The Demand for Corporate Law: Statutory Flexibility, Judicial Quality, or Takeover Protection?

Transcription

1 NELLCO NELLCO Legal Scholarship Repository New York University Law and Economics Working Papers New York University School of Law The Demand for Corporate Law: Statutory Flexibility, Judicial Quality, or Takeover Protection? Marcel Kahan New York University School of Law, Follow this and additional works at: Part of the Law and Economics Commons Recommended Citation Kahan, Marcel, "The Demand for Corporate Law: Statutory Flexibility, Judicial Quality, or Takeover Protection?" (2005). New York University Law and Economics Working Papers. Paper This Article is brought to you for free and open access by the New York University School of Law at NELLCO Legal Scholarship Repository. It has been accepted for inclusion in New York University Law and Economics Working Papers by an authorized administrator of NELLCO Legal Scholarship Repository. For more information, please contact

2 The Demand for Corporate Law: Statutory Flexibility, Judicial Quality, or Takeover Protection? by Marcel Kahan * JEL Classification: G30, G38, H70, K22 Revised: April 2005 * George T. Lowy Professor of Law, New York University School of Law. I would like to thank Barry Adler, William Allen, Jennifer Arlen, Yakov Amihud, Jennifer Arlen, Lucian Bebchuk, Steven Choi, Douglas Cummings, Robert Daines, Jeff Gordon, Zohar Goshen, Laurie Hodrick, Ehud Kamar, Geoff Miller, Mark Roe, Roberta Romano, Guhan Subramanian, Leo Strine, Jeffrey

3 Wurgler, three anonymous referess, and the participants of workshops at Columbia Law School and the NYU School of Law for helpful comments and acknowledge the financial assistance of the Filomen D Agostino and Max E. Greenberg Research Fund.

4 Abstract This paper provides an empirical examination of the determinants of firms decisions where to incorporate. Consistent with our theoretical predictions, we find substantial evidence that firms are more likely to incorporate in states with corporate law rules that offer firms flexibility to devise their governance arrangement and significant but less robust evidence that firms are more likely to incorporate in states with higher quality judicial systems. Unlike prior studies, we find no evidence that firms are more or less likely to incorporate in states with antitakeover statutes. The latter results are consistent with the hypothesis that anti-takeover statutes have no significant effect on a company s marginal ability to resist takeovers. 3

5 I. Introduction The federal structure of the United States offers companies a choice of corporate domiciles. Regardless of where a company conducts its business, it can incorporate in any state and be governed by the corporate regime of its domicile. This feature has generated a debate over how firms decide where to incorporate. According to some scholars (Winter (1977), Romano (1985)), companies incorporate in states that offer a regime that increases their value. According to others (Cary (1974), Bebchuk (1992)), companies incorporate in states that offer a regime that promotes managerial interests at the expense of shareholder interests. Which view is correct has obvious significance for a variety of issues. Whether firms prefer regimes that increase firm value or regimes that promote managerial interests will affect the shape of the law of Delaware and any other state that tries to attract incorporations. More generally, how firms decide where to incorporate is important in order to assess the merits of the present federalist regime, where firms have a choice among different corporate domiciles, compared to uniform federalized corporate law advocated by several commentators. And with respect to continental Europe, 1

6 it is important to assess the merits of the prevailing real seat regime, where firms must incorporate in their headquarter state, compared to a federalist regime that may be imposed by European Union law. Several recent empirical studies directly examine the incorporation choices of U.S. firms. Subramanian (2002) and Bebchuk and Cohen (2003) find that firms are more likely to be incorporated in their home state if that state has adopted anti-takeover statutes (ATS). Daines (2002) finds that firms are less likely to incorporate in states with ATS, but notes that these results are not robust. Ferris et al. (2004) construct a composite measure of the speed in which states adopt eight types of laws that increase managerial discretion (includes four ATS) and find that this measure is positively related to a state s ordinal incorporation ranking. In this paper, we examine incorporation choices from a broader perspective. ATS are not the only feature of a state s corporate regime that may affect incorporation choices. Indeed, as discussed beloww, there are strong theoretical reasons to believe that substantive differences in state law unrelated to takeovers have a greater effect on domicile choices than ATS do. In addition, several commentators (e.g. Romano (1985); Kahan and Kamar (2002)) have 2

