Does Delaware Entrench Management?

Murali Jagannathan AA210, School of Management Binghamton, NY 13902 MuraliJ@binghamton.edu (607) 777-4639 A.C. Pritchard * 1039 Legal Research University of Michigan Law School Ann Arbor, Michigan 48109 acplaw@umich.edu (734) 647-4048 This Draft: April 2010 Abstract Critics have charged that state competition in corporate law, which Delaware clearly dominates, promotes management entrenchment at shareholders expense. We present evidence here that is inconsistent with this hypothesis. Unconditional CEO turnover rates in Delaware are significantly higher than in other states. We explore the causal mechanisms for Delaware s higher turnover rate: we show that Delaware attracts higher demand directors, firms without founder influence, and higher institutional ownership. We find that the last two of these characteristics explain the higher CEO turnover for Delaware companies. JEL Classification: G30, G34, K22 Keywords: Corporate governance, CEO turnover, Investor Protection. * Corresponding author. The authors thank Keith Bishop, John Coates, Martijn Cremers, Rob Daines, John DiNardo, Michael Klausner, Srini Krishnamurthy, Y.C. Loon, Guhan Subramanian, and participants at the 2008 American Law & Economics Association and Conference on Empirical Legal Studies annual meetings, the 2008 New York Accounting and Finance Forum, and the Innovation, Business, and Law Colloquium at the University of Iowa for helpful comments and suggestions on an earlier draft of this article.

1. Introduction In the United States, corporations are free to choose the law of the state that best suits the needs of their directors, managers and shareholders, without regard to where the corporation principally does business. States can compete to attract firms by offering the most attractive menu of corporate law rules. In that competition, Delaware has clearly won. That state draws a clear majority of the nation s largest public companies to incorporate under its corporate code. Critics of issuer choice argue that states compete for corporate charters by providing rules which promote management entrenchment at the expense of shareholders (Cary, 1974), pointing to state antitakeover laws as evidence for their position (see, e.g., Bebchuk and Ferrell, 2001). On the other side, advocates for state control over corporate law respond that managers are constrained by competition in the capital markets to offer shareholders the corporate law rules that offer cost-effective means of constraining the agency costs inherent in the separation of ownership and control (Winter, 1977). Has Delaware prevailed in the competition for corporate charters by providing laws that entrench management? We examine the relation between state corporate law and management entrenchment, using the likelihood of involuntary CEO turnover as our measure of entrenchment. We find no evidence that firms incorporated in Delaware are less likely to terminate their CEO. Indeed, our comparisons show unconditionally involuntary turnover may be significantly more likely in Delaware. What explains this higher turnover rate for Delaware firms? Delaware law does not differ from other states on any dimension that might be thought to affect directly turnover rates. We instead postulate that certain features of Delaware law attract firms with specific financial characteristics, and that those financial characteristics correlate with governance structures that

also correlate with higher turnover. We argue that Delaware attracts firms are at greater risk of class action lawsuits. Delaware law also attracts firms that are more likely to grow through acquisitions or to be acquired. We argue that these firms may require directors and CEOs with strong strategic skills, which may be relatively scarce. We postulate that Delaware law s predictability attracts institutional investors to Delaware firms, and these firms are more likely to be managed by professionals rather than founders. Although some of these characteristics of Delaware law have been noted in prior work, our paper is the first to document how that law influences the governance architecture of Delaware firms. We also show how these governance characteristics associated with Delaware incorporation influence managerial entrenchment. We find that Delaware firms attract directors holding more directorships, more institutional ownership, and fewer founder firms; the latter two mechanisms significantly influence turnover rate. Once we control for these characteristics in our regressions, the variable for Delaware incorporation is no longer significant, confirming that the effect of Delaware law on turnover is indirect. These results are robust in a variety of specifications. In sum, Delaware attracts firms with governance characteristics associated with lower entrenchment. One hypothesis is that Delaware has simply been outflanked in the competition for charters by states adopting anti-takeover legislation. We find limited evidence that companies incorporated in states which offer particularly stringent anti-takeover protection are less likely to terminate their CEO. The supposedly shareholder-protective jurisdiction of California, however, does not have significantly higher CEO turnover than Delaware; in fact, the turnover rate among California firms is less sensitive to firm performance. This finding suggests that Delaware s higher turnover rate is unlikely to be related to its generally low level of anti-takeover protection 2

We proceed as follows. Section 2 compares Delaware s corporate law with that of other states, and based on those differences, develops hypotheses regarding causal mechanisms that might explain Delaware s higher turnover rate. Section 3 describes our sample. Section 4 presents our empirical results. We conclude with a discussion of our results in Section 5. 2. Background, prior research, and hypotheses 2.1. Relevance of state of incorporation for management tenure Does Delaware corporate law differ from that of other states in a way that is likely to affect management tenure? There is a substantial body of literature focusing on CEO turnover, but none of these papers focus on the role of state of incorporation. Our main focus is to explore potential causal mechanisms which might explain the higher turnover of CEOs in Delaware firms. Delaware s corporate code, like that of other states, does not speak directly to the decision by the board to retain or fire top management. The business judgment rule, in Delaware as in every other state, shields directors from liability for failure to terminate a poorly performing CEO, absent evidence that the directors were ignoring looting or other criminal conduct by the CEO. Given the states uniformity on this question, if state corporate law influences management tenure, it is clear that the effect is indirect. A number of papers examine the impact of internal and external governance mechanisms on CEO turnover (e.g., Weisbach (1988), Huson, Parrino, and Starks (2001)). These papers consider these internal control mechanisms as exogenous. Recent work (e.g., Linck, Netter, and Yang (2008), Coles, Daniel, and Naveen (2008)), however, suggests that these mechanisms may be determined by the monitoring and strategic needs of the firm. In this spirit, we argue these needs influence the firm s choice of state of incorporation, and may also influence corporate 3

governance in a way that affects management tenure. Accordingly, we first examine features of Delaware law that may attract firms with certain financial and governance characteristics. We then outline potential connections between those characteristics and the likelihood of CEO turnover. 2.2. Liability protection Delaware may appeal to firms with high exposure to shareholder lawsuits by offering liability protection to officers and directors. Moodie (2004) documents that Delaware reincorporations surge after Delaware adopts liability protections for directors. The lawyers who advise officers and directors are also likely to find liability concerns salient, and lawyers are the most common instigators of reincorporation decisions (Romano, 1985; Daines, 2001). Corporate officers and directors face liability from two primary sources: (1) breach of fiduciary duty under state corporate law; and (2) liability for misrepresentations under federal securities law, which may arise in either an SEC enforcement action or in a private class action. State law can directly insulate officers and directors from liability for the former, and indirectly through indemnification from the latter. Under the corporate law of virtually every state, the combination of the business judgment rule and stringent demand requirements means that directors face vanishingly small probabilities of being held personally liable for their acts as directors (Black, Cheffins & Klausner, 2006). Breach of fiduciary duty suits are common only in connection with mergers and acquisitions (Thompson & Thomas, 2004). These suits typically allege that the directors have failed to exercise due care in selling the company or neglected to disclose all of the relevant facts. Thus, state corporate liability is an important exposure only in connection with mergers and acquisitions, and even then, only for directors of the target corporation. 4

