5.01  Regulatory competition is a term that has been used in US legal scholarship to describe the competition amongst States to attract incorporations of companies in their jurisdiction. Its origins can be traced to the beginning of the twentieth century when New Jersey was dominating the market of incorporations, until its Governor of the time, Woodrow Wilson, introduced legislation to restrict stock ownership and redefine the business trust.¹ New Jersey’s popularity decreased and Delaware emerged in its place. It has since then dominated the market for incorporations for both (p. 126) public and private corporations.² By 1990 over 40 per cent of companies listed on the New York Stock Exchange and 50 per cent of Fortune 500 firms were incorporated in Delaware.³

5.02  This chapter discusses regulatory competition in corporate law (alternatively known as the ‘Delaware effect’) in the USA and the structure of the US market for corporate charters. It then assesses whether there is room for a similar effect in the EU.

5.03  A significant amount of literature has been devoted to the study of regulatory competition in the US. It is not the purpose of this book to offer a detailed account of the Delaware effect, which has been covered thoroughly elsewhere.⁴ For present purposes, a brief account of the US regulatory competition as well as the factors that have led to the predominance of Delaware will suffice. The focus is rather on whether such factors are present in Europe and whether it would be possible for regulatory competition to emerge in Europe, as several authors have argued in the post-Centros period.

5.04  Three main approaches to the Delaware effect have been indentified in legal scholarship. The first two view the competition as a race among States that leads either to the top or to the bottom. The third approach views the race as an equilibrium of regulation between States and the Federal Government. This latter view suggests that the success of regulatory competition is due to restraint shown by Federal authorities in interfering with the ability of States to compete.

5.05  Therefore, while the first two views present a market-based approach to regulatory competition, the third view is a political one. According to (p. 127) the first two views, States compete in order to attract incorporations by providing the law that entrepreneurs will like most, be that a good or a bad law. The third approach describes a tension between States and the Federal Government, who compete for regulating corporate affairs in the most efficient manner. To use a European term, it is a tale of subsidiarity.

5.06  In 1974 Cary, a former Chairman of the Securities and Exchange Commission (hereinafter SEC), argued that in order to attract incorporations, States adopt legislation that favours managers to the detriment of shareholders.⁵ Cary called this a race to the bottom, in which Delaware ‘a pygmy among the 50 states prescribes, interprets, and indeed denigrates national corporate policy’ in order to attract incorporations.⁶

5.07  In Cary’s view, Delaware’s primacy is explained by the fact that its corporate law as interpreted by the local judiciary favours managers at the expense of shareholders.⁷ Delaware’s incentive is the perks, ie the franchise fees⁸ payable annually by the businesses that incorporate in its territory, which in 1971 amounted to US$ 52 million out of a total revenue of US$ 222 million.⁹ The desire to retain business at home and derive the highest possible revenue through taxation has led the rest of the States to engage in a competition with Delaware. However, Cary argued, in doing so, States relax their shareholder protection laws in order to make incorporation under their laws more appealing to managers. This competition for lax laws Cary has called a race to the bottom. Indeed the low esteem in which Delaware’s corporate law is held is reflected in the case law of other US courts. Delaware law was considered lax and discarded in various cases.¹⁰

5.08  Federal incorporation, ie the adoption of a single corporate law code on a federal level, might be a response to the race to the bottom. Indeed it would eliminate competition among States. Cary rejected this solution as ‘politically unrealistic’ with ‘no public appeal’.¹¹ Instead, he argued, it would be more efficient to introduce a Federal Corporate Uniformity Act (p. 128) that would contain the minimum requirements that each State corporate statute would have to satisfy.¹²

5.09  The race to the bottom is no longer stated as robustly. Its modern version is still based on Cary’s main criticism, namely that the race increases managerial costs to the detriment of shareholders.¹³ A number of suggestions have been made for more power to be shifted from managers to shareholders. In particular, it has been proposed that shareholders satisfying some minimum ownership requirements would be able to place on the corporate ballot proposals for changing the charter or state of incorporation.¹⁴ For the time being, this trend assumes that the race has created a body of corporate law which ‘inefficiently benefits managers’¹⁵ over shareholders.¹⁶

5.10  The proponents of regulatory competition and its positive effect on corporate law think that regulatory competition does not lead to the adoption of lax corporate statutes that fail to maximize firm value. If this were the case, lower stock prices would either reduce the ability of the company to raise capital or would make it an easy takeover target.¹⁷ In both cases, managers would lose their jobs. Such an undesirable result would suffice to deter incorporations in jurisdictions that upset the balance of interests between managers and shareholders at the latter’s expense. Therefore, States would legislate in a way to avoid this undesirable result. In his criticism of Cary’s views, Winter went so as far as suggesting that the ‘problem is not that states compete for charters but that too often they do not’.¹⁸

(p. 129) 5.11  Winter’s criticism is understood to be based on the assumption that shareholders’ preferences determine firms’ demand for corporate law. The agency costs between managers and shareholders are minimized by the constraining influence that the differences among markets in which companies operate has on managers.¹⁹ Winter and his followers counter Cary’s argument that harmonization through a federal corporate statute would be beneficial. In their view, there is nothing to suggest that a federal measure would be more efficient than States’ legislation.²⁰

5.12  In its modern version, the supporters of the race to the top sustain that the race is beneficial for the shareholders. Winter’s main proposition has survived. It is still maintained that the fear of discouraging investment prevents managers from selecting a legal regime under which they are exculpated from fraud.²¹

5.13  According to one of the most significant proponents of the race to the top, federalism is what has made American corporate law so efficient and commercially successful.²² The Federal Government has abstained from regulating corporate law save in exceptional circumstances that required action on a national level. This left the field open for States to enact their own corporate statutes and compete for the attraction of incorporations. The quintessence of the success of American corporate law has been federalism, namely the diversity of legislatures and legal regimes that makes competition possible.

5.14  The federal nature of law and politics in the US is intertwined with two crucial characteristics which were conditions sine qua non for the success of regulatory competition. First, in a state of complete federal regulation of corporate law, there would be no incentive for the provision of efficient company statutes. Income from franchise fees is considerable for States, but for the Federal Government with its multi-billion dollar budget, franchise fees are not a high incentive.²³ Second, it is also suggested that in a world of harmonized corporate law there would be no courts whose bench would possess a high level of expertise in company law and that the connections between the bar and the legislature, which are essential for the production of efficient corporate statutes, would be lost. These points will all become much clearer immediately in the following, where the parameters that have made Delaware so successful will be analysed.