7 suggested that the quality of a state s court system may affect domicile choices. None of the earlier empirical studies on incorporation choices segregates the effect of these variables on incorporation choices from the effect of ATS. Subramanian (2002), Daines (2002), and Bebchuk and Cohen (2003) do not control for any differences in corporate regimes other than ATS and whether the state has adopted the Model Business Corporation Act. Ferris and et. (2004) combine the effect of ATS and certain other provisions into a single composite variable that they use in their regressions. But taking account of differences in state s corporate regimes that are unrelated to takeovers is important for two reasons. First, other features of a state s corporate regime should be included as control variables in studying the effect of ATS on incorporations. Second, these features shed independent light on the question of how firms make incorporation choices and thus on the merits of the U.S. regime which offers firms a choice among different domiciles. Consistent with our theoretical predictions, we find substantial evidence that firms are more likely to incorporate in states with corporate law rules that offer firms flexibility to devise their governance arrangement in areas unrelated to takeovers. We also find significant but less 3

8 robust evidence that firms are more likely to incorporate in states with higher quality judicial systems. After controlling for court quality and flexibility, we find no evidence for the hypothesis that firms are either more or less likely to incorporate in states with ATS. The latter results are consistent with the hypotheses that ATS have no significant effect on a company s marginal ability to resist takeovers or that they can be replicated by charter provisions. The rest of the paper is organized as follows. Part II briefly discusses the methodology used in this paper. Part III considers the features of a state s corporate regime that are likely to affect incorporation decisions. Part IV reports the results of the empirical examination of incorporation choices. Part V concludes. II. Methodology In this study, we calculate a retention rate for each state. The retention rate is the number of firms headquartered in the state that are incorporated in the state divided by the total number of firms headquartered in the state. We then regress the retention rate (or a logistic transformation of the retention rate) on the characteristics 4

9 of the state's corporate regime and certain control variables. Because we use state retention rates as observations, we have (at most) 51 observations in our regressions one for each state and for the District of Columbia. An equivalent methodology is used the cross-country studies by La Porta, Lopez de Silanes, Shleifer and Vishny (LLSV) and by others (LLSV (1997); LLSV (1998); LLSV (1999); Leuz et al. (2004)) of how differences in legal protections and other country-wide variables affect firms. By contrast, Subramanian (2002) and, in most of their regressions, Daines (2002) and Bebchuk and Cohen (2003) treat each firm's incorporation choice i.e., whether it incorporates in its headquarter state or in Delaware as a separate observation. 1 Accordingly, they have several thousand observations in their regressions. Treating each firm as a separate observation, however, is problematic for two reasons. First, the number of firms headquartered in a state differs substantially from state to state. By treating each firm as a separate observation, disproportionate weight is given to how traits of large states affect incorporation decisions. Second, treating each firm as 1 Daines (2002) and Bebchuk and Cohen (2003) note that unreported regressions using retention rates yield results similar to those using individual firm incorporation choices. 5

10 a separate observation is technically inappropriate if there are state-wide factors that influence incorporation choices but are not included among the independent variables. 2 Such omitted state-wide factors will generate correlated errors for firms headquartered in the same state. As a result, the error term would no longer be statistically independent, as required to yield reliable standard-error estimates for those statewide factors that are included among the independent variables. As we explain below and as our results confirm, it is indeed likely that omitted factors affect incorporation choices on a state-by-state basis. By using state retention rates rather than firm incorporation choices as dependent variable, this study reduces this problem. Relatedly, this study (like Daines (2002) and Ferris et al. (2004)) focuses on firm incorporation choices at the time of their IPO (IPO data). Subramanian (2002) and Bebchuk and Cohen (2003), in contrast, examine whether existing public firms were incorporated in the headquarter state or elsewhere in 2000 (stock data). (In Section IV(e), we also perform some tests using stock data.) IPO data and stock data differ for several reasons. To 2 Daines (2002) avoids this problem in some regressions by including a dummy variable for a firm s headquarter state. 6

11 the extent that domicile choices are sticky for firms that are public (Romano 1985), stock data reflect original IPO incorporation decisions for older companies (that went public before 1990, the start of our sample period) as well as changes in headquarter state subsequent to an IPO. This is likely to add noise to the analysis (e.g., because pre-1990 IPOs were affected by a different corporate regime than the one prevailing during the sample period and because changes in headquarter state are presumably unrelated to our independent variables). In addition, the dynamics of incorporation choices at the IPO stage differ from those of subsequent decisions whether to reincorporate. In particular, the classic argument that firms devise optimal governance structures in order to maximize firm value when securities are issued applies only to IPOs (Daines & Klausner (2001)). Reincorporation decisions involve no such market interactions, but require the approval of both the board of directors and of stockholders. Thus, states with provisions valued by managers but opposed by shareholders may be more successful in retaining firms already domiciled in the state and, depending on one s view of the relative efficiency of IPO pricing and shareholder voting, more or less successful in attracting reincorporations, than they are in attracting incorporations 7

