Daniel J.H. Greenwood

Home | Previous Page

Democracy and Delaware: The Mysterious Race to the Bottom/Top

23 Yale Law and Policy Review 381-454, Spring 2005

Daniel J.H. Greenwood [FNd1]

Copyright © 2005 Yale Law and Policy Review; Daniel J.H. Greenwood

download printable (.pdf) version

Unlike ordinary human citizens, corporations may choose the law that governs their most fundamental acts of self-governance. Corporate law scholars have devoted many pages to debating whether the surrender of corporate law to a market for corporate reincorporation generates substantively good or bad results – a race to the top or a race to the bottom. Recently, however, scholarship has begun to consider more seriously the underpinnings to the “race,” with some doubting whether the “market for law” is as competitive as the standard models presume.

This article suggests a different problem with the standard model: states, unlike producers in a competitive market, are not price takers. States can determine the legal framework within which the competition takes place; if their production of corporate law was largely a search for corporate tax revenue, the large commercial states could long ago have ended Delaware’s dominance and the “race” by abandoning the internal affairs doctrine.

Emphasizing that the “race” is not inevitable clarifies that it is neither to the “top” nor the “bottom.” Instead, it is a voluntary surrender of self-government to unelected corporate officials who are bound by the norms of their office–norms themselves created by the “race” system–to use the “race” in particular, and often unattractive, ways. Re-politicizing corporate law would allow us to see a series of difficult value choices that are currently concealed but ought to be the subject of political debate.

TABLE OF CONTENTS

I. Introduction

Corporate law scholarship has focused on the role of the states as competitive actors in producing corporate law. The standard story is that states compete to provide corporate law options for businesses, producing a race to the top or a race to the bottom in which corporate law is created by market rather than political processes. This story is deeply implausible: Though states are constrained, they are far from powerless. There can be no escape from politics in determining law.

In this Article, I attempt to determine what is viable in the story of the race to the top or bottom. In Part II, I first restate the conventional debate as a set of simple game theory models focusing on the behavior of incorporators, rather than states. These simple models assume a range of options and focus on the corporate managers who choose among them. Race theorists moved from a simple one-period game (yielding a race to the bottom) to an equally simple infinitely-repeating game (yielding a race to the top). More recently, they have begun to face the complexities and indeterminacy of a finitely-repeating game played by human managers often close to retirement age and always tempted to defect in a final period. The corporation-centered game theory models focus on one important truth: Managers choosing corporate law within their firm role constraints have neither the incentives nor the right to consider the full range of factors citizens might. The public interest is explicitly not part of the game; rather, managers will choose law that promotes their self-interest and the interest of their firms, narrowly construed. Whether this pursuit of private interests will lead to a desirable public result is entirely a function of how well the invisible hand works within the constraints of the particular legal structure we have created.

Second, I shift the focus to the states themselves and consider a series of conceptual problems underlying the game theoretical model. The race to the bottom/top depoliticizes corporate law: It presents corporate law as the result of market forces rather than political ones. This transformation endows corporate law with an air of sanctity, inevitability and virtue: Markets, notwithstanding a century of critique, continue to have an aura of blessedness in American theology. But states are semi-sovereign actors, not passive price-takers unable to influence a market. Unlike ordinary competitors in a market, states can change the terms of the game they are playing should they dislike the competitive results. There can be no escape from politics and the need for a political justification of the structure and results of the particular pseudo-market we've created.

In Part III, then, I seek to repoliticize corporate law: to make visible the political decisions that structure the race to the bottom/top. First, I examine the basic implausibility of the entire race story. In the usual story, the states are being exploited by Delaware. But if this were the whole picture, states could simply stop playing Delaware's game. States, unlike the classic price-takers of ideal markets, are entitled to change the rules under which they compete. More concretely: If the race consists of Delaware appropriating tax revenues from other states, the other states could simply reject the essential doctrinal underpinnings of Delaware's success, the internal affairs doctrine.

The race-to-the-bottom/top theories portray states as helpless, passive price-takers in a market beyond their control. This image depends intimately on an equally implausible view of the internal affairs doctrine as inevitable. In fact, as I suggest in Subsection III.B.2, the internal affairs doctrine is quite the opposite. Far from a natural, unchangeable element of the order of things, it is something of an anomaly in our law. First, it is quite contrary to ordinary choice of law rules. Second, it seems on its face to violate fundamental principles of state sovereignty in a federalist system. Third, as a doctrinal matter, its boundaries are contested and contestable and its ideological foundations largely unexamined. Not only has the political system retained the ability to intervene when the legally structured market for law turns out politically unacceptable results, but it has in fact done so in major ways.

Further consideration of the underpinnings of race-to-the-bottom/top theory shows another oddity. Race theorists model corporate law as an agency cost problem: Shareholders hire managers who then are tempted to defect, acting for themselves rather than for their principals. But shareholders are not principals and managers are not their agents, and in a free-market economy, the fiduciary concepts underlying agency are counterbalanced by an equally fundamental market/contract notion that there is nothing wrong with actors looking out for their own self-interest. The agency picture is flawed not only as a legal description but as an economic metaphor: The economic model suggests that managers could be imagined to be hiring shareholders just as easily as the other way around. The claim that managers are agents of shareholders is not a legal analysis so much as an attempt to tap into the highly asymmetrical fiduciary model rather than the equally-available symmetrical contract model. Calling shareholders "principals" is potent--but analytically empty--rhetoric seeking to strengthen dubious shareholder claims to corporate surplus.