(p. 130) 5.15  As one might imagine, this view has not been uncontested. Recent empirical studies have shown that other States are not competing to attract franchise tax revenue.²⁴ Nor are they interested in developing good corporate law courts or producing the law that managers and shareholders want, actually leaving Delaware alone in its race.²⁵

5.16  Roe is the major proponent of the view that State competition operates under the good graces of the Federal Government. The apparent dichotomy between the first two positions is thus misconceived.²⁶ Rather, the driving force that has placed Delaware at the lead of the race for incorporations is actually the equilibrium that the Federal Government maintains with States.²⁷ It is the Federal Government that draws the outer limits in which States can produce corporate statutes. If the matter is too serious to be left to States, or State legislation has upset the market, the Federal Government will intervene.²⁸

5.17  Therefore, Roe’s view is not one of competition, but of subsidiarity. The issue is to identify the level, State or federal, in which the pursued aim can be better achieved. The Federal Government may interfere when the issue can be dealt with at a federal level; ie it is of such importance that requires federal action. This fear of intervention keeps Delaware within certain limits and prevents the enactment of legislation that upsets the balance of interests between managers and shareholders to favour the former.²⁹ This very fine balance keeps State competition alive.³⁰

5.18  Hence safeguarding the interests of managers and directors has not been Delaware’s sole concern. It must be noted though that Congress has been reluctant to intervene save only in extreme circumstances. The 1929 crash led to the enactment of federal legislation on disclosure with regard to securities and their trading.³¹ The 2002 Enron scandal led to the adoption (p. 131) of federal rules on corporate accounting and reporting practices.³² In 2008, Delaware courts abstained from intervening in order to upset J.P. Morgan’s takeover of Bear Stearns which had been brokered by the US Treasury and the Federal Reserve, despite the fact that the takeover was conducted in a way contrary to Delaware law.³³

5.19  Delaware has been very cautious in creating this precious balance that would deter federal intervention and augment its income from franchise fees. Roe’s conclusion is that American corporate law is made on the basis of a triangular model.³⁴ Part of it is directly Washington made and part of it is State made, as a result of a horizontal competition. However, he adds, there are two more categories: corporate governance law which is Delaware-made, ‘with the eye on DC’ and Delaware-made, discretionary. This latter category comprises corporate rules that are ‘neither Washington influenced nor honed in state competition’.³⁵

5.20  In addition to the cautious approach of Delaware, shareholders, who lobby in Washington DC, use their voting power to enhance deterrence.³⁶ The only serious federal reaction has been the Securities Exchange Act 1934 whose broad provisions on shareholding apply to many corporations, which may have no major business in the US,³⁷ as well as the Sarbanes-Oxley Act 2002.

5.21  Therefore, the Federal Government has assumed a Procrustean role. In Greek mythology, Procrustes had a bed on which he invited all passers-by to lie. He would either amputate or stretch his victims depending on whether they were too tall or too short for his bed. Similarly, the Federal Government has a procrustean bed. If State regulation of corporate affairs goes too far or falls short of the necessary requirements, the Federal Government can either restrain it or stretch it, respectively. It should be noted though that no matter how intuitive one may find Roe’s approach, it has been criticized as incomplete to the extent that it fails to explain the reasons for which Delaware has not seized the opportunity to legislate in a way to lead or head off federalization threats.³⁸

(p. 132) 5.22  Although Roe’s theory is not universally endorsed, there have been instances where one can see the merit of his argument. One such instance is actually related to insolvency law, but is very telling of the kind of relations between States and the Federal Government. The work of Professor LoPucki, who attested the existence of forum shopping and a race to the bottom in relation to insolvency, prompted the reaction of Senator John Cornyn of Texas to propose a reform in the Bankruptcy Code that will require companies to file for insolvency in their home State and not in Delaware.³⁹

5.23  Joseph Biden, then Senator of Delaware, responded fiercely in defence of the status quo and refused the existence of a race to the bottom. Relying upon the work of Professors Kenneth Ayotte and David Skeel Jr, he declared that ‘bankruptcy courts do not abuse the venue rules, and companies choose a bankruptcy venue based on the expertise of the court in handling complex reorganizations, not in some sinister effort to game the system on their executives’ behalf’.⁴⁰ He concluded that Congress should not make the mistake of intervening. This debate shows how much fear federal intervention causes for States. However, it is quite another thing to deny the existence of a race to the bottom on the sole basis of this fear.

5.24  All three approaches are to a lesser or greater extent plausible. However, only the second one (race to the top) makes out the crucial point that restraint of interference on behalf of the federal authorities can actually improve the quality of the law. Bearing federalism as the genius of American corporate law in mind, there are several reasons that have allowed Delaware to win the incorporation competition in the US. There are two factors that play a key role in the success of States in regulatory competition: statutory flexibility and judicial quality.⁴¹

5.25  Delaware’s law and judicial system have four characteristics that played a major role in placing it at the lead of the regulatory competition for incorporations. First, its corporate law provisions are not in principle mandatory by nature, which allows for private ordering. Second, its legislature has deferred to case-by-case development of the law by the judiciary, and (p. 133) legislation that is prescriptive or proscriptive is avoided. Third, the enactment of new corporate laws is done in a way to avoid the impairment of pre-existing contractual relationships and expectations. Fourth, Delaware avoids legislative change in the absence of clear and specific practical benefits.⁴² These four components of Delaware’s success will now be presented and briefly analysed.

5.26  In regulating the agency problems between managers and shareholders, States may have recourse to various legal strategies. One of them is related to the nature of corporate rules as rules from which parties can derogate by agreement. Corporate law thus offers a standard form of contract from which parties can deviate only by putting down the points on which they wish to achieve a different bargain. This characteristic facilitates negotiations among parties.⁴³ Not only does it allow parties to negotiate the deal that is best suited for their purposes, but it also provides a regulatory framework that will apply to all matters that the parties did not deal with in their agreement or that parties can choose at the outset.