When the Delaware Supreme Court did the unthinkable in Smith v. Van Gorkom 1 holding the directors personally liable the Delaware legislature quickly restored equilibrium by allowing corporations to eliminate money damages for duty of care violations in their charters (Del. Gen. Corp. L. 102(b)(7)). The Delaware legislature s swift response actually had the effect of accelerating Delaware reincorporations (Moodie, 2004), particularly from California (Netter & Poulson, 1989). Investors apparently favor this motivation for reincorporation: Heron and Lewellen (1998) find positive abnormal stock returns for firms reincorporating for the purpose of obtaining liability protections for directors. This reaction suggests that shareholders are: (1) cognizant of the role of such protections in attracting directors, and (2) dubious of arguments that shareholder suits encourage active monitoring by directors. 2 The comparative advantage provided by liability limits is enduring: Kahan (2006) finds that states that have not adopted a liability limitation are significantly less likely to retain firms headquartered in their states. California again distinguishes itself in affording directors less protection than Delaware. California exculpates directors from liability for duty of care violations, but reckless acts are not covered (Cal. Corp. Code 204(a)(10)(A)(iv)). Delaware does not have a similar exclusion. Given the ease with which recklessness can be pleaded, this is a substantial limit on the exculpatory force of California s provision. State law limits on liability for breaches of the duty of care cannot bar federal securities liability, which brings with it liability exposure that is orders of magnitude greater than state law. For those claims, officers and directors must rely on indemnification and D&O insurance. Once again, California stands out in offering officers and directors less protection: California law 1 485 A.2d 858 (Del. Sup. Ct. 1985). 2 More recently, Delaware has allowed corporations to limit the scope of the corporate opportunity doctrine under the duty of loyalty (Del. Gen. Corp. L. 122(17)); this provision likely appeals to directors who have a wide range of business interests, e.g., Silicon Valley venture capitalists. 5

excludes indemnification for reckless acts (Cal. Corp. Code 204(a)(11)). Recklessness is the standard for liability under Rule 10b-5 of the Exchange Act, the principal basis for federal securities claims in private class actions. California also requires that the officer or director reasonably believe that their conduct was in the best interest of the corporation (Cal. Corp. Code 317(b)), rather than merely not opposed to that interest (Del. Gen. Corp. L. 145(a)), so indemnification for federal securities liability is subject to considerable uncertainty in that state. Delaware law, by contrast, is particularly generous on indemnification. Defense expenses can be a considerable burden for an individual. Officers and directors of Delaware corporation who prevail in a lawsuit against them, on the merits or otherwise have a statutory guarantee of indemnity from the corporation for the expense of their defense, (Del. Gen. Corp. L. 145(c)). California law is more restrictive, leaving out the or otherwise language, which likely excludes indemnification when the corporation pays the settlement. 3 Delaware also requires indemnification for partial success. 4 These statutory guarantees are critical because they are not subject to being rescinded by successor boards if an officer or director is ousted. Moreover, they protect directors against SEC demands to preclude indemnification. The counter-argument is that differences in indemnification can be muted by D&O insurance policies, which go beyond indemnification in the range of conduct that can be covered. Such policies are universal for public companies, but they are subject to contractual exclusions and coverage limits that may leave officers and directors vulnerable. Of particular significance in connection with securities claims, insurers are unwilling to write policies in excess of $300- $400 million, a number which is exceeded by several settlements each year. For directors facing parallel class actions and SEC enforcement actions, legal expenses can quickly burn through a 3 See American National Bank & Trust Co. v. Schigur, 83 Cal. App. 3d 790, 793-794 (Cal. App. 1978) (construing California law to require a judicial determination of the actual merits ). 6

substantial percentage of the policy limits. Moreover, the contractual exclusions in D&O policies provide fodder for potential coverage disputes with the insurer. These limitations mean that officers and directors of companies that may face securities lawsuits need to be concerned with both indemnification and insurance. Which companies, and which officers and directors, need to be most concerned about liability exposure? With respect to state law liability, it is companies that anticipate the possibility of being acquired. For a sample of exchange-traded U.S. corporations, Daines (2001) finds that firms incorporated in Delaware are significantly more likely to receive a takeover bid and to be acquired. For federal securities law liability, Johnson, Nelson, and Pritchard (2007) show that lawsuit targets tend to be companies with larger market capitalization, with more volatile stock prices and higher share turnover. Plaintiffs lawyers also target firms in industries that are R&D intensive with high variability of outcomes, such as the high tech and pharmaceuticals sectors. Daines (2001) finds a significant positive correlation between R&D expenditures and incorporation in Delaware. CEOs face a real threat of being named as a defendant in a securities class action, as they frequently act as a spokesman for the company, thereby exposing themselves to direct liability. Outside directors have less exposure, but they can be on the hook for SEC filings, particularly registration statements for public offerings. Thus, protection against liability may be a factor allowing Delaware firms to attract outsiders as executives and directors. H1: Delaware is likely to attract firms that are at risk of class action lawsuits. 2.3. Facilitating acquisitions Another source of Delaware s comparative advantage may relate to facilitating corporate combinations. Romano (1985) finds that firms are likely to reincorporate in Delaware before 4 See Merrit-Chapman & Scott Corp. v. Wolfson, 321 A.2d 138 (Del. Sup. Ct. 1974). 7

committing to a program of mergers and acquisitions. Delaware, with its doctrine of independent legal significance, gives corporations flexibility in structuring transactions. This doctrine takes on practical importance in allowing acquiring corporations to avoid shareholder votes and appraisal rights in most circumstances. The flexibility that Delaware affords merging firms may in part explain the pronounced exodus of California headquartered firms to Delaware found by Subramanian (2002). California law affords voting rights to acquiring company shareholders not only in mergers, but also in asset and stock purchases (Cal. Gen. Corp. L. 181(b) & (c), 1200(b) & (c), 1201(a)), if stock is used to complete the acquisition, and triangular transactions, if there is sufficient dilution of the parent company shareholders (Cal. Gen. Corp. L. 1200(e) & 1201(a)). California is also more generous in affording appraisal rights to acquiring company shareholders (Cal. Gen. Corp. L. 1300). Thus, growing firms intent on making acquisitions might opt for Delaware law to eliminate voting procedures with their attendant expense and delay. 5 Celikyurt et al. (2008) show that newly public firms make acquisitions at a very rapid pace, so Delaware s voting rules may be an important incentive for companies choosing their incorporation status at the IPO stage, particularly if they anticipate rapid growth after going public. On the other hand, more stable firms that plan to continue with an existing business plan would garner less benefit from reincorporating in Delaware and therefore would see less reason to pay the additional expense of Delaware incorporation. 5 Firms incorporated in California are also subject to cumulative voting (Cal. Gen. Corp. Law 708), which is intended to afford minority representation on corporate boards. Cumulative voting is unlikely to have much effect for firms with widely-dispersed shareholder bases, and California allows publicly-traded firms to opt out of the provision. (Cal. Corp. Law 301.5). The opt-out is limited, however, to firms that are listed on the NYSE, Amex, or NASDAQ Global. This means that many smaller public companies the status that most companies are likely to have at the time of their IPO, when the choice of incorporation becomes salient will be subject to cumulative voting, unless they opt to incorporate in Delaware or elsewhere. They are unlikely to switch back to California when they grow large enough to be listed. 8

Firms interested in growing through acquisition may also be amenable to being acquired. Some scholars point to anti-takeover provisions as an important driver of incorporation choice. Both Subramanian (2002) and Bebchuk and Cohen (2003) find that states that have adopted antitakeover statutes have more success in retaining the incorporations of firms headquartered there. After controlling for other factors that might influence choice of incorporation, however, Kahan (2006) finds no evidence that firms are likely to incorporate in states with anti-takeover statutes. And Boulton (2008) finds that IPO firms backed by venture capitalist are more likely to incorporate in states with fewer antitakeover protections, and that those firms are more likely to be taken over in the five years post-ipo. A number of papers consider the disciplinary role of takeovers; this work documents significant changes in management after such external control transactions (e.g. Martin and McConnell (1991), Denis and Denis (1995)). The arguments in these papers would predict that CEOs may choose to incorporate their firms in states with strong anti-takeover statutes to shield themselves from pressures to oust them. But, none of these papers test the proposition that state-level takeover protection leads to a lower likelihood of turnover absent a takeover. With respect to anti-takeover provisions, Delaware has adopted an intermediate position, standing between California, which arguably offers the least anti-takeover protections, and Georgia, Ohio, Pennsylvania, Maryland (post-1998), Massachusetts, and Virginia, which offer the most. California does not provide any explicit anti-takeover statutes, and it also stands out in that the validity of the poison pill has not yet been established there; the pill may run afoul of that state s provision precluding discrimination among shareholders (Cal. Corp. Code 203). 6 In 6 If the quest for anti-takeover protection were the primary motivation for fleeing California, Delaware seems an unlikely destination: the neighboring state of Nevada not only has a statutory language validating poison pills (Nev. Rev. Stat. 78.195(5), 87.350(4), & 78.378(3)), but also gives director greater discretion in redeeming pills than Delaware does (Nev. Rev. Stat. 78.139). Moreover, Nevada not only has a business combination statute (Nev. 9

