Primary Sources Used in This Chapter

ADW DRAFT 9/3/11 AP edits 9/5/11

Chapter 3. Corporate Federalism

Primary Sources Used in this Chapter

 DGCL § 394  New York State Business Corporation Law, § 1304  California Corporations Code § 2115  DGCL § 160(c)  DGCL § 203  Trustees of Dartmouth College v. Woodward  Shaffer v Heitner  McDermott Inc. v. Lewis  Edgar v. MITE Corp  CTS Corp. v. Dynamics Corp. of America  Amanda Acquisition Corp. v. Universal Foods Corp.

Concepts for this Chapter

• U.S. corporate law history • Internal affairs doctrine – Regulation of foreign corporations – Choice of law rules – Pseudo-foreign corporations • Federal abstention • “Race of laxity” – Delaware wins race – Race to bottom or top?

Introduction

Chapter 3 is the first of the three chapters in Module II: Corporations and Policy. Module II explores the relationship between federal and state corporate regulation, how corporate law views the corporation in society, and the corporation as a political actor.

Chapter 3 on corporate federalism (state vs. state, federal vs. state) reveals the essentially private nature of corporate law – and the importance of party choice. Later chapters assume students have understood the internal affairs doctrine, the history of the state-federal interplay in regulating corporations, and the relationship between the state bar/legislature/judiciary in formulating law. Later chapters also assume a knowledge of how corporate takeovers happen.

1 U.S. corporate law is mostly about state law, since there is no all-encompassing federal corporation law. Later chapters include material on federal law –such as federal securities law, federal environmental law, the Sarbanes-Oxley corporate governance provisions.

A. Brief History of U.S. Corporate Law

There is a long history of people attempting to organize in specialized hierarchies in pursuit of profit. The corporation has proven the superior organizational form for large enterprises. Later chapters describe the LLC (a corporate hybrid), which is proving superior for smaller enterprises.

Early antecedents of the corporation date back to ancient Rome. Forerunners of the U.S. business corporation included the incorporated and unincorporated English joint stock companies, for example the notorious South Sea Company, to which the English Parliament had granted a monopoly on trade with the Pacific Islands:

The South Sea Company was one of the arch speculators in, and manipulators of, its own shares. Its manipulations eventually caused a great increase in the market price of its shares. The huge increase in the price of South Sea Company shares led to a tremendous wave of company promotions and to speculation in the securities of newly formed companies. On a single day, for example, one thousand persons subscribed to shares in a company “for carrying on an undertaking of great importance, but nobody to know what it is.”1

In 1719, the South Sea Company launched an ambitious program to persuade investors holding government bonds and annuities to exchange them for shares of its stock. To make some funds available for speculation in its shares and to check the flotation of new companies competing for public funds, the South Sea Company inspired passage of the Bubble Act of 1720.2 The purported objective of the Bubble Act was to prevent unwary persons from investing in fraudulent projects or undertakings. It prohibited unincorporated companies from acting as though they were corporate bodies or pretending that their shares were transferable. The South Sea Company and certain other existing companies were exempted from its prohibitions.

The Bubble Act was crudely drawn and failed to define clearly the practices and offenses condemned. The product of haste and self-interest, this ambiguous and incoherent legislation long caused great uncertainty and confusion and raised unnecessary doubts about the validity of the issuance of transferable shares by legitimate unincorporated companies.3

1 VIII William Searle Holdsworth, A History of English Law 214–215 (5th ed. 1942); Leslie W. Melville, South Sea Bubble 97 (1921). See also John Carswell, The South Sea Bubble (1960); Virginia Cowles, The Great Swindle: The Story of the South Sea Bubble (1960). 2 6 Geo. I, ch. 18. 2 Wood's Collyer on the Law of Partnership §§ 826, 827 at 1200, 1203 (Horace G. Wood ed. 1878). 3 1 Wood's Collyer on the Law of Partnership § 828 at 1206 (Horace G. Wood ed. 1878); Armand Budington Du Bois, The English Business Company After the Bubble Act 1720–1800 203 (1938); 7 Halsbury's Law of England, Companies § 1739 (4th ed. 1973); B. Hunt, The Development of the Business Corporation in England, 1800–1867, 2 James D. Cox and Thomas Lee Hazen, 1 Treatise on the Law of Corporations (3rd), Chapter 2. The Evolution of Corporations in England and America, § 2:2. The Evolution of English Corporation Law. http://web2.westlaw.com/find/default.wl?rs=WLW11.07&rp=%2ffind %2fdefault.wl&vr=2.0&fn=_top&mt=208&cite=LAWOFCORP+ %c2%a7+2%3a2&sv=Split

We trace the U.S. corporation from 1800, about the time states began recognizing the usefulness of incorporation of private business (as opposed to municipalities, colleges and churches). Early corporations were formed often as political favors, leading to general incorporation statutes.

Question: Is the corporation private property or a social institution?

Answer: Both. Corporations are both “contracts” that cannot be unilaterally amended by the legislature and “artificial beings,” created by and modifiable by the legislature. The property vs. institution uncertainty is a recurring theme in corporate law. In Trustees of Dartmouth College v. Woodward. Chief Justice Marshall discusses the nature of the corporate charter of Dartmouth College.

Trustees of Dartmouth College v. Woodward, 17 U.S. 518 (1819),

Facts: Dartmouth College sued the state of New Hampshire claiming that amendments to its charter passed by the state legislature to give state officials a part in running the college were unconstitutional. Dartmouth’s trustees had originally been given the articles of incorporation by Great Britain.

Issue: Was the Dartmouth College corporate charter a private contract or a government-created institution?

Holding: Both

Reasoning: The corporation is both a contract between private parties and the state (by which the power to amend is enjoyed only by the parties) and a “creature of state law” that is created and can be modified as the state chooses.

Chief Justice Marshall wrote: “A corporation is an artificial being, invisible, intangible, and existing only in contemplation of law. Being the mere creature of law, it possesses only those properties which the charter of its creation confers upon it, either expressly, or as incidental to its very existence.”

Marshall’s opinion reinforces the basic attributes of a corporation learned in the last Chapter, but then the Court decides that the state can’t change the “corporate charter” because it is akin to contract. This leaves the nature of the corporation up in the air.

at 7–9, 41–44, 54 (1936); 1 W. Scott, The Constitution and Finance of English, Scottish and Irish Joint-Stock Companies to 1720 417 (1921); Edward H. Warren, Corporate Advantages Without Incorporation 329–333 (1929). 3 Justice Story’s concurring opinion suggested that states might grant future charters subject to a reserved right to amend them. Currently all states reserve the power to amend the statutes that govern corporations (and thus change corporate rights).

DGCL § 394. Reserved power of State to amend or repeal chapter; chapter part of corporation's charter or certificate of incorporation

This chapter may be amended or repealed, at the pleasure of the General Assembly, but any amendment or repeal shall not take away or impair any remedy under this chapter against any corporation or its officers for any liability which shall have been previously incurred. This chapter and all amendments thereof shall be a part of the charter or certificate of incorporation of every corporation except so far as the same are inapplicable and inappropriate to the objects of the corporation.

