I’m just catching up with this Board Member article about Delaware’s new competitor, Nevada. It notes that Nevada’s share of the out-of-state incorporation market rose from 4.6% in 2000 to 6% in 2007. Part of this may be due to lower fees than Delaware. But that can’t be the full explanation because all states are cheaper than Delaware. More interestingly, the article suggests Nevada may be succeeding by offering a haven for shady operators with low fiduciary standards and high barriers to takeovers.
The article features a discussion of Michal Barzuza’s article with David Smith, What Happens in Nevada? Self-Selecting into a Lax Law, which as the title indicates supports the competition-for-laxity position. This paper, as the Board Member article notes, shows that “Nevada corporations posted accounting restatements twice as often as the national average from 2000-2008.” Barzuza tells Board Member: “It should be a cause for concern if the companies that need regulation most are allowed to choose a lax legal regime.”
I get a chance to respond in the Board Member article. Here’s my quote: “The data show that riskier firms are going to Nevada, but risky firms need capital, too. What Delaware has to offer is its legal infrastructure. But it’s reasonable to ask what that is worth to me as a business.” This is along the lines of my comment on Barzuza-Smith at last year’s Conference on Empirical Legal Studies.
Barzuza also has a sole-authored paper that focuses on the normative aspects of the Barzuza-Smith empirical study. That paper doesn’t yet have a public link, but I’ve read it and saw it presented at ALEA last week.
Barzuza and I agree that Delaware and Nevada appeal to different segments of the incorporation market. We disagree on whether this is a problem. In a nutshell:
- Barzuza thinks the relatively high level of accounting restatements by Nevada corporations indicates Nevada offers an escape from regulation for firms that most need to be regulated. As Barzuza-Smith say in their abstract: “Our findings indicate that firms may self-select a legal system that matches their desirable level of private-benefit consumption, and that Nevada competes to attract firms with higher agency costs.”
- But I see an efficient contracting story, with Nevada offering smaller firms an opportunity to economize on monitoring and litigation costs. (Note: the more recent unposted Barzuza paper also discusses the efficient contracting story.)
The implications of this debate are important because it carries the threat of more federal regulation of corporate governance.
Here’s some support for my efficient contracting hypothesis:
- Nevada isn’t, in fact, a haven for defrauders. Its law provides for liability for fraud as well as intentional misconduct or a knowing violation of law. It couldn’t if it wanted to offer escape from federal securities law liability. Although B-S (Table 4) show a higher fraud percentage in Nevada restatements, the total percentage is tiny in Nevada as elsewhere. More importantly, B-S found no evidence that increased restatements followed incorporation under Nevada’s lax (post-2000) provisions. In other words, although Nevada may attract dishonest managers, there’s no indication these firms were reincorporating in Nevada in order to commit fraud.
- The value of Nevada corporations doesn’t suffer from any evident “fraud discount” as measured by Tobin’s q (B-S Table 5) (although it’s not clear how these values might be affected by pre- or post-restatement accounting).
- There are benign explanations for the larger number of Nevada accounting restatements. Nevada public firms are smaller than those in Delaware, increasing the per capitalization cost of setting up controls that could catch accounting errors. Small size is one of the factors associated with weaker controls (see Doyle, Ge and McVay). B-S show that Nevada has a relatively high percentage of mining firms, and Barzuza’s ALEA paper shows that Nevada has a relatively high percentage of family firms. Both of these characteristics relate to the amount and type of monitoring required, and therefore to the efficient contracting story.
In short, the article’s data is consistent with the hypothesis that firms choose Nevada for its better balance of costs and benefits of monitoring than they could get in Delaware. Its strict default standards for suing managers may tolerate some managerial misconduct, but they also reduce firms’ exposure to opportunistic strike litigation. Nevada removes from its statute the sources of legal indeterminacy that Delaware has been criticized for. This enables Nevada to offer a legal package that is attractive to some firms without the costly legal infrastructure required to apply Delaware’s open-ended good-faith and loyalty standards.