12 by IPO firms (Kahan & Rock (2003)). As stock data reflect IPO incorporation decisions over a longer period, changes in headquarter states, post-ipo reincorporations, and post-ipo affirmative decisions not to reincorporate, tests using stock data have less statistical power and any results obtained are harder to interpret. III. State Corporate Regimes and Incorporation Choices The notion that features of state law influence firm incorporation decisions, and thus affect a state s retention rate, has long been a staple assumption of corporate scholarship (see Cary (1974), Romano (1985)). This Part discusses various features of a state s corporate regime that we are using in our statistical analysis in Part IV. (a) Statutory Flexibility For purposes of this study, we identified statutory provisions, not related to takeovers, which shared the following elements: there was some significant variation in the law of the various states with respect to the element; some states ( mandatory states ) imposed their legal regime either as a mandatory rule or permitted only one-sided optouts; there are reasons to believe that many firms disfavored 8

13 the mandatory rule; and the rule, in our judgment, was plausibly significant for incorporation choices. Four statutory rules satisfied these criteria. (i) Merger Vote. Seven states require that mergers be approved by two-thirds of shareholders without permitting the company to adopt a lower threshold in their certificate of incorporation. Other states require either a regular or a two-thirds majority of shares entitled to vote, but permit companies to vary that percentage thorough a provision in the certificate of incorporation. Most companies that have the choice opt to require approval by a majority of shares entitled to vote to effect a merger. (ii) Limitation on Personal Liability of Directors. Delaware and many other states permit companies to eliminate the personal liability of directors for breaches of their duty of care. Six states, however, do not permit companies to limit the personal liability for directors or permit limits only on grounds that are narrower than Delaware s. These states, in effect, have a mandatory rule imposing personal liability on directors on grounds that are wider than Delaware s. Delaware companies tend to opt out of personal 9

14 liability to the extent permitted by Delaware law, thus indicating that companies, if given the choice, favor Delaware s narrower grounds (see Romano (1990)). (iii) Cumulative Voting. Six states have mandatory provisions requiring that directors be elcted through cumulative voting. The other states permit companies to opt either for cumulative voting or for regular (non-cumulative) voting. Under a cumulative voting regime, a minority of shareholders may obtain representation on the board of directors. Few, if any, public companies adopt a cumulative voting regime indicating that firms, if given the choice, prefer regular voting. (iv) Loans. Most states permit loans to officers and/or directors subject to the general constraints on self-dealing transactions. Four states, however, either hold directors personally liable for the repayment of such loans or subject them to special procedural requirements (such as requiring shareholder approval). In states that have no special statutory rules, companies could adopt stricter rules in the corporate charter. We are, however, not aware that any company has in fact adopted such a rule. The controversy over 10

15 a recent prohibition on such loans embodied in the Sarbanes- Oxley Act 3 indicates that companies may consider this issue important. More generally, these statutory provisions measure the degree of statutory flexibility. More flexible statutes give companies a choice -- between higher or lower thresholds for the approval of a merger, between narrow or wider grounds for opting out of personal liability, between regular or cumulative voting, and between stricter or laxer procedures for loans to officers and directors. Less flexible statutes force the choice on companies. (b) Judicial Quality Another factor that may influence incorporation choices is the quality and integrity of a state s judicial system. Indeed, the high quality and subject matter expertise of the Delaware courts is generally cited, along with or ahead of the substance of its corporate law, as a key reason why companies incorporate in Delaware (see Romano (1985), Kahan and Kamar (2002)). This suggests that the quality of a state court may more 3 Sarbanes-Oxley Act of 2002,

16 generally make states more or less attractive as corporate domiciles. By incorporating in Delaware rather than in its headquarter state, a company makes it significantly more likely that Delaware courts, rather than the courts of the headquarter state, will adjudicate its corporate and other disputes. For companies located in states with lower quality courts, incorporating in their headquarter state may thus be relatively less attractive. (c) Anti-Takeover Statutes We also examine the effect of ATS on incorporation choices of firms. Subramanian (2002) and Bebchuk and Cohen (2003) focus on the presence of five types of statutes constituency statutes, control share statutes, business combination statutes, fair price statutes, and pill validation statutes and, as an alternative specification, on the total number of statutes a state has adopted. Although we follow Subramanian (2002) and Bebchuk and Cohen (2003) in this regard, we note that the theoretical foundations for the use of these statutes as individual variables and of the total number of statutes adopted by a state are not well developed (see also Daines (2002)). Starting from the premise that ATS benefit managers but 12