5.27  Delaware though is a long way from adopting a corporate law which is totally composed by enabling default rules. Whilst some central matters, like economic rights and voting rights of stocks, can be altered by agreement of the parties almost without restraints,⁴⁴ others, such as the fiduciary duties of managers, are mandatory rules of Delaware corporate law from which parties cannot deviate by contract.⁴⁵ The trend in Delaware corporate law has been to keep mandatory rules to the necessary minimum.⁴⁶ In considering the possibility of an abuse of enabling provisions, the Delaware legislature considered that it would be unlikely for corporations to go public with ‘open-ended provisions’, and in any event Delaware courts were well equipped to tackle any problems that could arise.⁴⁷

5.28  A great part of Delaware’s success is owed to its legislature and judiciary. According to Delaware’s constitution, amendments to the Delaware General Corporations Law need a two-thirds majority in the Senate and (p. 134) House of Representatives.⁴⁸ Corporate law production is formally vested with the legislature. However, the latter has been wise enough to allow the Corporate Law Section of the Delaware State Bar Association to draft the relevant bills. Contrary to popular perception, corporate bills are not the product of some lobbyists engaged by corporations whose interests are at stake.⁴⁹ In fact, the Bar Association proceedings are conducted in camera, which implies that the lawyers participating do not reveal the content of the proceedings or discuss it with anyone, including their clients.⁵⁰

5.29  Members of the judiciary do not participate in the proceedings either.⁵¹ The judiciary though plays its own important role in the success of Delaware corporate law. The Delaware Court of Chancery and Supreme Court have accumulated years of experience in corporate litigation. Its members are not elected, as they are in other States, but are drawn from the business law bar and are appointed.⁵² Administration of justice is expedient. Trials take place without juries and punitive damages are prohibited.⁵³ The law is developed on a case-by-case basis. The judiciary takes advantage of the lack of codification of the law to evolve it incrementally. This may lead to what is perceived by some as indeterminacy, but it also allows for a certain degree of flexibility in cases prior decisions turn out to have been unwise.⁵⁴

5.30  Hamermesh writes of the existence of a principle of conservatism in Delaware’s legislative and judicial policy.⁵⁵ According to this principle, Delaware’s legislature and judiciary will not intervene to revise the law unless it is necessary to do so. There is an entrenched belief that the system has worked well so far. Delaware depends on franchise fees and permits corporations to reincorporate in and out of the jurisdiction. These fees actually constitute ‘a public choice bond’ in the sense that they indicate the group of managers and shareholders that will influence the shaping of Delaware corporate law.⁵⁶

(p. 135) 5.31  The fees also play the role of a ‘qualitative bond’.⁵⁷ Delaware thereby commits not to upset the status quo of administration of corporate affairs. This is achieved by generally not upsetting the deals that are brokered by the parties when negotiating and concluding a corporate charter. The legislature also ensures not to alter the law in a manner which is unpredictable or capable of causing entrepreneurs to worry. This provides businessmen with the valuable assurances that Delaware is committed to the non revocation of its beneficial provisions.⁵⁸

5.32  For instance, the extent to which private autonomy can limit the authority of the board of directors is not clear. Section 141(a) of the Delaware General Corporations Law might require revision. However, it is not clear what direction the amendment should follow. Several contradictory proposals have been put forward. The matter has been left to the courts. According to Romano, ‘[o]ne should not expect to see a legislative response on this issue until Delaware courts decide at least one case squarely presenting it, and even then, the preference may well be to let the courts continue to redefine the subject’.⁵⁹

5.33  This principle of conservatism and reluctance to upset established balances is also reflected in Delaware’s abstinence from amending the law in a way to upset or disrupt already existing commercial relationships.⁶⁰ For instance, section 141(c) of the General Corporations Law was amended in 1996 to allow for the board to delegate to a committee the power to set the terms of, and to issue, capital stock. However, this provision would apply only to newly incorporated companies. The rationale behind this limitation was that, especially with regard to closely held firms, parties may have relied on the prior to 1996 version of section 141(c) which prohibited such delegation.⁶¹

5.34  Hamermesh also points out that this unwillingness to upset existing bargains is evident in the legislative synopses that accompany amendments. This synopsis usually describes such amendments as clarifications so that it is clear to the judiciary that the amendment was not meant to alter the meaning of the old statute.⁶²

5.35  It had once been suggested that the increase in the value of the firm’s stock by immigrating to Delaware, as measured by its share prices, could just be correlated to the announcement of a new corporate strategy.⁶³ The counter-argument was made that such an announcement would not be enough per se to have a positive effect on the firm’s stock, if reincorporation in Delaware would have a negative effect on the value of stock.⁶⁴ However, this was not enough to establish the relation between reincorporation in Delaware and increase in firm value.

5.36  Recent empirical research has now shown that incorporation or reincorporation in Delaware when the firm decides to go public tends to improve the value of the firm.⁶⁵ The hypothesis tested by Daines is simple. ‘Delaware law affects firm value. If investors regularly pay more for assets governed by Delaware law, Delaware firms will be worth more.’⁶⁶ This is consistent with the finding that ‘Delaware firms are more likely to receive a takeover bid and to be taken over, controlling for other factors associated with takeover likelihood’.⁶⁷

5.37  This improvement in value (about 2 per cent on average)⁶⁸ is thus achieved for two main reasons. First, Delaware may improve firm value through its specialized corporate courts. Second, Delaware law is less likely to entrench incumbent management due to its takeover legislation, political economy, and specialised corporate courts.⁶⁹ This is made explicit by the significantly more takeover bids that Delaware firms receive in comparison to firms incorporated elsewhere. Simultaneously, Delaware firms are more likely to receive one bid and be acquired.⁷⁰ This finding is consistent (p. 137) with the finding that strong anti-takeover provisions in initial public offering charters do not increase firm value.⁷¹

5.38  The reason seems to be that strong anti-takeover provisions in a corporate charter might allow managers to defend themselves successfully against a takeover that would be beneficial for the shareholders, but not for them. In other words, anti-takeover provisions increase agency costs in a firm.

5.39  States would not compete for corporate charters if they derived no benefit from such competition. There are, however, multiple financial benefits from a successful engagement in regulatory competition. Thus the primary incentive for States to compete in the US market for corporate charters has been the increase in revenue from franchise taxes, ie the taxes that a company will pay to the State in return for the incorporation package and the quality of services the State will provide to the company.

