Archives For Jurisdictional competition

Barbara Black has suggested that the time may have come to reconsider arbitration of federal securities claims against issuers (and not just brokers).  And that’s only the beginning.  Here’s the abstract:

Ever since the U.S. Supreme Court held that arbitration provisions contained in brokerage customers’ agreements were enforceable with respect to federal securities claims, proposals have been floated to include in an issuer’s governance documents a provision that would require arbitration of investors’ claims against the issuer. To date, however, publicly traded domestic issuers and their counsel have not seriously pursued these proposals, probably because of several legal obstacles to implementation. In addition to these legal obstacles, publicly traded issuers may not have perceived significant advantages to arbitration. Recent legal developments, however, make inclusion of an arbitration provision in a publicly traded issuer’s governance documents a proposal worthy of serious consideration. In particular, because of the Supreme Court’s recent opinion in AT&T Mobility LLC v. Concepcion, issuers may be able to achieve an advantage through adoption of an arbitration provision in their governance documents that they were not able to achieve through PSLRA and the Securities Litigation Uniform Standards Act. They could finally achieve the demise of securities class claims.

And from the conclusion (footnotes omitted):

The overarching policy issue is the future of the securities class actions. Respected academics have previously called for the SEC to take an active role in assessing the strengths and weaknesses of the federal securities class action.  There have been similar calls for reform of state securities class actions. Currently there are numerous securities class actions working their way through the judicial system in the wake of the 2008 financial crisis. In short, the time is right for a re-examination of the costs and benefits of securities class actions.

I argued when it was decided that the AT&T case “could end up being one of the most important pro-business cases of the last several years.”  That may be an understatment.

The paper, with Kobayashi, is Law As A Byproduct: Theories Of Private Law Production.  Here’s the abstract:

Public lawmakers lack incentives to engage in a socially optimal amount of legal innovation. Private lawmaking is a potential solution to this problem. However, private lawmaking faces a dilemma: In order to be effective privately produced laws need to be publicly enacted, but under current law enactment eliminates the intellectual property rights that are essential to motivate private lawmakers. Because of this dilemma, much private lawmaking is done as a byproduct of other activities. The mixed incentives entailed in this “byproduct” approach make it a second-best response to the problems of public lawmaking. Potential solutions involve finding a better balance between public access and private rights.

The paper treats the creation of law as a form of intellectual property.  The central problem the paper identifies is the weakness of intellectual property protection of law.  This forces private lawmaking into the second-best world of “byproduct” lawmaking, where private lawmaking is essentially a form of lobbying.  This particularly includes the practicing bar’s significant role in lawmaking, and uniform laws.  The paper draws illustrations of byproduct laws from the development of the limited liability company, including the “L3C” spinoff.  We conclude with suggestions of how to fix intellectual property law to bring private lawmaking closer to a first-best world.

This paper is a natural outgrowth of several strands of my work alone and with others, including on LLCs and uncorporations, jurisdictional competition, lawyers as lawmakers, uniform laws, the “information revolution’s” effect on the law industry, and law teaching.

The literature on the state “market” for LLC law is growing.  Bruce Kobayashi and I published what I would modestly call the leading study (K & R) on jurisdictional competition for LLCs.  There is also an unpublished study to which our article is in part a response by Dammann & Schündeln (D & S). Now there’s a third study, Hausermann, For a Few Dollars Less: Explaining State to State Variation in Limited Liability Company Popularity.  Here’s the abstract:

The limited liability company (LLC) is a much more popular business entity in some U.S. states than in others. This empirical study provides the first detailed analysis of this phenomenon, using a partly original set of cross-sectional state-level data. I find that formation fees, rather than taxes or substantive rules or anything else, explain the variation in LLC popularity best. Differentials between the fees for organizing an LLC and the fees for organizing a corporation explain 17% to 28% of the state-to-state variation in LLC popularity. These formation fee differentials are not very big, but they are highly visible at the moment the business entity is formed. In contrast, the data show no relationship between LLC popularity and differentials in annual fees and state entity-level taxes. I find only weak evidence that the popularity of the LLC is associated with different substantive rules contained in state LLC statutes. However, LLCs are more popular in those states whose LLC statutes expressly uphold the principle of contractual freedom and thus reassure LLC members that courts will not rewrite their contract in the event of a lawsuit. Finally, I found no evidence that LLC popularity is related to different levels of uniformity of LLC statutes, the age of LLC statutes, and other factors.

