"Does the European Company Provide an Opportunity for
Jurisdictional Competition and is this/would this be Desirable?"
Edward A. Storey III
E-mail: estoreyiii@aol.com
December 10, 2002
Essay LLC Company Law 2002
Leiden University, The Netherlands
TABLE OF CONTENTS
INTRODUCTION
I. EU CONFLICT OF LAW
II. THE ECS: OPENING THE DOOR TO JURISDICTIONAL COMPETITION?
III. A "RACE TO THE BOTTOM" OR A "RACE TO THE TOP"?
IV. THE DENMARK EFFECT?
V. A STEP IN THE RIGHT DIRECTION?
VI. CONCLUSION
INTRODUCTION
After 30 long, negotiation-filled years, the Societas Europaea (SE) is finally a reality. Beginning in 2004, European corporations will finally have the opportunity to employ the SE as a new corporate form and enjoy the benefits it professes to provide. In particular, SE’s can benefit from cross border migration, cross border mergers, and reduced administrative costs through the consolidation of diffused companies; advantages historically granted to United States (U.S.) companies, but previously denied to European corporations. In light of these benefits, many view the recent passage of the European Company Statute (ECS), Council Regulation No. 2157/2001, and its counterpart, Council Directive 2001/86/EC, as a long-awaited victory for proponents of a single, integrated European market.
This victory, however, has come at a price. The adopted version of the ECS is a far cry from the all-encompassing body of corporate law envisioned by the original drafters. Instead of a comprehensive body of legislation resulting in the harmonization of European corporate law, the ECS merely creates a skeletal framework for which member states are intended to fill in the gaps. Many provisions within the ECS provide opportunities for legislative variance, while other major issues, such as taxation, insolvency, and intellectual property rights, have been left out of the ECS completely, falling prey to the negotiation process of the EU.
Despite its apparent shortcomings, proponents insist that any victory, no matter how tainted, is still a step in the right direction. Detractors, however, claim that this patchwork version of the ECS permits the one thing that the original drafters tried hardest to prevent: jurisdictional competition. By failing to harmonize all areas, they argue, the ECS will creates a competitive rulemaking atmosphere that encourages companies to seek out the most favorable jurisdiction, essentially creating the opportunity for a "race to the bottom" within the European community. Detractors often cite to the U.S. experience in which the state of Delaware has become the preferred state of incorporation for most U.S. companies, termed the "Delaware effect", as a prime example of the perverse effects such an atmosphere would create.
Many questions naturally result from this debate. Does the ECS create an opportunity for jurisdictional competition? Will the EU experience the same sort of "race to the bottom" as the U.S.? If so, is this a bad result?
It is against this backdrop in which this paper explores the ECS and jurisdictional competition. Broken into 6 sections, this paper argues that jurisdictional competition is an inevitable consequence of incomplete legislation, as embodied by the ECS. However, this paper insists that the U.S. does not provide an appropriate model for the EU and that, even if such competition occurs, a number of benefits will be derived from such competition. Section I begins by examining the status of EU conflict of laws prior to the ECS. Next, section II outlines the ECS and the opportunity for jurisdictional competition. Section III reviews the U.S. experience and the "race to the bottom" debate. Section IV argues that the U.S. is not an appropriate model for the EU. Finally, Section V discusses possible benefits and Section VI concludes.
I. EU CONFLICT OF LAWS
To understand why detractors are so concerned about jurisdictional competition, it is first necessary to review the differences between the conflicting systems of conflict of laws within the European Union (EU). In the U.S., company law is a matter of state sovereignty. Pursuant to traditional U.S. choice of law rules, the internal affairs of a corporation are governed solely by the laws of the state in which it was formally incorporated. This is true regardless of whether or not the business actually conducts any business within that state. Further, if it chooses to do so, a company may, with little expense, change the laws governing its internal affairs by simply reincorporating within another state.
Member states within the EU also consider company law a matter of national sovereignty. However, these states are divided into two lines of thought concerning conflict of law legislation. A minority of states, including the Netherlands, the UK, Ireland, and Denmark, subscribe to the incorporation theory, while the remaining member states subscribe to the theory of siege reel, or real seat theory.
Similar to the U.S. system, member states that subscribe to the incorporation theory will recognize any corporation that has been lawfully incorporated within another Member State’s jurisdiction, regardless of where the company locates its principle place of business. Therefore, "a company can carry on business in one Member State while being incorporated in another. The company laws of the latter will prevail."