5.40  In 1990 about half of the largest industrial firms as well as the majority of firms listed on Wall Street were incorporated in Delaware.⁷² In 1960 Delaware derived US$9,864,000 from franchise taxes, which amounted to 13.7 per cent of its total revenue. Thirty years later in 1990, Delaware received US$200,201,000 in franchise taxes, which made up 17.7 per cent of its total revenue that year.⁷³ Despite the fact that other States sought to compete with Delaware, in 1990 the States with the second highest revenue from franchise taxes were Pennsylvania and Tennessee, deriving 4.6 per cent of their entire annual income from franchise taxes.⁷⁴ Delaware was clearly at the lead of the race.

5.41  Income from franchise taxes is clearly the strongest incentive. Yet it is not the only one. Delaware’s economic prosperity is also enhanced indirectly. Increased income from franchise taxes can be used to lower taxation on in-state constituents.⁷⁵ Additionally, the concentration of incorporations increases the income of corporate lawyers and law firms, which is of course subject to taxation.⁷⁶ It has been even suggested that the increase of income (p. 138) for lawyers is so big that Delaware increases the likelihood of litigation, thus creating an agency problem between lawyers and shareholders.⁷⁷

5.42  One though may be keen to dispute the bold statement that lawyers earn more in Delaware. It may be true that successful lawyers in Delaware earn higher fees in comparison to successful lawyers appearing before other State courts, but not in comparison with such lawyers appearing before federal courts.⁷⁸ In a sample of 139 shareholder suits (with only 24 suits filed before the Delaware Chancery Court), the average fee awarded in settled cases in Delaware was US$337,000 (11 cases), in comparison with US$126,000 in other State courts (11 cases) and US$1,487,000 in federal courts (34 cases).⁷⁹ This counter-argument though does not rebut the core of the proposition, that success in regulatory competition equals increased income for corporate lawyers.

5.43  As the process of European unification is evolving, it can be plausibly argued that there will be increasing room for regulatory competition. This will depend on the extent to which the European institutions will decide to harmonize corporate law. With regard to this issue, two approaches have been identified; the so-called reflexive harmonization and competitive federalism.⁸⁰

5.44  The first one is ‘a basis for evolutionary selection of rules through mutual learning between national legal systems’ used to describe the European approach.⁸¹ On the contrary, the second term describes the US approach, at least in the way the race-to-the-top scholarship presents it, and signifies (p. 139) the removal of all inter-state mobility barriers ‘in an environment of minimal harmonization of regulatory standards’.⁸²

5.45  The harmonization approach is akin to Roe’s theory. If the thrust of Roe’s argument is that Delaware always keeps an eye open for the potential reaction of Washington, it should apply a fortiori to Europe. It seems that the EU institutions can get engaged with the same material much more easily that the federal authorities in the US. The Commission can always initiate a procedure against a Member State before the ECJ. Cases can reach the ECJ more easily and in greater numbers than they reach the US Supreme Court through the preliminary reference mechanism.

5.46  Member States always examine the compatibility of new legislation with EU law. Whether they will finally adopt a measure which they know to be in contravention of EU law is a separate question. Nonetheless, corporate law comes within the core of freedom of establishment and the Common Market. Consequently, EU institutions are probably less conservative in their interventions than their US counterparts. Perhaps Roe’s theory is more descriptive of Europe than it is of the USA.

5.47  The prospect of a Delaware effect in European company law is not a new topic. It goes at least as far back as the early 1980s. As will be shown immediately following, the debate in Europe is slightly different. The issue is not the nature of regulatory competition, but rather its likelihood of occurrence and its desirability. The nature of the instances of regulatory competition that have been observed are probably best described by Roe’s theory. Member States are aware of the prospect of ‘federal’ intervention by the Commission or the ECJ, more than their US counterparts are. Unlike the US, where Washington plays a more conservative role, in Europe the EU institutions have played a crucial role in bringing about some of the conditions that are necessary for regulatory competition to occur.

5.48  Contrary to popular perception, regulatory competition for corporate charters is not a phenomenon that is unknown in Europe. There was (p. 140) indeed a great deal of corporate mobility in pre-1914 Europe. Two World Wars and the Cold War eradicated all opportunity for cross-border mobility, which requires peace and stability. A brief comparison of European company law and regulatory arbitrage in the years prior to 1914 with the recent developments in the post-Centros state of affairs reveals striking similarities.

5.50  Save for the different dates, one can hardly see any difference between the pre-1914 and the current debate. Both the 1990s and the years prior to the First World War were characterized by a generalized spirit of economic liberalism.

5.51  Several questions arise out of this narrative. First, which factors facilitated regulatory arbitrage in the pre-1914 period? The period between the Franco-Prussian War of 1871 and the outbreak of the First World War in 1914 is characterized by peace between the Great Powers, extended trade between all European nations, technological innovation that improves the life of the middle and upper classes that are still unclouded by income tax, the flourishing of arts, and minimum State intervention in the economy. (p. 141) In fact, it is surprising that the Great Powers went to war with each other despite the impressive volume of trade that was going on amongst them.

5.52  Post-1990s Europe has some of these characteristics as well. The establishment of the European Communities and the European Union has guaranteed the longest lasting peace in Europe. The substantive provisions of the EU Treaties have encouraged intra-EU trade. Several national governments have sought to minimize the role that the State plays in the economy. Technological innovations have improved the lives of the poorer classes in an unprecedented manner.

5.53  Second, what has actually happened to that spirit of liberalism and what happened to regulatory arbitrage? The answer is simple. The First World War changed Europe radically. Recent empirical studies have actually shown that by most measures, European countries ‘were more financially developed in 1913 than in 1980 and only recently have they surpassed their 1913 levels’.⁸⁴ In a seminal article, Rajan and Zingales record that in 1913, France’s stock market capitalization (as a fraction of GDP) was almost twice that of the United States, whereas by 1980, France’s capitalization was almost one-fourth the capitalization in the United States.⁸⁵

5.54  The economic liberalism of the Belle Époque was succeeded by great State interventionism and protectionism, especially during the Great Depression. Maynard Keynes, the architect of the Bretton Woods agreement, is recorded to have said that: ‘[n]ot merely as a feature of the transition but as a permanent arrangement, the plan accords every member government the explicit right to control all capital movements. What used to be heresy is now endorsed as orthodoxy.’⁸⁶

5.55  Rajan and Zingales contrast this statement with:

the general desire of countries after World War I to return to the Gold Standard and thus reduce barriers to capital flow. If openness to trade is, by itself, insufficient to force financial development, then the restrictions on capital movements after WWII can explain why financial markets did not take off even though trade expanded. After all, they recovered rapidly after WWI. Even though the toll taken by the wars was admittedly very different, an important part of the explanation must be that there was no Bretton Woods after World War I endorsing capital controls.⁸⁷

(p. 142) 5.56  Aside from the restrictions on the free flow of capital which is necessary for cross-border corporate mobility, the First World War generated the theory of control in the field of private international law, which was employed by French and English courts in order to seize the assets of companies controlled by enemy aliens.⁸⁸ Instead of applying the incorporation or real seat theory, courts would look at the nationality of shareholders. After the conclusion of the Peace Treaties there was a great deal of controversy among French courts about which choice of law rule was preferable.⁸⁹ Put together, these factors eliminated the wish of business to incorporate companies in other jurisdictions and extinguished regulatory arbitrage.