Note that while K & R and D & S focus on state competition for out-of-state formations, Hausermann looks at the “popularity” of the LLC vs. the corporate form within each state.  Kobayashi and I found that Delaware has won the national competition, the most likely explanation being the quality of its courts.  This contrasts with D & S’s findings “that substantive law matters to the formation state choices of closely held limited liability companies” and that LLCs “appear to be migrating away from states that offer lax norms on minority investor protection.”

Hausermann mostly confirms K & R’s conclusion that the substance of the statutes is not determining parties’ formation choices.  His corporation/LLC comparison finds that the important variable is the difference in each state between the fees for forming an LLC and those for forming a corporation.

A few points to note about Hausermann’s study:

  • Although the author emphasizes K & R and D & S re state competition for LLCs, the closer comparison is with Kobayashi and my study of the state-by-state relative popularity of LLCs and LLPs, which Hausermann also discusses. We found that LLCs beat LLPs despite the expectation from the “network externalities” literature that the LLP’s connection to the “network” of partnership cases and forms would give it an advantage over the LLC.  Similar to Hausermann, we found that the costs of forming the two types of business associations (specifically, entity-level taxes) affected state-to-state differences in their relative popularity.
  • Hausermann finds that even tiny fee differences between corporations and LLCs make a difference in popularity of the two forms and that the parties ignore continuing fees and focus on upfront fees.  This rightly puzzles the author and calls for more theory and data.  I speculate that this reflects incomplete information on the part of many people who are forming LLCs.  This is clearly the case for ignoring continuing fees.  Moreover, since the vast majority of small firms should be LLCs rather than corporations (for more on this, see my Rise of the Uncorporation), making the choice based on tiny differences in upfront fees and ignoring continuing fees likely reflects bad advice and poor information.  In other words, Hausermann’s study arguably suggests the legal services industry is failing small firms.  Perhaps law’s information revolution will fix this.
  • Hausermann shows that freedom of contract regarding fiduciary duties matters to the corporation/LLC choice. This, coupled with the fact that the sheer number of mandatory rules in a statute doesn’t matter, indicates the importance to small firms of certainty that their contract will be enforced by its terms (see Hausermann at p. 36).  The importance of legal certainty is discussed in my and Kobayashi’s recently posted draft on private lawmaking (to be discussed here shortly).

Note what Hausermann finds doesn’t matter to parties’ choice between corporation and LLC:

  • Protection of third-party creditors.  This suggests creditors think they can protect themselves, and that the rise in LLCs vs. corporations is not about avoiding debts.
  • Default rules that members can easily vary by contract.  This is not surprising.  But perhaps default rules would matter if parties had a better and more varied menu of private forms from which to choose. This also relates to Kobayashi and my work on the potential role of private lawmaking.
  • Uniformity in general, and adoption of NCCUSL-promulgated uniform laws in particular.  This casts more doubt on the value of NCCUSL.  My most recent uniform laws article with Kobayashi helps explain why parties aren’t attracted to NCCUSL-drafted laws.

Hausermann rightly suggests the need for further research, including on the effect of overall formation costs, and the role of lawyers in guiding parties to particular forms.

More generally, I would suggest the need not only for more data but also more theory to guide both what kinds of data to get and how to interpret the data that is gotten.  In other words, Rise of the Uncorporation should be required reading for scholars seeking to mine the potentially rich data produced by the leading business law phenomenon of our time — the rapid rise and evolution of the LLC.

NY’s decision to fully legalize same sex marriage (here’s a useful news roundup) can be seen among many other things as a demonstration of legal evolution in our federal system.

For some background on marriage and the market for law see Buckley and Ribstein (published 2001 Illinois Law Review 561), Ribstein 2005, and O’Hara & Ribstein, Chapter 8.  The 2001 and 2005 articles anticipated the state law competition that unfolded at a time when the once-promising same sex marriage movement was floundering.

Three years ago I summarized the state of play, noting the ups and downs in the marriage law market.  Fifteen years ago Hawaii looked like it was going to lead the nation.  This spurred federal DOMA and the state DOMAs.  But these developments left the “market” intact in any state that had not rejected same sex marriage, and therefore an opening for the same sort of evolution of choice of law as happened with corporate law.