Delaware, by contrast the validity of the pill is firmly established, 7 although there are limits on the type of pill that can be adopted; Delaware courts have held invalid dead hand and no hand pills. 8 Most states provide more statutory anti-takeover protection than Delaware, most conspicuously the states we classify as Anti TO. Pennsylvania, Georgia, and Virginia appear to authorize dead hand or slow hand pills. 9 Ohio and Pennsylvania have statutes that force disgorgement of short-term gains by hostile bidders (Ohio Rev. Code Ann. 1707.043; 15 Pa. Cons. Stat. 2571-2575.); Massachusetts imposes classified boards on companies by statute (Mass. Gen. Laws Ann. Ch. 156B, 50A) and Maryland allows boards to adopt an effective classified board structure without shareholder authorization (Md. Code Ann., Corps. & Ass ns 3-803). This range of anti-takeover options suggests that firms may sort themselves based on their willingness to be taken over. Delaware s relatively mild anti-takeover provision may attract firms that are willing to sell themselves if an offer is made. H2: Delaware is more likely to attract firms that intend to grow through acquisitions or to be acquired. 2.4. Directorship demand Our earlier discussions suggest that Delaware may attract firms confronting legal issues related to growth and attendant volatility: protection against personal liability for officers and directors, which may be important both to firms contemplating a sale and those with highly Rev. Stat. 78.438) with fewer exceptions than Delaware s (Del. G. Corp. L. 203), but unlike Delaware, it has a control share statute (Nev. Rev. Stat. 78.379). In addition to Nevada s relatively stringent anti-takeover protections, it is also cheaper than Delaware for both franchise fees and potential litigation costs. Thus, it seems unlikely that California firms choose Delaware incorporation for anti-takeover reasons. 7 Unitrin, Inc. v. American General Corp., 651 A.2d 1361 (Del. 1995). 8 Quickturn Design Sytems, Inc. v. Mentor Graphics Corp., 721 A.2d 1281 (Del. 1998). 9 AMP Inc. v. Allied Signal Inc., 19987 U.S. Dist. Lexis 15617 (upholding slow hand pill under Pennsylvania law); Ga. Code Ann. 14-2-624(d); Va. Code Ann. 13.1-646. 10

variable returns, and voting rules, which may be important to firms planning rapid growth through acquisition. These firm characteristics are also likely to have implications for the type of individuals selected to lead the firms. Delaware firms are more likely to require both CEOs and directors with strong strategic skills and a greater appetite for risk. Such characteristics may be relatively scarce, so individuals with such characteristics may enjoy greater demand for their services. Conversely, firms incorporated in other states may seek custodian types who can manage an existing business, control costs, and produce consistent profits. One measure of demand is the compensation paid to a director for his or her services. Another measure is the number of directorships held. Ferris et al. (2003) present evidence that firm performance affects the number of directorships held by an individual, which they call the reputation effect. Individuals who serve on multiple boards are most likely to be concerned about the potential for personal liability because each additional board membership increases the threat of liability. CEOs who also serve as outside directors for other firms are likely to share this concern. They are likely to be selected as outsider directors for other firms on the basis of a strong reputation as CEO. Boards may be more forgiving of temporary poor performance by CEOs who have strong reputation outside the firm. On the other hand, directorships held by the CEO could also reflect agency costs (Fich and Shivadasani 2006), as the CEO could be distracted from his main employment by outside directorships. H3: Delaware CEOs and directors are likely to be paid more and hold more directorships. 2.5. Ownership 11

Another motive for incorporating in Delaware may be to attract institutional investors. 10 This point is supported by anecdotal evidence from corporate lawyers, who say that they counsel clients to reincorporate in Delaware before their IPOs because Delaware law provides a known quantity for investors attempting to evaluate the firm (Klausner, 1995). Delaware law is predictable because of the large stock of precedents to which its courts can look in deciding cases and Delaware s experienced and expert judges who sit on its Court of Chancery (Fisch, 2001). Incorporating in Delaware allows those investors to economize on information costs, which may be important if they have a large number of portfolio companies. H4: Delaware firms are likely to have greater institutional ownership. If firms opt for Delaware incorporation in an effort to attract institutional investors, this suggests a potential selection effect. Boulton (2008) shows that firms making IPOs that are backed by venture capitalists are significantly more likely to incorporate in Delaware. If a firm is backed by a venture capitalist, the VC is likely to insist on professional management if the founder lacks the management skills to run a public company, which means that such firms are less likely to retain founders as CEOs. Founders who insist on maintaining a post-ipo role in management may be more interested in maintainng their positions than in maximizing growth; these firms are less likely to choose Delaware. H5: Delaware firms are less likely to have a CEO who is a founder. 2.6. Impact of characteristics of Delaware firms on managerial entrenchment Falaye (2007) notes, in untabulated results, that the Delaware incorporation dummy is positively related to turnover, but does not discuss the issue further. We present evidence below consistent with that finding. We have posited that firms choosing Delaware incorporation are likely to have certain financial and governance characteristics. Specifically, we posit that 10 Mansi et al. (2006) find a positive correlation between Delaware incorporation and institutional ownership. 12

Delaware firms are more likely to: (1) face a class action lawsuit; (2) grow through acquisition or be acquired; (3) have directors with greater demand for their services; (4) have greater institutional ownership; (5) have a CEO who is not a founder. How do those characteristics relate to management tenure? Lawsuits are associated with poor performance, so directors of firms more at risk of suit may be more willing to terminate poorly-performing CEOs in an effort to avoid liability. Alternatively, a lawsuit may push directors to replace a CEO who is implicated in wrongdoing (Niehaus and Roth, 1999). Moreover, liability protections may also afford Delaware firms a greater supply of executives, which may lower their costs from terminating their CEOs for poor performance (Hermalin, 2005). In high growth firms, poor decision making can lead to substantial losses. If Delaware firms seek to attract directors with strong strategic skills to manage growth, this may have implications for management tenure. The reputation of directors is closely tied to the performance of the firms that they serve, so the market for directors creates an incentive to promptly terminate a CEO in the face of poor performance. Critics (e.g., Fich and Shivdasani 2006), however, contend that directors who serve on multiple boards may have their attention spread too thin, making them ineffective monitors. If this is correct, then liability concerns and the market for directors may not be sufficient motivating forces for CEOs to be terminated for poor performance. A concentration of institutional investors may be relevant to management turnover because institutional investors, particularly if they own substantial blocks, may exert pressure on board members to be active monitors of management performance. Standard agency cost theory posits that larger shareholders may be able to overcome collective action problems and keep 13

management on a tighter leash, a theory supported by the findings of Denis et al. (1997). Del Guercio et al. (2008) find that shareholder activism is associated with greater CEO turnover. The relative absence of CEOs who are founders may also have implications for CEO tenure: CEOs who founded the company (or are members of its founding family) are likely to have considerably greater job security than would a professional manager brought in from the outside. H6: Delaware directors are more likely to terminate CEOs for poor performance. The characteristics of firms likely to be attracted to Delaware allow us to predict a direction for the expected rate of turnover. Anti-takeover laws, however, are more ambiguous. The standard agency cost view adopted by most corporate law scholars would posit that discouraging takeovers may lead to lower sensitivity of turnover to performance: if directors are protected from the threat of takeover, they may feel less pressure to replace an underperforming CEO. Denis et al. (1997) find that the threat of takeover increases the probability of turnover. A more optimistic view would posit that turnover is a substitute for takeover, so if takeover is foreclosed, directors committed to enhancing shareholder value would be more likely to terminate an underperforming CEO. The scholarly consensus is probably more closely aligned with the agency cost view, however, so we predict that anti-takeover statutes are likely to correlate with lower turnover. H7: Firms incorporated in states with strong anti-takeover protections are less likely to terminate CEOs for poor performance. 3. Data Description 3.1. Identifying CEO Turnover Our sample period is from 1993 to 2004. We collect our primary data set from Execucomp, which provides data on S&P 1,500 firms, so our sample firms are larger than the 14

