demand side (neo-classical) as well as the supply side (public choice)
2. who are the market participants? Firms (owners and managers), state and federal legislatures, lobby- and interest groups, business lawyers and accountants, courts and judges
3. what incentives do they have?
4. what are possible barriers to the market? path dependencies, interstate and network externalities, information asymmetries, interjurisdictional incompatabilities

Methodologically, the theoretical framework of New Institutional Economics will be helpful to relax some neo-classical assumptions such as zero transaction costs, perfect information (e.g. how judges in Member state courts will further interpret the conflict of laws rules in detail when determining which national corporate law is applicable is hard to predict from today’s perspective) and knowledge problems (e.g. it must be taken into account that efficient regulatory solutions might become inefficient from a dynamic perspective, i.e. over time), as well as bounded rationality.

Taken these considerations into account, a normative conclusion shall define which parts of corporate law are better harmonized and which parts should be left open to regulatory competition and if this conclusion is different for the US and the EU. Also it will be asked regarding the barriers that exist to an efficient, well functioning regulatory competition how they should be tackled by new legislation. In other words: how can market (for corporate charters) inefficiencies best be addressed.

One proposal by the literature is to allow for a separate competition of the procedural aspect, i.e. to “unbundle” courts jurisdictions in corporate law from the corporate statutes themselves.^[1] Another is to provide for more incentives for states to engage in regulatory competition, e.g. through higher mandatory franchise taxes. These proposals have to be assessed. Especially the problem of interjurisdictional incompatibilities has important implications for institutional reform.

In the US it is principally the states that are in charge of regulating the internal affairs of corporations. States allow firms to relocate in other states. Hence, it is argued that states are engaging in a process of competing for corporate charters.

In the EU this basic setting is today quite similar: the EU Member States have separately created their own corporate law systems for decades. Though only since the European Court of Justice (ECJ) ruled in a series of famous decisions from Centros to Inspire Art that Member States have to recognize firms who are incorporated under other Member States’ corporate law, the possibility for regulatory competition in corporate is opened in the EU as well.

Comparing the situations in Europe and America from a law and economics perspective, the guiding hypothesis of this thesis is that while regulatory competition in corporate law can lead to efficient results, several problems have to be taken into account. Inefficiencies in American and European regulatory competition in corporate law are mainly due to these problems. A possible normative solution to such inefficiencies is assessed.

Other findings of this thesis involves the following aspects:

Firstly, while regulatory competition in corporate law in the U.S. might have been economically efficient in the past, it now can be identified several factors that lead to suboptimal outcomes which can be explained positively by applying existing theories on the issue as complementary ones.

Secondly, the European legal and economic situation resembles important factors of the American one while there are some major differences that will probably lead to different outcomes to those in the U.S. – though these are suboptimal as well.

Thirdly, a normative conclusion is drawn from these comparative observations. It can be efficient to restructure the framework in which regulatory competition in corporate law takes place in both, the U.S. and the EU. It is proposed a form of procedural harmonization and a simplification of conflict of laws that will allow states to compete for separate modules of legal sectors in corporate law. Thus innovation and learning processes in corporate regulations will be easier comparable and a sustainable race to the top may begin.

The arguments are developed as follows:

Part B summarizes the contemporary theories on regulatory competition in corporate law shortly to provide an overview over the debate.

Part C goes a step back and reviews the underlying theoretical foundations that shape the discussion. Due to the complexity and scope of the issue it will be necessary to cover a variety of different approaches from economic federalism theory over the theory of the firm to special features of corporate law. Employing neoclassical as well as public choice theory several advantages and problems of regulatory competition will be assessed.

Part D deepens and applies the theoretical insights to the markets of corporate law. Differences between the U.S. and the European market are shown as well as normative conclusions that may prevent the problems with regulatory competition in corporate law to fully harm both economies.

Given the limited size of this paper it has to be acknowledged that not every factor that might have its effect on the issue can be assessed nor even mentioned.

In this paper I identify and assess only the most important factors that have the largest effect. This is feasible since the smaller factors do not have a significant impact large enough to come to different conclusions as the major factors will imply.

B. Literature Overview

The question on the nature and possible effects of regulatory competition in corporate law has been addressed by a vast number of legal and economic scholars in the U.S. already for decades. Until now there is no consensus in sight. Several streams of the academic debate can be distinguished:

The more classic debate is whether it is a race (between the states) to the bottom or to the top. More recent arguments are that the race leads to neither top nor bottom, that the race is very weak or even that there is no race at all. It also has been stated that the race is of a vertical rather than a horizontal kind, i.e. the competition takes place between Delaware and the federal legislator.

The European debate – which only started recently following the recent legal development of the ECJ decisions in Centros and Inspire Art – resembles to a large extent these lines of arguments although differences between both jurisdictions are emphasized.

1. Race to the Bottom

The modern “race to the bottom”-view was taken first by William Cary in 1974.^[2] He argued that Delaware corporate law puts only minimal limits on manager’s ability to extract capital from investors.^[3] It does so because managers in fact dominate incorporation decisions and Delaware wants to attract and retain firms in order to collect as many franchise fees as possible. So Delaware has to cater to the managers’ interests.