5.57  Why did it take more than 60 years to see change? The Great Depression, two World Wars, and the Cold War all played a role in delaying the coming of age in which corporate mobility would flourish again. Corporate mobility and regulatory arbitrage require some degree of free capital flow. However, after two World Wars, European governments were required to ‘provide the various kinds of insurance that was increasingly being expected of them by their citizens, especially given the terrible state of post-war government finances’.⁹⁰

5.58  The establishment of the Common Market was critical in providing the assurances that entrepreneurs would need to set up cross-border corporate formations. The guarantee of freedom of establishment in the Treaty and the pro-integration role of the ECJ assisted cross-border mobility. It is thus astonishing to realize that it took about 100 years for Europe to reach exactly the same position as it was in 1900s: the recognition of the freedom of incorporation with an exception for letter-box companies.

5.59  In these very similar conditions, one may reasonably wonder as to the identity of the reasons that encouraged regulatory arbitrage in the years prior to 1914. As evidenced in several French judgments, many French businesses sought to establish corporations in England for the sole reason of benefiting from English company law and avoiding the relevant French provisions on subscription of capital, payment of a quarter of the capital, and the issue and trading of shares.⁹¹

5.60  Nowadays, the TFEU guarantees the free flow of capital and freedom of establishment. Regulatory arbitrage has been prompted so far primarily (p. 143) by minimum capital requirements. One conclusion that can be drawn is that regulatory competition in Europe is rule-specific. As soon as differences amongst European company laws are obliterated in relation to the specific rule in question, then that particular wave of cross-border mobility dies out.

5.61  In examining the details of regulatory competition for minimum capital requirements, it has been argued that there is room for a regulatory competition in Europe,⁹² although this is unlikely to be of the same scale and extent as that in the USA.⁹³ To support their view, they have referred to the enactment of French legislation on SARL⁹⁴ with the effect of abolishing the minimum capital requirement of E7,500 and leaving the settling of the company’s capital at the discretion of the founders (SARL à un euro),⁹⁵ and to the proposal to reduce the minimum capital requirement of the German GmbH,⁹⁶ which has now been enacted. The new GmbH, called Unternehmergesellschaft (hereinafter UG) is not though allowed to distribute its profits until it has consolidated the amount of E25,000, which the minimum capital requirement of the traditional GmbH.⁹⁷ Similar developments have taken place in other European countries, such as The Netherlands and Spain.⁹⁸

5.62  Other countries, like Greece, chose a different path. Article 10(2) of Law 2339/1995 amending article 20(3) of Law 2190/1920 on public limited companies allowed for the first time the board to convene outside the seat, even abroad, if all of its members are present or represented and none has objected to this practice. More recently, article 27 of Law 3604/2007 amending article 20(1)-(2) and (3a) has allowed for a secondary seat, either within or (p. 144) without the jurisdiction, to be included in the articles of association; for board meetings to take place abroad without leave from the competent administrative authority; and for board meetings to take place by means of a teleconference, provided that the articles of association allow it or all of its members have agreed to it.

5.63  Thus, while not abolishing minimum capital requirements, the real seat theory is only partly relaxed. Article 34 of Law 3604/2007 amending article 25 of Law 2190/1920 requires that the general assembly of the shareholders meet at the seat of the company in Greece, if the company’s shares are listed in the Athens Stock Exchange. By contrast, the general assembly may take place abroad if the articles of association so provide or the entirety of the capital with voting rights is represented in the meeting and nobody objects to this practice.

5.64  In this general mood of corporate reform, it appears that dissenting Member States would be unable to react to such a possibility of the Delaware effect.⁹⁹ Unlike the US Supreme Court, the ECJ has virtually prohibited the enactment of rules on pseudo-foreign corporations.¹⁰⁰ Those who agree that regulatory competition will occur, do not however agree on its nature.

5.65  Some have suggested that there might be a case for forum shopping since directors may choose to incorporate in the country that has the most lenient directors’ liability provisions (race to the bottom).¹⁰¹ It has been persuasively argued that regulatory competition should not be viewed as a negative effect but as ‘a significant and beneficial mechanism for the development of European company law’ (race to the top).¹⁰² In any event, there is no jurisdiction in the EU with lax company law and if ever a Member State went down that road, harmonization could prevent this,¹⁰³ or the ECJ would reverse its proportionality balancing in the Gebhard test.

5.66  Last but not least, it has been argued that EU intervention on the matter will be merely procedural.¹⁰⁴ In principle, as Roe’s theory would suggest in the European context, harmonization will ‘seek to influence the process by (p. 145) which national law’ develops, and not the substance of the rules. This will still allow national legislatures to design ‘local level approaches to regulatory problems’ within a framework common to all Member States.¹⁰⁵

5.67  Bearing these observations in mind, it might be possible for a Member State to seek to claim for itself the position of a pan-European Delaware. Relying upon the preceding arguments, English authors have argued that in the post-Inspire Art world, the UK in particular may find incentives to engage in regulatory competition. The latter can be driven in favour of the UK not by tax privileges but by ‘professional services firms facing an increasingly competitive global environment’.¹⁰⁶ It should be stated though that for regulatory competition to exist, there is no need for a State to wish to lead the race. Regulatory competition can begin to exist just by the mere fact that for historic or other reasons businesses prefer the law of a particular State. The explicit desire of a State to lead and win the competition would without doubt enhance the chances of a more rigid and clear competition.