In contrast, member states that follow the real seat theory require the internal affairs of a corporation to be governed by the laws of the state in which the company has placed its "real seat." In other words, real seat theorists will not recognize a company as a legal entity unless the company’s "real seat" is located in the same jurisdiction as its place of incorporation. Therefore, under this theory, a company that transfers its real seat will not be recognized unless it reincorporates within the jurisdiction to which it has moved. Unlike the U.S., however, European companies cannot simply reincorporate into another jurisdiction. A change in governing Member State law cannot be accomplished without winding up or liquidating the business first. Clearly, this procedural requirement places a severe restriction on the movement of corporations and often, "[t]he advantages conferred by a company transfer to more favorable company laws in a neighboring jurisdiction are likely to be outweighed by the costs associated with winding up."
From an American perspective, this restriction makes little sense. Americans will argue that one of the prerequisites to a common market must be the mutual recognition of each member state’s company law, which the real seat theory effectively prevents. Proponents of the real seat theory insist, however, that this system is beneficial because the country in which the real seat is located is guaranteed to exercise effective governmental and judicial control over corporations conducting business within their borders. In particular, member states with stricter, more conservative corporate laws, such as Germany’s co-determination laws or mitbestimmung, argue that the real seat prevents the avoidance and eventual dilution of these laws by pseudo-foreign companies that incorporate elsewhere. "Indeed, real seat theory’s chief virtue lies in the fact that, by design, it prevents regulatory competition often associated with a ‘race to the bottom.’"
For the most part, it was these member states that pushed for harmonization of European corporate law. They believed that a harmonization program would create a level playing field for all countries involved and, at the same time, prevent a "race to the bottom" from occurring. Ironically, instead of precluding a "race to the bottom," the recent passage of the ECS has seriously undermined the protections granted by the real seat and, in fact, may have provided the catalyst for such a race to begin.
II. THE ECS: OPENING THE DOOR TO JURISDICTIONAL COMPETITION?
Two fundamental requirements must be met before a "race to the bottom" can occur: (1) management must have an incentive to choose the corporate law of one jurisdiction over another and (2) management must have the ability to exploit these variances through corporate migration. In the U.S., such exploitation is possible because (1) corporate law differs greatly between states and (2) U.S. companies may incorporate or reincorporate anywhere within the U.S. without losing corporate status. In comparison, European companies have historically been unable to participate in a "race to the bottom" because of the limitations placed on corporate migration. In particular, migration has been heavily restrained due to the limitations imposed by real seat member states and because reincorporating requires a company to go through the process of liquidating operations in the Member State from which the company is moving. "[A]lthough companies had the incentive to migrate, legal barriers prevented their interstate movement."
Originally, the ECS was intended to reverse this dichotomy. The original drafters of both the Treaty of Rome and the ECS viewed the freedom of movement as one of the essential elements to the creation of a common market. However, the drafters were also wary of a possible "race to the bottom." To avoid this possibility, "the ECS envisaged a supra-national company completely independent of the national laws of the [Member States]." Through the harmonization of corporate law, the drafters endeavored to facilitate corporate migration and remove the incentives for jurisdictional exploitation at the same time. In effect, the ECS intended to offset the possible negative affects of the freedom of movement by promulgating an autonomous body of corporate law.
While the ECS succeeded in facilitating corporate freedom of movement, the gaping holes left by the 30-year negotiation process has failed miserably to achieve harmonization. Pursuant to Article 8 of the ECS, "[t]he registered office of an SE may be transferred to another Member State." Further, "such a transfer shall not result in the winding up of the SE or in the creation of a new legal person." Therefore, European companies that choose to employ the SE form may now re-incorporate freely to anywhere within the European Community. This freedom, however, is not without limitation. Pursuant to Article 7, "[t]he registered office of an SE shall be located within the Community, in the same Member State as its head office." Thus, reincorporating must be made in conjunction with a transfer of the SE’s head office, or vice versa. This pseudo-real seat compromise provides some form of protectionism for member states, but the shortcomings of the harmonization process has done little to prevent the possibility of a "race to the bottom."
"Unlike the original proposal for a European Company, which would have regulated virtually all aspects of law related to SE’s, the [ECS] only harmonises limited aspects of the law." The preamble to the ECS itself admits to its deficiencies: "This regulation does not cover other areas of law such as taxation, competition, intellectual property, or insolvency. The provisions of the Member States’ law and of Community law are therefore applicable in the above areas and in other areas not covered by this regulation." Moreover, many provisions within the ECS explicitly allow for corporate law variance by Member States. A complete examination of the all areas in which variance may occur is well beyond the scope of this paper. However, a quick review of the ECS resulted in the observance of at least 20 provisions that state, "a Member State may" adopt or provide additional legislation. This form of "opt-in" legislation is guaranteed to produce wide legislative variations between the Member States and, combined with the freedom of movement, will inevitably result in some level of regulatory competition between Member States.