17 reduce shareholder wealth, Subramanian (2002) and Bebchuk and Cohen (2003) view their regressions as testing whether the incorporation pattern supports the hypothesis that firms chose their domicile to maximize firm value (race-to-the-top), and thus incorporate in states without ATS; or the hypothesis that firms chose their domicile to promote managerial interests (race-to-the-bottom), and thus incorporate in states with ATS. There are, however, significant structural differences among the statutes that makes the use of the total number of statutes that a state has enacted questionable. Some statutes (such as control share acquisition statutes) are regarded as beneficial even by commentators generally opposed to ATS because they protect shareholders against coercive offers without empowering managers to resist bids (Bebchuk (1987)). Other statutes, such as fair price and business combination statutes, can be substantively duplicated by charter provisions and should thus neither attract incorporations at the IPO stage (since firms from state without statutes that want to be subject to such a provision can insert one in their charter) nor deter them (since firms from states with such statutes that do not want to be subject to such a provision 13

18 can opt out from the statute). 4 Moreover, as Coates (2000) has pointed out, ATS interact in important ways. Both control share statutes and fair price statutes primarily inhibit coercive bids, but do not otherwise make it more difficult to acquire a company. Business combination and pill validation statutes have the direct effect of giving the board greater power to block a bid; and because board resistance is overcome through a shareholder vote in a proxy contest, they also protect shareholders against coercive offers. Within either set, the two statutes largely duplicate each other: 5 having both is thus no better than having one. Furthermore, the statutes in the second set business combination and pill statutes go beyond those in the first set control share and fair price statutes and thus render them redundant. Duplicative and redundant statutes, however, should have no marginal effect on incorporations. 4 Since Subramanian (2002) and Bebchuk and Cohen (2003) use stock data in their regressions, opt-out default statutes may affect their incorporation data with respect to companies that were incorporated in states with such statutes before the statute was enacted. 5 The main difference is that fair price statutes and business combination do not affect bids where the raider does not want to freeze-out non-tendering shareholder in a second step merger, but control share and pill validation statutes do. 14

19 Finally, there is a strong theoretical basis for the hypothesis that none of these ATS have a significant effect on a company s marginal ability to resist a bid. Coates (2000) suggests that the effective judicial validation 6 of a poison pill has rendered most ATS redundant. 7 As to constituency statutes, which relate to the board s fiduciary duties in responding to a takeover bid, they are strictly speaking not made redundant by a pill (fiduciary duties may require a board to redeem a pill), but commentators have expressed doubts whether such statutes have any material effect (see Block (1998)at ). To the extent that ATS are ineffective, they should not affect incorporations. 8 To take account of the interactive effects noted above and to create a theoretically founded test to distinguish 6 No court has invalidated poison pills as a generally permissible defensive device since 1989, every single court decision that invalidated poison pills as a generally permissible defensive device has been legislatively overruled, and pills have long become widely accepted. See Coates (2000); Kahan & Rock (2002). 7 Consistent with this hypothesis, neither fair price nor business combination charter provisions are currently found in IPO charters of companies in states that lack such statutes. See Daines and Klausner (2001). 8 Bebchuk and Cohen (2003) have suggested that the number of ATS may nevertheless matter because it signals the state s commitment to help managers fend off takeovers. Both Subramanian (2002) and Daines (2002), however, have rejected this argument. 15

20 between the various hypotheses regarding ATS, we constructed a measure that rates each state by the aggregate effect of its ATS as to (i) whether they protect shareholders against coercive bids, (ii) whether they empower the board to block bids, and (iii) whether they establish a standard of judicial review of board actions that is more deferential than Delaware law. 9 If ATS are effective, the race-to-the-bottom hypothesis predicts that all three effects increase a state s retention rate; and the race-to-the-top hypothesis predicts that laws that protect shareholders against coercive bids increase and (in the standard account) that laws that generate board power and establish a deferential standard of review decrease a state s retention rate. The hypothesis that these statutes do not affect a company s marginal ability to resist a bid predicts that none of these laws affect incorporation choices. (d) The Model Business Corporation Act Another factor that possibly affects retention rates is whether a state has a corporation law based on the Model Business Corporation Act (MBCA). Adoption of the MBCA may 9 The latter includes states that have adopted constituency statutes and states that have a statute expressly lowering the standard of review applicable to takeover defenses. 16

21 affect incorporations either because of the quality of the MBCA s substantive provisions or because the MBCA generates learning and network effects that make a state more attractive as corporate domicile (Klausner (1995)). The substantive laws of states that have not adopted the MBCA, however, are not uniform. Comparing MBCA states with non-mbca states thus implicitly compares the MBCA with some average of the laws of other states, some of which may be superior and others inferior to the MBCA. Similarly, the laws of non-mbca states are not uniform with respect to their learning and network benefits. In particular, neither Delaware nor four of the five largest states (by population) have adopted the MBCA, but they may still enjoy significant learning and network benefits with respect to their corporate law. Finally, the quality of the laws of MBCA states differs because some states do not adopt revisions to the MBCA or do not adopt them as rapidly as others. Given these theoretical issues, we urge caution in interpreting any statistical effect of the adoption of the MBCA on retention rates. While the variables discussed above capture many differences in the corporate regimes of the various states, they inevitably cannot capture everything. For one, several 17