Delaware General Corporations Law, Title 8. Corporations. Chapter 1. General Corporation Law. Subchapter XVII, Miscellaneous Provisions. § 394. Reserved power of State to amend or repeal chapter; chapter part of corporation's charter or certificate of incorporation http://web2.westlaw.com/find/default.wl?rs=WLW11.07&rp=%2ffind %2fdefault.wl&vr=2.0&fn=_top&mt=208&cite=8+Del.C.+%c2%a7+394&sv=Split

INSERT MBCA §102 and/or link? [Alan: good idea to include actual section]

Question: What hinges on the property vs. institution question?

Answer: If the corporation is property, it is only accountable to maximize wealth for its shareholders. If the corporation is a social institution, its obligations run beyond the shareholders to non-shareholder constituents and society.

Early corporate statutes distrusted corporate power -- placing limits on corporate purposes, activities, and capitalization. The evolution of corporate law has been one towards liberalization for corporations. At one time, the articles of incorporation had to describe the powers, purposes and activities in exhaustive detail. Today, the practice is to leave the description of powers and purposes to broad statutes.

Question: Which state passed the first “liberal” corporate law?

Answer: New Jersey passed the first “liberal” corporate law, allowing corporations to own stock in other corporations (permitting holding companies). The holding companies allowed by New Jersey law were the “trusts” addressed by the Sherman Antitrust Act. Lawyers on New York City’s Wall Street used New Jersey law to create corporate power structures. New Jersey’s statute was an example of the trend toward liberalization in corporate law.

New Jersey later lost its “lead” to Delaware when NJ Governor Woodrow Wilson re- regulated NJ corporations. Delaware adopted the New Jersey statute verbatim and Wall

4 Street looked across the Hudson to tiny Delaware. Delaware took the lead in advancing corporate law and has never looked back. This is the story of corporate law. If a jurisdiction gets too regulatory, private parties can migrate. Corporate migration depends on the internal affairs doctrine.

Question: What is the relationship between federal and state regulation of corporations?

Answer: Over time there has been an ebb and flow between federal and state law, with the federal government responding to reassert itself after state law failures to rein in unfettered capitalism or “choice”.

 1800 State legislative special chartering  1819 Dartmouth College Case  1830- General incorporation statutes passed in many states (starting with New York)  The Sherman Antitrust Act in 1890 responded to corporate holding companies that engaged in monopolization of the oil industry and railroads.  1888 New Jersey passed incorporation statute departing from strict limitation on corporations  1899 Delaware passed enabling statute modeled on New Jersey’s statute with a view to attracting incorporations and generating franchise tax revenues  1913 New Jersey amended its corporation law to reimpose a number of restrictive provisions  1933, 1934 the federal securities acts passed in response to corporate fraud and investor speculation that led to the Stock Market Crash of 1929  2002 the Sarbanes-Oxley Act passed in response to the accounting fraud at Enron and other corporate scandals of the 1990s.

Question: What was the impact of the wave of hostile tender offers in the 1980s?

Answer: Hostile tender offers are a takeover device in which buyers forego the consulting the board of directors and appeal directly to shareholders to give them control. Even in companies during this period that did not get a hostile bid, incumbent management changed the company to avoid being targeted. The resulting restructuring transformed the relationship between public shareholders and corporate management.

Question: What is a leveraged buyout (or LBO)?

Answer: The breakout box on p. 63 defines an LBO as the purchase of a controlling interest in a corporation in which the bulk of the purchase price comes from borrowed money (leverage). The assets of the target company are often used as the collateral for the borrowed money. Leveraged buyouts allow outside acquirers to purchase companies without committing a lot of capital.

Question: What is a hedge fund?

5 Answer: The breakout box on p. 64 explains that a hedge fund is an investment fund open to a limited group of investors, such as wealthy individuals and large institutional investors. Hedge funds (private investment pools) have been successful in pressuring managers to generate high returns for shareholders. Hedge funds were originally meant to diversify risk – to create a floor to downturns in market. However, they have become active investors, and engage in such practices as buying votes, creating downturns in company share prices and selling stock short to make money. But hedge funds also bring change …

Notice that there was not a federal response to the takeovers of the 1980s – in fact, we’ll soon see how the Supreme Court essentially abstained.

B. Horizontal Federalism: State View of Corporate Law

The Internal Affairs Doctrine

Question: What is a “foreign corporation”?

Answer: A “foreign corporation” is a corporation that does business in a state in which it is not incorporated.

Hypothetical Example (from p. 65)

A multi-state corporation operates in several states. The business is headquartered in North Carolina, incorporated in Delaware, does business in California and has investors in Florida.

Question: Which law applies to its various business affairs?

Answer: It depends on whether it is a question of corporate internal affairs or non- corporate law – such as the timing of a shareholders’ meeting or a question of consumer product safety.

Question: What is the internal affairs doctrine?

Answer: The internal affairs doctrine provides that the law of the state of incorporation should govern any disputes regarding that corporation’s “internal affairs.”

Question: What are “internal affairs”?

Answer: “Internal affairs” are matters peculiar to the relationships among the corporation and its officers, directors, and shareholders. Some examples include voting, selling shares, and fiduciary duties.

Question: What if the corporation sells bad doughnuts in California?

6 Answer: Selling bad doughnuts involves the relationship with customers and the corporation-- an external affair. The relationship between shareholders and management is not implicated.

Question: What if investors in Florida demand payment of dividends and sue in Florida court?

Answer: This is a conflict between shareholders and management-- an internal affair. The Florida court will probably determine that under Florida choice of law the substantive corporate law of Delaware applies.

Question: What if board members are sued in Delaware, but never have set foot in the state?

Answer: “Minimum contacts” analysis requires more than mere stock ownership in a corporation incorporated in that state.

The Supreme Court considered this question in Shaffer v Heitner in 1977. In Shaffer, a nonresident shareholder of Greyhound Corp. brought a shareholder’s derivative suit against Greyhound and its wholly owned subsidiary Greyhound Lines, Inc., as well as 28 present and former officers and directors [“managers”], who were also nonresidents of Delaware. The suit alleged that the individual managers had violated their duties to Greyhound by causing it and its subsidiary to engage in actions (which occurred in Oregon) that resulted in corporate liability for substantial damages in a private antitrust suit and a large fine in a criminal contempt action.

The Court ruled that Delaware's assertion of jurisdiction over the managers, based solely on the statutory presence of their' property (Greyhound stock) in Delaware, violated the Due Process Clause because the managers did not have contacts, ties or relations with Delaware. The managers’ holdings in Greyhound were unrelated to the cause of action of the derivative suit and this did not provide contacts with Delaware sufficient to support Delaware’s jurisdiction of the managers.