In the foregoing analysis, much of the debate over regulatory competition was based on the assumption that, without complete harmonization, companies will naturally migrate to those states with the most favorable laws. Consequently, Member states will be forced to compete in a "race to the bottom," resulting in the gradual lowering of corporate standards throughout the EU. But is this a realistic assumption? Does regulatory competition ultimately lead to a "race to the bottom," or is this talk of a "race to the bottom" just a form of political lip service used to preserve protectionist measures?
"The term ‘regulatory competition’ refers to a process whereby legal rules are selected (and de-selected) through competition between decentralized, rule-making entities (which could be nation states or other units such as regions or localities)." The most notable example of regulatory competition has been that of the U.S. and the so-called "Delaware effect."
As stated earlier, U.S. conflict of laws allows companies to incorporate and reincorporate anywhere within the U.S., thus providing an incentive for companies to search for those jurisdictions with the most favorable corporate laws. Likewise, however, states are also given an incentive to promulgate laws that attract incorporations within their jurisdiction. "Incorporations yield franchise tax and fee revenues and also provide patronage for local law firms, corporation service companies, and other businesses." "Such franchise taxes can represent a potentially enormous source of revenue to a state with a small fiscal base."
Over the past century, the state of Delaware has overwhelmingly become the most popular jurisdiction in which companies formally incorporate. "As of 1996, Delaware accounted for 56% of all corporations listed on major stock exchanges and 62% of New York Stock Exchange corporations." Why Delaware has become so dominant has become one of the most hotly debated topics of the past quarter century.
Leading the debate, Professor William Cary, who coined the phrase "race to the bottom" in his seminal article Federalism and Corporate Law: Reflections upon Delaware, suggests that the aforementioned tax revenue incentive has given rise to a situation in which states are encouraged to compete against one another for corporate charters. Cary argues that Delaware’s pre-eminence is a direct result of its propensity to adopt legislation that is most favorable to corporate management, but detrimental to shareholder interest. Consequently, Delaware is leading a "race to the bottom" in an effort to attract lucrative corporate charters and thus, "contributing to the deterioration of corporate standards" within the U.S. To prevent the continuation of this process, Cary proposes that the U.S. adopt federal legislation containing corporate minimum standards.
Despite the reasonable logic behind Cary’s assertions, "Cary’s skeptical view of state competition has not been widely accepted by corporate law scholars." Some proponents of regulatory competition, such as Ralph Winter, have challenged Cary’s thesis, arguing that market forces would eventually deter managers from selecting jurisdictions that promulgate laws adverse to shareholder interests. If managers choose ineffective jurisdictions, he argues, stock prices for these companies would drop in value, reflecting abuse by managers towards shareholders. Lower prices, in turn, would make these companies susceptible to take over bids. "A bidder could take advantage of the situation, take over the corporation at a discount price and add value by reincorporating in a jurisdiction with an optimal legal framework." In such a situation, managers would be at risk to lose their jobs. Therefore, it is in management best interests to conscientiously avoid these jurisdictions in favor of jurisdictions designed to maximize shareholder value.
On this basis, Winter views Delaware’s emergence to be a byproduct of its ability to promulgate laws that most effectively balance the interests of both shareholders and managers, and not just management. Thus, regulatory competition does not create a "race to the bottom," but a "race to the top." Even Cary admits that regulatory competition has "effected simplification and flexibility and [has] eliminated unnecessary and vestigial procedures." Accordingly, the competitive process that has occurred should not be viewed as a gradual deterioration of corporate standards, but as a constant weeding out of corporate law inefficiencies.
In response to these conflicting claims, a number of commentators have performed empirical studies to determine if shareholders are in fact disadvantaged by re-incorporation into Delaware. Results to these studies have been anything but consistent. Two of the most popular studies found that, on average, companies that reincorporate resulted in "significant positive abnormal returns" for shareholders. Conversely, other studies have questioned these results, finding the empirical evidence to be, at best, unclear. In any case, however, "no empirical evidence that would suggest re-incorporation in Delaware had a negative effect on stock prices has ever been found."