22 states have adopted idiosyncratic laws that may well effect incorporation choices. 10 New York s Business Corporation Act, for example, imposes personal liability on a company s 10 largest shareholders for wages and salaries payable to the company s employees. 11 California s Corporation Code prohibits a cash-out merger of minority shareholders in a controlled corporation unless the controlling parent owns at least 90% of the stock of the controlled corporation, the merger is approved by a California governmental agency, or shareholders approve the merger unanimously 12 and limits the safe-harbor provided by disinterested director approval of conflict transactions to transactions that are just and reasonable Corporate regimes also differ as a result of judicial decisions. In the regressions below, we do not control for idiosyncratic case law because most states have no reported cases for any specific issue; because the precedential value of legal decisions may vary depending on the age of the decision, the reasoning, whether the decision was rendered by a state or federal court or whether it was rendered by a trial or appellate court; and because rules established by case law are often hard to categorize. 11 New York Business Corporation Act, 630. For how this provision affects publicly-traded companies, see Kahan & Kamar (2002) at Cal. Corporations Code, 1101, Though California is commonly viewed as having no ATS (see, e.g., Bebchuk & Cohen (2003)), this statute resembles fair price and business combination ATS in that it inhibits freeze-out mergers following a tender offer. 13 Id. 310(a)(2). 18

23 Given the design of this study, however, these and other 14 idiosyncratic laws do not pose a significant problem. As long as these laws are not correlated to variables included in the regressions, their effect is picked up in the error term (noise) that is an element of any regression and does not bias the results of the included variables. IV. Empirical Analysis (a) Data Our initial sample consists of all public new issues of common stock between 1990 and 2002 by companies headquartered and incorporated in one of the 50 states or the District of Columbia contained in the SDC database. We excluded spinoff and financial companies because other factors may influence incorporation choices by these firms and one observation for a company that was included twice in the database. This left Other idiosyncratic corporate laws include those of Illinois, which imposes treble damages on directors and officers engaged in bribery (Ill. Business Corporation Act of 1983, 5/8.70); Minnesota, which prohibits increases in the compensation of any director or officer during a tender offer (Minn. An. Stat., Ch. 302A, 255, sub. 3); Alabama, which requires super-majority shareholder approval for any issuance of preferred stock (Al. Const., 237); and Oklahoma, which limits the right of corporations to own real estate (Ok. Const., art 22, 2). 19

24 observations. Using these observation, we calculated the retention rate for each state as the total number of firms headquartered and incorporated in the state divided by the total number of firms headquartered in the state. The retention rate served as the dependent variable for our regressions. As independent variables related to statutory flexibility, we used separate dummy variables as follows: whether state law offers flexibility on whether a regular majority or a supermajority of shareholders must approve a merger; whether the state permits companies to opt-out of the personal liability of directors on terms that are as generous as those in Delaware or less generous; whether the state law offers flexibility on whether directors are elected in regular or cumulative voting; and whether the state law treats loans to officers and directors as other interested transaction or imposes special restrictions on these transactions. The dummy variable takes the value of 1 if state law provides more flexibility and 0 otherwise. In addition, we calculated a statutory flexibility index variable defined as the sum of the four dummy variables. Table 1 provides the coding for each state on these and other key variables. As a proxy for state court quality, we used the overall 20

25 state grade for the state reported in the 2001 State Liabilities Ranking Study. 15 To our knowledge, this study is only nationwide study of the quality of state court systems and the year 2001 is the first time the study was conducted. The study rates each state along ten key elements, including timeliness of summary judgement/dismissal, treatment of class action suits, discovery, judges impartiality, and judges competence. 16 Though the study has shortcomings it does not focus specifically on the state courts quality with respect to corporate law and was conducted towards the end of the sample period it appears likely that the quality of state courts is reasonably constant across subject areas 17 and over time and several of the key elements are of obvious importance for the 15 The study was conducted for the U.S. Chamber of Commerce by Harris Interactive Inc. and the results are based on interviews with a representative sample of 824 in-house counsel or other senior litigators at companies with annual revenues of at least $100 million. Litigators were only asked about states with which they asserted to be very familiar or somewhat familiar. 16 The other elements are: overall treatment of tort and contract litigation; punitive damages; scientific and technical evidence; juries predictability; and juries fairness. 17 The study found the rankings on individual elements were highly correlated. That the study examines overall quality, rather than the quality of corporate law adjudication also has the benefit that rankings are unlikely to be endogenous. 21