The Court also ruled that Delaware state court jurisdiction was not supported by its interest in supervising the management of a Delaware corporation and defining the obligations of its officers and directors, since Delaware based jurisdiction, not on the managers’ status as corporate fiduciaries, but on the presence of their property in the State. See Shaffer v Heitner, 433 US 186 (US Sup Ct 1977). http://web2.westlaw.com/find/default.wl?rs=WLW11.07&rp=%2ffind %2fdefault.wl&vr=2.0&fn=_top&mt=208&cite=433+U.S.+186&sv=Split

Delaware’s corporate statute now says that a director of a Delaware corporation is deemed to give consent to personal jurisdiction of Delaware courts.

Question: How does a corporation organized under the laws of one state do business in other states?

7 Answer: Doing business in other states requires that the foreign corporation be registered. Registration is typically easy. For example, a foreign corporation may apply for authority to do business in New York by filing an application that includes:

 its name  the jurisdiction and date of its incorporation  the purpose or purposes for which it is formed  the county in New York in which its office will be located  a designation of the secretary of state as its agent upon whom process against it may be served  the name and address of its registered agent, if any  a statement that the foreign corporation has not, subject to certain exceptions, engaged in any activity in New York

and attaches:

 a certificate by an authorized officer of the jurisdiction of its incorporation that the foreign corporation is an existing corporation.

New York State Business Corporation Law, Art. 13 Foreign Corporations, § 1304 Application for Authority; Contents. http://public.leginfo.state.ny.us/LAWSSEAF.cgi? QUERYTYPE=LAWS+&QUERYDATA=$$BSC1304$ $@TXBSC01304+&LIST=LAW+&BROWSER=EXPLORER+&TOKEN=22914679+& TARGET=VIEW

The Internal Affairs Doctrine

The internal affairs doctrine is a basic aspect of U.S. corporate law – a choice of law rule not necessarily used elsewhere in the world. For example, in Europe until recently a corporation’s headquarters determined what law governed its internal affairs.

Question: What are the reasons for the internal affairs doctrine in the United States?

Answer: Uniformity, predictability and private choice.

It would be complicated if corporations had to accommodate the conflicting laws of each state in which they did business. For example, when must the corporation hold the shareholders’ meeting? Who votes at the meeting? On what matters? Imagine if different states (as they do) gave different answers. The internal affairs doctrine lets the parties (management and shareholders) choose the rules that govern their relationship.

Question: What business affairs are “internal affairs” and what business affairs are not?

8 Answer: Internal affairs are the issues specific to the relationships among the corporation and its officers, directors and shareholders:

 shareholder voting rights,  fiduciary duties of directors, and  procedures for corporate action.

McDermott Inc. v. Lewis, 531 A,2d 206 (Del 1987)

Facts: A Delaware corporation in the marine construction business reorganized its capital structure so its shareholders came to hold a Panamanian corporation.

McDermott Inc., a Delaware corporation, became a 92%-owned subsidiary of McDermott International, a Panamanian corporation principally involved in the business of marine construction, through a 1982 Reorganization. McDermott Delaware, which became subsidiary, came out of the Reorganization owning approximately 10% of McDermott International common stock. The Plaintiffs sued to enjoin the 1982 Reorganization.

The dispute centered on a conflict between Panamanian and Delaware law. McDermott International admitted in its prospectus that McDermott International would vote the 10% voting interest given to McDermott Delaware. The law of Delaware (and all other U.S. jurisdictions) prohibited the practice of voting stock by a majority owned subsidiary. Panamanian law allowed that country’s corporations to place voting shares in a majority-owned subsidiary.

Issue: Can a Delaware state court could resolve a dispute involving a corporation incorporated in another nation whose corporate law conflicts with that state’s corporate law.

Holding: Basing its opinion on Delaware conflicts of law principles and the U.S. Constitution, the Court held that the internal affairs doctrine did apply and that the law of Panama—as the jurisdiction of McDermott International’s incorporation—should resolve the dispute.

Reasoning: Delaware followed its long established law, consistent with the Supreme Court’s 1933 decision in Rogers v. Guaranty Trust Co. of New York, which compelled deference to the laws of the jurisdiction of incorporation.

“…. [courts and legislatures] have consistently applied the law of the state of incorporation to the entire gamut of internal corporate affairs. In many cases, this is a wise, practical, and equitable choice.”

“ … application of the internal affairs doctrine is not merely a principle of conflicts law. It is also one of serious constitutional proportions —under due process, the commerce clause and the full faith and credit clause.”

Question: What was the Delaware law which prohibited the practice of voting stock by a majority-owned subsidiary?

9 Answer:

DGCL § 160 (c) Corporation's powers respecting ownership, voting, etc., of its own stock; rights of stock called for redemption

(c) Shares of its own capital stock belonging to the corporation or to another corporation, if a majority of the shares entitled to vote in the election of directors of such other corporation is held, directly or indirectly, by the corporation, shall neither be entitled to vote nor be counted for quorum purposes. Nothing in this section shall be construed as limiting the right of any corporation to vote stock, including but not limited to its own stock, held by it in a fiduciary capacity.

http://web2.westlaw.com/find/default.wl?rs=WLW11.07&rp=%2ffind %2fdefault.wl&vr=2.0&fn=_top&mt=208&cite=8+Del.C.+%c2%a7+160&sv=Split

Question: How did the U.S. Constitution support this analysis? Why does a state court refer to the federal constitution?

Answer: The Court also grounded its opinion in bedrock constitutional principles. Due process, the Court noted, requires that “directors, officers, and shareholders be given adequate notice of the jurisdiction whose laws will ultimately govern the corporation’s affairs.” Application of Delaware law would unfairly and unconstitutionally subject McDermott International’s corporate participants to the laws of Delaware.

The meddling of Delaware in the internal affairs of a foreign corporation would send a message that a foreign corporation and its internal affairs can be subjected to the laws of all fifty states. The burden this would place on “foreign corporations” doing business in various U.S. states would violate the commerce clause.

Question: Why was the Delaware court so committed to the internal affairs doctrine?

Answer: The internal affairs doctrine is the lifeblood of Delaware corporate law. There would be little reason for businesses to incorporate in Delaware if courts did not respect the choice.

Points for Discussion (pp. 71-2)

1. Corporation voting of its own shares. The plaintiffs complained that, after the recapitalization, McDermott International was able to vote its own shares held by its subsidiary McDermott Delaware. What is so wrong with this? Why is this practice prohibited in Delaware and all 50 states?

Answer: A corporation cannot vote its own shares – or have a subsidiary do it – because doing so would undermine the shareholder franchise. It would be like the Democrats (the party in power) being able to cast a certain number of votes in political elections, beyond those cast by electors in the election. Corporate voting of its own shares dilutes the voting power of shareholders – one of the most important checks on management. 10 2. Why the internal affairs doctrine? Notice that the effect of the recapitalization and the allocation of McDermott International’s voting shares to its Delaware subsidiary diminished the ability of International’s shareholders to sell in a takeover. Why was this? How can it be said that this diminishment of their rights promotes the “autonomy of the parties”? What protections do shareholders have if management chooses to incorporate in a jurisdiction that disfavors shareholder interests?