In Part IV, I briefly outline the political consequences of our pretense of depoliticizing corporate law. State acceptance of the internal affairs doctrine creates market processes of law selection that in turn demand that corporate decision-makers seek to subvert other law and norms of good citizenship. Under the current regime, corporate managers are commanded to treat all corporate participants (indeed, all their fellow citizens and all other values) as outsiders and competitors, mere tools to be exploited as much as possible within the effective limits of the law. If Kant held that one should always treat fellow humans as ends rather than means, the corporate law that results from the race enacts the anti-Kantian principle: Treat us all as means, never ends.

A more political conception of corporate law, made possible by abolishing the internal affairs doctrine and therefore the race to the bottom/top, might seek, instead, to import some republican virtue into corporate decision-making. Instead of treating law, morality, and human values as mere constraints in the pursuit of profit, managers might be commanded to take other roles or values as ends as well. Regulatory law would look quite different if corporate managers were told to treat the law's ends as their own, rather than to see the law merely as an external constraint to be complied with or evaded as the search for increased share value directs.

The race theories, then, serve a heavily ideological function, obscuring the peculiar political decisions we've made in corporate law. By portraying the political process that creates corporate law as a market, they suggest that no political choice has been or need be made. But in fact, our race, like most markets, is a heavily structured competition with rules determined by political processes (even if not consciously) and subject to change by political processes should the states decide that either the current process or its results are unattractive.

Several rounds of critics, beginning with Berle and Means, have advocated federalization of corporate law (or parts of it) as a solution to the race to the bottom. [FN1] This Article suggests an alternative to both the race and federalization: a genuine federalism, in which different states may enforce differing views of corporate law on businesses doing business in their territory. No state is required to sacrifice its sovereignty to Delaware, and ordinary democratic theory suggests that no state should. [FN2] Neither law, market, nor democracy demands that states allow the constitutive law of their most important economic actors to continue to be determined outside of normal political processes. [FN3]

II. Gaming The Race To The Bottom/Top

Scholars and practitioners are largely agreed on the non-democratic process that creates American corporations law. [FN4] Corporate law, the standard account goes, is created by a process of competition between the states. Each state has an incentive to entice out-of-state corporations to incorporate under its law because it derives tax revenue from the corporation. [FN5] In the case of a corporation with business operations (including employees, customers, suppliers, and shareholders) largely located out-of-state, the state of incorporation may have no interest in the firm except as a tax source. [FN6] When a corporation pays taxes, it is never entirely clear which human beings are bearing the ultimate costs; but for the taxes, the corporation might increase its dividends, its wages, or what it pays to other suppliers of inputs, or it might increase its investments, or, alternatively, it might decrease the prices it charges to customers. However, when the business, and thus all the relevant people, is located out-of-state, it is clear that taxes on the corporation are not borne by voters in the taxing jurisdiction. Thus, states seek to have out-of-state corporations incorporate locally in order to externalize local costs onto non-citizens. [FN7] States competing for revenues in this way will seek to offer corporations corporate law that reflects precisely what corporate decision-makers seek--any negative costs of such leniency will in any case be borne by the firm's customers, employees, etc., all of them, by hypothesis, out-of-staters.

One might expect that the corporation's home state--that is, the one where the business and/or shareholders are located--would seek to resist this exploitative behavior. Indeed, one might even imagine that basic federalism concerns would bar one state from raising much of its revenue by taxing citizens of other states. We fought a revolution to establish the principle of no taxation without representation.

However, our legal doctrine developed differently. [FN8] Unlike the practice in some European countries, a corporation incorporated in any American state is presumed to exist in every American state, without any need to create a separate subsidiary or sister corporation in each jurisdiction, or (as some early railroads did) to obtain federal incorporation. Indeed, states do not require even purely domestic businesses to organize themselves under domestic law: California does not require that California citizens doing business in California apply California law to their businesses. [FN9] Thus, a corporation may choose to be governed by the law of any state, regardless of where it is headquartered, operates, or does business.

Given this competition between the states, or more precisely given the willingness of states to allow corporations to choose their own constitutive law without regard to normal principles of territorial sovereignty, the conventional account demonstrates that corporate law develops rapidly to meet the perceived needs of corporations. Corporations will reincorporate in the state that offers them the law they seek; states that attempt to respond to other interests or ideologies in their corporate law will find that their corporations (though not necessarily the associated business) migrate elsewhere.

The story is not simply theoretical; history shows the competition in action. At the end of the last century, states offered substantially differing models of corporate law. When New Jersey offered a corporate law designed to appeal solely to corporate management it quickly attracted so many incorporators that the associated tax--imposed almost completely on out-of-staters--obviated any need to tax its own citizens. [FN10]

However, a reform movement in New Jersey under Governor Woodrow Wilson amended the New Jersey corporate law to impose various restrictions that the Progressive movement endorsed but which weren't necessarily attractive to corporations. Shortly thereafter, Delaware, blessed with a small size, central location, and minimal countervailing interests, outdid the original New Jersey law and obtained the distinction of creating American corporate law. Because Delaware is small and not a major industrial state, its local politics are relatively free of the type of reformist politics that made New Jersey unattractive to firms. Delaware corporations are likely to be physically located elsewhere; thus, politicians and citizens have little relationship with the corporations that incorporate there except as legal entities. Moreover, Delaware remains heavily dependent on tax revenues from its sale of the privileges of incorporation. Accordingly, Delaware is relatively unconstrained in its pursuit of corporate franchise taxes. Together with its sophisticated institutional structures to support its corporate law (including special courts, a dedicated bar, and specialized legislative committee mechanisms), this creates a reasonable assurance that Delaware will seek to keep its corporate law attractive to corporations. Indeed, should any other state find an attractive corporate law innovation, Delaware will match if not better it. [FN11]