While this lack of negative evidence seemingly favors Winter’s view on regulatory competition, it does little to explain Delaware’s continued dominance. To explain this phenomenon, Romano has advanced various lines of reasoning. First, Romano argues that Delaware’s heavy reliance on incorporations, in the form of tax revenues and income for local corporate services, offers businesses a guarantee that Delaware will remain responsive to corporate needs. In effect, Delaware’s financial need to remain at the top will perpetuate its supremacy. Second, the procedural restrictions imposed on Delaware’s corporate code provide a high level of corporate law stability. A change in Delaware’s code requires a two-thirds vote of both houses of the state legislature. Thus, it is very unlikely that any major changes to Delaware’s code will happen in the future. This is desirable to corporations because it ensures that the laws governing its internal affairs will "be no worse that it was at the time of incorporation." Finally, the Delaware judiciary has been able to develop into a leading authority on U.S. corporate law as a direct result of the pre-eminence of Delaware as the state-of-choice for incorporations. "The most important selling point of the product of Delaware General Corporation Law is probably its experienced judiciary that has over the years produced an impressive body of case law that tends to make Delaware law comparatively predictable." In fact, Delaware courts are so highly regarded that its decisions are often viewed as precedence for other jurisdictions. In Romano’s view, all three of these factors represent positive byproducts of regulatory competition.
In the end, whether the "Delaware Effect" has resulted in a process of corporate law degradation or of corporate law refinement within the U.S. remains unanswered. From a European perspective, however, a review of the American experience is necessary, for a better understanding of the "race to the bottom" debate. But, does the U.S. provide an appropriate model for the EU? In other words, will regulatory competition produce similar effects?
IV. THE "DENMARK EFFECT"?
According to a number of critics, the lack of harmonization provided by the ECS leaves Member States with little choice but to join the "race to the bottom" or be left behind. Correspondingly, Member States will be forced to follow in the footsteps of their American state counterparts and watch their traditional (presumably higher) corporate standards slowly disintegrate. But, is this truly the case? Logically speaking, the EU can only replicate the U.S. experience if all things are considered equal. In other words, the assumption that the EU is destined to repeat the U.S.’s "Delaware Effect" can only be true if the internal situations of the U.S. and the EU are comparable. However, a comparative examination clearly demonstrates that this is not a legitimate assumption. Many barriers currently exist within the EU that were not present in the U.S. during Delaware’s rise to prominence.
First and foremost, the revenue incentive provided to U.S. states through the imposition of franchise taxes, considered to be the principle motive behind a "race to the bottom," does not exist within the EU. In Delaware, revenues collected from franchise taxes constitute a rather large percentage of Delaware’s total tax base. "In 1998, franchise taxes accounted for 19% of all taxes collected in Delaware, a figure mounting to over $396 million." As such, the desire to retain franchise tax revenues significantly influences local and state legislation.
Conversely, Member States within the EU do not levy franchise taxes upon incorporation. Instead, Member States typically charge only a small filing fee, covering the costs of registration. "Only a few Member States, most notably Belgium, Italy, and Spain, charge a duty of up to 1% of the company’s capital upon incorporation. Even these charges, however, are unlikely to produce significant revenues for Member States. Thus, Member States will not have sufficient financial incentive to modify their long-standing, national corporate standards without considerably increasing their tax revenue possibilities.
Such an increase, however, is unlikely to occur. In fact, EU legislation may explicitly prohibit Member States from engaging in such behavior. Pursuant to Directive 69/335/EEC, Member States are prohibited from raising capital through the indirect taxation of certain transaction, such as company formation. Member States are permitted to charge fees. "The fees, however, can only be charged in an amount that covers the (actual or typical) costs of a certain transaction." Therefore, it is in fact illegal for Member States to utilize profit-making tax schemes similar to those employed by Delaware. This lack of financial incentive presents a serious blow to those that argue a full-blown "race to the bottom" is inevitable.
Secondly, unlike the U.S., which is composed (relatively speaking) of 50 homogeneous states that share a common culture and language, the EU consists of 15 – soon to be 20- Member States and eleven official languages. Moreover, each Member State represents a completely different national identity for which their citizens take great pride. Therefore, these differences in cultures, customs and languages each represent formidable obstacles to development of pseudo-foreign incorporations.
Related to this problem, the differing legal systems that exist within the EU, i.e. common law system versus civil law system, may also discourage potential re-incorporations. Unsurprisingly, managers are wary about being subjected to unfamiliar laws. How can managers successfully run a business if they cannot understand the laws and legal procedures applicable to the company itself? Secondly, working within two legal systems necessitates the employment of both foreign and domestic council, which can greatly increase costs. "The problem is exacerbated by the fact that England – the likely place of incorporation in a world without transaction costs – is also Europe’s most expensive legal market."