Answer: If management controls 10% of voting in a company, it will be harder to gain a shareholder majority to elect a new board or vote to rein in management abuse. But the court decides that shareholders, who had to approve the recapitalization, can decide to give management some voting power – it’s their property. Shareholders can always sell their shares, driving down prices and making it easier for an acquirer to get a voting majority (or supermajority in this case) and take control.

3. Importance of internal affairs doctrine to Delaware. Notice the effort that the Delaware court made to justify the application of Panamanian law. At one level, it would seem the court should have wanted to uphold the corporate rule in Delaware (and every other U.S. jurisdiction) that parent companies cannot place their voting shares in a controlled subsidiary. Yet the court went out of its way to apply the “rogue” Panamanian law. Why?

Answer: Delaware is the home to most public corporations. As such, the state (including its judiciary) has an interest in the uniform and unswerving application of the internal affairs doctrine. Under this choice of law rule, any business that chooses to incorporate in Delaware will be assured – wherever corporate litigation might arise – that Delaware corporate law will apply to the internal disputes between shareholders and managers, and among shareholders.

State Regulation of Pseudo-Foreign Corporations

Most states follow the internal affairs doctrine unswervingly. A few states, however, have modified it and apply their own corporate law to foreign corporations. The states (mostly California, New York) attempt to regulate the internal affairs of corporations that have substantial operations in the state but are incorporated in another jurisdiction. These corporations are sometimes called “pseudo-foreign” corporations since they are incorporated outside the state, but conduct a majority of their business and have most of their shareholders in the state.

Wilson v. Louisiana-Pacific Resources, Inc. (California) and Vantagepoint Venture Partners 1996 v. Examen, Inc (Delaware) present minority (California) and majority (Delaware) treatment of the same issue: which state’s law applies to shareholder voting rights in pseudo-foreign corporations (firms which do substantial business in one state but which are incorporated elsewhere).

Cumulative and Straight Voting

11 Wilson requires a basic understanding of the difference between cumulative and straight voting, as explained in the breakout box on p. 73.

Straight voting: Each shareholder votes his shares for each open board seat. Board candidates who receive the most votes are elected. This is the usual method for electing directors.

Cumulative voting: Each shareholder receives votes equal to the number of shares times the number of open board seats. The shareholder can cumulate their votes and distribute them among a few or even one candidate. Board candidates who receive the most votes are elected.

Under straight voting, a shareholder with a majority of voting shares can elect the entire board of directors because shareholders vote their shares for each open director position. Under cumulative voting, a minority shareholder can cumulate his votes and allocate them to a few or even one candidate – increasing the chances of electing someone to the board. Some state statutes (and once even state constitutions) require cumulative voting to guarantee board representation for larger minority shareholders.

Example

Suppose a corporation has authorized five directors and there are two shareholders.

 A is a majority shareholder with 60 shares  B a minority shareholder with 40 shares.

Under straight voting, A and B would each cast their votes five times for five different candidates.  Each of A’s candidates would receive 60 votes;  each of B’s candidates would receive 40 votes.;  all of A’s vote-getters would be elected under straight voting.

Straight Voting

A1 A2 A3 A4 A5 B1 B2 B3 B4 B5 60 60 60 60 60 40 40 40 40 40

Under cumulative voting,

 A would have 300 (60 times 5) votes to allocate among her candidates as she chooses.  B would have 200 (40 times 5) votes.  So long as B votes intelligently, he is guaranteed at least one director under cumulative voting (and possibly more, depending on how shrewd A is).

Cumulative Voting

A1 A2 A3 A4 A5 B1 B2 B3 B4 B5 101 101 99 100 100

12 There is no way that A can prevent B from taking two seats, if B cumulates her votes. But if B votes foolishly – spreading her votes too thinly – she might not get any seats. And if A votes foolishly – spreading his votes too thinly – he might not get control of the board.

Wilson v. Louisiana-Pacific Resources, Inc., 138 Cal. App. 3d 216, 187 Cal. Rptr. 852 (1982)

Facts: Plaintiff Ross A. Wilson brought an action against Louisiana-Pacific Resources, Inc. seeking a declaratory judgment that the corporation met the tests of [California Corporations Code] § 2115 and that he was therefore entitled to cumulative voting in accordance with section 708. Louisiana-Pacific was incorporated in Utah but, in the years preceding the action, over 50% of the average of its property, payroll, sales, and over 50% of its voting shareholders were in California. California requires companies to provide cumulative voting to all of its stockholders, Californians or non-Californians, but Utah requires straight (plurality) voting.

Issue: Which state’s law applies to shareholder voting rights when a firm does substantial business in California but is incorporated elsewhere?

Holding: California (minority rule). The corporation was required by Cal. Corp. Code §2115 to provide cumulative voting.

Reasoning: The California court found that the state may constitutionally impose its law requiring cumulative voting by shareholders upon a corporation which is domiciled elsewhere, but whose contacts with California, as measured by various criteria, are greater than those with any other jurisdiction. California had a “greater interest” and therefore its voting provisions were applicable.

The court examined the cumulative voting requirement under the federal Constitution and ruled that it did not violate:

 the full faith and credit clause (U.S. Const., art. IV, § 1), since California had a significant aggregation of contacts with the Utah corporation, since the state interests created by those contacts were substantial, and since Utah law permitted cumulative voting if the articles of incorporation so provided;  the commerce clause (U.S. Const., art. I, § 8, cl. 3), since its effect upon interstate commerce was minimal in relation to its purpose of preventing pseudo-foreign corporations from circumventing the social policies of California;  the due process clause; or  the equal protection clause.

The Court said:

“If California's statute were replicated in all states, no conflict would result. We conclude that the potential for conflict is, on this record, speculative and without substance.”

13 “We conclude that to the extent that the cumulative voting requirement imposed by § 2115 upon pseudo –foreign corporations is shown to have any effect upon interstate commerce, the effect is incidental, and minimal in relation to the purpose which that requirement is designed to achieve.” http://web2.westlaw.com/find/default.wl?rs=WLW11.07&rp=%2ffind %2fdefault.wl&vr=2.0&fn=_top&mt=208&cite=138+Cal.App.+3d+216&sv=Split

Note: Wilson v. Louisiana-Pacific Resources, Inc. came before CTS Corp. v. Dynamics Corp. of America.

Cal. Corp. Code §2115. Foreign corporations subject to corporate laws of state; tests to determine subject corporations; laws applicable; time of application (p. 72)

(a) A foreign corporation (other than a foreign association or foreign nonprofit corporation but including a foreign parent corporation even though it does not itself transact intrastate business) is subject to the requirements of subdivision (b) commencing on the date specified in subdivision (d) and continuing until the date specified in subdivision (e) if:

(1) The average of the property factor, the payroll factor, and the sales factor (as defined in Sections 25129, 25132, and 25134 of the Revenue and Taxation Code) with respect to it is more than 50 percent during its latest full income year and

(2) more than one-half of its outstanding voting securities are held of record by persons having addresses in this state appearing on the books of the corporation on the record date for the latest meeting of shareholders held during its latest full income year or, if no meeting was held during that year, on the last day of the latest full income year.