average public company. 11 We limit our sample to firms with CRSP share codes of 10 or 11, which excludes foreign firms and closed end funds, which are subject to different governance regimes. Execucomp provides executive names and the date they become CEO, which we use to identify CEOs and their turnover. We then use Factiva to search and classify these turnovers as Forced or otherwise. Based on the methodology in Parrino (1997), news reports which state the CEO was fired, forced out, or suggesting irreconcilable differences are classified as forced turnover. If the CEO leaves to join another firm, if they die, or if they retire, the turnovers are classified as unforced. For our robustness check, we collect CEO names and ages from Compact Disclosure, which contains information for most public firms, for the period 1992-2004. From this list, we identify a forced CEO turnover as the year in which there is a change in the name of the CEO and the CEO is less than 60 years of age at that time. 3.2. Identifying State of Incorporation We obtain state of incorporation from Compact Disclosure and from historical quarterly Compustat. We then check for reincorporation when we find a change of state of incorporation and verify it with a reincorporation proposal in proxy statements. 12 We sort the sample firms by firm year into four categories of incorporating states: (1) California; (2) Delaware; (3) Georgia, Maryland (post-1998), 13 Massachusetts, Ohio, Pennsylvania, and Virginia, for which we use the shorthand Anti TO ; and (4) Other States. We classify California separately because of the weaker protections it affords against liability, its idiosyncratic voting rules, and its generally low level of anti-takeover protection. 11 Recent studies (Jenter and Kanaan, 2008, Bhagat and Bolton, 2008) use the Execucomp database to identify turnover. The sample size used in earlier papers (Weisbach, 1988 and Parrino, 1997) are smaller and were concentrated to larger firms. 12 Mansi, Maxwell, and Wald (2006) collect this information from Mergent online. 13 Maryland s classified board statute was adopted in May 1999, so we include Maryland firms in this category only after the statute s adoption. 15

We classify separately firms incorporated in the Anti TO states on the strength of those states anti-takeover statutes, which are generally regarded as a step above those found in other states, including Delaware. If anti-takeover statutes promote management entrenchment, the effect should be most pronounced for those six states, and least pronounced for California. Other States provide our baseline. 3.3. Identifying Governance Characteristics Data for most of the governance variables used in this study are obtained from the IRRC database. From here, we collect information on director tenure, number of directorships held by the directors, CEO-Chair separation, ownership by the CEO, percent of outside directors, voting power held by those directors, and board size. IRRC data is available only since 1996 and so our sample size drops significantly when we use these variables. Institutional ownership and block ownership are obtained from the Thomson Reuters database. We obtain information on Director Retainer from Execucomp. For each firm in our sample, we read through the history of the firm and handcode information about whether the founder or the founder family members are CEOs (or directors) of the firm. 14 3.4. Sources for other data Variable definitions are provided in the Appendix. We get all returns measures and the delisting codes from CRSP. All accounting data are from Compustat. We use Andrew Metrick s website for the G-index used as a measure of corporate governance. 15 We obtain the E-index of entrenchment from Lucian Bebchuk s website. 16 These variables are available every 14 We use firms histories from the firm s website, fundinguniverse.com, and Answers.com to determine founder and founder families. 15 http://www.som.yale.edu/faculty/am859/webpages/data.html. 16 http://www.law.harvard.edu/faculty/bebchuk/data.shtml. We note that Bhagat and Bolton (2008) find that firms with higher governance indices are less likely to have forced management turnover. Based on this finding, they argue that these governance indices may be poor measures of entrenchment. Core, Guay and Rusticius (2006) find no causal relationship between these measures of 16

two or three years. Since these variables change little from year to year, we impute these numbers for the in-between years. We collect information on securities class action filings from the Securities Class Action Clearinghouse. 17 Information about acquirers and targets are from SDC. 4. Empirical Results 4.1. Descriptive Statistics 4.1.1 Incorporation Table 1, Panel A breaks down our sample by state of incorporation and firm headquarters. Consistent with prior work, we find that Delaware incorporated firms represent 58% of the sample. Also consistent with prior work, California is the conspicuous loser. Although firms headquartered in California make up 15% of our sample, firms incorporated in California constitute less than 3%. For our sample, 78% of the firms headquartered in California opted for Delaware incorporation. By contrast, 45% of firms headquartered in the Anti TO states and 51% of firms headquartered in Other states opted for Delaware incorporation. These percentages are comparable to those reported by Bebchuk and Cohen (2006) for all Compustat firms. <<Table 1 here>> Panel B of Table 1 offers descriptive statistics on the survival rates for firms in the sample. Consistent with Hypothesis H2, slightly more of the Delaware firms left the sample due to mergers (32%), relative to the overall average (31%). Despite California s lack of antiweak governance and subsequent long-run performance, casting doubt either on the effectiveness of governance to affect returns or the effectiveness of these indices to measure governance. 17 http://securities.stanford.edu/. 17

takeover protection, fewer of the California firms (26%) leave the sample as a result of acquisition than do firms incorporated in the Anti TO states (29%). 4.1.2 Financial, governance, and shareholder characteristics Table 2, Panel A provides descriptive statistics on firm characteristics that may influence choice of incorporating state and firm performance. The legal differences identified in the prior section suggest that firms incorporated in Delaware may differ systematically from those that incorporate elsewhere, so we compare the averages of our categories with Delaware. 18 <<Table 2 here>> We find that Delaware firms, as compared to Anti TO or Other, tend to have characteristics commonly associated with growth firms: lower book to market, lower dividends and total payouts, greater volatility of operating results, greater research and development expenditures, and fewer years have passed since their initial public offering. Given these characteristics, it is not surprising that Delaware firms also have more volatile stock returns, which would make them more vulnerable to securities class actions. These differences are generally reversed when comparing firms that opt for Delaware over California incorporation. California firms have a lower book to market ratio, less leverage, greater operating income, greater stock return volatility, and fewer years since their IPO. Delaware firms tend to have considerably greater total assets than firms incorporated in California. This suggests that abandoning California for Delaware may be prohibitively costly for firms below a certain size (or expectations of growth to that size through acquisition). Correlation ratios (untabulated) would appear to support this conjecture: the correlation between Log Total Assets (Total Assets) and Years since IPO is 0.62 (0.66) for California firms, compared to 0.42 (0.10) for Delaware 18

firms, 0.47 (0.17) for Anti TO firms, and 0.50 (0.13) for others. These differences are all statistically significant at the 5% level or better. California firms take longer to grow, which might suggest that they are less likely to grow through acquisition. When we look at acquisition rates, however, California firms are not significantly less to make an acquisition than Delaware firms, although the acquisitions they do make are significantly smaller. Delaware firms are significantly more likely to be acquired than firms incorporated in Anti TO states, and Other, but less likely to be acquired than California firms, although this latter difference is not significant. Thus, firms do not appear to be moving to Delaware to avoid being acquired. Overall, the comparison of financial characteristics offers some support for Hypothesis H2. We next look at differences in governance characteristics. The discussion in the prior section suggests that incorporation in Delaware might allow a firm to attract different kinds of CEOs and directors. If Delaware firms attract higher quality directors, then this may translate into Delaware boards hiring higher quality CEOs and more effectively monitoring them. Panel B of Table 2 provides univariate statistics comparing the board characteristics of firms incorporated in Delaware with those incorporated elsewhere. Looking at the characteristics of the directors, directors of Delaware firms receive larger retainers than other directors, perhaps suggesting higher demand for their services. Greater compensation for Delaware directors does not reflect entrenchment: Delaware directors have a significantly shorter tenure than directors of firms incorporated elsewhere. Despite this shorter tenure, Delaware directors wield significantly greater voting power. We find additional evidence of higher demand for Delaware directors. Outside directors of the Delaware firms in our sample serve on a significantly greater number of boards than do 18 Because the Sarbanes-Oxley Act may have constrained firms governance choices, we divide the sample into two periods, 1993 to 2001 and 2002 to 2004. The results, not tabulated here, are generally similar to the overall averages 19