This setting leads to the erosion of corporate law standards and a reluctant judiciary. Thus Delaware leads a race to the bottom to the expense of shareholders and social welfare.^[4]

The solution to this problem is seen in changing the institutional arrangements either in putting limits to the downward race (e.g. in adopting federal rules^[5] ) or in allowing the favorable market mechanisms to work without its inefficient distortions.

2. Race to the Top

Ralph Winter rejected the race to the bottom-view saying that states have an incentive to adopt efficient corporate rules benefiting shareholders. This is so because inefficient rules in one state would lead to lower share prices of companies incorporated there compared to companies in other states with more efficient rules. The former companies thus would become a target to hostile takeovers. To prevent this, managers seek efficient rules that maximize share prices. States in turn provide these rules in order to attract and retain incorporations to collect more franchise fees.

3. Race to somewhere in between

The third branch of literature argues that while historically there has been a race between the states nowadays Delaware has established a quasi-monopoly. This status created prohibitive market entrance costs, network externalities and political barriers that hinder other states to make efforts in order to engage in a further competitive race.^[6] Thus Delaware is interested only in protecting its market power and maximizing its revenue which lead to a corporate law that is pro-managerial biased and generally of sub-optimal quality.

4. No Race at all

Recent Scholarship suggests that there exists no race at all.^[7] Nearly all corporations that choose to incorporate out of state choose Delaware as its home state.^[8] Other states do not compete actively with Delaware for charters.^[9] The design of statutes, court systems and franchise taxes of these states is insufficient to allow them to generate additional revenue by attracting firms’ incorporations.^[10]

5. Race with the federal legislator

Another perspective first developed by Mark Roe holds that the current state of U.S. corporate law can be explained to a great extent by the competition that Delaware faces from the federal government.^[11] Federal authorities have intruded into states’ corporate law in respect to a number of important issues. Most prominently example of such interference is the enactment of the Sarbanes-Oxley Act.^[12] Delaware designs its laws in order to preserve its dominant position in relation to other states having in mind the threat from the federal legislator to take corporate law issues away.

This theory implies that if Delaware law is efficient it is not necessarily a result of a race to the top. And if it is inefficient, it is not necessarily a result of a race to the bottom.^[13] Instead Delaware’s corporate law is a result of a race with the threat of a federal intervention. Another approach to the vertical relationship between Delaware and Washington D.C. is describing it as a symbiotic rather than a competitive relation. According to this theory the ‘federal threat’ exists only in times of corporate scandals. It views the relationship between Delaware and the federal level as beneficial in supplying complementary parts of corporate law.

6. The European Debate

The European debate on the issue began only a couple of years ago in the aftermath of the recent ECJ decisions that for the first time opened up the possibility for regulatory competition in corporate law.^[14] Consequently the discussion can be characterized as a predictive one, looking more forward rather than drawing on – admittedly hardly existing - historical experience. Most ‘European’ scholars review the debate in the U.S. and then draw conclusions to the situation in the EU.

The majority of scholars so far took the view that regulatory competition in corporate law in the EU will be either not of great significance or a race to the bottom.^[15]

Only a minority views it as being desirable and beneficial;^[16] though at the same time stressing that it will differ from the U.S. development.^[17]

Also the relationship between the ‘federal’ level (the EU) and the (Member) states is stressed.^[18]

7. Summary and Empirical Evidence

a. The American Case

Both traditional theories (the “race to the top” and the “race to the bottom”-theory) have in common, that each of them consist of a basic mechanism that is very convincing at first sight.^[19] The race to the bottom view employs a model of political behavior that politicians maximize tax revenue which depends directly on the number of incorporations over which the self-interested managers decide. The race to the top view employs a mechanism of highly mobile capital that flows into the jurisdiction that provides the value-maximizing system for the investor.

The problem with both theories is that they implicitly assume situations and behavioral hypothesis that are heavily discussed in scholarship without consensus in sight. These assumptions partially resemble the strict assumptions on rationality of actors in neoclassical and public choice theories.

The problem of the other more recent theories is that they shed light on important factors that may have an impact on corporate lawmaking but are not able to explain the developments in corporate law holistically.

While the existing theories for themselves remain enlightening though not fully convincing, an integrating approach that views the theories as complementary ones rather than contradictory ones might be more promising.^[20]

The empirical evidence might support this view. It appears that every scholar - independently of the theory she follows – finds empirical data that proves her opinion.

To begin with, empirical evidence is clear on the fact that Delaware is attracting almost every single out-of-state incorporation. The Majority of Fortune 500 firms and Dow Jones Index-listed firms are incorporated in Delaware. But this fact alone does not imply an efficient corporate law.

A critical assessment of research on the correlation between Delaware incorporation and firm value or returns leaves ambiguous results:^[21]

Firstly, the evidence on whether incorporation in Delaware is correlated with a higher firm value (measured with Tobin’s Q^[22] ) is rather mixed.^[23] Even if such a correlation could be found, a possible alternative explanation than that of the efficiency of the Delaware corporate law may be a tendency of higher-value firms to incorporate in Delaware.

