August 18, 2010
Larry Ribstein on Manesh on "Delaware and the Market for LLC Law"
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I am very happy to see somebody exploiting the theoretical and empirical potential of expanding the study of business organizations to fully include unincorporated business entities. And I applaud Professor Manesh’s selection of an intriguing question to study, something that I’ve been curious about but never pursued: Why do Delaware’s fees for forming LLCs look so much different than those for corporations?

To briefly summarize his thesis, Manesh argues that Delaware’s flat $250 fee for LLCs, compared to its much higher and graduated fees for corporations, indicates Delaware’s lack of market power in the market for LLCs. Kahan & Kamar (Price Discrimination in the Market for Corporate Law, 86 Cornell Law Review 1205 (2001)) theorized that Delaware’s scaling of corporate fees to firms’ capitalization showed price discrimination, something a producer can do with market power. Since Delaware doesn’t do that for LLCs it must not have market power in that area.

One problem with this analysis is that it assumes LLCs and corporations are comparable for purposes of pricing. But there is no reason to think this is the case. Corporations are standardized products. Delaware builds on this standardization to compute the corporate franchise tax in ways that apply fairly simply to all corporations in the state, as described in the article. LLCs’ main attraction, by contrast, is that they are not standardized, but rather creatures of contract, as Manesh discusses. LLCs’ capital structures depend on idiosyncratic contracts rather than statutory standard terms. If Delaware tried to apply something like the corporate franchise tax to LLCs they would simply engage in regulatory arbitrage to minimize the tax.

Why doesn’t Delaware force LLCs to be just as standardized as corporations so it can charge for them like it does for corporations? First, there just isn’t as much money in it because there’s much less variation in size of LLCs than corporations. Second, if Delaware forced LLCs to be as standardized as corporations, LLCs would lose a lot of their attraction, as Manesh himself argues. As a result, Delaware would get a lot fewer LLCs. By contrast, corporations, or at least large Delaware corporations, benefit from standardization apart from law compliance: they are traded in a public securities market, where variations cause information costs that would be reflected in securities prices. Corporations trying to arbitrage Delaware’s franchise tax would have to pay a penalty for being different.

(A broader problem with Manesh’s analysis is that the relationship between price discrimination and market power is less clear than Manesh assumes. See Kobayashi and Wright on Illinois Tool Works vs. Independent Ink on the non-inference of anti-competitive markets from price discrimination in the antitrust context. )

So, contrary to Manesh’s assumption, Delaware doesn’t necessarily lack market power in the LLC market just because it doesn’t price discriminate. But having made his assumption, Manesh then explains why the assumed fact about lack of market power is true: LLC law is based on the parties’ contracts and therefore is less indeterminate than its corporate law. Delaware therefore cannot attract LLC business to its courts through indeterminacy as it does for corporations.

I agree with Manesh’s observation about corporate vs. LLC indeterminacy – in fact I wrote and published that article a couple of years ago. I don’t necessarily buy K & K’s reasoning as to corporations. Rather, as discussed in my indeterminacy article, I think indeterminacy is inherent in the corporate form. But even assuming LLCs and corporations differ in this respect, I disagree with where Manesh goes from there.

Let’s begin with the evidence that Delaware does attract LLCs to its courts. Kobayashi and I find that Delaware is a massive winner in the national market for formations of large LLCs. Although this would be seem to suggest Delaware has power in the LLC market, Manesh doesn’t seem troubled by this finding, since he is relying on the absence of price discrimination. More interesting for present purposes is that Kobayashi and my regression analysis indicates that Delaware’s success is not because of any feature of Delaware’s law that we could find. Indeed, Manesh also notes that the feature that one might expect would attract LLCs to Delaware – the statutory provision allowing freedom of contract – has been replicated by other states. This suggests that large LLCs are attracted to Delaware because of Delaware’s legal infrastructure of courts and lawyers.

So why are LLCs drawn to Delaware’s courts if, as Manesh concludes, there’s relatively little those courts need to do for LLCs?The answer is that courts do have a lot to do for LLCs – that is, enforce their contracts. The contractual nature of LLCs increases the value of Delaware courts’ contract-enforcement technology. It is easy for a state to say in its statute that its courts will enforce contracts, but much more difficult to actually follow through on that promise, and to come up with intelligible and coherent contract-enforcement jurisprudence. As I have discussed in several writings, including my indeterminacy article above, my book (Rise of the Uncorporation and a number of blog posts (e. g. , Delaware courts have developed a very sophisticated approach to contract interpretation and enforcement in unincorporated firms. Other states can’t pick up formation business simply by linking to Delaware’s law because they also need to provide assurances as to how they’ll decide future cases.

In other words, LLCs are not flocking to Delaware just because it enforces contracts, but because of the way it enforces contracts. Although Manesh thinks that the “network” of Delaware’s cases is all about interpreting mandatory rules, in fact it is at least partly about applying any rules, whether or not contractual, to necessarily unpredictable fact situations. If Delaware were to follow Manesh’s suggestion and become more indeterminate to compete for LLCs, this would threaten, not solidify, its dominance in the market for LLCs.

(As an aside, I have a quibble about Manesh’s analysis of “network externalities” as a reason for the attractiveness of Delaware law. This confuses network effects in business association law and network externalities. My article with Kobayashi about choice of form, which Manesh cites a couple of times, shows some pretty good evidence that these aren’t network externalities. Contrary to Manesh’s brief discussion of this paper, this holds for both choice of form and choice of law, since the basic constraints are the same in both areas. )

Finally, Manesh discusses interest group pressures that might promote indeterminacy. He argues that lawyers would favor indeterminacy plus low LLC taxes to attract LLCs to Delaware and then produce more work for lawyers. I have also theorized that lawyers work on their states’ laws to attract clients to their states, and that lawyer licensing gives lawyers a kind of informal “property right” in their state’s law. However, it does not follow that lawyers would seek to attract business by promoting indeterminacy. If the market for business organizations is competitive (and, as shown above, Manesh hasn’t shown otherwise) lawyers can accomplish this goal by promoting laws that are not too indeterminate. Also, even if lawyers do seek more work from the clients Delaware attracts, this may mean different things to transactional lawyers (who want to encourage contracting by having contracts enforced) and to litigators (who want to undo contracts through litigation).

In conclusion, I applaud Professor Manesh’s choice of topics. This is a good start. I would encourage him to follow up this early draft with more extensive reading and analysis. Rather than putting all his eggs in the price discrimination basket, I would urge him to step back and keep an open mind about why competition in the corporate and LLC markets might differ, and alternative reasons why Delaware prices these products differently. I think the time spent on this reading and analysis will be rewarded by more robust conclusions.

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