the directors for the firms in other jurisdictions, although the difference is only marginally significant for the Anti TO firms. The California firms are considerably smaller, so this difference is not surprising, as firm size and directorships are highly correlated (0.392 for the California firms, 0.105 for Delaware, and 0.197 for Other), but the average size of firms in Other States is slightly larger than the average Delaware firm. The greater incidence of multiple directorships translates into a greater likelihood that Delaware boards are Busy, defined as a majority of outside directors holding three or more directorships, although the difference is significant only for California and Other. Overall, we find some support for Hypothesis H3 Panel C of Table 2 presents evidence on shareholder influence. Delaware firms have significantly greater institutional ownership and blockholdings, suggesting they may face greater external scrutiny, thus supporting Hypothesis H4. Delaware firms have a significantly higher G- Index than California firms, but lower than Anti TO and Other firms. This pattern holds as well for the E-Index, which focuses on structural anti-takeover features. Both indices rely in part on the law of the state of incorporation, so these patterns are expected. With respect to securities class actions, Delaware firms are significantly more likely to be sued than Anti TO and Other firms, but not California firms, offering partial support to H1. In Panel D of Table 2, we look next at the other side of the turnover equation, the CEO. Delaware CEOs have shorter tenure than their counterparts in other states, in particular California, but the differences are not consistently significant. A reputation for quickly terminating CEOs in response to poor performance might dissuade some candidates from taking the CEO position (Murphy and Zabojnik, 2007). Delaware firms are more likely than Other firms to hire their CEOs from outside the firm, but less likely than California incorporated firms. We also find some evidence that Delaware CEOs may be higher profile, defined as being reported in Table 2. 20

included in various Top N lists published by business periodicals. We find additional evidence of differences in demand for CEOs services. Delaware CEOs hold more directorships than their counterparts in California, but less than CEOs in Anti TO states. We also find significant differences in measures that may reflect CEO power, and hence, their likelihood of being terminated for poor performance. Delaware firms are more likely than California firms to combine the position of CEO and Chair, which is likely to enhance the CEO s job security. CEOs may have greater influence if they also serve as Chair, or they may receive the Chair title as a result of prior strong performance. This greater likelihood of combining the CEO and Chair positions in Delaware firms may reflect greater bargaining power wielded by outsider candidates to become CEO, or of a higher quality CEO candidate. Either way, they are less likely to later be removed involuntarily. Delaware CEOs are significantly less likely to be the founder of the firm, most strongly when compared to California firms, thus supporting Hypothesis H5. Founding families are also significantly more likely to serve on the board of California firms. To assess these differences in governance characteristics and shareholder influence more rigorously, we include Delaware incorporation as an independent variable in regressions using the governance characteristics likely to influence turnover as the dependent variables. Few models of governance structure exist in the literature motivating the relationship between firm characteristics and measures of governance. So, for all our models (except class actions), we include the same control variables that are likely to be related to governance needs: Book to Market, Log Total Assets, and Years Since IPO. We also include an indicator variable, Period, which corresponds to the years 2002-2004 in our sample, when listing requirements mandated by 21

the Sarbanes-Oxley Act may have affected governance choices. We use clustered standard errors to account for clustering at the firm level due to the use of firm years. The results of these regressions are presented in Table 3. The results for the board characteristics are shown in Panel A. The coefficient estimates for the Delaware variable are positive and significant at the one percent level for Director Retainer and Multiple Directors, further supporting the notion that Delaware directors have greater demand for their services. The Anti TO coefficient is also positive and significant for the Multiple Directors regression. The significant negative coefficient for the Period variable suggests that service on multiple boards has diminished since 2002. We also note Director Tenure is almost a year shorter for Delaware firms, which does not suggest entrenchment of directors. The coefficients for the incorporation variables are all insignificant for Director Voting Power. <<Table 3 here>> In Panel B of Table 3 we look at shareholder influence. Institutional Ownership is significantly higher in Delaware firms, and more institutions hold blocks in those firms. These findings suggest that firms succeed in attracting institutional investors when they reincorporate to Delaware, supporting Hypothesis H4. The Delaware coefficient is negative and significant at the one percent level for the E-Index regression. As expected, the Anti TO variable has a positive coefficient and the California variable a negative coefficient in this regression, with both significant at the one percent level. 19 We also examine the incidence of shareholder class actions in a multivariate framework, adding the standard deviation of stock returns as a control variable. Once we control for financial characteristics Delaware firms are no more likely to be sued than the baseline. The coefficient for California firms is significant and positive, suggesting that they are more likely to 22

be sued, which is inconsistent with Hypothesis H1. 20 This counterintuitive result can perhaps best be explained by the relatively smaller size of the California firms. These firms are large enough to be sued, but not so large that any settlement is likely to exceed the limits of the company s D&O policy. Only the very largest firms are vulnerable to paying such megasettlements; those firms have generally reincorporated in Delaware. An alternative explanation would point to the influence of legal counsel; firms incorporated in California may be less likely to have national (i.e., New York) lawyers, who would generally recommend Delaware incorporation (Daines, 2002). In Panel C of Table 3 we show results of regressions using the CEO characteristics as the dependent variable. We find a negative coefficient for the Delaware indicator variable for the regressions with CEO Tenure, significant at the one percent level. The CEO Tenure coefficient is insignificant for the California and Anti TO variables. We also find that Delaware CEOs are significantly less likely to be a Founder, consistent with Hypothesis H5. We also find a positive and marginally significant Delaware coefficient in the CEO Directorships regression, while the coefficient for this variable is strongly significant for California, suggesting that California CEOs are more likely to serve as outside directors, once we control for the generally smaller size of the California firms. For the CEO Voting Power regression, only the California variable is significant, and then only marginally so. 4.1.3. Turnover statistics Overall, the data analyzed in Tables 2 and 3 support the proposition that Delaware attracts firms with significantly different governance, shareholder influence, and CEO characteristics. How do these differences translate into the governance outcome of terminating 19 We get similar results (untabulated) when we use the G-Index as the dependent variable. 23

the CEO? Table 4 summarizes the proportion of CEOs turned over in each of our three incorporation groups, presenting both forced turnover and the overall (forced + voluntary) turnover for our sample. The forced turnover rates in Delaware incorporated firms is about 2.7%. This percentage is significantly higher than the rates observed in other incorporation states, which supports Hypothesis H6. Overall turnover is also higher for the Delaware firms, but the difference seems largely attributable to the higher forced turnover for those firms. <<Table 4 here>> 4.2. Regression Analysis The univariate statistics presented in Table 4 show that Delaware firms are more likely to terminate their CEOs. As discussed above, however, this higher turnover rate is unlikely to be the direct result of Delaware law. Accordingly, in this section we use a multivariate framework to examine whether any of the potential causal mechanisms identified might explain the relation between Delaware incorporation and the likelihood of forced turnover. We use Forced Turnover as the dependent variable, which equals one if the CEO is turned over in that year and zero otherwise, in a series of single stage logistic regressions. We present the results in Table 5. <<Table 5 here>> We control for firm performance by including stock market returns for the current and the last fiscal years. We industry adjust this measure (using the Fama/French 48 industry classification) to filter out exogenous industry shocks. 21 The standard errors presented in the table account for potential clustering at the firm level. We have included year dummies to control for any potential time trends. 20 We get similar results (untabulated) when we add operating income and standard deviation of operating income as control variables. The coefficients for these two variables are insignificant. 21 The results are qualitatively unaltered if we use raw returns. 24

The base regression includes only the performance variable, an indicator variable for Delaware, and an interaction variable for the first two variables. In this regression, the coefficient for the Delaware indicator variable is positive and significant at the 1% level, offering further evidence in support of Hypothesis H6. In the second model, we add indicator variables for California and Anti TO incorporation, along with interaction variables for each. In this specification, the coefficient for the Delaware variable is significant only at the ten percent level. The coefficient for California incorporation is positive, but insignificant, so we do not find any clear evidence for the hypothesis that California s supposedly pro-shareholder corporate law discourages management entrenchment. The interaction variable for California and industry adjusted return is positive, however, suggesting that CEO tenure at California firms is less sensitive to firm performance. The coefficient for the Anti TO indicator variable is negative and significant at the ten percent level, which offers at least weak support for the hypothesis that the stringent antitakeover protections in those states entrench management. The main focus of our analysis, however, is the models presented in Table 5 which include characteristics of the board, shareholder influence, and the CEO that may affect the odds of termination. We saw in the previous sections that Delaware firms differ from their counterparts from other jurisdictions with respect to a number of these characteristics; thus, Delaware incorporation is likely to be serving as a proxy for these characteristics which our hypotheses suggest may affect turnover. Do any of these characteristics explain Delaware s higher turnover rate? The Institutional Blocks variable is consistently positive and significant at the one percent level, suggesting that outside shareholder influence is an important influence on directors decisions to terminate an underperforming CEO. CEOs who are founders or who also hold the 25