Indeed, the market did develop.  First Massachusetts, then California.  This put pressure on NY, which actually adopted same sex marriage by gubernatorial decree in 2008 recognizing the validity of out of state same sex marriages.  Then Massachusetts, with an eye on the lucrative market for marriage ceremonies, decided to let out of state couples marry in Massachusetts. At that point I asked “Any bets on how long it will take for NY to allow same sex marriages to be performed in NY? When that happens, the marriages will be fully legal in NY, California and Massachusetts.”

Then Connecticut went for same sex marriage via court decision. I said at the time, “this move by the state located between NY (which recently recognized out-of-state same sex marriages) and Massachusetts, and next to Vermont (which has quasi-same-sex-marriage), was predictable.”

As I said just before the 2008 election, when things seemed to be looking pretty good for same sex marriage:

Those favoring a particular legal regime can further their interests not just by lobbying a particular legislature, but also by “shopping” for law in other jurisdictions, including by getting married in the relevant state. These other jurisdictions have an incentive to supply law to attract residents, ceremonies, legal work. Even non-supplier jurisdictions have an incentive to enforce the foreign law because the “shoppers” (including affluent and productive same sex couples) can avoid non-recognizing states. We’ve seen this competition play out, among other areas, in corporations and commercial contracts, and it is happening in Europe as well as the US.

But then, as we know, Prop 8 happened, and the legal aftermath.  The 2008 election was generally bad for same sex marriage, as significant Obama constituencies voted against it. (There’s no mystery why he’s still dithering on the issue.)

Although the NY decision may end up being a watershed, all indications for the future aren’t necessarily favorable for same sex marriage.  Even NY couples aren’t so much better off than they were the day before yesterday.  Basically what’s changed is they can get married at home rather than in Greenwich, benefiting NY caterers and hotels (which as just indicated may have figured in the political decision).  But their marriages still may not be enforceable in 45 jurisdictions.  Priests, ministers and rabbis don’t have to marry the couples (and this religious exemption might end up triggering invalidation of the NY law). 

There is an increasingly strong temptation to clear up the legal chaos confronting same sex couples, added to the moral and philosophical reasons for legalizing same sex marriage.  Moreover, NY’s recognition of same sex marriage is likely to register in public opinion which will directly affect Congress and perhaps even the Court.

On the other hand, as I said in my 2005 article (footnotes omitted):

[T]he relevant question is whether the process is likely in the long run to disregard rights that deserve recognition. A decision invalidating laws against same sex marriage would leave many questions unanswered concerning potential differences between same sex and heterosexual relationships. Agnosticism is particularly important for family law, given the clash of normative views and the difficulty of getting reliable data. * * * Courts and legislators can observe the results, particularly as children grow up under different regimes. Evolution also permits the law to adapt incrementally to unpredictable future events and changing mores, provides feedback as to alternatives, and minimizes the cost of mistake compared to a Supreme Court decree.

So what should happen now?  About half of the country is still opposed even after having been exposed to it in the media and their daily lives.  Many (particularly African-Americans) believe that recognition of same sex marriage would weaken marriage, which is still a valuable institution.  On the other hand, same sex couples have increasing state law options, including but not limited to marriage, for supporting their relationships.  On the third hand, their situations are far from ideal. 

I personally favor same sex marriage and would vote for it whenever I have the opportunity.  The plight of same sex couples registers more heavily with me than the more abstract objections that many have to same sex marriage.  But, believe it or not, I don’t have a bottom line.  I just have the observation that the market for law should have something to do with it.

Moving the Merc?

Larry Ribstein —  15 June 2011

I’ve been writing (here and here) about Illinois’s troubles, in a mobile, multi-jurisdictional world, raising taxes on corporations to pay for its past profligacy.  And now a symbol of Chicago might be in play:

The line of businesses looking for tax relief in Illinois keeps growing, with the latest plea coming from the owner of the iconic Chicago Mercantile Exchange and Chicago Board of Trade. CME Group Executive Chairman Terrence Duffy told a shareholders meeting last week that Illinois Governor Pat Quinn’s 30% hike in the corporate tax rate enacted in January will cost the company $50 million this year. “We don’t want to leave Chicago,” Mr. Duffy said, but “we have to do what’s right for our shareholders.” A spokesman confirmed that the company is exploring all options to save money. * * *

The Chicago Tribune reports that CME pays 8.9% of its income in state tax, while most businesses pay well below 7% and many pay no tax at all thanks to rich deductions. * * * The Merc and Board of Trade are Chicago’s equivalent of Wall Street, engaging in trillions worth of trades each year and directly employing some 2,000 employees. At least 60,000 more Chicago-land workers have jobs linked to the trading centers.

