Academic journal article Harvard Law Review

The Case for Federal Threats in Corporate Governance

Academic journal article Harvard Law Review

The Case for Federal Threats in Corporate Governance

Article excerpt

Corporate law scholars have long debated whether competition among states to attract corporate charters makes for a race to the top or a race to the bottom. (1) Scholars' positions on the issue have traditionally informed their stances on the desirability of federal intervention in corporate lawmaking: those who believe that states race to the top argue against intervention by the federal government, while those who believe that states race to the bottom contend that the federal government should provide a remedy. Recently, Professor Mark Roe has reframed this debate by arguing that regardless of Delaware's relationship with other states, the primary shaper of Delaware's corporate law is competition with the federal government. (2) This Note starts where Professor Roe leaves off by reconsidering the proper role of the federal government in light of the influence of federal players on state law. This inquiry requires first determining the extent to which state law would be efficient in the absence of federal pressures. Next, an assessment of whether either of two mechanisms of federal influence would produce more efficient results is necessary. As many scholars have noted, the federal government could directly regulate corporate law. An alternative approach that the literature has overlooked, however, consists of the federal government threatening intervention in order to prompt states to adopt more desirable rules.

Part I summarizes the different views of state competition and argues that the view that the federal government influences state law is not an alternative theory, but is instead a necessary backdrop to the other theories on the race. It then considers the implications of the different theories on the role of federal intervention. Part II reevaluates studies on the effectiveness of state corporate law in light of the federal government's influence on state lawmaking. Part III examines the drawbacks of corporate lawmaking at the federal level. Part IV proposes a system in which federal players do not create new law, but merely threaten to do so in order to induce states--particularly Delaware--to improve their legal rules. Part V concludes.

I. THE FEDERALISM DEBATE IN CORPORATE LAW

This Part reviews the literature on state competition and corporate law-making. Section A summarizes the traditional race-to-the-bottom and race-to-the-top theories, as well as the more recent view that there is no race. Section B presents the view that states compete against the federal government and examines how it fits with the other theories. Section C discusses the implications of these theories on the desirability of corporate lawmaking by the federal government.

A. Theories of State Competition

1. Race to the Bottom.--Former Securities and Exchange Commission (SEC) Chair William Cary was among the first to advance the race-to-the-bottom theory, which contends that state competition for corporate charters drives states to adopt corporate law rules that benefit managers at the expense of shareholders. (3) States benefit from attracting corporate charters by earning franchise tax revenues. (4) Because only the board of directors has the power to initiate incorp-oration decisions, and because shareholders typically ratify the board's proposals without showing opposition, states need to cater to managers (5) to attract incorporations. Under this view, Delaware wins the state charter competition because the Delaware legislature and courts are leaders in loosening constraints on managers. (6) Early critics argued that the race-to-the-bottom theory is flawed because it fails to account for market forces that constrain managers' behavior. (7) More recent defenses of the race-to-the-bottom view acknowledge that market forces provide an incentive for managers to adopt value-increasing rules, but argue that such market forces do not always lead to the most efficient result. (8)

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