26 quality of corporate adjudications. A more severe issue with the study is that a high grade may reflect a pro-business tilt of the state court system (the rankings are based on responses of in-house counsel and senior litigators at large companies) rather than objective quality. This issue, however, relates to the interpretation of the results rather than to the usefulness of including the rankings as independent variable. As measures of takeover protection, we used different sets of variables: the anti-takeover index measure for each state as reported by Bebchuk and Cohen (2003); a revised antitakeover index variable which is identical to the Bebchuk- Cohen index except that it excludes ATS passed in or after (as these laws should not have influenced incorporation choices for most firms during the sample period); a set of dummy variables for each of the five main ATS studied by Subramanian (2002) and Bebchuk and Cohen (2003); and a set of effects dummy variables a coercive offer protection dummy with a value of 1 if the state has adopted a fair price, control share, business combination or pill validation statute 18 Data for enactment dates of ATS were obtained from Subramanian (2002), table 3 and checked with Robinson et al. (1989). Six statutes were excluded on that basis, two from 1997, two from 1998, and two from Connecticut s constituency statute was retained since it was originally enacted in 1988 and just recodified in

27 or has case law validating the use of poison pills and 0 otherwise; a board control dummy with a value of 1 if the state has adopted a business combination or pill validation statute or has case law validating the use of poison pills and 0 otherwise; and a deferential review dummy with a value of 1 if the state has adopted a constituency statute or a statute expressly establishing a lower standard of review for defensive action than the one used in Delaware and 0 otherwise. Given the sample size (51 observations of state retention rates), we are somewhat limited in our ability to include control variables. State-wide control variables included by at least one of the published studies of incorporation choices include: a dummy variable for the MBCA; state per capita income; a variable for state population (the logarithm of state population); a variable for the number of firms incorporated in the state; the percentage of vote for the Democratic party candidate in the 2000 presidential election (as proxy for the state s liberal political culture); and a set of three regional dummy variables to distinguish between states located in the Northeast, South, Midwest and West. We include each of these variables in our regressions, with two exceptions: we omitted the number of firms incorporated in the 23

28 state because that number is endogenously determined; and we omitted the regional dummies because the one study to include these variables provides no theoretical basis for their conclusion and no such basis was evident to us. Both of these variables, however, are included in robustness checks discussed in Section IV(e). (b) Descriptive Statistics Table 2 presents some summary descriptive statistics. The overall percentage of firms incorporating in their headquarter state and the average state retention rate are about the same (31% v. 32%). The vast majority of firms that are not incorporated in their headquarter state incorporate in Delaware. The firm-level data also show the disproportionate weight of large states if no proper adjustments are made. Firms headquartered in the largest state (California) accounted for over one quarter of the firm level observations and companies headquartered in five largest states account for more than half of the firm-level observations. Table 3 presents a correlation matrix for the independent variables. (Correlations among variables never included in the same regression are omitted.) The matrix shows that the largest positive correlations are among the different anti- 24

29 takeover measures. Most disconcertingly, the matrix indicates that the variables for board control and coercive protection are highly correlated. Since this makes it effectively impossible to distinguish the effects of these two variables, we include only one of them when we run multiple regressions. (c) Univariate Analysis Table 4 presents an univariate analysis of differences in means related to the various dummy variables. Reported significance levels throughout are based on two-sided test for all variables. We find that for three of the four state law flexibility variables merger vote, liability opt-out, and loans the retention rates of states offering more flexibility are significantly higher than those of states offering less flexibility. In addition, two of the five ATS -- control share statutes and business combination statutes -- and the variables for coercive protection and board control are associated with significantly higher retention rates. In separate regressions using as single independent variable the measure for state court quality and the three index variables (the state law flexibility index, the Bebchuk-Cohen ATS index, and our revised ATS index), each of the independent variables 25

30 was statistically significant (see Table 4, panel B). Coefficient estimates and significance levels for the Bebchuk- Cohen and the revised ATS index variable are virtually identical and henceforth we use only the revised ATS index variable. (d) Multiple Regression We next run a set of multiple regressions including variables related to court quality, the flexibility of state law, and the level of anti-takeover protection as well as control variables for whether the state has adopted the MBCA, state population, per-capita income, and the percentage of the Democratic vote. In addition to regular OLS regressions on the retention rate (Table 5, panel A), we also run regressions on a logistic transformation of the retention rate: 19 log((retention rate + a)/(1 - retention rate + a)) (Table 5, panel B) since the range of the dependent variable is bounded between 0 and 1. Heteroskedasticity is generated by the fact that retention rate calculations are less precise for small states (absolute values of residuals are significantly negatively correlated with population). We thus 19 This transformation is suggested by Cox(1970, p. 33). The term a = 0.5/N, where N is the sample size. 26