(b) Except as provided in subdivision (c), the following chapters and sections of this division shall apply to a foreign corporation as defined in subdivision (a) (to the exclusion of the law of the jurisdiction in which it is incorporated):

Chapter 1 (general provisions and definitions), to the extent applicable to the following provisions; Section 301 (annual election of directors); Section 303 (removal of directors without cause); Section 304 (removal of directors by court proceedings); Section 305, subdivision (c) (filling of director vacancies where less than a majority in office elected by shareholders); Section 309 (directors' standard of care); Section 316 (excluding paragraph (3) of subdivision (a) and paragraph (3) of subdivision (f)) (liability of directors for unlawful distributions);

14 Section 317 (indemnification of directors, officers, and others); Sections 500 to 505, inclusive (limitations on corporate distributions in cash or property); Section 506 (liability of shareholder who receives unlawful distribution); Section 600, subdivisions (b) and (c) (requirement for annual shareholders' meeting and remedy if same not timely held); Section 708, subdivisions (a), (b), and (c) (shareholder's right to cumulate votes at any election of directors); Section 710 (supermajority vote requirement); Section 1001, subdivision (d) (limitations on sale of assets); Section 1101 (provisions following subdivision (e)) (limitations on mergers); Section 1151 (first sentence only) (limitations on conversions); Section 1152 (requirements of conversions); Chapter 12 (commencing with Section 1200) (reorganizations); Chapter 13 (commencing with Section 1300) (dissenters' rights); Sections 1500 and 1501 (records and reports); Section 1508 (action by Attorney General); Chapter 16 (commencing with Section 1600) (rights of inspection).

(c) This section does not apply to any corporation (1) with outstanding securities listed on the New York Stock Exchange, the NYSE Amex, the NASDAQ Global Market, or the NASDAQ Capital Market, or (2) if all of its voting shares (other than directors' qualifying shares) are owned directly or indirectly by a corporation or corporations not subject to this section. http://web2.westlaw.com/find/default.wl?rs=WLW11.07&rp=%2ffind %2fdefault.wl&vr=2.0&fn=_top&mt=208&cite=West's+Ann.Cal.Corp.Code+ %c2%a7+2115&sv=Split

Wilson v. Louisiana-Pacific Resources, Inc. (California) illustrates the minority rule, in contrast to Vantagepoint Venture Partners 1996 v. Examen, Inc (Delaware) which illustrates the majority rule for the internal affairs doctrine.

Class Voting

Vantagepoint Venture Partners requires a basic understanding of class voting, which is explained in the breakout box on p. 74.

Class voting is a method of shareholder voting in which different classes of shares vote separately on fundamental corporate changes that affect the rights and privileges of that class. Black’s Law Dictionary 1608, 8th ed. (2004). Class voting is the MBCA approach.

In contrast, under Delaware law all classes vote together, eliminating the possibility of a single class of shares holding up the transaction in question. Under Delaware law, for a merger to be approved, a vote in favor by a majority of all shares (common and preferred) is sufficient.

15 Vantagepoint Venture Partners 1996 v. Examen, Inc. 871 A.2d 1108 (Del. 2005)

Facts: Examen, Inc. filed a complaint in the Court of Chancery against VantagePoint Venture Partners, Inc., a Delaware Limited Partnership and an Examen Series A Preferred shareholder, seeking a judicial declaration that, pursuant to the controlling Delaware law and under the Company's Certificate of Designations of Series A Preferred Stock, VantagePoint was not entitled to a class vote of the Series A Preferred Stock on the proposed merger between Examen and a Delaware subsidiary of Reed Elsevier Inc.

Examen was a pseudo-foreign corporation incorporated in Delaware, but most of its assets, payroll, sales and shareholders were in California. With respect to shareholder voting, California requires separate class voting while Delaware has “single class” voting.

Issue: Which state’s law applies to shareholder voting rights when a firm does substantial business in California but is incorporated elsewhere?

Holding: Delaware (majority rule). Delaware's well-established choice of law rules, due process clause, and commerce clause mandated that the issue of whether preferred shareholder had the right to a class vote on proposed merger be adjudicated exclusively in accordance with law of Delaware as state of incorporation.

Reasoning: The “internal affairs doctrine” is a long-standing choice of law principle which recognizes that only one state should have the authority to regulate a corporation's internal affairs, the state of incorporation. By providing certainty and predictability, the internal affairs doctrine protects the justified expectations of the parties with interests in the corporation. The internal affairs doctrine applies to those matters that pertain to the relationships among or between the corporation and its officers, directors, and shareholders. It provides certainty and predictability, and thereby protects the justified expectations of the parties with interests in the corporation.

The Court found:

“The internal affairs doctrine is not … only a conflicts of law principle.”

“In CTS, the Supreme Court concluded that ‘so long as each State regulates voting rights only in the corporations it has created, each corporation will be subject to the law of only one State.’ Accordingly, we hold Delaware's well -established choice of law rules and the federal constitution mandated that Examen's internal affairs … be adjudicated exclusively in accordance with the law of its state of incorporation, Delaware.” http://web2.westlaw.com/find/default.wl?rs=WLW11.07&rp=%2ffind %2fdefault.wl&vr=2.0&fn=_top&mt=208&cite=871+A.2d+1108+&sv=Split

Question: What motivates the Delaware court?

16 Answer: Constitutional notions. The Supreme Court took a more sober approach on whether to apply the law of the state of incorporation (Delaware) or the law of the state with the most business operations and shareholders (California). In applying the internal affairs doctrine, the court stated that the case presented not only choice of law issues, but matters of constitutional import as well.

Corporations are creatures of state law, the court said, and as such, are governed by the law of the state of incorporation. The Due Process Clause is implicated in such cases because corporate actors have the right to know what law will be applied to the directors and officers of corporations. The Commerce Clause is implicated as well because a state has no interest in regulating the internal affairs of foreign corporations.

Points for Discussion (p. 75)

1. Nature of shareholder voting. Why does California law require cumulative voting and class voting for shareholders of pseudo-foreign corporations operating primarily in California? Is it legitimate for California to seek to protect investors in the state from unfair business practices? Is shareholder voting really an internal affair of the corporation?

Answer: California law requires cumulative voting and class voting in these scenarios to protect minority shareholders. It is perfectly legitimate for California to seek to protect investors in the state from unfair business practices, but it is questionable whether their method for doing so passes constitutional muster. Shareholder voting is a right of the shareholders and relates to a legal relationship between shareholders and directors, two traditional corporate participants. As such, it is an “internal affair.”