Chair position are significantly less likely to be fired. The variables relating to the demand for the directors services, Director Retainer and Directorships, are insignificant. Director Voting Power is marginally significant in one model, but the coefficient is not significant when we control for other governance characteristics. Not surprisingly, the coefficient of the Delaware indicator variable is consistently insignificant when we add these explanatory variables. The coefficient does, however, retain a positive sign in all specifications, so we find no evidence that Delaware CEOs are more entrenched. We estimate the marginal effects of each of these variables on forced CEO turnover from the logistic regressions described above and report it in Panel B of Table 5. The inferences from the marginal effects are largely similar to those discussed above. In regressions with just industry adjusted market returns as controls, the Delaware coefficient continues to be positive and significant suggesting higher turnover rates in Delaware. Once we add the director and CEO characteristics and the shareholder influence variables, we find the same variables to be significant; Founder CEOs, and CEOs who hold both the CEO and Chairman positions are less likely to be forced out, and more institutional blocks associated with higher forced turnover. 4.3 Robustness Checks To test the robustness of our finding, we also use a two stage approach similar to Jenter and Kanaan (2008). In the first stage we decompose the returns in a year into systematic component based on industry returns and firm-specific component. In the second stage, we estimate the CEO turnover regression using the Cox proportional hazard model. In this model, we estimate the probability that the CEO will be fired in a given year, conditional on (s)he continues to be employed after last year. In these regressions, we consider voluntary turnovers 26

to be right-censored. 22 The results, untabulated, mirror those presented in Table 5. In the base models, the Delaware coefficient is significant at the five percent level. When we include the board and CEO control variables, the coefficient for the Delaware incorporation variable is no longer significant at conventional levels, and the pattern of significance is essentially the same for the control variables. The results are also similar if we add the Heckman correction model to control for potential selection bias of incorporating in Delaware. Tables 1-5 present results for the Execucomp sample of S&P 1500 firms. As a test of robustness for our central findings, however, we do a similar analysis for a larger sample of Compact Disclosure firms. For this larger sample, we define Forced Turnover as CEO departure before age 60, a relatively noisy measure which may limit the power of our tests relative to the more refined data that we have for the Execucomp sample. Despite this relatively noisy measure of the dependent variable, the results of these regressions (untabulated) are consistent with the results presented earlier. 23 5. Conclusion This study focuses on the relation between a firm s state of incorporation and its corporate governance. Overall, we find little support for the proposition that competition for corporate charters promotes managerial entrenchment. Our findings suggest that Delaware firms are more likely to terminate their CEOs than firms incorporated in other states. The greater willingness of Delaware firms to fire their CEO seems to be largely driven by the influence of 22 Given the small proportion of forced CEO turnovers each year, we use annual observations instead of monthly observations as in Jenter and Kanaan (2008). If we use monthly observations, the Delaware variable is stronger than the results discussed here. 23 Altering the age threshold to 61 or 62, or redefining turnovers to include managers whose stock was delisted due to performance reasons or whose firms were acquired, does not alter the principal results. 27

institutional owners in Delaware firms and the lower likelihood of a founder serving in a CEO role. We also find no evidence that firms incorporated in shareholder protective California are more likely to terminate their CEO. Indeed, the evidence presented here suggests that California firms may be less sensitive to firm performance. We do, however, find weak evidence that the Anti TO firms are less likely to terminate their CEOs, although they do not appear to be less sensitive to industry adjusted return. State of incorporation and governance characteristics are simultaneously determined. Delaware firms attract greater institutional ownership, which appears to keep CEOs on a tighter leash. Founder firms, in which the CEO is apparently less vulnerable to involuntary termination, tend to incorporate in states other than Delaware. Overall, we conclude that our findings are inconsistent with the hypothesis that Delaware promotes managerial entrenchment. 28

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APPENDIX: VARIABLE DEFINITIONS Variable Forced Turnover All Turnover California Delaware Anti TO Other Period Total Assets Book to Market Leverage Dividends Total Payout R&D Operating Income Income Volatility Description Indicator variable equal to one if newspaper reports indicate that CEO was forced out, if the board mentions dissatisfaction with firm performance, if there are disagreements between the CEO and the board of directors, or if the departure is unexpected and no particular reason was provided for the departure; zero otherwise. Source is Factiva news searches. Indicator variable equal to one if the CEO is different from the prior year; zero otherwise. Source is Execucomp. Firm incorporated in California. Firm incorporated in Delaware. Firm incorporated in Georgia, Ohio, Maryland (post 1998), Massachusetts, Pennsylvania, or Virginia. Firm incorporated in any other state. Indicator variable that takes the value of 1 for observations after the enactment of Sarbanes Oxley Act (post 2001) and a value of 0 for earlier years. In millions. Ratio of the book value of equity to the market value of equity (shares outstanding x price at end of the year) Ratio of long term debt plus the debt in current liabilities scaled by total assets. Dividends paid to common shareholders, scaled by earnings available to common shareholders. Sum of dividends and stock repurchases, scaled by earnings available to common shareholders. Amount of research and development, scaled by Sales. Operating income, scaled by total assets. Standard deviation of operating income over prior five years. 31

Stock Volatility Years Since IPO Capital Expenditures Target (Acquirer) Target (Acquirer) Value Ind. Adj. Ret. Board Size Percent Outsiders Board Meetings Director Retainer Director Tenure Director Voting Power Multiple Directors Busyness Institutional Ownership Inst. Blocks G-Index Standard deviation of monthly stock returns estimated over the last two years (Year 2 and Year 1) prior to the current fiscal year (Year 0). Number of years since firm s initial public offering. Investment in long term assets, scaled by total assets. Percentage of firms that are targets (acquirers) in a particular year, as identified from SDC. Value of transaction in SDC. Returns for stock for year 1 and year 0 adjusted by Fama-French 48 industry classification. Total number of directors. Percentage of outside directors on the board. Average number of meetings per year held by the full board for the prior three years. Cash compensation paid to directors. Mean number of years that outside directors have been on board. Percentage of votes held by outside directors. Mean number of external directorships of public companies held by outside directors. Indicator variable equal to one if a majority of outside directors hold three or more directorships, and zero otherwise. Percentage of shares held by institutions. Source is IRRC; if not available on IRRC, the data are obtained from Compact Dislosure/Spectrum. Number of blocks of 5% or more held by institutional investors. Governance index from Gompers, Ishii, & Metrick (2003). When the G-index is not available for a particular year, we use the nearest past years index as our measure of the current year s G-index. 32

E-Index Class Actions CEO Tenure CEO Directorships CEO Voting CEO Age CEO-Chair CEO Founder Founder Firm Outsider Appointee High Profile CEO Entrenchment index from Bebchuk, Cohen, & Ferrell (2004). Federal securities class actions, as reported by Securities Class Action Clearinghouse. Number of years since CEO s appointment. Number of outside directorships held by CEO. Percentage of votes held by CEO. Age of CEO in years. Indicator variable equal to one if the CEO also serves as Chair, and zero otherwise. Indicator variable equal to one if CEO founded firm, and zero otherwise. Indicator variable equal to one if either founder or member of founder s family, serves on the board, and zero otherwise. Indicator variable equal to one if CEO named to that position within one year of joining the firm, and zero otherwise. Indicator variable equal to one if CEO is included in one of the following lists, and zero otherwise (Rajagopal, Shevlin, and Zamora, 2006). Source List Years Business Week The Best Managers 1992-2004 Financial Times World s Most Respected Business Leaders 1998,1999,2002 Financial Times Most respected companies 1998-2003 Time Magazine Time/CNN 25 Most Influential 2001 Fortune 50 Most Powerful Women in Business 1998-2004 Fortune Most Powerful Black Executives in America 2002 All variables are computed at the beginning of the year. Financial variables are from Compustat and governance variables are from Execucomp and IRRC, except for G-Index, which is obtained from Andrew Metrick s website, http://www.som.yale.edu/faculty/am859/webpages/data.html, and the E-Index, which is obtained from Lucian Bebchuk s website, http://www.law.harvard.edu/faculty/bebchuk/data.shtml. Ownership data is from Compact Disclosure. 33