Finally, and possibly most importantly, a "race to the bottom" is less likely to occur within the EU because of the difference in political environment. It is important to note that, though Delaware attracts the most incorporations, few companies actually locate their business within Delaware’s borders. Instead, much of Delaware’s economy depends on the business derived from instate incorporations. "The incorporation of businesses is a source of revenue, not only from taxation but also from the service activities it involves (local agents, legal advice, etc.)." As such, a number of commentators, beginning with Cary, have noted that the Delaware phenomenon is not only a byproduct of increased tax revenues, but also of the political influence exerted by interest groups determined not to surrender Delaware’s lead. Strong lobby groups, such as the Delaware corporate bar, place constant pressure on state legislatures to maintain a body of law that promotes their interests. Their efforts have been successful, in large part due to the lack of countervailing lobby groups. Unlike Delaware, however, Member States economies are much more diverse. Legislators are forced to balance the interests of a wide variety of interest groups. Presumably, this diversity will diminish the amount of influence any one interest group can exert. Thus, Member States will feel less pressure to satisfy those that would benefit most from increased incorporations.
In light of the significant internal differences between the U.S. and the EU, assumptions that regulatory competition will have the same effects can be dismissed as an oversimplification. Granted, numerous similarities also exist, making the U.S the most reasonable model for which to make predictions, but many other factors need to be considered.
V. A STEP IN THE RIGHT DIRECTION?
Since the passage of the ECS, numerous European scholars and commentators have spent massive amounts of time and effort declaring, over and over, that the ECS has failed in its purpose and predicting the forthcoming apocalypse of European corporate law. All too often, these commentators are quick to herald the negatives of regulatory competition and the dreaded "Delaware Effect," but few speak of the positive aspects of regulatory competition. As noted above, U.S. regulatory competition has produced a number of positive byproducts, such as a more flexible and efficient body of corporate law, reduced barriers, easier access to courts, corporate law predictability and a specialized judiciary. Similarly, the EU is likely to profit from these, and other, competition-induced benefits.
One major benefit regulatory competition will have in the EU is increased innovation, something that has been markedly lacking in real seat Member states. "[R]egulatory competition between the different states in America has, over the course of the 20th century, proved to be a steady source of innovation in corporate law – as it should be expected from a competitive process." In comparison, real seat Member States have deliberately avoided competition, leading to stagnate and out-dated legislation. Consequently, businesses within these countries were forced work within these rules, and were unable to maximize their potential. Without infusing competition, "we [would] probably continue to see living fossils of corporate law in the European Union." Instead, the freedom to migrate company incorporations under the ECS will allow companies to choose jurisdictions that best suit their needs and consequently, increase their profits.
Also, the unique atmosphere of the EU may present opportunities for benefits not seen within the U.S.. For example, the EU may develop a more shareholder-friendly environment. In his "race to the bottom" argument, Cary presupposed that management made incorporation decisions and not the shareholders. Therefore, jurisdictions would place a pro-management tilt on their corporate laws, probably at the expense of shareholders. In Europe, however, shareholders often possess more control than their American counterparts. For example, in the UK, it only takes 5 % of the shareholders to call a general meeting at which the director may be dismissed by a majority vote. The ECS only requires a maximum of 10% of the shareholders. American corporate laws, on the other hand, grant far greater protection to directors from disgruntled shareholder action. Therefore, realizing that shareholders wield greater power to influence management decisions, such as where to incorporate, Member States will be under pressure to develop legislation more favorable to shareholders.
Thus, while a discussion on the potential effects of regulatory competition is bound to be speculative in nature, it would be irresponsible to dwell on only the negatives.
VI. CONCLUSION
The recent passage of the ECS has undoubtedly changed the face of European corporate law forever. However, only the future will reveal whether it has been changed for better or for worse. Until then, commentators and scholars are forced to try and predict the future, with cheerleaders lining up on both sides of the debate. One the one hand, proponents of the ECS view its passage as another step towards European integration and the establishment of a common market. Critics, however, only see failure. They view the lack of complete harmonization as a gaping corporate loophole that will create jurisdictional competition between Member States. Further, as evidenced by the U.S. and the "Delaware Effect," this competition will ultimately result in a "race to the bottom" and the degradation of European Corporate laws.
These critics are short sighted. While they may be correct in that the ECS is destined to create some form of jurisdictional competition between the Member States, this competition will not, per se, result in a "race to the bottom." The fundamental differences that exist between the EU and the U.S. will prevent the EU from replicating the Delaware effect. In fact, the results of jurisdictional competition in the EU may even change the minds of critics who view "competition" as a dirty word. Only time will tell whether the ECS will shed light on the potential benefits of a competitive corporate atmosphere in the EU.