31 report t-statistics based on Huber-White robust standard errors. In columns one through three, we use the state law flexibility index and three separate measures of anti-takeover protection: the ATS index; separate dummies for individual ATS; and effects dummies for board control and board review. Columns four through six use the same three measures of antitakeover protection combined with separate dummies for the four components of the state law flexibility index. In each model, the court quality variable is significantly positive. The state law flexibility index as well is highly significant and positive. In the regressions using individual dummies for state law flexibility, two of the four dummies for merger vote and narrow liability opt-out are consistently significant and positive. States with better courts and with corporate statutes that offer more flexibility thus have a significantly higher retention rate. Coefficient estimates for these variables indicate that the effects are economically meaningful. By contrast, neither the ATS index variable, nor any of the dummy variables for the five individual ATS, nor any of the effects dummies are significant. Unreported F tests for specifications where more than one ATS variable was included 27

32 (columns 2, 3, 5, and 6 of both panels) cannot reject the hypothesis that each ATS coefficient is equal to zero. These results differ from those reported by Subramanian (2002) and by Bebchuk and Cohen (2003), who find that the ATS index and three of the five individual ATS (control share, business combination, and pill validation) significantly increase the likelihood that a firm is incorporated in its headquarter state; and those by Daines (2002), who finds that control share and pill validation statutes significantly reduce the likelihood that a firm incorporates in its headquarter state. 20 The results for ATS are consistent with the hypotheses that these statutes are irrelevant. Given the sketchy empirical results for the anti-takeover variables, we also ran regressions without any variable for anti-takeover protection. The results are reported in columns 7 and 8 of Table 5. Exclusion of the anti-takeover variables does not have a material effect on the remaining variables. (e) Robustness Checks As robustness checks, we performed several additional tests. First, we included regional dummy variables to mark 20 The results are not directly comparable with those of Ferris et al. (2004) since they do not test the effect of ATS by themselves on a state s attractiveness as domicile. 28

33 the state s regional location (Northeast, South, Midwest and West). Inclusion of these dummies does not have any qualitative effect on the other variables: the variables for court quality, state law flexibility, merger approval and narrow liability opt-out are significant in all specifications, the various variables for anti-takeover protection are all insignificant. Consistent with the lack of theoretical basis for the inclusion of regional dummies, F- tests for the joint significance of these variables cannot reject the hypothesis that the coefficient for each regional dummy is equal to zero. Second, we included a control variable for the total number of firms incorporated in a state. This variable, which was included in some prior studies, was omitted from the main regressions because the number of incorporated firms is endogenously determined. Inclusion of the variable did not affect the significance of the variables for courts quality, flexibility, and anti-takeover protection. 21 As expected, the coefficient estimates for the total number of firms incorporated in a state were significant and positive. 21 In the logistic regressions, inclusion of a variable for the total number of incorporated firms had some effect on the individual dummies for state law flexibility: the merger dummy became insignificant in two specifications and the loan dummy become significant in one additional specification. 29

34 Third, to address the concern that the results are driven by states with a small number of IPOs, we performed two sets of tests. First we ran regressions where the variables for each state are weighted by the number of firms headquartered in the state, with the sum of the weights normalized to N. The advantage of this methodology is that is takes account of the fact that retention rates calculated for each state are based on a different sample size of firms headquartered in the state. This methodology, however, also suffers from the flaw noted above: when state-wide factors that are not included among the independent variables influence incorporation decisions, weighted regressions give excessive weight to observations from large states. Second, we ran regressions including only observations from states in which at least 25 firms that went public during the sample period were headquartered ( large states only ). While this methodology gives equal weight to the observations from each state included in the regression, it reduces the number of state observations to 27. Table 6, panels A and B, reports the results of these regressions. 22 Since weighted correlations among individual 22 Throughout the paper, all regressions were run as OLS and logistic regressions. For space reasons, we report only the results of the OLS regressions in tabular format. Unless 30

35 state-law flexibility variables and among individual ATS variables are high and because of the low N in the large states only regressions, we only report regressions with index and effects variables. Regardless of specification, the variable for state law flexibility remains positive and significant in each of the weighted and large states only regressions. Neither the ATS index variable nor any of effects dummies are significant in any of the regressions. The court quality variable is significant only in two of the three specifications of the weighted regressions (when the level of anti-takeover protection is controlled for by the ATS index variable and when no control in included). Overall, the robustness checks confirm the significance of state law flexibility for incorporation decisions. The court quality variable, however, is less robust. In particular, court quality was never significant in the large states only regressions, suggesting that the earlier results may have been driven by retention rates observations from states with a tiny number of companies going public. As an additional check, we therefore repeated the regressions, this time excluding only observations for states with fewer than ten headquartered firms. In these large and modest size noted, results from the logistic regressions were similar. 31