Table 1 Headquarters and Incorporation The table shows the frequency of firms headquarters state and the state in which they incorporate. The sample includes all firm-years for which CEO data is available on Execucomp from1993-2004. Only firm years with positive total assets on Compustat and CRSP share code of 10 or 11 are included in the sample. Foreign firms incorporated in the US and US firms incorporated in foreign countries are excluded. Own/Other shows the number of firm years where the firm incorporates in its own headquarters state versus other states within that group. CA DE Anti TO (Own/Other) Headquarters Other (Own/Other) Total Incorporation DE 2504 83 1863 7604 12054 Anti TO 25 6 2033 / 78 330 2472 CA 513 0 13 37 563 Other 158 6 186 6141 / 934 5791 Total 3200 95 4173 15046 20880 Panel B: Survival rates for firms in sample The table shows the frequency (percentage of firms in the corresponding incorporation state sample) of CRSP delisting codes of the firms in our sample at the end of 2004. Incorporation Trading in 2004 Mergers Exchanges Liquidations Dropped Total DE 972 506 13 0 109 1600 (60.75) (31.63) (0.81) (0) (6.81) Anti TO 185 84 1 2 9 281 (65.84) (29.89) (0.36) (0.71) (3.20) CA 63 24 0 0 4 91 (69.23) (26.37) (0) (0) (4.40) Other 464 215 3 1 31 714 (64.99) Total 1684 (62.70) (30.11) 829 (30.86) (0.42) 17 (0.63) (0.14) 3 (0.11) (4.34) 153 (5.70) 2686 34

Table 2 State of Incorporation and Financial and Governance Characteristics The table provides the means (medians in parentheses) of firm and governance characteristics classified by the firm s incorporation choice. The sample consists of all Execucomp firm years with positive total assets on Compustat during the period 1993-2004 that have a CRSP share code of 10 or 11. Governance variables from IRRC are available only from year 1996. All accounting ratios are winsorized at the 1% and 99% levels. Panel A summarizes the firm financial characteristics. Panel B and C present our measures of internal and external monitoring mechanisms. Panel D presents the characteristics of the CEOs. We test for differences in characteristics between Delaware incorporated firms and other firms using two sample t-test and Wilcoxon rank sum test. Statistical significance of the differences between Delaware and other incorporation choices at the ten, five, and one percent levels are shown in italics, bold italics, and bold, respectively. Panel A: Firm Characteristics based on Incorporation choice DE Anti TO CA Other Total Assets 8643.72 6492.70 3012.44 9237.51 (916.11) (1098.21) (316.02) (1194.70) Book to Market 0.479 0.511 0.432 0.543 (0.403) (0.439) (0.350) (0.479) Leverage 22.94 22.16 12.96 23.92 (20.77) (20.90) (5.81) (23.46) Dividends 39.74 53.38 34.30 50.30 (13.32) (35.78) (0.00) (32.03) Total Payout 15.53 26.96 14.99 28.44 (0.00) (19.17) (0.00) (17.39) R&D 9.54 4.01 14.39 4.84 (0.00) (0.00) (5.03) (0.00) Operating Income 15.02 15.91 18.14 15.83 (15.09) (14.20) (17.24) (14.40) Income Volatility 7.77 4.74 8.40 4.72 (4.13) (3.21) (5.72) (2.80) Stock Volatility 13.35 11.22 13.43 9.29 (11.51) (9.68) (14.85) (10.86) Capital Expenditures 6.60 5.60 6.76 6.85 (4.87) (4.47) (5.36) (5.33) Years Since IPO 19.29 27.67 16.55 25.47 (12.61) (25.22) (10.20) (23.06) Acquirer (%) 10.35 9.90 10.10 11.40 Acquisition Value 1234.55 1296.98 475.21 1277.05 (201.10) (226.57) (96.07) (213.86) Target (%) 1.71 0.77 2.36 1.30 Target Value 5012.79 6740.82 309.86 7132.84 (422.95) (2055.28) (150.00) (1081.26) 35

Panel B: Director Characteristics DE Anti TO CA Other Board Size 9.27 10.38 8.46 10.12 (9.00) (10.00) (8.00) (10.00) Percent Outsiders 63.68 66.97 64.63 64.52 (66.67) (70.59) (66.67) (66.67) Board Meetings 7.26 7.27 7.72 7.21 (7.00) (7.00) (7.00) (7.00) Director Retainer 20.72 19.73 14.16 18.87 (20.00) (18.51) (14.00) (18.00) Director Tenure 6.89 7.84 7.86 8.21 (6.40) (7.60) (7.20) (7.67) Multiple Directors 1.010 1.054 0.701 0.864 (0.875) (1.000) (0.600) (0.714) Director Voting Power 4.04 2.68 1.93 3.25 0.00 0.00 0.00 0.00 Busyness 0.242 0.220 0.124 0.169 Panel C: Shareholder Influence Measures DE Anti TO CA Other Institutional Ownership 57.95 55.51 50.46 52.42 (59.99) (57.00) (50.50) (52.98) Institutional Blocks 1.79 1.61 1.48 1.43 (1.75) (1.50) (1.25) (1.25) G Index 8.99 10.47 6.03 9.56 (9.00) (10.00) (6.00) (10.00) E Index 2.23 2.94 1.16 2.61 (2.00) (3.00) (1.00) (3.00) Class Actions (%) 3.34 2.35 4.26 2.40 Panel D: CEO Characteristics DE Anti TO CA Other CEO Tenure 7.65 8.05 9.08 8.57 (5.50) (5.50) (5.67) (6.00) CEO Directorships 0.616 0.889 0.374 0.572 (0) (0) (0) (0) CEO Voting 4.50 3.24 3.59 4.27 (1.30) (1.10) (1.20) (0.00) CEO Age 54.30 55.15 54.58 55.08 (54.00) (55.00) (54.00) (55.00) CEO-Chair 1.69 1.69 1.47 1.69 CEO Founder (%) 24.12 25.69 37.30 25.97 Founder Firm (%) 38.19 41.34 56.31 39.58 Outsider Appointee (%) 43.75 45.11 55.98 34.88 High-Profile CEO (%) 2.52 1.17 3.15 1.82 36

Table 3 Multivariate Comparison of Governance Characteristics, Shareholder Influence, and Incorporation The table shows the results of regressions using certain governance characteristics as the dependent variable. Standard errors are clustered at the firm level. The variables are defined in the Appendix. All regressions are estimated either using OLS or using logistic regression when the dependent variable is binary. Coefficients that are significant at the ten, five, and one percent levels are shown in italics, bold italics, and bold, respectively. Panel A: Board Characteristics Director Retainer Director Tenure Director Voting Power Multiple Directors Coeff. Std. Err. Coeff. Std. Err. Coeff. Std. Err. Coeff. Std. Err. Intercept 15.091 1.857 9.330 0.727 11.029 3.235 1.006 0.138 Book to Market 1.697 2.121 0.134 0.121-0.367 0.303 0.088 0.022 Log Total Assets 3.898 0.182 0.283 0.060 0.398 0.156 0.230 0.011 Years Since IPO 0.062 0.015 0.052 0.005-0.017 0.013 0.003 0.001 DE 1.890 0.690 0.954 0.193 0.567 0.576 0.085 0.031 CA 0.351 1.045 0.147 0.572-0.571 0.630 0.036 0.070 Anti TO 0.029 0.682 0.446 0.250-0.578 0.615 0.130 0.049 Period 6.656 0.704 0.047 0.078 0.288 0.290 0.148 0.014 Industry Dummies Yes Yes Yes Yes N 20224 9679 10297 9683 R 2 0.088 0.112 0.070 0.286 37