Within the self-imposed constraints of the principles of free incorporation and the internal affairs doctrine, other states then faced a limited number of possible approaches to corporate law. They could imitate Delaware, in the hope that at least some of their local corporations would not find it worthwhile to reincorporate in Delaware, perhaps with an occasional special twist for a large local company with idiosyncratic needs more difficult for Delaware to fulfill. They could attempt to out-" Delaware" Delaware--but that was a difficult prospect once it became clear that the Delaware citizenry was willing to sacrifice its views, if any, on proper corporate law in order to obtain the tax advantages of being the incorporation center of the nation, and that Delaware's specialized institutions worked well enough to assure that it kept its law the most attractive (to incorporators) in the country. Or they could attempt regulation--and see all significant local business reincorporate in Delaware. Whichever course the states took, the result would be the same: All important corporate law is made in Delaware. And regardless of where it is made, state corporate law either is directed to the perceived needs of corporate management or is empty, "rusted girders, internally welded together and containing nothing but wind," [FN12] because all management need do to avoid unwanted regulation is to reincorporate in Delaware.

The general agreement on this story of how corporate law is made is somewhat hidden by a continuing controversy over whether the process is good or bad, reflected in claims that the process should be seen either as a race to the bottom or a race to the top. The argument, in somewhat simplified terms, is over the appropriate time frame in which to understand managerial strategy.

A. Race to the Bottom as a One Time Game

The early race-to-the-bottom theorists modeled a simple one-period game. This formulation assumes that self-interested managers [FN13] prefer law that does not restrain them, so that they are free to use their position to appropriate corporate surplus. In particular, race-to-the-bottom theorists assume that management will choose corporate law that allows it to exploit shareholders and other corporate participants. In game theory terminology, managers look for rules that allow them to defect: to enter into mutually advantageous arrangements with shareholders but then to renege on the agreement and take a larger than anticipated share. On this view, the radical simplicity of Delaware's corporate law and its general permissiveness are little more than legalized theft.

In the early liberalization, Delaware eliminated compulsory regulation of minimum capitalization, [FN14] par value, [FN15] preemptive rights, [FN16] and ultra vires rules, [FN17] universalized perpetual existence and limited liability, [FN18] permitted corporations to hold the stock of other corporations and eliminated other restrictions on corporate behavior common in early codes, [FN19] and drastically limited the powers of shareholders, placing governance in the board of directors instead. [FN20] It completely failed to develop a doctrine limiting monopoly or anti-competitive mergers and combinations. [FN21] More recently, it has reduced compulsory fiduciary duties almost to the vanishing point. [FN22] The race-to-the-bottom theorists interpret this general reduction in regulation straightforwardly as simple pandering to managers.

Similarly, Delaware's general acceptance of limits on hostile takeovers fits nicely into the basic picture: Managers get the law they want. So-called hostile takeovers are transactions in which a target company's shareholders agree to sell their shares (and thus the company) over the objections of the target's incumbent management. Such transactions were rare until Milken's invention of the new-issue junk bond revolutionized their financing. Junk bonds briefly made the hostile takeover a key part of our market for corporate control. Within a few years, however, the poison pill offered managers a new technique to prevent shareholders from acting without managerial permission. [FN23] Delaware was quick to correct courts that saw poison pills as a violation of its equality-of-shares principle, [FN24] and later enacted a statutory pill, [FN25] both of which have the general effect of requiring target board approval before a tender offer is consummated. Delaware case law has generally upheld the right of management to refuse to put the company up for sale even against strong shareholder opposition and has allowed managers to defend against breach of duty actions by contending that actions seemingly taken without regard for shareholder interests were motivated by concern for other corporate participants, such as employees, creditors or customers, or even for the product itself or the process of making it (e.g., Time Culture). [FN26] The net result is that takeovers are now effectively impossible without the consent of incumbent management.

Race-to-the-bottom views also easily explain another aspect of takeover regulation: While state law restricting hostile takeovers appears to invoke values of stability or other stakeholder interests, these concerns disappear when managers support the takeover. Paramount v. Time is the most-famous Delaware statement of a phenomenon enshrined in most state laws in so-called "constituency statutes"--in the takeover context directors are free to define the interests of the corporation to include values and participants the stock market would exclude. But this shield is no sword. As a general rule, directors are not required to consider those other participants should they wish to act contrary to their interests. [FN27] Moreover, no corporate participant other than the fictional shareholder has standing or a cause of action with respect to director decisions. Accordingly, directors are entirely free to ignore all non-shareholder interests and values except in the most extraordinary circumstances (and they would risk suit from shareholders if they were to explicitly consider those other concerns). [FN28] It would be peculiar in most areas of the law to find rules permitting decision-makers to simply ignore the interests and values of those most intimately affected by their decisions. But if state law is simply pandering to managers, as the race-to-the-bottom view contends, it is not surprising that state corporate law generally permits but never requires management to invoke non-shareholder interests in takeover contests. [FN29]

In the ordinary course, non-share corporate participants and claimants have only contract law to protect them; that is, as a matter of corporate law, managers are invited to treat corporate participants as badly as their contracts permit. Contract law, however, more often than not instead protects the autonomy of the corporation to defect or not as it pleases.