Is this an empty bluff?  A not-so-nice part of Indiana is not far from downtown Chicago.

Back in January Illinois raised corporate taxes to, as I said then, “try to bail Illinois out of the results of their fiscal profligacy.” But I added that raising taxes wouldn’t necessarily work “because of jurisdictional competition– there are many other places the would-be taxpayers can go.”  And that “the tax ‘solution’ will drive out the most mobile residents and investors.” The Governor was skeptical that firms like Caterpillar would leave Illinois, which he called the “strongest” state.  I responded, “yes, and remember when Detroit was Motor City?”

I added last March:

Potential exit of firms can be a powerful way to discipline a state where political discipline is profoundly weak.  If you don’t believe this, try driving through Peoria and imagining what it would be like without Caterpillar.

So how’s this tax increase thing working out for Illinois? Let’s check in with a WSJ editorial today:

according to the state’s Department of Commerce, Illinois has already shelled out some $230 million in corporate subsidies to keep more than two dozen companies from fleeing the state. And more are on the way.

The editorial focuses on the fact that high taxes empower the governor to dole out “corporate welfare” to favored firms. He can be a populist to his base while at the same time looking business friendly (except that Illinois is far from that).

I agree, but want to emphasize a different point. As I said last January and March, raising taxes just won’t work.  As the editorial notes: “The irony is that the recipients of these sweetheart deals are the very enterprises that Mr. Quinn was counting on to pay more taxes.” So the less mobile businesses and individuals end up paying the costs in the short run.  It’s too late for these firms, but a lesson not lost on other firms thinking about moving to or expanding in Illinois.  So in the long run the state loses.

In short, jurisdictional competition is a check on the sort of state profligacy that got Illinois into this fix. It can’t tax its way out of it without causing more problems.  The only solution for the long haul is spending restraint. 

Something the US might want to think about as it competes in the global economy.

I’ve previously written about the increasingly unruly market for corporate law, in which many cases involving the governance Delaware corporations are being brought outside of Delaware.  Now Jennifer Johnson writes about Securities Class Actions in State Court.  Here’s the abstract:

Over the past two decades, Congress has gradually usurped the power of state regulators to enforce state securities laws and the power of state courts to adjudicate securities disputes. This Paper evaluates the impact of Congressional preemption and preclusion upon state court securities class actions. Utilizing a proprietary database, the Paper presents and analyzes a comprehensive dataset of 1500 class actions filed in state courts from 1996-2010. The Paper first examines the permissible space for state securities class actions in light of Congressional preclusion and preemption embodied in the 1998 Securities Litigation Uniform Standards Act (SLUSA) and Class Action Fairness Act of 2005 (CAFA). The Paper then presents the state class action filing data detailing the numbers, classifications, and jurisdictions of state class action cases that now occupy the state forums. First, as expected, the data indicates that there are few traditional stock-drop securities class actions litigated in state court today. Second, in spite of the debate over the impact of SLUSA and CAFA on 1933 Act claims, very few plaintiffs attempt to litigate these matters in state court. Finally, the number of state court class actions involving merger and acquisition (M&A) transactions is skyrocketing and now surpasses such claims filed in federal court. Moreover, various class counsel file their M & A complaints in multiple jurisdictions. The increasingly large number of multi-forum M&A class action suits burden the defendants and their counsel, the judiciary and even plaintiffs’ lawyers themselves. The paper concludes that absent effective state co-ordination, further Congressional preemption is possible, if not likely.

The basic problem is that SLUSA’s “Delaware carve-out” exempting Delaware corporate cases from preemption under SLUSA doesn’t clearly require the cases to be heard in Delaware, despite the legislative history indicating that Congress’s respect for Delaware courts was a justification for the carve out. 