5.68  Armour has forcefully argued that the UK may find it possible to prevail over the Continental jurisdictions, despite the various relaxations of their national laws to which they may proceed by means of defence of the regulatory competition. He has argued that the market-oriented English company law in combination with valuable ‘soft law’ developed by entrepreneurs themselves, like the UK Listing Rules and the City Code on Takeovers and Mergers, may constitute the UK’s spearpoint.¹⁰⁷

5.69  However, one should not neglect the fact that the whole issue of attracting incorporations has so far excluded the big multinational corporations,¹⁰⁸ which choose to incorporate subsidiaries in every single jurisdiction they wish to operate. It may well be the case that such a practice will be continued. However, it may also be the case after Cartesio and the Cross-border Mergers Directive (hereinafter CBM Directive)¹⁰⁹ that even large parent corporations may seek to relocate in more favourable jurisdictions.

(p. 146) 5.70  This attitude towards reincorporations should be distinguished from the possibility of regulatory competition at the start-up level. Incorporating in one favourable jurisdiction in order to activate in another less favourable will probably be an issue for SMEs who will try to make the most out of limited capital and incorporate at the most convenient jurisdiction from the beginning trying thus to avoid the cost of reincorporating at a later stage. Crossing the border and incorporating in the Netherlands or in England and then returning to Germany or the Netherlands respectively may be cheap and easy to do for reasons of geographical proximity.

5.71  Although the UK may find itself attracting incorporations from other jurisdictions, the possibility of a multi-polar regulatory competition is not out of the question. For instance, several countries may be able to attract incorporations on a regional basis. This could happen because of stronger economic and cultural ties that exist between certain countries in the EU. Thus, while one can imagine the UK attracting incorporations from the Netherlands and Germany, it may be the case, for instance, that Finland may be able to attract incorporations from Estonia, or Germany from Austria, or vice versa.

5.72  In this sense, it may be the case that Europe will see the rise of certain jurisdictions that will dominate the market for incorporations on a regional basis by virtue of the strong financial and cultural influence they exercise in their particular region. To this list one should also add the significant role that similar industrial structure and share ownership may play. Whether this will happen in the immediate future is extremely doubtful, as Europe sinks deeper in recession and a deep sovereign debt crisis.

5.73  One should be cautious not to underestimate the various practical problems that the use of a foreign corporate vehicle may involve. Even after the Überseering and Inspire Art case, German courts continue to apply German law with regard to directors’ liability of companies incorporated in other Member States,¹¹⁰ even though the compatibility of such practice with the TFEU is considered doubtful. In any event, this practice increases the risks of using pseudo-foreign corporations in real seat countries.¹¹¹

5.74  It is true that the number of German businesses selecting England as the place of incorporation has increased considerably after the delivery of the (p. 147) judgments in the Überseering and Inspire Art case. On one account German incorporations of limited liability companies increased from about 3,000 in 2003 to about 16,000 in 2006.¹¹² In the meantime though, the German Ministry of Justice has enacted legislation on transparency and disclosure of information concerning corporate governance with the entry into force of the 2002 Corporate Governance Code.¹¹³ The more Germany reforms its corporate legislation, the less likely it becomes that German businesses will wish to use foreign vehicles. In any event, it will be interesting to see what will happen to all these German incorporations in the UK in the post-Cartesio and Services Directive world.

5.75  However, one might think that all the changes that have been made so far in the company laws of various Member States are actually meant to facilitate the start-up of SMEs, rather than to attract incorporations from other Member States. By employing these defensive mechanisms, Member States can compete to prevent companies from leaving, rather than attracting them from elsewhere. This does not preclude the adoption of more aggressive measures. For instance, one of the explicit aims of the Companies Act 2006 was to make English company law more attractive to foreign entrepreneurs.¹¹⁴

5.76  Some commentators have compared the US and the European approaches¹¹⁵ and found no political intention among EU Member States to imitate Delaware.¹¹⁶ This is so because, contrary to Delaware practice, Articles 2(1), 4 and 10(a) of the Council Directive 2008/7¹¹⁷ allow franchise fees, whose imposition was the main incentive of Delaware, to be imposed only by the (p. 148) Member State of the real seat.¹¹⁸ Countries, like the UK, which have arguably the most commercially appealing corporate legislation, have indicated no eagerness to become the Delaware of Europe.¹¹⁹

5.77  The ruling of the ECJ in the Überseering case has not abolished the real seat theory. Despite the fact that the applicability of the real seat theory appears to be subject to the Gebhard test, it is still possible that the law of the real seat may be applied to a corporation. The Cartesio case has confirmed this proposition. This is probably one of the biggest threats to the occurrence of a Delaware effect in European company law.¹²⁰

5.78  What reasons though that make the real seat theory the primary enemy of regulatory competition? The characterization of the real seat theory as an inefficient conflict of laws rule is based on the fact that ‘it precludes ex ante the possibility of using foreign regulations for efficient purposes and leads to an inefficient asset partitioning between creditors.’¹²¹ Once ownership costs outweigh the increase in the costs of credit, the use of a foreign company will become more attractive.¹²² All the real seat theory does is to discourage corporate mobility.

5.79  The prohibition of re-incorporations without prior dissolution by both common and civil law with few exceptions, and the stop of progress of the 14th Directive on the cross-border transfer of the registered office, have made in the recent past the possibility of a Delaware effect in Europe even more remote.¹²³ However, the Cartesio case has clarified that such a prohibition of re-incorporations is contrary to the Treaty. The enactment of the CBM Directive and the SE Regulation, and the possible adoption of the (p. 149) Regulation on the European Private Company might facilitate regulatory competition a lot.¹²⁴

5.80  Although usually contemplated as a choice of law mechanism, the real seat theory is also one of the grounds that establishes jurisdiction within the realm of the Brussels I regulation. The question is whether grounds of jurisdictions, other than the place of incorporation, can have a positive, neutral, or negative effect on the prospect of regulatory competition. Under the current state of the law, the possibility that internal corporate disputes might be litigated in courts of a Member State other than the jurisdiction of incorporation has two main effects.

5.81  First, it grants jurisdiction for all corporate disputes to the court of the Member State in which a letter-box company has its real seat or head office. If the courts of this country are seized first then, all other things being equal, the Member State of incorporation will have to recognize and enforce the judgment in question. More importantly, the judgment might not even require recognition and enforcement at all, as the real seat and perhaps all the assets of the company are within the territorial jurisdiction of the forum. Second, it offers more venues for litigation and thus encourages all interest groups within a firm to look for the forum where they have more prospects of success.