Thus, for example, under the standard analysis of bond, pension and employment contracts, directors and managers are free to take any action not explicitly barred by the contract. But it is a trivial matter for a firm to radically change the likelihood that the company will perform its future contractual obligations to long-term debtors, such as unsecured bondholders, long-term employees and pensioners. [FN30] Anytime the firm unexpectedly increases its risk level, it reduces the value of all its long-term contracts, because it reduces the odds that it will fulfill its obligations. Indeed, every time the firm pays a dividend, it reduces the security of its long-term contracting counterparties. Except in the most egregious situations, neither contract nor corporate law offer any meaningful remedy. [FN31]

Even more dramatically, employment contracts are interpreted against background rules assuming that the employer has the unilateral right to set and control working conditions, including the unfettered discretion to organize or reorganize the business in any fashion without consideration of employee interests or desires, that employees have waived any right to internal termination proceedings (whether for cause or not), that employee work products (including inter-employee relationships) are the property of the employer to be disposed of as the employer sees fit, and even that (except where ERISA changes state law) pension promises create at most a junior unsecured claim to whatever assets the employer chooses to have available.

Contract law, thus, offers cold comfort for corporate participants. Corporations will be held to the terms of their contracts but are free to reorganize in ways that make those terms worth less or worthless. Corporate law offers non-shareholders even less: Corporations can deliberately take maximum advantage of non-shareholder participants in the firm to the fullest extent permitted by other law without violating any corporate law duty whatsoever and, indeed, such an action is liable to be interpreted as a commendable concern for fictional shareholder interests. [FN32]

In short, for race-to-the-bottom theorists, corporate law is mostly about freeing managers to do as they please, most dramatically in hostile takeover law--which allows managers to prevent shareholders from selling the company, even though buying and selling would seem to be the core area of shareholder expertise--and with respect to non-shareholder corporate interests--who have virtually no standing at corporate law.

B. Race to the Top as a Repeating Game

Race-to-the-top theorists, in contrast, contend that managers and shareholders should be seen as playing a repeating game. If shareholders fear that managers will appropriate gains that shareholders anticipated would go to them--that is, if shareholders fear managerial defection in the way that race-to-the-bottom theorists predict--they can easily defend themselves by charging for the defections ex ante. In other words, if shareholders think managers are going to steal, they will reduce the returns they expect to earn by the amount available to be stolen. If stealing were entirely unrestrained, the result would be that only the naïve would invest in the public stock markets: Rational investors would not expect any returns except perhaps by accident.

The race-to-the-top point is that in this repeating game, managers have a potential common interest with shareholders. Managers who convince the financial market that they will work for shareholders, not themselves or other corporate participants, will be able to obtain investment capital at far lower cost than competitors who do not. For companies that raise capital in the IPO market, rational investors should discount the amounts they are willing to pay for the company's stock to reflect their view of the likelihood of managers working for shareholders and the adequacy of protection against future changes of heart. Since the value of stock is dependent on its future returns, rational IPO investors should price protections that will inure to the benefit of later secondary market investors as well. But even a company that relies principally on retained earnings for investment capital will be better able to compete if its stock is highly valued; it can use stock as a currency to purchase other companies, compensate employees, and so on. This should give share-oriented managers a major advantage in the product market by allowing them to produce products at a lower cost and underbid their competitors.

Moreover, if there is an active market for corporate control (that is, if hostile takeovers are possible), managers who are percieved by the stock market as not acting in shareholder interests will quickly find themselves out of a job. If the stock market bids a company's stock below what would be the company's value if it were run in the interests of shareholders, it is a clear takeover target. Any manager who makes the shift should be rewarded with an immediate jump in share price. Nor is the pool of managers who could make the change limited. Shifting corporate surplus to shareholders is not rocket science--because it doesn't require improving the product or production processes, outsiders should be able to redirect a company's surplus to its shareholders even with no particular knowledge of the industry. Moreover, Wall Street should have no trouble understanding the profit potential here, so financing for hostile takeovers should be readily available. Thus, both incumbent management and outsiders have both the means and powerful incentives to do what the stock market wants. [FN33]

In short, managers who appear to be running the company for the benefit of shares will be rewarded with a lower cost of capital; those who don't will be penalized and their firms targeted for takeovers. Accordingly, the race-to-the-top analysis contends that race to the bottom has it backwards: Far from looking for ways to abuse shareholders, managers should be searching for ways to prove that they have only the best interests of shareholders in mind.

Although race-to-the-top theorists do not always emphasize the point, precisely the same argument can be made with respect to all other corporate participants. [FN34] If bondholders or employees fear defection in a rational game, they will charge ex ante as well. Bondholders, after RJR Reynolds, should demand additional protection (causing drag on the firm's flexibility) or charge higher interest to compensate for the risk the firm will later change its risk profile to their detriment. Employees who fear that they will be treated unfairly are more likely to spend their time resume padding, loafing, or even stealing than those who view the firm as on their side. [FN35] Thus, managers who can persuade bondholders, employees, suppliers, or customers that management is acting in their interests will also gain a competitive advantage in the product marketplace.

In this best of all possible worlds, managers should search for the corporate law that most clearly assures all corporate constituents of managerial good will, whether by restraint or alignment of interests. Since, on the assumptions of rational actors and competitive markets, every participant can make every other participant internalize the costs of all attempted impositions, no one has any interest except to work for the common good.