As Jennifer indicates, this is, indeed, a regulatory coordination problem.  As Erin O’Hara O’Connor and are explaining in a forthcoming paper, this may justify giving SLUSA broad preemptive effect — i.e., a narrow reading of Delaware carve-out exemption from preemption.  The catch is that it’s not clear preemption would be justified on regulatory coordination grounds for forum choice, as distinguished from law choice.  The coordination problem involves parties’ ability to anticipate what law will be applied.  On the other hand, the nature of the legal rules depends to some extent on which court is applying them.

Congress has the last word on this.  As Jennifer suggests, Congress might respond by repealing the Delaware carve-out or by requiring actions within the carve-out to be filed in Delaware.

In any event, this situation shows that regulatory coordination is a dynamic problem, aka whack-a-mole.  The PSLRA tightens requirements for federal securities class actions, the actions pop up in state courts, Congress enacts SLUSA to stop these, plaintiffs start filing “holder” actions in state courts, the Supreme Court stops those in Dabit (see my paper on this case), but state court M & A cases still manage to sneak in through the Delaware carve-out.

Fortunately this will never end so I’ll keep having stuff to write about.

PoL tips a Mercury News story about California regulation:

Carl’s Jr. is halting expansion in California and moving its headquarters to Texas. The California permitting process can take up to two years; combined with other regulations, it costs an extra $250,000 more to open a restaurant in California than in Texas.

Some details from the story:

The permitting process alone can take up to two years, while in Texas it can be done in as few as 11/2 months. * * *

California ‘s strict work rules classify general managers as employees, requiring that they take breaks at specified times, harming their ability to manage the business effectively.* * *

If you own a restaurant and your bartender chooses to forgo a break to collect extra tips, you can be sued for wage-and-hour violations. If your trash can is moved by someone else in your store, you can be sued under the Americans with Disabilities Act. If you try to bring renewable energy to the desert, you can be sued by environmentalists and unions. Is it any wonder that many owners are deciding doing business in California is not worth it?

Meanwhile, former TOTMer Todd Henderson visited a small SF business that makes what are reputed to be the best bags in the world and talked to the owner.  Todd reports that

the regulations here drive up costs, which makes his business tough. When I asked why [the owner] didn’t hire more staff, since a made-to-order bag takes 8 weeks to deliver, he told me there was too much uncertainty. Health care is too expensive, and he doesn’t know what costs are coming down the road. And getting good people is difficult when your standards are so high.

Fortunately there are states other than California.  We may soon find out exactly how much California dreamin’ is worth to small businesses. And of course the US isn’t the only country in the world.

I recently discussed the Supreme Court’s latest decision not to preempt an Arizona law imposing tough sanctions on firms that employ illegal aliens. I concluded it was a close case but that there was a policy argument for the Court’s result based on Erin O’Connor and my theory of regulatory coordination.  Employment laws like Arizona’s do not impose the “spillover” effects on national markets that are associated with, say, state design standards for nationally marketed products. In general, although businesses often favor bringing federal order to messy state law, it is also important to recognize the benefits of the state “laboratory” for regulation —  what Erin and I call The Law Market.  

Ross Douthat, writing in today’s NYT reminds us of the value of state experimentation in this context.  He notes that the law  

reduced Arizona’s population of working-age illegal immigrants by about 17 percent, or roughly 92,000 people, in just a single year. * * * And the swift attrition was mainly achieved through voluntary compliance: the number of employers prosecuted under the law can be counted on one hand.  These results suggest that maybe — just maybe — America’s immigration rate isn’t determined by forces beyond any lawmaker’s control. Maybe public policy can make a difference after all. Maybe we could have an immigration system that looked as if it were designed on purpose, not embraced in a fit of absence of mind.

There is a vigorous debate about immigration policy.  As the grandchild of immigrants and as a believer in the significant benefits this country reaps from immigration, I lean toward open doors.  But these general views don’t answer specific questions about where to draw the lines in immigration policy.  Opening the door to state experimentation provides data about the effects of specific approaches and thereby informs policymaking.  This is a lesson the courts need to keep in mind when considering the scope of preemption.

The Supreme Court has issued yet another preemption opinion in Chamber of Commerce v. Whiting.  The federal Immigration Reform and Control Act makes it unlawful to employ a known unauthorized alien and preempts state sanctions “other than through licensing and similar laws.”

The majority held this didn’t preempt Arizona’s broad definition of license to include such documents as articles of incorporation, certificates of partnership and foreign firms’ authority to transact business in the state. Five conservative justices rejected express preemption, four (excluding Thomas) rejected implied preemption, and there were two separate dissents joined by a total of three liberal justices (Kagan was recused).

