Barzuza Examines Why Businesses Choose Nevada

July 2, 2010

Associate Professor Michal Barzuza, a law and economics scholar, has pursued a data-enriched approach to corporate law research. In one of her most recent working papers, "What Happens in Nevada?", written with UVA Professor David C. Smith of the McIntire School of Commerce, she explores how firms that incorporate in Nevada differ from firms that incorporate in Delaware and in other states, and what those differences could mean.

Michal Barzuza

Barzuza, who received her S.J.D. and LL.M. from Harvard Law School and her undergraduate degrees in law and economics from Tel Aviv University, recently presented the paper with Smith at the annual meeting of the American Law and Economics Association.

What is this article about?

The article tries to answer the question, what firms choose lax law? It shows that firms that incorporate in Nevada, which offers relatively lax law, have a significantly higher ratio of accounting restatements than firms incorporated in other states and in Delaware, where most businesses incorporate. We find that in Nevada the frequency of restatements - when firms change their results retroactively - is double that of other states. After controlling for differences among firms in Nevada and other states, that frequency is around 40 percent higher. These are not firms that are located in Nevada. Their headquarters are spread across other states, but they choose to incorporate in Nevada in order to adopt its corporate law and legal system.

What makes this an interesting area of research right now?

There are several reasons. First, this is the first article to show what kinds of firms are attracted to lax law. This finding has important implications. It suggests that if we offer firms the option to opt into law that benefits shareholders, the firms that need it most - those with weak internal controls and higher agency costs - may not opt in. Second, there was not much focus on Nevada and the kind of firms it attracts. These findings support an argument that I develop in another project that there is some differentiation and self-selection in the market for corporate law. Not everyone is racing in the same direction.

Why are the majority of businesses incorporated in Delaware?

Delaware offers many advantages. It has a specialized judiciary and a developed body of case law. Another significant advantage is that it has a large number of corporations incorporated there already.

How is Nevada's corporate law different than Delaware's?

Nevada's corporate law is more protective to managers. For example, while Delaware law releases managers from liability only for breach of duty of care and only if they acted in good faith, Nevada protection from liability does not include Delaware's exceptions. Rather, Nevada law releases directors from liability as long as there was no "intentional misconduct, fraud, or a knowing violation of the law." Unlike in Delaware, in Nevada this protection applies also to officers and it applies as a default law.

Why would Nevada make their corporate laws more lenient toward managers?

Legislative history suggests that Nevada legislators were conscious about the need to differentiate themselves from Delaware, by offering stronger protection to managers. They raised concerns about the kind of corporations that will be attracted to these laws, but believed this was the only way Nevada could attract firms and collect incorporation tax revenues given Delaware's dominant position.

Why should we care about where businesses are incorporated?

The choice of state of incorporation is really a choice of law, and to some extent also of a courts system.

Why do states, rather than the federal government, have so much influence in corporate law? Should that change?

We have a system of state corporate law, unlike our securities law, which is federally regulated. There are advantages and disadvantages to this system.

Delaware has strong incentives to invest in its corporate law and legal system in order to attract incorporations. The concerns are that federal officials have less information, weaker incentives and are more vulnerable to political pressures. On the other hand, some have argued that the current system may encourage Delaware to cater to managers' interests since managers have some power on deciding where to incorporate.

How does this paper fit into your broader research goals?

This project is part of a larger goal to look into differences among companies and differences in agency costs. Heterogeneity raises several questions that I am interested in. What are the sources of heterogeneity in agency costs? How does this heterogeneity affect firms' choice of law? Are firms with high agency costs attracted to lax law? Are firms with low agency costs attracted to strict law?

The question of which firms choose which law deserves more research. Firms' choices may signal information to investors. Firms' self-selecting may also have some policy implications.

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