1. The Complexities of Finite Repeating Games: The End-Game Problem in the Race to the Top

The race to the top can exist only if managers can demonstrate to potential investors that managerial and investor interests are aligned. There are two basic ways to do this: reputation or external regulation. This Subsection discusses reputation.

In an infinitely repeating game without external regulation, only managers with a reputation for not stealing would be able to sell their services, and those who had a reputation for focusing on shareholder value would obtain the lowest-cost capital. Accordingly, managers would seek to develop a favorable reputation, as the race to the top contends.

But there is a final period problem with this optimistic story. CEOs are typically near retirement age, and a retiring CEO may find it attractive to cash-in on a hard-acquired reputation for honesty: Now that he has his hands on the cookie jar, why not help himself and sacrifice his reputation? If a CEO of a large public company can seize enough corporate assets (via salary and perks, stock or option grants, an MBO, or golden parachutes) to make future employability or company success an irrelevant consideration, he may do so. A large piece of even a much smaller pie may be more attractive to a self-interested individual than a smaller share of a larger pie. Even if his company suffers from a sudden jump in its cost of capital, the CEO himself will be both rich and retired.

Moreover, the simple model of dishonest defection omits other, perhaps even more common, situations in which managers may act as if they were stealing from the company--even without any bad intent. Most people find it easy to assume that their personal self-interest is aligned with their responsibilities, and in this case, an entire army of academics and consultants has spent two decades explaining that managers cannot be expected to do a good job unless they are paid very well. Any reasonably optimistic and self-confident manager is likely to decide that the theorists are right: He would do a better job (tomorrow) if he were given a significant chunk of the company today. That is, even non-defecting managers may act as if they were defecting.

Generalized, this end-game problem presents a very serious problem indeed. If potential shareholders take these possibilities into account ex ante, the public market may decide that reputation is not reliable. Kenneth Lay, after all, had a fine reputation until it was too late; Enron was run according to the best advice of the consultants. At this point, the situation appears to be a market for lemons. [FN36] Investors should refuse to pay for quality that they cannot verify. Moreover, since the odds are entirely under the control of the managers themselves, the risk should be essentially uninsurable. Investors in an impersonal market would invest in companies on the assumption that top managers will steal, which suggests very low multiples of expected earnings indeed. Since honest managers would not be paid for their honesty, they would disappear.

As in any market for lemons, willing buyers of a high quality (or honest) investment product and willing sellers would be unable to make a bargain; all that would be available would be high risk at low cost. But investors are not like car buyers who simply suffered with poor-quality cars until foreign manufacturers figured out how to escape the lemons trap. Americans can't live without cars, but investors can easily shift out of the stock market. If CEOs can determine unilaterally whether and how much to steal, investors cannot price future returns in any rational way. When the risk is under the control of the insured, insurance companies refuse to sell; the financial markets should act no differently.

The implications then are dire. If investors were to conclude that managers are freely able to appropriate corporate assets, the public financial markets might largely close down or, at a minimum, would charge extraordinarily high risk premiums. (How do you price the risk of someone defecting when the defector can change the odds unilaterally?)

Reputation, then, is unlikely to work as a disciplining mechanism in a finitely repeating game where the key players (CEOs) are inevitably near the final period. Investors should fear that CEOs will find the temptation to cash in on their reputations too hard to resist, and acting on their fear, they should treat all CEOs, even ones with good reputations, as likely defectors. A reputation-based race to the top should quickly collapse into a market for lemons.

A market for lemons is not the end of the world--even a total collapse of the public stock markets wouldn't necessarily cripple the economy permanently. Most investment by major corporations is financed by retained earnings and most of the rest by debt. Moreover, private financing transactions (for example, intra-family financing, where other methods of preventing defection are possible) would pick up some of the slack, as they do in countries with less developed public finance markets.

Still, any loss of finance capital should result in lower growth and flexibility in the economy, to the detriment of all of us. Moreover, were investors to withdraw from the stock market due to suspicion of self-dealing managers, it seems somewhat implausible that they would entirely put aside those suspicions in the bond market. Bond markets suffer from their own problems: After RJR Nabisco, bondholders should be quite aware of the possibility that they too may be taking unquantifiable risks of defection. Accordingly, the net result of greater suspicion of the public finance market ought to be both lower stock prices (perhaps dramatically lower) and higher interest rates, each leading to slower growth directly (especially of smaller companies less able to generate investment capital internally) and indirectly, as managers use higher "hurdle rates" to determine the desirability of investment opportunities.

In addition to a slowing of growth, we'd see a reduction in social mobility. Public markets depend on trust between strangers and on the actuarial calculation of the odds of success. When the odds are controlled by one party, public markets must fail. Instead, people will rely on less impersonal methods of determining on whom to rely. With the public markets less useful, we would likely see a dramatic increase in influence of banks, large corporations, and wealthy families able to escape the market for lemons by personal relationships. In general, investments would be more determined by both "connections" and bureaucratic processes--large firms and banks deciding to support a business plan based either on old-boys networks or on Weberian rationality--and less by markets. Personal connections, status and background, and the ability to articulate a plan to a peer group would became more important relative to raw market smarts, the common touch, and pure luck, leading to a closing of the elite.

2. Corporate Law as the "Credible Commitment"

What is needed, then, is a different way out of the end-game problem: some device, more reliable than reputation, that managers can use as a "credible commitment" that they will not defect. That device could be corporate law.

