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Editor’s Note: In a previous version of this article, we failed to note that some of the companies asked to re-incorporate in North Dakota were incorporated in states other than Delaware. We regret the error.
This Motley Fool series examines things that just aren't right in the world of finance and investing. Here's what's got us riled up this week. If something's bugging you, too -- and we suspect it is -- go ahead and unload in the comments section below.
In perhaps my favorite movie of all time, Wayne's World, Mr. Wayne Campbell enthusiastically asks the audience to "Imagine being able to be magically whisked away to ... Delaware. [Long, uncomfortable pause.] Hi. I'm in Delaware [extended awkward discomfort]." Beyond boardwalks, chicken farms, and chemical plants, there's just not a whole lot going on there, which is, of course, the point of the joke. Fortunately, something is up in Delaware.
The mystery before you today is how one relatively insignificant state, the sixth-smallest by population and the second-smallest by land area, was able to craft itself into the official state of incorporation for 2,560 companies traded on major U.S. stock exchanges, including 308 of the S&P 500 index and more than 50% of all public companies in the USA.
The answer is this week's walk of shame.
Farms, fries, and big business
According to Delaware's own information pamphlet Why Corporations Choose Delaware, "The people of Delaware are aware that the income received from corporation franchise taxes is an important part of the state budget and that Delaware law firms that specialize in business law matters employ significant numbers of people. As a result, the Delaware citizenry supports the legislature in keeping Delaware's business laws state-of-the-art."[Emphasis mine.]
On its own, this is a pretty funny (and shameless) statement. But, there's a lot more going on here than just a cozy relationship. The proud state of Delaware just garnered the incredible honor of being named the world's most secretive tax haven by the Tax Justice Network (as reported by CNBC). That's ahead of the Cayman Islands and Switzerland, which you must admit is one staggering accomplishment. But before I cast the state off completely, let me say that Delaware did not become the proud home to big business by mere accident.
When it comes to corporate law, Delaware is said to run the show. According to a lawyer friend of mine, the state has the most thorough case history, the least ambiguity, the best professionals, and a very well-acclaimed operational record. In his words, "... the judges at the Delaware Court of Chancery understand business and corporations better than judges anywhere else in the U.S." So says a corporate lawyer from New York City, at least. For precisely these reasons, The Motley Fool is incorporated in the state as well.
Here's the problem
The problem is that Delaware, home to so many large, public companies, does not make decisions in a vacuum. Yet it operates as if it does. Shareholders across the world who have a problem with the makeup of a Delaware company's board, for example, tend to be bound by Delaware corporate law, even if that shareholder doesn't live there and even if the company doesn't do a whole lot of business there. So what might otherwise be a decision of minor, state-level significance in another place has the tendency to morph into a policy decision of national or global importance in Delaware simply because of the sheer numbers of companies involved. This is a problem.
At the same time, corporations in Delaware understand the power that they have over the folks in state legislatures and other public offices (judicial offices, for example) thanks to the massive amount of money they drive toward state revenues every year.
The nexus presented here creates some very serious problems for the shareholding world. Is it worth asking if judicial or political impartiality can even exist under these circumstances?
Look ma, no law school
Admittedly, a real lawyer can probably make a better argument than I can, but among circles that understand this topic well, many will agree with this logic. For example, Nell Minow, founder of the watchdog The Corporate Library, believes that, "Delaware is corporate governance, and since it openly seems so willing to keep that revenue stream coming, it seems to spend a lot more time accommodating the people who run companies and not so much time accommodating to people who invest in them."
Where it shows
Delaware's various dealings with big business are exposed on a fairly regular basis, but the latest manifestations of this greater situation are twofold and are quite topical:
1. The public's demand for say on executive pay.
2. A desire to have greater control over the terms of director elections.
In both cases, despite significant public outcry and heavy congressional pressure, Delaware has not done a whole lot to show that it cares. Delaware seems to do what Delaware wants, which is largely the same thing that its corporations – ahem, constituents -- want. While the issues du jour are somewhat smaller in their scope, the response from Delaware is consistent with a larger attitude that can be quite antagonistic toward shareholders as a group.
If investors can't get a fair shake on two, fairly reasonable issues in a state where half of our nation's public companies are incorporated, then we have a much larger, much more serious problem on our hands.
Arguments against any kind of change generally hinge on the fact that business owners are freely able to incorporate wherever they please and shareholders are under no compulsion to purchase shares of companies listed in Delaware. Because companies and shareholders have the freedom to shop around, the market for state incorporation is efficient and competitive. This is a glib, overly simplistic argument to make, but I'll entertain it merely for the purpose of destroying it in just a second. The thinking continues that if Delaware's laws were truly not shareholder-friendly, then why are they associated with abnormal positive returns, which they are according to two (somewhat curious) studies cited in just about every piece of pro-Delaware material I've read? Nothing need be done to reform the system because shareholders are being "treated" just fine.
This is an interesting counter-argument, but it doesn't fly.
Here comes the science
Beyond the fact that I have a few problems with the actual construction of these studies, I refuse to believe that Delaware's systems are flawless. We already knew that Delaware provides the best case history, the "smartest" judges, and the most ideal environment under which a corporation can operate. This is supposedly why so many corporations claim to go there in the first place.
Isn't it then plausible to believe that these abnormal returns investors generate are associated entirely with the good parts of Delaware's corporate environment, and the bad parts are just holding them back? Who knows, with a few shareholder-friendly tweaks here and there, returns associated with Delaware could be even higher.
Just because the state is good at some things, doesn't mean it can't get a lot better at other things. Still, Delaware appears to refuse, which is why it is shamed.
So what can be done?
From a federal level, there's talk of creating nationwide standards of incorporation. Federal business regulation tends to be problematic, but perhaps in this case, it's a necessity. Other states have tried to develop better systems on their own (this whole free-market-of-state-incorporation idea), but these efforts have largely failed for a rather unsurprising reason.
Delaware's established lead is simply too great. Lest we forget, management teams of companies already located in Delaware have many other, less noble incentives to stay. Shareholders of several companies (incorporated both in Delaware or elsewhere), including ExxonMobil (NYSE: XOM ) , Continental Airlines (NYSE: CAL ) , Southwest Airlines (NYSE: LUV ) , Whole Foods (Nasdaq: WFMI ) , Oshkosh (NYSE: OSK ) , and Biogen Idec (Nasdaq: BIIB ) , have in the past asked them to reincorporate in North Dakota (one of those states that is trying to change the game) and all, not surprisingly, failed to budge. So what to do?
Stand up, shareholders
I suspect that it's physically impossible for Delaware to provide an equitable environment for shareholders. The perverse design of this system is probably too great to overcome. Unfortunately, it's also fairly unreasonable to expect other states to improve the quality of their sales pitch as a home to corporations in short order (meaningful case history and informed judges don't just grow on trees).
Short of typically messy federal legislation, the only possible alternative is a forceful response from shareholders themselves, who unfortunately are about as active as a pile of wet noodles. Activists like Carl Icahn constantly push for reform on their own, but it really would require the collective force of all shareholders, including institutional ones, to spur substantive change. The real owners of public companies can and should learn to speak with their feet. Your audible discontent would be a great start, however.
Have any thoughts on this issue? Did I miss the point completely? Chime in below with your own comments.