I’m interested in this partly because of my work in progress with Erin O’Hara O’Connor on Preemption and Regulatory Coordination (preliminary draft summarized here, and applied to the Court’s recent arbitration decision here).  

It’s hard to disagree with the dissenters that Arizona’s additional sanctions are inconsistent with the milder and more tentative approach of the federal law.   The question is whether the Arizona law is saved by the licensing exception.

Erin’s and my regulatory coordination theory arguably helps justify if not explain the result.  Employment rules generally vary from state to state. Adding immigration variations doesn’t necessarily make them much more onerous, especially given Arizona’s use of federal standards.  Thus, there’s arguably a greater need for interstate coordination for arbitration cases that might find themselves in courts all over the country than for employment practices that are necessarily based in specific states and turn on state-specific factors. This policy could drive the result if preemption is ambiguous. 

Another aspect of the immigration case particularly interested me.  The majority held that the “licensing and similar laws” savings clause allowed Arizona to suspend or revoke articles of incorporation, certificates of partnership and grants of authority to foreign firms for companies that employed illegal workers.  The court said:

A license is “a right or permission granted in accordance with law . . . to engage in some business or occupation, to do some act, or to engage in some transaction which but for such license would be unlawful.” Webster’s Third New International Dictionary 1304 (2002). Articles of incorporation and certificates of partnership allow the formation of legal entities and permit them as such to engage in business and transactions “which but for such” authorization “would be unlawful.”

The Court based this interpretation on the Administrative Procedure Act.  It’s not clear this definition should be controlling. In any event, it involves a fundamental misunderstanding of the nature of a corporation.  Business associations are contracts or sets of contracts among the participants.  See, e.g., Butler and Ribstein, Opting Out of Fiduciary Duties:  A Response to the Anti-Contractarians, 65 Washington Law Review 1 (1990).  Articles of incorporation or certificates of partnership don’t allow people to engage in transactions that otherwise would be illegal, they just make it easier to enter into these governance arrangements.  (However, grants of authority to foreign business associations might be a different matter.)

The main exception to this generalization is limited tort liability.  I don’t think this takes limited liability out of the contractual realm (see my Limited Liability and Theories of the Corporation, 50 Md. L. Rev. 80 (1991)).  But even if it does it still leaves business association formations a long way from the type of license that IRCA must have been referring to that allows firms to engage in certain types of business.

In any event, asssuming preemption was unclear here, our coordination policy would not tip the scale toward preemption.

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.

AT&T Mobility LLC v. Concepcion, 2011 WL 1561956 (April 27, 2011) could end up being one of the most important pro-business cases of the last several years — even more important than Citizens United.

The case involved the application of Section 2 of the Federal Arbitration Act (9 U.S.C. §2), which makes agreements to arbitrate “valid, irrevocable, and enforceable, save upon such grounds as exist at law or in equity for the revocation of any contract.” Justice Scalia’s majority opinion held that this preempts California’s unconscionability rule applied in Discover Bank v. Sup.Ct., 36 Cal.4th 148, 30 Cal.Rptr.3d 76, 113 P.3d 1100 (2005) conditioning enforceability of arbitration on the availability of class arbitration.

The Court reasoned that

[t]he overarching purpose of the FAA, evident in the text of §§ 2, 3, and 4, is to ensure the enforcement of arbitration agreements according to their terms so as to facilitate streamlined proceedings. Requiring the availability of classwide arbitration interferes with fundamental attributes of arbitration and thus creates a scheme inconsistent with the FAA.* * *

[T]he switch from bilateral to class arbitration sacrifices the principal advantage of arbitration—its informality—and makes the process slower, more costly, and more likely to generate procedural morass than final judgment. * * *

[C]lass arbitration greatly increases risks to defendants. Informal procedures do of course have a cost: The absence of multilayered review makes it more likely that errors will go uncorrected.

Arbitration is a matter of contract, and the FAA requires courts to honor parties’ expectations.* * *

Justice Thomas, concurring, relied on a textual argument that “the FAA requires that an agreement to arbitrate be enforced unless a party successfully challenges the formation of the arbitration agreement, such as by proving fraud or duress.”  The California rule is preempted under this approach because the Discover Bank rule “does not relate to defects in the making of an agreement.”