If managers can find law that allows them to prove to investors that they won't defect, some managers should seize on it as a way out of the market-for-lemons problem. If they can demonstrate that the law requires them to keep their agreements, they should be able to attract lower-cost financing by eliminating the fear of last-period defection. Lower financing costs, in turn, should allow them to beat their competitors. Accordingly, race-to-the-top theorists propose that managers acting in their own private interest will choose law that prevents them from defecting, thus solving the end-game problem in a beneficial race to the top.

On this story, managers and shareholders unite in choosing the law that is in their mutual best interests. Since they are the ones most intimately involved in the process, it seems reasonable to assume that they will do a good job of defining those interests and the law that will support them. It follows, then, that corporate law, like contract law, must be about enforcing voluntary agreements.

Oddly, however, Delaware's law doesn't actually look like the law this story would predict. If choice of corporate law is driven by the need to find a credible commitment that managers will not defect in an ever-imminent end-game, one might expect to see legal regulation obviously preventing defection. Such a law would solve the market-for-lemons problem by enabling CEOs to credibly claim that an outside enforcer will force them to keep their promises.

This credible commitment model is a plausible explanation for the extensive regulatory apparatus of our federal securities laws: Free markets work best when players are not free to break their commitments. Markets are more likely to rely on disclosure and reputation when those who lie or cheat go straight to jail or are subject to suit by highly motivated private attorneys general under generous class action rules. But this isn't Delaware law, at least in any obvious way. The usual story of Delaware law is one of increasing permissiveness, not careful elucidation of minimum standards of behavior and effective joint government/private enforcement. Race-to-the-top theorists, accordingly, have some explaining to do.

If Delaware law is, as it seems to be, centrally about permissiveness, the implication is that a market for lemons, not a race to the top, is the most likely result of our corporate finance regime. On this analysis, current investment in the financial markets must be based on (irrational?) faith in the honesty of managers who have every incentive to cheat. The limits of that trust limit our market. Were the trust to break down further, we might see a major collapse of stock prices. [FN37]

Moreover, accepting this story of Delaware's loose regulation of a market with strong tendencies to collapse suggests that more investment capital would be available were corporate law more regulatory. At the peak of the boom, several best-selling authors suggested that the stock market "ought" to be priced much higher because the risk premium for holding common stock is inappropriately high. [FN38] Here, the claim is inverse: Were corporate law able to eliminate more of the risk of defection than it does, the appropriate risk premium indeed would be lower, and a good deal of cash now under mattresses would shift to the finance markets. As it is, the risk premium is as low as it is only because investors are puzzlingly confident that managers will place honor over self-interest and will not defect even where they might well get away with it. [FN39]

Race-to-the-top theorists contend, however, that the markets are driven by rationality, not faith. Accordingly, they are driven to explain that appearances mislead. Delaware law--they must say--is not permissively pandering to managerial temptations to renege or leaving investors undefended against dishonesty. Rather, if the race is to the top, Delaware's apparent permissiveness actually must be flexibility. It must be that the older regulatory regime imposed costs that were not to the advantage of either shareholders or managers, simple deadweight costs that the efficient processes of competition for law have eliminated. Shareholders, after all, require managers who can freely and quickly adapt to the rapidly changing environment of a capitalist marketplace; the old law must have clogged up the works. Perhaps defection is not as large a problem as the game theory model might suggest, or at least it is a smaller problem than the problem of excess rigidity resulting from the older rules (even race to the top only assumes that managers will choose the best of the proffered compromises, not that an ideal legal solution exists). Maybe, for example, managers are less rationally self-interested than extremely honest, professional and selfless. [FN40] What is absolutely clear, however, is that if the race-to-the-top analysis is correct, the law must be mutually-beneficial for shareholders and managers (relative to real alternatives), appearances to the contrary notwithstanding.

C. Lifting the Race-to-the-Top Assumptions: The Potential for Lemons

Race-to-the-top analysis, however, is not pure Dr. Pangloss. [FN41] Our world comes with no guarantees. Most fundamentally, it is always possible that no reasonable solution to the corporate law problem has yet been proposed. [FN42] If the only available choices are either to allow defection or to so hamstring managers that they cannot manage in the first place, race to the top predicts only that managers will choose the lesser evil, not that their choice will be attractive.

But even within a restricted set of possibilities, evolution by market selection need not reach the best one. Under some realistic scenarios, even in a repeating game, managers will choose law that is not the best available from a collective perspective. So long as they can fool some of the people some of the time, some managers will conclude that it is more profitable (for them, if not for their companies) to choose law that appears to be shareholder-protective, but still allows room to defect. Race-to-the-top theory assumes that these managers will be penalized by a higher cost of capital which will, in turn, penalize them in the product and takeover markets to such an extent that, as a practical matter, we need not worry about the problem. This prediction's plausibility depends on a number of assumptions that aren't necessarily correct.

First, for shareholder-oriented managers to prevail over those who would like to retain the option to defect, both the product and the finance market must be thoroughly competitive. Most American companies finance most of their expansion through internally-generated funds (retained earnings). Most of the rest is financed through debt. Accordingly, we cannot simply assume that companies that suffer in the stock market will quickly be competed into insolvency. Especially in a rapidly changing economy, other factors (including not only past success but also current product innovation, fashions and luck) may overpower the marginal effects of even clearly counterproductive corporate governance. [FN43] Similarly, the takeover market is marked by high transaction costs: We can't assume that every company that could be run with shareholder interests more front and center quickly will be.