In other words, in contrast to the B-S claim that Nevada “competes to attract firms with higher agency costs,” in fact Nevada may be attracting firms seeking lower agency costs defined by Jensen & Meckling to include monitoring and bonding costs as well as agent misconduct (Jensen & Meckling, Theory of the Firm: Managerial Behavior, Agency Costs and Ownership Structure, 3 J. Fin. Econ. 305 (1976). This recognizes that the costs of hiring an agent, and thereby separating ownership and control, are never zero. Attempting to reduce agent misconduct to zero could actually increase total agency costs as compared with cheaper monitoring that tolerates a reasonable level of agent misconduct.
None of this is to say that Nevada law offers an optimal set of terms. We could probably benefit from additional standard forms to match firms’ diverse governance needs. (Watch for my forthcoming paper with Kobayashi on the production of private law.) But Nevada law doesn’t have to be optimal to be welfare-increasing. The question is whether the Nevada package of terms offers a better match for some firms than a Nevada-less market for corporations in which only Delaware competes for out-of-state incorporations.
Aside from substantively evaluating Nevada law, it is worth asking whether the Nevada story suggests market failure in the corporate law market. B-S show that Nevada is not pretending to be something it isn’t. It clearly advertises its “laxity,” so both shareholders and managers know what they’re getting. Moreover, the Board Member article indicates there’s inherent resistance to any state that departs from the Delaware standard. Investors may over-discount Nevada corporate shares out of distrust or fear of the unknown so Nevada laxity is, if anything, over-reflected, in the price of Nevada IPOs. If Nevada shareholders don’t get an adequate voice on Nevada reincorporations (as where an existing firm merges with a Nevada shell) this is a problem with the law of the non-Nevada states where the firms originate.
So more work needs to be done to flesh out the Nevada story. This might include
- More specific comparisons of the firms that are and aren’t choosing Nevada to get a clearer picture of the effect of Nevada incorporation.
- As somebody suggested at ALEA, perhaps California-based firms incorporating in Nevada may not really be choosing Nevada governance law because of California’s “quasi-foreign” provisions.
- Is there an “out of Nevada” effect analogous to the “out of Delaware” effect documented by Armour, Black and Cheffins, in which Nevada corporate cases, particularly those involving fraud, are being litigated in, say, California or federal court? This would negate any effort by Nevada to attract managers seeking to escape fraud liability.
- Is Nevada using a similar strategy to compete in the market for LLCs? Kobayashi and my data on the market for LLCs suggest not, and that the overall market for LLCs differs from that for corporations. So why don’t firms opt out of Delaware corporate law by opting into uncorporate law? I show that this strategy could produce a Nevada-like reduction of indeterminacy.
In short, Barzuza & Smith are right and clever to focus on this evidence of segmentation in the incorporation market. This contradicts those who contend that the so-called market for out-of-state incorporations is really a Delaware monopoly.
But it’s a mistake without much more data to jump to the conclusion that this is a “cause for concern.” This sort of argument could feed building pressures to federalize corporate law. So far the Nevada story shows that there’s a significant demand for rules that reduce governance costs even in the face of strong pressures toward Delaware standardization. This cuts against rather than for increasing federalization, particularly as we are learning that even federal law competes in a global market for corporate law.
I’m a big believer that small firms need a place to incorporate that is cheaper than Delaware. Still my experience as a risk arb both before and after Nevada began its big campaign to attract incorporation business is that Nevada companies rank among the shadiest in our marketplace. Hence its shell corporations remain the targets of choice for chinese reverse mergers–for reasons discussed in the article you cite. I’m no academic but I’m sure the evidence will
eventually show it is not generally efficiency that attracts companies to Nevada incorporation. It is more likely to be “race to the bottom” factors. After all find me the state who says (and adopts laws that say) explicitly “incorporate here–you get Delaware law without the pricetag”. Certainly if this was just a matter of efficiency you would get some state who would do just that and that might get some silicon valley business.
I also chuckle at the quotes from Wilson Sonsini’s David Berger given his recent experiences (that ended well for him thanks to Greg Williams of Richards, Layton) with Chancellor Laster in representing Nighthawk Radiology in the Virtual Radiologic merger-related shareholder litigation.