2. Reconciling the cases. The California and Delaware courts do not leave much room for doubt. Is there any way the two cases can be reconciled?

Answer: Both involved closely-held corporations with most of their operations and shareholders in California. Both involved voting rights that, if California law had applied, would have given minority shareholders important governance prerogatives. In Wilson, the complaining shareholder got voting rights different from those implicit in the corporation’s Utah charter. In VantagePoint, the complaining shareholder got only the votes implicit in the Delaware charter. We might say that the first shareholder got voting rights he had not negotiated for; and the second shareholder got exactly what he negotiated for.

Notice, though, that the California case may have involved less sophisticated parties than the complaining shareholder (a venture capital firm) in the Delaware case. Delaware may have assumed that corporate participants in its corporations know what they are doing, not so much in California.

C. Vertical Federalism: Federal View of Corporate Law

State Antitakeover Regulation

17 In addition to horizontal federalism, corporate federalism operates in the vertical relationship between federal and state corporate law. State corporate law, for the most part, has been the beneficiary of federal abstention.

In the absence of a clear federal statutory intervention, corporate law is left mostly to the states. Still, federal law is supreme under the U.S. Constitution, and where it is intended to, it preempts state law.

Question: The history of corporate law in the United States is marked by periods of intensive federal intervention, usually in response to market failure after periods where the federal government has refrained from mingling in corporate law. Can you think of any examples of that cycle?

Answer: Enron, World Com scandals followed by the Sarbanes Oxley Act of 2002. 2008 financial crisis followed by the Dodd-Frank Wall Street Reform and Consumer Protection Act (2010)

Two Supreme Court cases, Edgar v. MITE Corp. (U.S. 1982) and CTS v. Dynamics Corp. of America (U.S. 1987) mark the federal limits on state corporate law. These cases both dealt with challenges to state statutes regulating corporate takeovers.

Question: What is a “tender offer”?

Answer: As explained in the breakout box on p. 77, a tender offer is the offer by a bidder to buy a company’s shares during a specified period subject to certain conditions (e.g., price). If enough shareholders accept the offer, the bidder may be able to acquire control of the company without dealing with the incumbent board of directors.

There are three “generations” of state antitakeover statutes:

1 st Generation (before MITE/ 1982)

 Often enacted in response to large number of hostile takeovers  Enacted at urging of corporate managers (who argued that unsolicited tender offers caused corporations to damage or to leave their communities)  State securities laws  “Fairness” review  Example: Illinois

Edgar v. MITE Corp. 457 U.S. 624 (1982)

Facts: An Illinois statute required offerors to give 20 days’ notice to the Secretary of State of any tender offer bid and empowered the Secretary to hold a hearing to review the fairness of the tender offer.

18 Issue: Was the Illinois statute unconstitutional?

Holding: Yes. The Illinois antitakeover statute was unconstitutional

Reasoning: Illinois claimed that the internal affairs doctrine insulated the law from constitutional criticism, but the court rejected the argument because of the statute’s inclusion of certain non-Illinois corporations (ones with the requisite number proportion of Illinois shareholders and either their principal offices in Illinois or sought no less than 10 percent of the shares in the tender offer from residents of Illinois).

2 nd Generation (between MITE /1982 and CTS /1987)

 Courts invalidated many of the 1st generation statutes  States enacted a second generation of antitakeover statutes  Regulated corporate internal affairs  Did not use separate securities regulation  Management lobby  Applied only to domestic corporations (incorporated in that state)  Often included price or voting conditions to combat hostile tender offers  Example: Indiana

CTS Corp. v. Dynamics Corp. of America, 481 U.S. 69 (1987)

Facts: Dynamics Corp. owned 9.6% of the shares of CTS Corp. which was incorporated in Indiana. Dynamics attempted a hostile tender offer seeking to acquire 27.5% and thus obtaining control of CTS.

The Indiana antitakeover statute, the Indiana Control Shares Acquisition Chapter (ICSAC) mandated a special shareholders meeting be called within 50 days of a tender offer seeking control of the corporation. Also, the ICSAC disallowed the acquirer of control the right to vote for a merger without the prior approval by a majority of the disinterested shareholders of the corporation.

The Indiana statute, unlike Illinois’, applied only to corporations that were incorporated in Indiana and had at least 100 shareholders, their principal place of business or substantial assets in Indiana, and a significant portion of Indiana shareholders. ICSAC sought to repel hostile takeovers by requiring that disinterested shareholders vote before giving voting rights to any bidder seeking to obtain a controlling interest in the corporation. In other words, voting rights were not given to a bidder’s shares until the shareholders had themselves voted to award them.

The 50-day timeline for a special meeting was not the same as the Williams Act (a federal statute that prescribed the timeframes for dealing with tender offers in public corporations). Dynamics sought to enjoin enforcement of the Indiana Law claiming that the ICSAC was preempted by the Williams Act, and violated the Commerce Clause.

19 The 7th Circuit ruled that the ICSAC was both unconstitutional based on the Commerce Clause violation and preempted by the Williams Act. The Court of Appeals upheld the decision based upon a violation of the commerce clause because of the ICSAC’s perceived interference and hindrance of tender offers.

Issues: (1) Does the ICSAC violate the commerce clause, and therefore, is it unconstitutional? (2) Is the ICSAC preempted by the Williams Act?

Holding: (1) No. The ICSAC was consistent with the Commerce Clause because it fell within the power of states to regulate the internal affairs of their domestic corporations. (2) No. ICSAC requirement of a shareholder vote before enfranchising an acquirer of stock did not violate the Williams Act because it did not interfere in any way with the bidding process.

Reasoning: Justice Powell wrote:

“The markets that facilitate… ownership of corporations are essential for providing capital…. The beneficial free market system depends at its core upon the fact that a corporation… is organized under, and governed by, the law of a single jurisdiction [its State of incorporation].”

“It is thus an accepted part of the business landscape in this country for States to create corporations, to prescribe their powers, and to define the rights that are acquired by purchasing their shares.”

The Court ruled that, on its face, the ICSAC evenhandedly determines the voting rights of shares of Indiana corporations and does not conflict with provisions or purposes of the Williams Act. To the limited extent that the ICSAC affects interstate commerce, it is justified by the State’s interests in protecting shareholders of its corporations.

Dynamics’ argument that the ICSAC would greatly restrict the number of successful tender offers, thus violating the commerce clause, was rejected because the ICSAC only provided “regulatory procedures” in the event of a hostile takeover and did not prevent any resident of non-resident from attempting a takeover.

1. The CTS blueprint Does CTS Constitutionalize the internal affairs doctrine?

Answer: It is arguable that the CTS decision constitutionalizes the internal affairs doctrine, at least for multi-state corporations with public shareholders. Any attempt by a state to regulate the internal affairs of foreign corporations risks inconsistent regulation.

2. State protectionism Does CTS mean that a state could choose to enact antitakeover laws designed to protect the interests of in-state management, in-state employees . and the local tax base, - so long as the law applies only to domestic corporations? Isn’t this protectionism?