Even if these markets are competitive enough so that they will have their way in the long run, managers may not take a long term perspective: As suggested above, it often will be wealth maximizing for any individual CEO to defect even at the cost of substantial long term damage to the company. If the markets are only imperfectly competitive, the costs are likely not to hit home until after the CEO has retired.

Moreover, CEOs--being an optimistic group--may be likely to overestimate the odds that any shenanigans can be put right at the next upturn before ever being discovered, or to use the powerful tools of self-deception and cognitive dissonance to convince themselves that what they are doing is good for the company in any event. If CEOs convince themselves that it is in the company's best interest to be in a jurisdiction with rules that give CEOs great discretion, imperfectly-competitive markets may not be powerful enough to convince them of their error.

Second, the race-to-the-top thesis assumes that investors can incorporate their views of different corporate law into share prices. While this seems a plausible assumption, it too is by no means certain. Current corporate law leaves companies entirely free to determine their state of incorporation. Reincorporation in a new state typically requires approval of both the board of directors and the shareholders but otherwise is unrestricted. The shareholder vote, however, is largely a formality in practice--perhaps because investors take the sensible view that if you can't trust managers, who are the experts in running the company day to day, then you shouldn't be a shareholder in the first place, with the result that the electorate at any given time consists of those who have faith in current management. If the shareholder vote is a formality, then managers are largely in control of the reincorporation decision.

But if managers can change the state of incorporation pretty much at will, we are back in a market for lemons. Rational shareholders will assume that, whenever it matters, the corporation will be incorporated in the state that is most advantageous to managers. Paradoxically, that could well mean that regardless of where the company is incorporated, the stock market will price it as if it were in the least shareholder-friendly jurisdiction. [FN44] There isn't much point in paying for protection from rapacious managers if managers can choose to eliminate the protection whenever they please; the commitment simply isn't credible. On this story, the market price for shares would not include any bonus for corporate law protection--and the race-to-the-top mechanism would collapse. [FN45]

Third, much depends on the interpretation investors place on any given share-friendly or unfriendly situation. Rational investors are forward-looking, valuing investments based on predictions about future returns, not based on sunk costs. Accordingly, past problems are important only if they are predictors of future ones. If investors interpret past defections as the result of anomalous bad actors, a few arrests may convince them to view the problem as over and done with and not as predicting anything about the future. After all, Kenneth Lay, the disgraced CEO of Enron, is unlikely to have another chance to sink a public company. This understanding would break the link between past bad acts and stock price, thus eliminating both the market for lemons and the pressure towards a race to the top.

So too, if investors see the problem as one of a particular technique--the junk-bond-financed two-tier takeover, or improper accounting for off-balance sheet entities, for example--overcoming those particular problems may satisfy them. If problems are isolated and resolved, there is no reason to bid down the price of the stock, and (new) managers will not be penalized for the sins of the past or, for that matter, rewarded for choosing law that prevents them from defecting in new and unprecedented ways.

The race-to-the-top mechanism, in this instance, would be limited to eliminating specific known and identified problems after they have become well-known to the investor community. But if investors take these views, then so long as managers continue to turn over on a regular basis and can command the services of clever lawyers and bankers to find new (legal) distortions, we can expect to see regular crises, each dismissed by the market as an isolated case.

On this story, we will never see a race to the top, but we will not necessarily see a full market for lemons either. Americans are pretty trusting. Whether because a sucker is born every minute or because Charlie Brown-like investors keep believing that their Lucy-like managers will keep the faith this time, enough capital should continue to flow into the market to allow reasonable, if not optimal, function. Presumably, however, finance capital is more expensive than it could be were corporate law better able to convince more skeptical investors.

In contrast, if investors begin to conclude that what they suffer is a pattern, not isolated instances, matters are different. If defection appears to be routine, then it will seem reasonable to conclude that the problem is that the law is not powerful enough to control it. Corporate law, investors may conclude, puts managers in charge of investors' money and leaves it to them to decide whether to keep it or not. On this view, the stock market has a serious moral hazard problem and rational investors should avoid it.

For the race to the top to work, investors must conclude that managerial defection is predictable, systematically controllable, and differentially affected by different state corporate law. If they view defection as just a problem of isolated bad actors, they will not reward companies that provide systemic safeguards against it. Conversely, if they conclude that clever corporate lawyers, bankers and managers will always find a new (and as yet unpreventable) way to defect--so that corporate law will constantly be solving last year's problem--closing barn doors after the horses are gone, they will again not discriminate among companies based on choice of law. Investors who conclude that corporate law cannot help them should, in a self-fulfilling prophecy, destroy the very race-to-the-top mechanism that is supposed to save them. In short, if investors do not distinguish carefully between different legal regimes, concluding that some but not all can prevent defection, the incentives of the race to the top fail: Investors and honest managers will simply be caught in the low value trap of a market for lemons.

Fourth, "excess volatility" can destroy the race-to-the-top mechanism. [FN46] Many investors specialize in predicting not future returns but rather investor sentiment regarding future returns. [FN47] These "momentum" investors should have the effect of amplifying and distorting any changes they discern in underlying views, making the market more herd-like than it might otherwise be. Herds need to be where the grass is, but for each individual the safest place to be at any given time is the center of the herd. This combination of some need to be where food is and a more immediate need not to be food results in the difficult-to-predict movements and sudden changes of direction of stampedes. In the market, fundamental value plays the same role as grass: In the long run, fundamental value is the nutrient that keeps investors alive, but in the meantime you can get killed by unexpected movements of the market, changes in liquidity, or simple trampling. A surer way to make money, if you can manage it, is to be in the front of the herd (or at least not at the back), an inherently competitive contest much like that created by the need of each wildebeest to be in the center of its herd. The result ought to be a market characterized by great volatility, lurching stampede-like from crisis to crisis.