36 states regressions, which are reported in Table 6, panel C, court quality was significant in each specification. (f) Subperiods To determine whether the significance of ATS may have changed in the course of the sample period, e.g. because the validity of the poison used to be less well established in the early parts of the sample period, we split our sample midway into two subperiods, one for IPOs in the years 1990 to 1995 (1794 IPOs) and another for IPOs in the period 1996 to 2002 (2013 IPOs) and calculated separate state retention rates for each period. 23 We then regressed these retention rates on measures of state law flexibility and anti-takeover protection prevailing during each sub-period. 24 This test can also be considered a very crude control for changes in the type of firms going public over time and time varying state retention rates. (The correlation between the retention rates in the two subperiods is.63) The results are reported in Table 7. None of the anti- 23 In each period, two states had no IPOs by companies headquartered in the state. We deleted these states from the sample, reducing the number of observations to Since the State Liabilities Ranking Study was not performed before 2001, we used the same measure of court quality as in the earlier regressions. 32

37 takeover variables are significant in any of the regressions. Coefficient estimates for these variables do not differ significantly between subperiods. The regressions thus provide no evidence that the significance of ATS changed in the course of the sample period. The state law flexibility variable is significant in the predicted direction in each specification for both subperiods. The courts quality variable is consistently significant in the second sub-period; in the first sub-period, it is significant in only two of four specifications. 25 (g) What Accounts for the Different Results for ATS? To examine further what accounts for the difference between our results for ATS and those reported by Subramanian (2002) and by Bebchuk and Cohen (2003), we performed two additional sets of tests. First, we ran regressions similar to those in Table 5, but omitted the controls for court quality and state law flexibility. In these regressions, the results of which are reported in columns 1 and 2 of Table 8, the ATS index variable is significant and positive (though 25 In logistic regressions for the first sub-period, the court quality variable in insignificant in all specifications and the state law flexibility variable in insignificant in specification 3. For sub-period 2, the logistic regressions yield results equivalent to those reported in Table 7. 33

38 none of the ATS dummy variables are significant). But when either one of the omitted controls is added (columns 3 and 4), the ATS index variable becomes insignificant. Notable, inclusion of either control significantly improves the explanatory power of the regressions. Second, we ran regressions using the stock retention rates reported by Bebchuk and Cohen (2003) as dependent variable. As discussed in Part II, stock data contain more noise than IPO data, but stock data may also reflect a failure to reincorporate out of, or reincorporations into, states with pro-management laws. ATS may therefore be more likely to affect stock data than IPO data. Since stock data also relate to a large number of firms that went public prior to 1990, we use the measures for state law flexibility and ATS that we used for the 1990 to 1995 sub-period. The results of these regressions, which are reported in Table 8, panel B, indicate significance neither for the ATS index nor for the individual ATS dummy variables. The state law flexibility index and the dummies for merger vote and liability opt-out were significant, though the variable for court quality was not. 26 Consistent with the presence of greater noise, the R-squared 26 In logistic regressions, the dummy variable for merger vote was insignificant. 34

39 values for these regressions were substantially below those for the equivalent regressions in Table 5. Taken together, these results of these tests suggest that it is the addition of controls for court quality and state law flexibility, rather than the distinction between IPO data and stock data, that accounts for the different results for ATS. V. Conclusion We find substantial evidence that firms are more likely to incorporate in states with a corporate law that offers firms flexibility in areas unrelated to takeovers and significant though less robust evidence that firms are more likely to incorporate in states with a higher quality judicial system. This evidence is consistent with theoretical predictions about the significance of various legal factors for firm incorporation decisions. Firms value flexibility and a high-quality judicial system in setting up their governance arrangements and are more likely to incorporate in their headquarter state if it has a legal regime that offers these features. We find no evidence for the hypothesis that firms are either more or less likely to incorporate in states with antitakeover statutes. When dividing the data set into two 35

40 subperiods, we found no evidence that any measures of antitakeover protection were significant in either sub-period or that the importance of these statutes changed from one period to the other. The results for anti-takeover statutes are most consistent with the hypotheses that anti-takeover statutes are irrelevant either because they have no significant effect on a company s marginal ability to resist takeovers or because the can be replicated through charter provisions. While our results shed light on the relative merits of the present federalist regime, where firms have a choice among different corporate domiciles, compared to an uniform federalized corporate law advocated by several commentators, they do not conclusively answer whether firm choice (or state competition) is desirable. Proponents of firm choice and state competition could argue that firms use the flexibility provided by corporate statutes to design governance arrangement that maximize the value of the firm and that shareholders benefit from a high-quality judicial system. Proponents of a uniform federalized corporate law could argue that the measure used to assess the quality of the judicial system is biased towards judicial systems that are promanagement and that firms use flexibility to benefit managers at the expense of shareholders. Similarly, the general lack 36

41 of a significant effect of anti-takeover statutes points neither towards firm choice nor to uniform federal law as the superior regime. 37

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