I joined several other academics (Randy E. Barnett, Omri Ben-Shahar, Henry N. Butler, Richard A. Epstein, Michael I. Krauss, Gregory E. Maggs, Geoffrey A. Manne, Robert H. Mnookin, Michael P. Moreland, Nathan B. Oman, Stephen B. Presser and co-TOTMs Geoff Manne and Josh Wright) in an amicus brief that not only argued for the winning side, but supplied specific reasoning supporting Justice Thomas’s concurrence. See the brief at 31-32, n. 7, arguing that “the reference in the savings clause to ‘revocation’ applies only to defects in the formation of contracts (procedural defects affecting offer and acceptance) rather than substantive ‘public policy'”.

The AT&T dissent reasoned that the California rule was not preempted because it merely applied the general contract principle of unconscionability, applied to all class action waivers whether or not in arbitration, and comported with the FAA’s purpose of “ensur[ing] judicial enforcement” of arbitration agreements.”

Thus, the issue joined between the majority and dissent was whether a rule that was not arbitration-specific, and therefore arguably fit within FAA §2’s “revocation of any contract,” nevertheless was preempted because it did not permit “enforcement of arbitration agreements according to their terms so as to facilitate streamlined proceedings” and “interferes with fundamental attributes of arbitration.”

Although I agree with the Court’s result, the conclusion is not facially obvious.  The case also leaves several questions, including what other state limits on arbitration will be preempted even if they apply to all contracts (suggesting an advantage of Justice Thomas’s relatively clear rule upholding only state rules dealing with formation of arbitration agreements), and the extent to which the principles in this case apply to other preemption issues.

These questions cry out for an articulation of federalism concerns that underlie preemption generally and should apply to preemption by the FAA.  The majority opinion fails to do this at all.  The dissent at least addresses this point:

By using the words “save upon such grounds as exist at law or in equity for the revocation of any contract,” * * * Congress reiterated a basic federal idea that has long informed the nature of this Nation’s laws. * * * Here, recognition of that federalist ideal, embodied in specific language in this particular statute, should lead us to uphold California’s law, not to strike it down. We do not honor federalist principles in their breach.

I disagree, for reasons that Erin O’Hara O’Connor and I are developing in a work in progress currently titled “Preemption and Regulatory Coordination.”  Our basic idea (subject to work that is ongoing as I write) is expressed in a summary of a talk we gave last fall.

Our analysis begins, as it must, with Congressional intent.  But the intended scope of preemption is often murky.  The courts therefore need some principle to help fill the Congressional intent gap. 

We would look to the principle of regulatory coordination.  This principle requires recognition that regulation by many states entails both costs and benefits.  The benefits include the opportunity for experimentation, greater individual autonomy, and different rules to suit different needs.  On the cost side, empowering each state to regulate national or international firms can significantly impede growth and innovation.  Contrary to the AT&T dissent’s unqualified celebration of state sovereignty, preemption must take account of the need for coordination. 

More specifically, here’s a quick take on how we would approach coordination from the above summary of our talk:

Even if Congress has neither expressed nor implied a particular preemptive preference, courts are entitled to assume that Congress intended the statute to advance the purpose of the Constitutional provision that provides its authority. For example, when Congress chooses to enact a statute pursuant to the Commerce Clause, it makes a collective judgment that the need for federal economic coordination outweighs the need for state sovereignty, and courts should broadly effectuate this intent where coordination is appropriate. Accordingly, to the extent a statute is ambiguous and coordination is unnecessary, the court should presume against preemption. * * *

We then apply this principle to arbitration:

The Federal Arbitration Act makes unenforceable state laws aimed at restricting arbitration clauses. The coordination principle developed here leads [the authors] to conclude that ambiguity concerning the FAA’s application to class action waivers should be resolved in favor of state coordination, which, in the case of the FAA, favors broad enforcement of parties’ contractual dispute resolution devices.

There is ample evidence that the FAA was in fact intended to promote regulatory coordination in order to enhance the US’s position in international competition. See The Law Market, Chapter 5, and a shorter summary in our recent paper, Exit and the American Illness.

Notably, the rule the Supreme Court applied in AT&T comports with our “broad enforcement” approach.  Our analysis squares this rule with general policies underlying preemption. We hope that our approach will help clarify the general implications of this important case for preemption.