20 Answer: The CTS decision seems to allow protectionism – clearly the motivation of antitakeover statutes – if the law applies only to domestic corporations. Powell shows much deference to corporate incumbents. Other members of the Court respected his knowledge of corporate law.

3 rd Generation (after CTS /1987)

 States were emboldened by the CTS decision  States enhanced their second generation statutes  Incorporation based: most limited to regulating the internal affairs of “domestic corporations” management (courts have struck down all third generation statutes that regulate takeover bids directed at “foreign corporations”)  Example: DGCL § 203 o Three-year moratorium on any merger by the target corporation after a hostile takeover (unless bidder acquired 85% control) o Applies to Delaware corporations without regard to where they do business or where their shareholders reside

http://web2.westlaw.com/find/default.wl?rs=WLW11.07&rp=%2ffind %2fdefault.wl&vr=2.0&fn=_top&mt=208&cite=8+Del.C.+ %c2%a7+203&sv=Split

Amanda Acquisition Corp. v. Universal Foods Corp., 877 F.2d 496 (7 th Cir. 1989), cert. denied, 493 U.S. 955 (1989)

Facts: Wisconsin passed “third generation” antitakeover statute, limited to domestic corporations. It imposed a Delaware-style moratorium on transactions after a hostile bidder acquired control, thus making two-step leveraged buyouts difficult.

Issue: Was Wisconsin’s antitakeover law constitutional?

Holding: No. The 7th Circuit upheld the Wisconsin law.

Reasoning: Citing the fact that Wisconsin had in 1947 prohibited corporate mergers, the 7th Circuit upheld the statute stating “a state with the power to forbid mergers has the power to defer them for three years.” Despite his personal doubts about the wisdom of having such a statute, Judge Frank Easterbrook stressed that it was not the court’s place to do away with it:

“If our views of the wisdom of state law mattered, Wisconsin’s takeover statute would not survive.… Wisconsin’s law makes a potential buyer less willing buy, but this is equally true of [many] other rules of corporate law.”

“Courts seeking to impose “good rules” on the states diminish the differences among corporate codes and dampen competitive forces . . . Our Constitution allows the states to act as laboratories; slow migration (or national law on

21 authority of the Commerce Clause) grinds the failures under. No such process weeds out judicial errors, or decisions that, although astute when rendered, have become anachronistic in light of changes in the economy.”

Question: What keeps states from going too far in enacting antitakeover laws?

Answer: Judge Easterbrook explains that there is a “market” floor on anti-takeover laws. If a state goes too far the market in corporate chartering will discipline it. Corporations in the state will have trouble attracting capital, the business will suffer, the corporation will reincorporate to a more shareholder-friendly climate.

“To say that states have the power to enact [inefficient anti -takeover laws] is not to say that investors should kiss their wallets goodbye. States compete to offer corporate codes attractive to firms.”

Question: What does this opinion add to an understanding of CTS?

Answer: The opinion shows the deference courts show to states in formulating laws governing the internal affairs of domestic corporations. Judge Easterbrook’s opinion also indicates the reluctance of the courts to second-guess the business decisions even of states, a reluctance not unlike that shown toward decisions made under the business judgment rule.

D. Market in State Charters

Delaware plays a preeminent role in making corporate law for U.S. public companies.

Question: What is the difference between public and close corporations?

Answer: This question reviews material from Chapter 2. As used in this course, a “public corporation” refers to a for-profit corporation created under state law whose ownership interests (shares) are owned by a large group of shareholders who trade their shares on stock markets open to the public – thus, making it publicly owned. Shareholders of public corporations can typically sell their shares easily. Shareholders of public corporations do not usually have a relationship with the corporation and are not involved in the management of the corporation. A public corporation cannot be one that is non-profit.

In contrast, a close corporation is a for-profit corporation created under state law whose shares are not publicly traded, but closely held. There is no ready market for the shares of close corporations. It is typical for the participants in a close corporation to overlap substantially (e.g. directors and officers with ownership stakes, owners involved in the management).

22 Remember that Delaware in 1899 modified its corporation statute to resemble New Jersey’s, and when New Jersey amended its corporation statute in 1913 to be more restrictive, Delaware became the corporate home of choice. Delaware took the “lead” with its business friendly statute and has not forfeited it since. It has retained this lead through the cooperative work of its legislature, its bar, and its judiciary.

Delaware’s corporate statute is the most innovative in the United States. Its legislature is often the first to spearhead reforms such as  teleconferencing at board meetings,  hybrid financing techniques, and  electronic shareholder voting.

The success of the corporate statute is due in large measure to the reforms drafted by a special committee of the Delaware Bar Association: the Council of the Corporate Law Section. The drafts of the Council are then passed by the legislature. Delaware’s judiciary is also uniquely suited for corporate law. All corporate law cases go to the Court of Chancery, a court of five judges appointed based on their corporate law expertise. The Court of Chancery has a docket composed almost entirely of corporate law cases and sits in equity without a jury. Without a jury, the Court of Chancery makes both findings of facts and conclusions of law. This allows cases to be disposed of with remarkable speed and expertise. The work of the chancellors in their opinions and scholarly writings is widely influential.

Question: What is meant by “incorporation-based private ordering”?

Answer: The term identifies the fact that private parties (usually management) decide on the rules that will govern the internal affairs of the corporation by choosing where to incorporate.

Question: What is the meaning of the term “race of laxity”?

Answer: This term was first used by Louis Brandeis and refers to a trend of increasing flexibility in U.S. corporate law. Delaware has won this race – by being more enabling, flexible, and predictable than other states.

Question: Is this good or bad?

Race to the Top vs. Race to the Bottom

There has been and continues to be a vigorous policy debate on whether Delaware has “sold out” its corporation law to maximize filing fees and other advantages of being the home of most U.S. public corporations. Managers, the assumption runs, control the decision where to incorporate a business and choose Delaware to maximize their power and pay.

The “race to the bottom” vs. “race to the top” debate reinforces much of the learning about corporate federalism.

23 Question: What is meant by “race to the bottom”?

Answer: Law school professor (and former SEC chairman) William Cary was the primary mouthpiece for the idea that Delaware was engaged in a “race to the bottom.” His argument was that shareholder protections had been systematically eliminated or minimized by Delaware. He supported his argument with evidence from Delaware’s statutory provisions that had reduced the shareholder vote to approve mergers from two- thirds to a majority. Professor Cary also pointed to numerous court decisions in which he accused the courts of broadly applying the business judgment rule and allowing management to resist public officers.

Question: What is meant by “race to the top”?

Answer: In response to Cary, Ralph Winter (a federal appeals court judge and former law professor) argued that the market had shaped a “race to the top,” and that Delaware was winning. Judge Winter argued that the horizontal competition among states for corporate charters prompted states to make corporate law that provided the greatest benefit to the shareholders. A race to the bottom, Judge Winter argued, did not make sense because doing so would disadvantage Delaware in attracting capital. Shareholders would eventually learn that Delaware allowed managers to profit at the expense of shareholders and stop investing. Eventually this would drive share prices so far down a hostile bidder would take over and reincorporate the enterprise in a state more hospitable to shareholders.

