Getting Stuck between Bottom and Top: State Competition for Corporate Charters in the Presence of Network Effects

74 Pages Posted: 29 Oct 2002

See all articles by Brett McDonnell

Brett McDonnell

University of Minnesota Law School

Date Written: September 4, 2002

Abstract

For decades, American legal scholars have debated over the implications of allowing corporations to choose in which state they will incorporate, irrespective of where they do business. Until recently the debate has centered almost exclusively on whether the managers who choose where to incorporate have incentive to choose a state whose laws favor managers to the disadvantage of shareholders (the "race to the bottom" thesis) or whether their incentives are to choose states whose laws treat shareholders properly (the "race to the top" thesis). Recently, some scholars have questioned whether the state charter competition process will necessarily lead to an optimal choice from the point of view of corporate decisionmakers, whatever the incentives of those decisionmakers might be. The presence of a variety of network effects may cause corporations to incorporate in a state which already has taken the lead in the charter race, even if some other states might offer better substantive law. For instance, corporations may prefer a state which has a well-developed, and hence more predictable, body of corporate law, or they may prefer to appear before judges who from much experience are familiar with corporate law matters. These effects may cause the whole system to get stuck with sub-optimal laws dominating.

This paper takes the presence of significant network effects in corporate charter competition as a given. It then asks whether allowing competition between states is an attractive option, and how much competition is best. Even if network effects create the possibility of getting stuck with a sub-optimal dominant state, allowing competition may improve the odds of reaching a good corporate legal system. The paper presents a very simple model of charter competition as a way to start thinking about the issues involved. Within that model, some competition tends to lead to better results than no competition at all. However, more competition is not necessarily better than less, and a very large amount of competition may be as bad as no competition at all.

The paper considers many questions that remain quite open in this area. It concludes by posing the question of how to make empirical recommendations where theory and empirical evidence suggest no clear answers. It suggests that little change from the present structure is likely, and that critics have yet to make a persuasive case for such change.

Keywords: Delaware, state competition, corporate charters, network effects, lock-in, race to the bottom, path dependence

JEL Classification: G34, K22

Suggested Citation

McDonnell, Brett H., Getting Stuck between Bottom and Top: State Competition for Corporate Charters in the Presence of Network Effects (September 4, 2002). Available at SSRN: https://ssrn.com/abstract=330661 or http://dx.doi.org/10.2139/ssrn.330661

Brett H. McDonnell (Contact Author)

University of Minnesota Law School ( email )

229 19th Avenue South
Minneapolis, MN 55455
United States
612-625-1373 (Phone)

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