5.82  As far as the first of these consequences is concerned, it is a desirable outcome only to the extent that an anti-letter-box company policy makes sense in itself. It has been demonstrated earlier that for the time being, no fully convincing reason has been advanced to support such a policy. With regard to the second effect, Article 27 Brussels I regulation provides that when several courts enjoy jurisdiction, all other courts should decline jurisdiction in favour of the court first seized, once the latter’s jurisdiction has been established. Thus it is actually impossible to speak of impermissible forum shopping within the context of the Regulation. If a court has jurisdiction under the Regulation and it is seized first that will be normally the end of this inquiry.

5.83  This latter conclusion may appear inequitable to some. However, as the Roman maxim has it, ius civile vigilantibus scriptum est.¹²⁵ The famous jurist of the Late Republic, Quintus Mucius Scaevola (c 159–88 BC), asked the question whether a creditor, who had recovered a debt from his debtor, before the latter’s property was sold, should be liable to repay the amount he received. Scaevola responded that the man who has watched over his interests and has (p. 150) improved his condition should not be liable. The reason is that the civil law is written for those who are diligent in protecting their rights.

5.84  Similarly, why should a minority shareholder be prevented from enforcing the judgment that he or she managed to obtain first in courts of the real seat? After all, why should he or she be required to sue to in the courts of the Member State of incorporation, only to find out that there is no asset against which the judgment can be enforced, and thus require him or her to incur the extra cost of recognition and enforcement abroad?

5.85  Nonetheless, it is still debatable whether corporate law would benefit from such a solution. Would the possibility of by-passing the courts of the Member State of incorporation discourage regulatory competition for corporate law? This is a hard question with no clear answer. Perhaps the right way to look at this is that the danger to regulatory competition does not come from the real seat theory as grounds of jurisdiction, but as a choice of law mechanism.

5.86  If it is then desirable to facilitate regulatory competition for corporate law through harmonizing national private international law, why should one prefer the place of incorporation as a connecting factor over the real seat? Legal certainty is probably one of the reasons. However, there are criteria that enable courts to identify the location of the real seat. Additionally, a universal acceptance of the real seat theory would have the benefit of a simple solution to the issue of letter-box companies and most probably the bundling of company, tax, and insolvency law. This should definitely tidy up the existing mess.

5.87  The real problem that such a solution entails is that a company that wishes to change the law governing its internal affairs would have to move both its registered office and the real seat to another country, which is considerably more costly than the transfer of the registered office. If the 14th Directive is ever to be adopted, the Commission should think carefully about the new dynamics it will release into the field of private international law. The public consultation process indicated that ‘registration in the host Member State should result in the company losing its legal personality and being removed from the register in its home Member State’.¹²⁶ The consultation process showed that 99 interviewees out of 127 agreed or completely agreed with this proposition, whereas only 24 disagreed or completely disagreed.

5.88  Undoubtedly, if the 14th Directive is ever adopted it will constitute a step in the direction of the universal acceptance of the incorporation theory. (p. 151) It may turn out that a reasonable outcome resulting from the balancing of all the preceding considerations would be the universal acceptance of the incorporation theory, and perhaps, the exceptional application of the law of the forum in relation to letter-box companies and other corporate schemes that are considered abusive.

5.89  For the time being, the courts applying the real seat theory should keep an eye on the European institutions and be mindful of the possibility of EU intervention that will harmonize private international law rules in this field. Expressing this point in Roe’s term, the more inequitable or harsh the outcomes reached by national courts are the more likely it is that EU intervention will be triggered.

5.90  In addition to the aforementioned objections and obstacles to the possibility of regulatory competition for corporate charters in Europe, it is necessary to examine the consequences of imposing restrictions on letter-box companies, via either a re-interpretation of the abuse doctrine or the implementation of the Services Directive after 28 December 2009. These concerns could not have been raised in earlier literature as the ruling in the Cadbury Schweppes case had not been delivered and the enactment of the Services Directive had not taken place yet.

5.91  It has to be seen whether these changes will affect regulatory competition for corporate charters in Europe. So far in post-Centros Europe letter-box companies have been the main vehicle for regulatory competition. For example, German businessmen who wished to avoid the rigid provisions of German corporate law would incorporate an English limited liability company and use it to do business in Germany.¹²⁷

5.92  The Cartesio case has made it clear that the real seat theory may be applied to any company subject to the condition that the law applicable to the merits—in this case, German law—will not lead to a result that constitutes a breach of freedom of establishment. Additionally, both the doctrine of abuse has been revisited in the Cadbury Schweppes case and the notion of establishment has been defined by the Services Directive in a way to make the benefits of freedom of establishment less readily available to letter-box companies. This might have the consequence that for such companies the real seat theory may be applied on certain occasions without even having regard to the consequences of its application.

(p. 152) 5.93  Assuming for present purposes that this is going to be the way that the relevant law will be interpreted, there will be only one way out for the corporations in question. They will have to elevate their presence in the jurisdiction of incorporation from a mere letter-box to a place where a real economic activity is actually pursued. In doing so, it may be the case that some head office functions will have to be carried out at the registered office, or that the registered office performs the duties of a branch of the corporation in the jurisdiction of incorporation. This elevation of a mere letter-box to a place where an actual economic activity is pursued may also be determinative of the centre of main interests, as the Court has indicated in the Eurofood case.¹²⁸

5.94  It can be easily imagined that a lot of SMEs will have to take relocation to the country of their real seat into serious consideration. This might not be the case as Germany has now abolished the minimum capital requirement for private companies and thus migration for this reason may decrease in numbers. However, the argument made here is that in the future there might be another reason, which may not be foreseeable now, which would make immigration more attractive. In such a case, it may well be the case that the financial consequences of preserving an establishment instead of a mere letter-box in the country of incorporation would be too tough to bear for many SMEs. This does not mean that regulatory competition will be out of the picture. However, it will be severely obstructed as SMEs will find it more expensive to preserve a registered office in the jurisdiction of incorporation. This is perhaps a reason for which regulatory competition is likely to be associated more with larger companies.

5.95  Last but not least, it is not clear whether such an interpretation of the abuse doctrine, as proposed by AG Maduro, would actually make sense. After the Centros case it is clear that the abuse doctrine may be applied to corporations that are, in the Court’s terms, ‘wholly artificial arrangements’. However, what is the necessity of this restriction if the relevant stakeholders, especially the creditors, can be protected under the law applicable to insolvency prescribed by the Insolvency Regulation?