Question: Which theory is correct?

Answer: Neither theory is necessarily correct. Both have strengths and weaknesses. The goal of the exercise is not to crown a winning theory, but to weigh their strengths and weaknesses.

Question: Is there a way to resolve the debate empirically? If so, how?

Answer: There have been several attempts to resolve the debate once and for all through empirical studies. One such study found that firms incorporated in Delaware were worth more than firms incorporated elsewhere. This study suggested that Delaware was leading a “race to the top.” Daines, R. 2001. “Does Delaware Law Improve Firm Value?” 62 Journal of Financial Economics 525-58.

However, the findings of a follow-up study indicated that the increased worth of Delaware firms occurred only in small firms (with less than $50 million in net sales). Guhan Subramanian, “The Disappearing Delaware Effect,” 20 J.L. Econ. & Org. 32 (2004). Unlike the other study, this data suggests Delaware may be leading a “race to nowhere.”

For more on empirical studies pertaining to the race to the bottom, top, or nowhere – see:

24 Allen Hyman, “The Delaware Controversy-The Legal Debate,” 4 Del. J. Corp. L. 368 (1979) (1.8% to 2.9% positive returns during the two weeks surrounding announcement of reincorporation) Peter Dodd & Richard Leftwich, “The Market for Corporate Charters: 'Unhealthy Competition' versus Federal Regulation,” 53 J. Bus. 259, 274-75 (1980) (30.25% positive abnormal returns during two years before event Roberta Romano, “Law as Product: Some Pieces of the Incorporation Puzzle,” J. L. Econ & Org. at 269-70 (4.1% positive abnormal returns for all reincorporations during sample period, within 99 days before and after event). Michael Bradley & Cindy A. Schipani, “The Duty of Care Standard in Corporate Governance,” 75 Iowa L. Rev. 1 (1989) (6.17% positive abnormal returns around event date) Jeffry Netter & Annette Poulsen, “State Corporation Laws and Shareholders: The Recent Experience,” 18 Fin. Mgmt (No. 3) 29, 36 (1989) (5.67% abnormal returns in interval around event)

Question: Is there true competition for corporate chartering?

Answer: Maybe not. At least not always. Firms incorporate locally if they are local. They choose between Delaware and the law of their headquarters’ state if they are multi- state and public. For such public firms the decision to stay in the state of their headquarters may well turn on having local political clout.

For example, Wachovia in North Carolina, got the state legislature to adopt a statutory change to thwart a takeover by Georgia-based Suntrust.

Question: Where does Delaware really feel the heat?

Answer: Corporate law professor Mark Roe views Delaware’s competition as coming from as much if not more from the federal government as from other states. As major corporate law issues come up on the horizon, it is the federal government that acts—or threatens to act—often beating Delaware to the punch. Thus, Professor Roe sees vertical federalism contributing as much to Delaware’s competition in pioneering corporate law as horizontal federalism.

1. Corporate law as product. Is it appropriate to describe state corporate law (statutes, court system, lawyers) as a “product”? If so, is corporate law unique, or do states sell other law products? Isn’t this unseemly?

Answer: State competition – lower tax base, special programs for new industries, better schools – is part of our federalism. It should not be surprising that one aspect of this competition is to offer business firms “risk allocation and conflict minimization” services -- namely, corporate law. Remember, however, that corporate law is different from mandatory law

25 2. Delaware’s partial dominance. Although Delaware is the legal home of most public corporations in the United States, it is far less dominant with respect to close corporations. If Delaware corporate law offers so many advantages to public corporations, why don’t close corporations flock to Delaware also? Notice, for example, that Delaware offers a special statutory provision (DGCL §§ 341-356) just for close corporations.

Answer: Delaware is more expensive, its courts and corporate bar farther away and less accessible, and its legislature less attuned to close corporation issues. It is cheaper and simpler to incorporate local businesses locally. Local lawyers tend to know their own state statute, courts and local bar better.

Delaware’s close corporation statute is not used very much. ultimately based on two testable views of Delaware corporate law. For example, Professor Cary sought to prove that Delaware law was deficient since it had abandoned two thirds-voting for mergers and adopted a majority-voting requirement in its place. Judge Winter pointed to the willingness of investors to invest in Delaware companies as proof that Delaware’s corporate law is no worse, and perhaps better, than any other.

3. Assessing Delaware’s corporate law. How would you assess whether Delaware corporate law is, indeed, a superior product?

Answer: Some possible ways to approach empirical tests of whether Delaware law is a superior product include:

 Are Delaware corporations more successful in attracting capital?  Are they more profitable?  Do they have fewer intra-corporate disputes?  What do lawyers and business persons say about Delaware law?  What happens when a corporation reincorporates in Delaware – to its stock price, to other measures of value (like accounting data), to its employees’ happiness.

Summary

The main points of the chapter are:

 U.S. corporate law has developed over time, first from special state-granted charters, to liberal incorporation, to federal regulation of corporate activities (antitrust and securities), to Sarbanes-Oxley regulation of audits and legal compliance

 There is a longstanding debate over whether corporations are “property” (for the exclusive benefit of shareholders) or “social institutions” (to advance broader public interests)

26  U.S. corporate law is incorporation-based private ordering: corporations are creatures of the law of the state where the parties decide to incorporate

 The internal affairs doctrine is a choice of law rule that the internal relations of a corporation (the relations between shareholders and managers) are governed by the law of the state of incorporation

o Delaware respects the internal affairs doctrine, even when the foreign corporation’s rule is contrary to Delaware statute and policy o Some states, especially California, regulate the internal affairs (voting, etc.) of “pseudo-foreign corporations” (incorporated elsewhere but operating primarily in-state) o Respect for pseudo-foreign corporation regulation depends on which court hears the case

 State antitakeover regulation tests the limits of state power over corporations

o First-generation statutes protect corporations, domestic and foreign, doing business in the state from takeovers under state securities law (held to be unconstitutional interference with commerce under MITE) o Second-generation statutes protect domestic corporations from takeovers under state corporate law (held to be constitutional under CTS) o Third-generation statutes are more protective of domestic corporations (constitutional because the chartering market disciplines excessive protection in Amanda Acquisition)

 Is state chartering competition a race to the bottom (Cary) or a race to the top (Winter) or to nowhere (recent studies)

o Delaware wins the race for public corporations with (1) corporate statutes drafted by the bar, requiring 2/3 legislative approval; (2) state leader in corporate reforms; (3) judges are experts and independent – the Court of Chancery hears all corporate law cases without a jury; and (4) a well- developed body of corporate case law o Studies show Delaware reincorporation produces value, but recent studies question whether Delaware incorporation produces financial value

 Beware the long arm of Delaware (which is why law students everywhere are asked to study Delaware corporate law)