The state's role in changing corporate contracts

Henry Hansmann has posted his 2004 ALEA Presidential address, Corporation and Contract. Here's the abstract:

Publicly traded corporations rarely use the nearly absolute freedom afforded them to draft charters that deviate from the default terms of state corporation law. Conventional explanations for this phenomenon are unconvincing. A more plausible reason lies in the lack of any feasible amendment mechanism that will assure efficient adaptation of charter terms as changing circumstances dictate during the long expected lifetime of a public corporation. In effect, by adopting state law default terms, corporate shareholders and managers delegate to a third party - the state - the process of amending charter provisions over time. This theory provides much stronger reason for deferring to the law's default rules than do the other theories that have been offered. It implies that default rules may often be nearly as influential as mandatory rules, and that scholars are not wasting their time debating whether one rule of corporate law is more desirable than another even if, as is typical, the rule chosen will be formulated only as a default. This theory also suggests that it might be beneficial if leading corporate law jurisdictions were to provide greater choice among default terms than they currently do.

I think the article is important enough to warrant an extended analysis.

Hansmann correctly observes that other explanations of the choice between state and privately drafted forms don't wash. For example, private parties are perfectly capable of internalizing drafting costs; and he's skeptical of network effects and pricing problems (as for the former, see my article with Kobayashi, Choice of Form and Network Externalities). Hansmann cites as evidence of his theory that statutory standard forms are used primarily when the parties want to delegate the process of change to the state: firms with customized contracts typically have either a small number of owners or a relatively short life that doesn't lend itself to the statutory amendment process.

I have a few comments, and will use this opportunity to add some citations to my work.

First, it's important to distinguish between federal and state law. Hansmann's theory provides a rationale for relying on state law, where states can compete on the "efficient change" frontier just as they do in other respects. By contrast, federal law removes competition and is notably inflexible – e.g., the 1933 and 34 acts are still on the books in much their historic form. Also, federal law, with its interest group clashes over corporate regulation, can hardly be considered as trustworthy an agent of change as Delaware.

This leads to a second point -- the paper does not fully address the political risk inherent in delegating the power to change contracts to the state. It's true, as Hansmann says, that there's less risk in Delaware than elsewhere. But while Delaware has the Fortune 500 business, many public corporations are not incorporated in Delaware. For example, Hansmann discusses Georgia incorporation regarding fair price provisions.

Statutory changes affecting existing charters present a significant political rent-seeking opportunity as compared to prospective-only changes that firms can avoid. The Constitution protects against such changes through the Contracts clause. See my articles with Butler, The Contract Clause and the Corporation, 55 Brooklyn Law Review 767 (1989) and State Anti-Takeover Statutes and the Contract Clause, 57 University of Cincinnati Law Review 611 (1988), and a chapter in our book, The Constitution and the Corporation (1995). More generally, see my article Changing Statutory Forms as to the policy tradeoffs between flexibility and stability. Indeed, I argue in Why Corporations? that the risk of political manipulation is a disadvantage of the corporate form.

Hansmann indirectly addresses these issues by noting that statutes appropriately defer to private contract terms. But as I argue in the above articles and elsewhere, corporate statutes are appropriately viewed as part of the corporate contract, suggesting that the constitution will, or at least should, restrict change.

Hansmann might respond that the parties choose among standard forms, including those offered by a given state, in part according to how much they want the state involved in this change process. In other words, the choice of a corporate statute of a particular state involves an option to submit to a state process of change, and this solves any potential contract clause problem. With respect to the general availability of intra-jurisdictional choice, see my articles Making Sense of Entity Rationalization, 58 Business Lawyer 1023 (2003) and Statutory Forms for Closely Held Firms: Theories and Evidence from LLCs, 73 Wash. U. L. Q. 369 (1995). If this is what Hansmann is saying, he needs to develop it and address the question of whether this solves the constitutional problem.

Third, the analysis isn't complete without a discussion of the parties' decision to delegate drafting to such institutions as the National Conference of Commissioners on Uniform State Laws (NCCUSL) (which is a quasi-public institution receiving some state financial support), the ALI (see Schwartz and Scott), and the ABA (as to the MBCA). Like Delaware, these groups provide both the possibility of change and at least some insulation from interest group capture compared to individual states and the federal government. But they have significant problems. See my articles with Kobayashi, Economic Analysis of Uniform State Laws, 25 Journal of Legal Studies 131 (1996), Uniform Laws, Model Laws and ULLCA, 66 Colorado Law Review 947 (1995)and Evolution and Uniformity, 34 Economic Inquiry 464 (July, 1996)

So, the Hansmann paper is best viewed as a blueprint for further research, but research that is worth doing.

Comments

[Henry Hansmann]

I generally agree with Larry's thoughtful comments about my essay. In particular, one expects the process of delegated contracting that I describe to work less efficiently where the state has a stronger monopoly on the chartering process. For that reason, in jurisdictions that (like many European states pre-Centros) follow the real seat doctrine, under which corporations must be chartered under the corporation law of their principal place of business, one might expect less deference to the default rules of the state-provided corporate law. But, of course, one would also expect the law to have more mandatory as opposed to default rules in such jurisdictions.