Panel B: Shareholder influence measures Inst Ownership N Blocks E-index Class Actions Coeff. Std. Err. Coeff. Std. Err. Coeff. Std. Err. Coeff. Std. Err. Intercept 21.388 2.533 1.552 0.125 2.427 0.257 6.479 0.380 Book to Market 3.351 0.673 0.223 0.031 0.103 0.038 0.289 0.069 Log Total Assets 3.332 0.240-0.073 0.013 0.012 0.023 0.337 0.030 Years Since IPO 0.048 0.020 0.003 0.001 0.001 0.002 0.009 0.003 Stock Volatility 2.792 0.693 DE 2.523 0.708 0.228 0.041 0.281 0.066 0.143 0.106 CA 0.434 1.880 0.044 0.109 1.338 0.136 0.453 0.207 Anti TO 1.159 0.992 0.114 0.057 0.341 0.091 0.003 0.160 Period 11.890 0.372 0.434 0.025 0.181 0.024 0.250 0.096 Industry Dummies Yes Yes Yes Yes N 20497 20497 16270 20045 R 2 / Pseudo R 2 0.240 0.141 0.119 0.0739 Panel C: CEO Characteristics CEO Tenure Founder CEO CEO Chair CEO Directorships CEO Voting Power Coeff. Std. Err. Coeff. Std. Err. Coeff. Std. Err. Coeff. Std. Err. Coeff. Std. Err. Intercept 9.222 1.066 0.248 0.373 1.047 0.341 1.073 0.152 16.100 2.241 Book to Market 0.157 0.181 0.090 0.056 0.112 0.064 0.082 0.023 0.209 0.347 Log Total Assets 0.029 0.096 0.180 0.031 0.182 0.031 0.175 0.014 1.111 0.152 Years Since IPO 0.018 0.007 0.031 0.004 0.010 0.002 0.006 0.001 0.022 0.014 DE 1.136 0.340 0.446 0.113 0.039 0.093 0.065 0.039 0.251 0.502 CA 0.417 1.211 0.017 0.263 0.686 0.261 0.005 0.089 0.678 0.871 Anti TO 0.433 0.485 0.061 0.160 0.055 0.132 0.275 0.070 0.899 0.526 Period 0.135 0.163 0.199 0.051 0.141 0.052 0.124 0.020 0.190 0.194 Industry Dummies Yes Yes Yes Yes Yes N 19120 20543 12007 9499 10169 R 2 0.029 0.121 0.040 0.155 0.102 38

Table 4 CEO Turnover and State of Incorporation The table shows the percentage of turnovers each year under each incorporation category. The sample consists of all Execucomp firms on Compustat and CRSP during the period 1993-2004. Turnovers are classified as forced using a methodology similar to Parrino (1997). The significance of the differences in proportions between DE and the other groups for the overall sample at the ten, five, and on percent levels are shown in italics, bold italics, and bold, respectively. DE Anti TO CA Others Forced Turnover All Turnover Forced Turnover All Turnover Forced Turnover All Turnover Forced Turnover All Turnover 1993 0.77% 3.84% 0.59% 3.55% 2.33% 6.98% 2.49% 4.30% 1994 1.31% 6.41% 1.12% 6.18% 0.00% 2.27% 2.09% 7.95% 1995 2.62% 8.19% 2.16% 8.65% 0.00% 4.55% 2.03% 6.69% 1996 3.49% 7.72% 2.70% 4.86% 0.00% 1.72% 1.17% 5.28% 1997 2.58% 6.51% 1.52% 9.09% 4.84% 11.29% 2.31% 9.42% 1998 2.50% 7.68% 3.02% 9.05% 5.88% 11.76% 1.55% 7.17% 1999 4.13% 9.39% 0.48% 5.77% 0.00% 6.82% 2.56% 9.17% 2000 3.45% 10.77% 2.00% 10.00% 0.00% 5.13% 4.17% 10.65% 2001 2.45% 8.40% 2.49% 9.45% 0.00% 2.70% 2.09% 8.35% 2002 3.17% 8.36% 3.37% 9.13% 2.63% 2.63% 2.55% 8.82% 2003 2.72% 7.11% 0.49% 5.85% 4.88% 9.76% 2.70% 9.21% 2004 2.93% 8.02% 1.01% 7.07% 2.50% 10.00% 1.35% 8.11% All 2.72% 7.77% 1.76% 7.46% 2.03% 6.47% 2.23% 7.89% 39

Table 5 Logistic Regression predicting forced CEO turnover The table presents models of forced CEO turnover. Sample does not include mergers. All variables are defined in the appendix. Reported standard errors are clustered at the firm level. Panel B presents the marginal effects of the variables on Forced CEO turnover. The marginal effects are evaluated at the Mean. Coefficients that are significant at the ten, five, and one percent levels are shown in italics, bold italics, and bold, respectively. Panel A: Logit Model of Forced CEO turnover Model 1 Model 2 Model 3 Model 4 Model 5 Model 6 Coeff. Std. Err. Coeff. Std. Err. Coeff. Std. Err. Coeff. Std. Err. Coeff. Std. Err. Coeff. Std. Err. Intercept 4.542 0.263 4.487 0.271 4.066 0.305 4.620 0.275 2.835 0.277 2.830 0.321 Ind. adj.return 0.579 0.099 0.608 0.122 0.522 0.140 0.596 0.123 0.596 0.164 0.536 0.148 DE 0.275 0.106 0.211 0.119 0.104 0.156 0.166 0.121 0.185 0.154 0.068 0.160 DE*ind.adj. return 0.082 0.127 0.110 0.146 0.010 0.172 0.101 0.146 0.103 0.189 0.040 0.180 CA 0.056 0.319 0.160 0.453 0.063 0.320 0.085 0.438 0.224 0.445 CA*ind.adj return 0.576 0.184 0.525 0.354 0.565 0.184 0.610 0.369 0.588 0.325 Anti TO 0.401 0.217 0.218 0.258 0.447 0.222 0.227 0.264 0.275 0.272 Anti TO*ind adj.return 0.360 0.248 0.180 0.309 0.380 0.256 0.014 0.342 0.048 0.344 Director Retainer 0.002 0.004 0.003 0.005 Directorships 0.080 0.087 0.059 0.094 Director Voting Power 0.006 0.003 0.006 0.004 Institutional Blocks 0.127 0.038 0.182 0.048 Founder CEO 0.869 0.220 0.943 0.245 CEO Chair 0.713 0.136 0.734 0.146 CEO Directorships 0.080 0.077 0.096 0.082 Year Dummies Yes Yes Yes Yes Yes Yes N 19008 19008 8600 18889 9142 8349 Pseudo R 2 0.037 0.040 0.036 0.039 0.058 0.067 40

Panel B: Marginal Effects of variables on Forced CEO turnover Model 1 Model 2 Model 3 Model 4 Model 5 Model 6 Coeff. Std. Err. Coeff. Std. Err. Coeff. Std. Err. Coeff. Std. Err. Coeff. Std. Err. Coeff. Std. Err. Ind. adj.return 0.012 0.002 0.013 0.003 0.013 0.004 0.012 0.002 0.013 0.004 0.011 0.003 DE 0.006 0.002 0.004 0.002 0.003 0.004 0.003 0.002 0.004 0.003 0.001 0.003 DE*ind.adj. return 0.002 0.003 0.002 0.003 0.000 0.004 0.002 0.003 0.002 0.004 0.001 0.004 CA 0.001 0.007 0.004 0.013 0.001 0.007 0.002 0.010 0.005 0.012 CA*ind.adj return 0.012 0.004 0.013 0.009 0.011 0.004 0.013 0.008 0.012 0.007 Anti TO 0.007 0.003 0.005 0.006 0.008 0.003 0.005 0.005 0.005 0.005 Anti TO*ind adj.return 0.007 0.005 0.005 0.008 0.008 0.005 0.000 0.007 0.001 0.007 Director Retainer 0.000 0.000 0.000 0.000 Directorships 0.002 0.002 0.001 0.002 Director Voting Power 0.000 0.000 0.000 0.000 Institutional Blocks 0.003 0.001 0.004 0.001 Founder CEO 0.015 0.003 0.016 0.003 CEO Chair 0.017 0.004 0.017 0.004 CEO Directorships 0.002 0.002 0.002 0.002 41