August 18, 2010
Bob Lawless on Manesh on Delaware and the Market for LLC Law
Posted by Bob Lawless

With one of his first articles, Professor Mohsen Manesh has boldly waded into a deep academic debate about the nature of regulatory competition for organization charters. There are a number of things I like about this paper, especially Manesh's instinct to look for empirical evidence. My advice for junior scholars is generally to think big, but write small. On balance, I found myself wishing this paper was smaller--not shorter, but smaller.

To understand Manesh's paper requires a background in the literature. In 2001, Marcel Kahan and Ehud Kamar published Price Discrimination in the Market for Corporate Law (Cornell L. Rev., vol. 86, p. 1257) and examined Delaware's fees and franchise taxes on corporations. I distinctly remember reading a working draft of the article over a stout while sitting in a pub during a business trip. Both the stout and the paper were excellent. Kahan and Kamar found that Delaware was able to charge a premium for the privilege of a Delaware incorporation. More controversially, they found that Delaware price discriminated by charging a higher price to publicly traded corporations, which were particularly likely to value Delaware corporate law. Together, these findings suggested Delaware enjoyed substantial market power in the market for incorporations. Although almost ten years has passed since Kahan and Kamar's article was published, there is no reason to think the situation has changed.

Manesh expands the methodology of Kahan and Kamar to the competition for LLC formation. He convincingly shows that Delaware neither charges a premium to form an LLC or price discriminates against small or large LLCs. Therefore, Manesh concludes (p. 26), "Delaware's relatively meager LLC tax suggests that, in the competition for LLC charters, Delaware lacks the kind of market power it has long enjoyed in the corporate context." But, Manesh's conclusion, does not necessarily follow from his evidence.

Kahan and Kamar observed evidence--Delaware's corporate fees and franchise tax have a particular structure indicative of market power. Manesh observes the absence of evidence--Delaware's LLC fees and taxes do have this structure. Observing the absence of evidence about a fact is not proof the fact does not exist. By looking at LLCs fees and taxes, we have looked under the street light, but are there darker places where there might be evidence of Delaware's market power in the competition for LLC charters?

One distinct possibility is that Delaware's accounting, finance, and legal professionals are able to extract a premium for their services related to Delaware LLC formation. Through their special-interest groups, these professionals would shape Delaware LLC law so as to attract LLCs and create market power. Under this hypothesis, Delaware's market power for LLCs would not line the state coffers but instead would line the pockets of some of its residents.

Manesh recognizes the exact possibility (p. 79) that interest groups may reap benefits from Delaware's LLC law but in a different context. After asserting the fact that Delaware lacks market power for LLCs, the bulk of the paper discusses the "why" and then the "who cares" that stem from that basic fact. Part of the answer, Manesh asserts, to the "why" is that Delaware corporate law is indeterminate but that Delaware LLC law is determinate, with "determinancy" roughly meaning predictability about what courts will do. Manesh writes (p. 66) that determinate LLC law not only diminishes Delaware's advantage of having a large body of case law but "also marginalizes Delaware's judicial advantage by limiting the role and importance of Delaware's judges in the interpretation of the law." Part of the "who cares" is then that Delaware lawyers will push for Delaware LLC law to become indeterminate because "Delaware lawyers . . . stand to reap benefits from LLC charters in the state only if Delaware provides an indeterminate, litigation-intensive LLC law that would require the service of local lawyers." (p. 79)

For my money, this argument makes an often-repeated mistake in legal scholarship. The legal academy is so drawn to normative argumentation that papers often spend more effort on the normative implication of a fact than on ensuring the fact is true. Manesh recognizes the possibility of interest-group dynamics in the formation of Delaware LLC law but does not consider whether these interest groups may be reaping the benefits of the market power that Manesh says does not exist.

In any event, there is no reason to think that lawyers benefit only (p. 79) from "an indeterminate, litigation-intensive LLC law." Furthermore, there is no reason that the relevant interest groups have to be lawyers. At former station at UNLV, I casually knew one person who was in the registered agent business and was active in ensuring that Nevada corporate law helped attract clients for that business. Consider the following business model. For a flat fee, a Delaware service--it does not necessarily have to be a law firm--processes thousands of LLC formations using a routinized set of documents. For another fee, the service will serve as a registered agent and generally monitor compliance to ensure the LLC stays in good standing. If Delaware has market power in LLC formation, the premium the firm extracts would not even have to be monetary. It might be that the business model allows its principals more leisure time. It might also be a business model that works for professionals who lack the licensing or perhaps the native ability to benefit from a litigation-intensive LLC law. Indeed, one can imagine a set of specialists who benefit from a litigation-intensive corporate law (big law firm partners and associates) and another set of specialists who benefit from a determinate, routinized LLC system (owners and employees of business services firms).

Contrary to the paper's assertions, there are reasons to think that a determinate and contractible (that is, the ability of the parties to modify by contract) law is exactly what would be most attractive to LLCs and hence give a state market power. Manesh's prototypical LLC is a classic business firm, one with customers and employees and sales and a coffee pot. In these firms, legal issues between owners will predominate, and the legal dynamics that Manesh identifies may be salient in the decision where to organize. Many LLCs and especially LLCs forming in Delaware, however, are probably not operating business firms. Rather, they are financial shells set up for legitimate purposes in securitizations or other financial transactions. In these firms, legal issues with third parties will predominate. For example, a creditor or a bankruptcy trustee might make a claim against the LLC's assets. In anticipation of such a claim, the parties forming the LLC would most value a state LLC law that was determinate and most certain to respect the LLC's separateness.

Because of the nature of the records, it is difficult to know how many new LLCs fit my hypothesized description. The trend in LLC filings from Manesh (p. 16), however, suggests that nonoperating LLCs may constitute a significant portion of the total Delaware LLC filings. First, the annual growth in LLC filings from 2003-2007 is high (24%, 28%, 10%, 15%) and well beyond the level of growth that would result from increased economic activity as implied by GDP growth during those years. Instead, the growth in LLC filings is more consistent with the growth rate in securtizations during those years. (See, e.g., the Fed's G.19 releases.) Also, a huge annual decrease (27%) in LLC filings occurs after the 2007 financial meltdown and again is more consistent with the relative huge decline in securitizations rather than the substantial but relatively smaller decline in economic activity.

None of the facts that I have hypothesized are necessarily true, but that returns me to the point where I began. I wish this article was smaller. This article is not necessarily wrong, but it has not laid the groundwork to convince a reader that it is probably right. Tellingly, the paper almost seems to recognize this point by starting the last paragraph with the summary phrase, "If this analysis is right . . ." With the evidence at hand, I think the paper could sustain an argument something along the following, "If Delaware has market power for LLCs, it's not showing up in the state's fees and taxes for LLCs. The market power might show up in the way some professionals charge and deliver their services. It might also show up in the following creative ways that Lawless is too dumb to imagine: <insert your list here>. These are the next steps in a long-term project on regulatory competition and LLCs."

Manesh has done a great job in the first part of the paper where he convincingly peels back the Delaware structure for LLC fees and taxes. He shows that this structure is nothing special, and that portion of the article is a strong contribution to the literature. Let's not kid ourselves, however. There are huge pressures on junior scholars to produce big, path-breaking works right from the start. The legal academy needs to give its junior scholars support to write smaller. Manesh continues the article with a bold swing at a broad and established literature on an important topic. It's an ambitious project, and there a lot of details to pin down. I look forward to seeing where it goes from here.

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