5.96  Several legal systems choose to protect creditors in different ways. Creditor protection can be effected both through insolvency and corporate law. Rules on minimum capital requirements, restrictions on payments out to shareholders, rules on actions that must be taken following serious depletion of capital are all part of corporate law.¹²⁹ At the other end, each (p. 153) legal system selects governance strategies¹³⁰ that apply to a corporation during the period of transition to insolvency and to the control of firms in insolvency.¹³¹ These strategies usually form part of insolvency law.

5.97  Indeed, the Court itself in the Centros case, and AG Maduro in the Cartesio case have made it clear that incorporation in another Member State for the mere purpose of evading minimum capital requirements does not constitute abuse. By positioning its registered office and centre of main interests in a different Member State, a company may be able to select a debtor-friendly national corporate law and the least creditor-friendly national insolvency law.¹³² Thus far there is nothing in the judgments of the ECJ to indicate that this could be an impermissible construction.

5.98  There is one last point to be made here. In order to position the centre of main interests at a location different to that of the place of incorporation, companies will frequently seek to set up a branch in the Member State in which they wish to have their headquarters and carry on business from there. Establishing a branch is in itself a costly procedure.¹³³ Empirical research has demonstrated that the use of ‘UK Ltd’ in another Member State by setting up a branch may cost from E551 and 5 weeks in Ireland to E5,007 and 7.5 weeks in Italy.¹³⁴ Not surprisingly, bureaucracy and translation requirements increase the cost of the use of Centros-like Ltds in other Member States.¹³⁵ Thus it has been argued that major steps remain to be made, such as the revision of the 11th Directive,¹³⁶ so as to eliminate the obstacles imposed to freedom of establishment by bureaucracy.¹³⁷

5.99  There is another factor that influences regulatory competition in Europe more than it does in the US and which plays a significant role in corporate (p. 154) mobility in Europe. In Europe corporate tax is due at the place of central management and control. The latter does not have to correspond to the registered office, but it may be the case that companies incorporated in a jurisdiction are also thought to be tax-resident there. Indeed this is the case in the UK.¹³⁸

5.100  Therefore, it may be possible that a heavy taxation regime can discourage companies from incorporating in a specific jurisdiction, despite the fact that its company law regime could be otherwise very appealing. Simultaneously, such a regime can also discourage companies already incorporated within the jurisdiction to move out, eg by means of a cross-border merger. For instance, the latter can be effected through the application of exit charges that a company should pay before moving its tax residence out of the jurisdiction. There is a very persuasive argument that such charges are contrary to freedom of establishment.¹³⁹

5.101  Taxation poses a great deal of complexity at the level of regulatory competition. For present purposes, suffice it to say that there have been instances were tax has acted as a deterrent to incorporate in a particular jurisdiction. In the UK this has happened twice; in 1988–1993, and in 2008.¹⁴⁰ The first exodus is relevant here. The second was motivated primarily by the wish to avoid UK taxation, and company law considerations were not involved at all.¹⁴¹

5.102  Soon after the delivery of the ruling in the Daily Mail case and subject to pressure from other European Governments, the UK introduced the Finance Act 1988. According to s 61(1), ‘a company which is incorporated in the United Kingdom shall be regarded for the purposes of the Taxes Acts as resident there’. Until that point many companies had avoided paying corporate tax in the UK by the mere fact that their central management and control was located overseas despite the fact that they had been incorporated in the UK. This had led many European Governments to protest to the UK Government for this tax evasion. As a result, the Finance Act 1988 was introduced and several companies fled the UK between the years 1988–1993 by means of reincorporation authorized by private acts of Parliament.

5.103  Several of these companies shared certain common characteristics. They had been incorporated in England at the end of the nineteenth century and (p. 155) the beginning of the twentieth. They had done so for a variety of reasons. Among other things, they wished to be subject to English company law, which at that point was thought to be more flexible and developed than the company laws of the place they wished to activate. Several of these companies were actually running businesses in parts of the world where the local laws were considered unsuitable for the purposes of conducting business in a modern and efficient manner.

5.104  Another significant reason was the wish to list their shares on the London Stock Exchange, which at that time, was beyond doubt the most developed stock market in the world with the biggest volume of transactions. They also wished to be able to raise capital in debt from credit institutions established in London. All of these companies had just their registered office in London. Their central management and control, ie the place where the board of directors holds its meetings,¹⁴² had always been overseas. Thus they had never been subject to UK tax.

5.105  By 1988, the considerations that had warranted incorporation in the UK almost century ago had more or less disappeared. The possibility of becoming liable to UK taxation was a huge deterrent to remain incorporated in the UK. Thus they sought and managed to obtain the necessary private acts of Parliament that allowed them to exit the UK without dissolution. The law as it stands now allows for companies that have their registered office in the UK, but their central management and control is exercised abroad, to pay corporate tax only to one of the two jurisdictions, provided that a double tax treaty with a tie-breaker has been concluded between the UK and that other country. In such a case, a company is liable to tax only in the country of effective management.¹⁴³

5.106  This shows that countries like the UK, which, unlike most of its European counterparts, taxes worldwide profits, as opposed to profits realized within the jurisdiction, will have serious problems in attracting incorporations. Several entrepreneurs may be discouraged from incorporating in the UK because that could make them potentially liable to UK tax. This fear is alleviated to a certain extent by the existence of double tax avoidance treaties which provide for the aforementioned tie-breakers. Nonetheless, it is clear that tax can potentially nullify the company law incentives to incorporate in a specific jurisdiction.

5.107  Part II has sought to demonstrate the influence that freedom of establishment had on private international law for corporate affairs. It has demonstrated the reasons for which, contrary to what many have thought, the real seat theory is not contrary to freedom of establishment. It has also demonstrated the way in which the Services Directive and the refinement of the doctrine of abuse can restrict the use of letter-box companies. The possibility of a regulatory competition to attract incorporations is not eliminated. An analogy with the regulatory competition for corporate charters in the USA depicts all the reasons for which an analogous competition could and could not take place in the EU. In any event, it appears likely that those who have predicted a ‘sea of free reincorporations’¹⁴⁴ may have to reconsider the unconditional nature of this statement.