The last decade has been unkind to investors in some of America’s most prominent corporations, from Adelphia Communications Corp. to WorldCom Inc. Flawed governance lay at the root of many bankruptcies (and of many near-bankruptcies that necessitated government bailouts).
Is Delaware the problem? The tiny state has long chartered most of the nation’s large, nonbank corporations. And critics of corporate governance argue that Delaware won a “race to the bottom,” enticing out-of-state companies to charter there by offering the laxest regulations. Defenders counter that the state won a “race to the top” by maintaining the best system of governance available.
What really happened was more of a “marathon to the middle.”
The first state to learn that it could garner significant revenue by chartering out-of-state corporations was New Jersey, which in the 1880s and ’90s invented and refined the interstate holding company, an innovation that allowed the state’s corporations to own and control out-of-state subsidiaries with minimal fuss.
Before that, most corporations had chartered in the state where they conducted most of their business. Interstate corporations, such as railroads, received identical charters from multiple states or interlocked their boards and shareholders.
As the economy integrated nationally after the Civil War, such makeshifts became increasingly burdensome and were eventually rendered moot by court decisions that allowed nonbank corporations to conduct business across the nation, regardless of their state of incorporation.
By 1900, New Jersey had grown so fat from corporate fees that several fiscally challenged states -- including Arizona, Delaware, Maine, South Dakota and West Virginia -- followed its example and began competing to charter as many corporations as possible. Some states competed by charging lower fees, others promised laxer regulations, and several offered both.
In 1913, New Jersey, fiscally secure (for the time being), destroyed its own chartering business when it passed antitrust measures urged by its lame-duck Democratic Governor Woodrow Wilson, who argued that the fast-growing state no longer needed the revenue that chartering provided.
Delaware emerged as the corporate favorite after 1913 because it adopted New Jersey’s well-understood and respected corporate law and legal precedents, minus the antitrust attitude. As an additional inducement, it offered the whole package at half of what New Jersey charged.
The other charter-hungry states failed to keep pace for several reasons. South Dakota offered the nation’s lowest chartering and franchise fees, but business executives feared its volatile political climate, which featured powerful populist, progressive and Democratic forces. Its courts sometimes engaged in what the local newspaper described as “corporation lynching” and its capital was a tiny town at the very end of the railroad line adjacent to a large Indian reservation.
West Virginia and Arizona were also distant destinations with reputations for violence and bad weather that rendered them unattractive to corporate executives and their attorneys, even if the need to visit was merely prospective.
Most damning was that investors distrusted securities issued by all three states because their governance systems were much too lax. “Investors look with distrust on any corporation which operates under one off their charters,” corporate attorney William Lough wrote in 1909.
“The mere fact that a corporation is organized in Arizona, South Dakota” or similar states, warned another contemporary, “is sufficient to put experienced investors on their guard and renders the sale of corporate securities difficult.”
West Virginia was arguably the worst of the bunch, “a snug harbor for roaming and piratical companies” and the “Mecca of irresponsible corporations,” as William W. Cook put it in his “Treatise on Stock and Stockholders.”
“Any one who buys a minority interest in a West Virginia corporation does so at his peril,” warned corporate attorney Thomas Conyngton in 1901. “It is doubtful if any more thoroughly vicious corporation laws were ever enacted.”
It took decades for Delaware to dominate corporate chartering. Its system of governance was stricter than those of other states jockeying for the lucrative corporate-chartering business, and hence more acceptable to investors, but was also more flexible, and hence more agreeable to executives than the systems offered by Massachusetts, New York, Pennsylvania and other states.
The reasons some of our biggest corporations are poorly governed, then, are more complicated than the state in which they’re chartered.
(Robert E. Wright is the Nef Family Chair of Political Economy at Augustana College in South Dakota and the author of numerous books, including, with David Cowen, “Financial Founding Fathers: The Men Who Made America Rich.” The opinions expressed are his own.)
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