Secondly, the evidence is ambiguous as to whether reincorporation in Delaware correlates with a positive abnormal return.^[24] Even if such a correlation did exist, it would not imply that Delaware law increases value but could that such correlation could be due to e.g. the circumstance that firms have a tendency to propose reincorporation in case of good news for shareholders.^[25]

Thirdly, even if these types of empirical work found that Delaware law is superior to other states’ law it could also mean that all state laws are in a suboptimal equilibrium.^[26]

Several reform proposals are hotly discussed in the U.S. to strengthen the efficiency of corporate law. The proposals include the empowerment of shareholders to counter-balance the alleged pro-managerial bias of Delaware law^[27] as well as a simplification of corporate law in form of a “delayering”^[28] of the state and federal rules to allow both levels to regulate separate parts of the corporate reality. Without being able – due to the limited size of this thesis - to discuss such proposals in detail, especially the proposal of simplification and delayering of corporate law is partially resembled in the European debate under the proposal of a “modulization” of corporate law areas in context with a reform of the conflict of laws rules. It contains promising solutions to problems of regulatory competition in corporate law both in the U.S. and Europe and will be assessed in more detail.

[...]

^[1] Kirchner et al., Regulatory Competition in EU Corporate Law after Inspire Art: Unbundling Delaware’s Product for Europe, University of Illinois Working Paper No. LE04-001, 2005, available at: http://ssrn.com/abstract=617681

^[2] William L. Cary, Federalism and Corporate Law: Reflections upon Delaware, 83 Yale Law Journal, (1974)

^[3] Id. p. 663

^[4] Id. pp. 668-670

^[5] Cary argued for federal rules on corporate responsibility, Id. p. 671; Bebchuk, Desirable Limits on State Competition in Corporate Law, 105 Harv. L. Rev. Vol. (1992), pp. 1499-1507 (arguing for federal rules or at least federal minimum standards for self-dealing transactions, the appropriation of corporate opportunities, freeze-out mergers, takeover bids, proxy contests, and limitations on dividend)

^[6] Kahan and Kamar, The Myth of State Competition in Corporate Law, 55 Stanford Law Review, 2002, p. 679

^[7] Bebchuk, Cohen and Ferrell, Does the Evidence Favor State Competition in Corporate Law?, 90 Cal. L. Rev. 1775 (2002)

^[8] Kahan and Kamar, supra note 6; Bebchuk and Hamdani, Vigorous Race or Leisurely Walk: Reconsidering the Competition over Corporate Charters, 112 Yale L.J. 553 (2002)

^[9] Kahan and Kamar, supra note 6, pp. 580-582

^[10] Kahan and Kamar, supra note 6, p. 701

^[11] Roe, Delaware’s Competition, 117 Harv. L. Rev. 588 (2003)

^[12] Id. pp. 600-611

^[13] Id. pp. 635-637

^[14] see above

^[15] Enriques, “EC Company Law and the fears of a European Delaware, 15 EBL Rev 1259 (2004)

^[16] e.g. John Armour, Who Should Make Corporate Law: EC Legislation vs. Regulatory Competition, Cambridge University Law Working Paper 54, 2005, http://ssrn.com/abstract=860444

^[17] Armour, supra note 16, predicts that no dominant state like Delaware will emerge but rather that states will specialize in supplying corporate charters for different types of business

^[18] Enriques, supra note 15

^[19] Romano, Law as a Product, Some Pieces of the Incorporation Puzzle, Vol. 1, J. of L., Econ. and Org. (1985), p. 228

^[20] For such an approach see Barzuza, Prize Considerations in the Market for Corporate Law, 26 Cardozo L. Rev. 127 (2004)

^[21] Compare most recently Bebchuk, Letting Shareholders Set the Rules, Discussion Paper No. 548, Harvard (2006), pp. 29-30, available at: http://papers.ssrn.com/abstract=891823

^[22] A standard measure of firm value used by financial economists

^[23] Compare on the one hand Daines, Does Delaware Law Improve Firm Value?, 62 J. Fin. Econ. (2001) p. 525 (finding a positive correlation between firm value and Delaware incorporation) and on the other hand Bebchuk and Cohen, Firms Decisions Where to Incorporate, 46 J.L. and Econ, 383 (2003) (finding no evidence of such a correlation in 1999) and Subramanian, The Disappearing Delaware Effect, 20 J.L. Econ. and Org. 32, 41 (2004) (finding no evidence of such a correlation during the 1990s except for firms with a very small market value)

^[24] Compare on the one hand Romano, supra note 19, pp. 233-244 (finding abnormal returns) and on the other hand Bebchuk, supra note 7 (finding a more mixed result)

^[25] Bebchuk, supra note 21, p. 30

^[26] Bebchuk, Bar-Gill et al., The Market for Corporate Law, forthcoming in Journal of Institutional and Theoretical Economics (2006), already available at: http://papers.ssrn.com/abstract_id=275452

^[27] Especially active for these proposals is Lucian Bebchuk

^[28] Dibadj, Delayering Corporate Law, 34 Hofstra L. Rev. 469 (2005)