But if market pricing is highly volatile and often based on herd movements rather than fundamental underpinnings, the race-to-the-top mechanism will not work. Any reasonably optimistic or Machiavellian CEO with a short time before retirement should be willing to gamble that the reduction of share value associated with his making himself rich by defection will be lost in the general noise of the market. Note that it doesn't even matter if he is right: So long as enough managers make this calculation or enough investors fear that managers will make this calculation--even if they are all wrong--we will not see a race to the top. Rational investors, fearing this type of miscalculation, will withdraw from the market or assume possible defections in their calculations, leading to low valuations.

Fifth, limited rationality could also interfere with the simple race-to-the-top story in another way: Investors may not be able to tell the difference between abuse and brilliant management. Indeed, there may not even be a difference. Over the last couple of decades, CEO compensation has increased to a truly extraordinary degree. CEOs are now taking a historically-unprecedented share of the corporate pie. But it is not clear, even post-Enron, that shareholders have necessarily suffered; they, too, seem to have done rather well. High CEO compensation, even if it is not closely tied to company results, likely has the effect of changing CEO class solidarity: They are now among the ultra-rich, not mere upper middle class working stiffs. [FN48] This should make it easier for CEOs to identify with shareholders and reduce any tendency to think of the "corporation" as those who work for it. And I need not rehearse the simpler financial incentives of massive stock and, even larger stock-option grants: A shareholding CEO has a powerful incentive to keep the stock price up at least until he can make a graceful exit.

If the stock market believes wealthy CEOs have similar interests to shareholders, then it has no need to demand credible commitments. Rather, shareholders may view their shareholding interests as best served by allowing top managers the maximum freedom of maneuver to work on behalf of themselves and their teammates, the shareholders (much as bondholders before junk bonds assumed that few contractual covenants were necessary; managers were likely to use any discretion in their mutual interest anyway). If the finance market bought this story, it would be likely to see little need for protection from managers and therefore to support managerial flexibility and discretion. Race to the top, then, would mean race to permissive, non-regulatory law.

But the story about the joint interests of managers and shareholders could very well be generally true and still a gross oversimplification. If the story of beneficent managers working for shareholders has a significant place in the collective Wall Street heart, there should be plenty of room for CEOs to abuse their positions without the market noticing. [FN49] So long as shareholders were making the extraordinary returns of the 1980s and 1990s, they were unlikely to look too closely at what managers were taking home. Indeed, before the late 1990s, it might even have seemed likely that the amount a top manager could possibly appropriate was trivial by comparison with the gains to shareholders of having managers firmly allied with capital against labor. Even if managers were grossly overpaid, there weren't enough of them to matter, or so investors might have imagined until quite near the end.

Thus, it is at least possible that the stock market could press for deregulation during boom times only to be astonished by the resulting abuses (which will not be highly visible until the next bust), accentuating market volatility without approaching any equilibrium level of regulatory restraint. This is particularly true because the end-game problem is endemic on Wall Street as well as in the CEO offices: In an industry where most players have very short expected job tenure, many may prefer to overlook known abuses, hoping to make their own pile before the house of cards collapses. [FN50]

D. Summary: Gaming the Race to the Bottom/Top

In summary, the race-to-the-bottom and race-to-the-top theories are closely related models of competition between managers and shareholders. Race-to-the-bottom theorists assume that management is relatively free to choose corporate law that allows it to exploit shareholders and other corporate participants. Race-to-the-top theorists contend, in contrast, that the market for shares and/or corporate control is sufficiently competitive to assure that shareholders can force managers to internalize the costs of any possible exploitation of shareholders, thus giving managers an incentive to choose corporate law that bars such exploitation (except, of course, where the benefits to managers outweigh the costs to shareholders).

Race to the bottom is easily generated in a one-shot game, race to the top in an infinitely repeating one. In the more complicated finite repeated game, however, the models can lead to potential races to the top, races to the bottom, or to market-for-lemon traps depending on relatively minor changes in the assumptions about market competitiveness and participant motives and rationality. Shareholders may be less rational than race-to-the-top theorists have assumed, unable to see the potential defections in advance and thus regularly surprised when managers find new ways to increase their share of the corporate pie. Or credible commitments may not be available: The very restrictions that would protect shareholders from managers would also make it impossible for managers to manage, so there is no value-maximizing choice. Empirical studies have found little evidence that share prices suffer when companies reincorporate in Delaware, [FN51] suggesting, perhaps, that Delaware law is no worse for shareholders than any other or, if the decision to reincorporate is largely in the hands of management, that the prospect of future reincorporation is already priced in, leaving little further price change for researchers to find. Finally, the empirical contingency of the assumptions necessary to generate a race to the top suggests little basis for an a priori conclusion that free choice of corporate law will drive the law towards any equilibrium, let alone optimality.

III. Situating the Race to the Bottom/Top: Conceptual Problems

The agreement between proponents of the race-to-the-bottom and race-to-the-top theories far outweighs any disagreement. It is nearly universally acknowledged, first, that corporate law's evolution is relatively free of normal political processes; second, that the ability of corporate management to choose where the corporation will incorporate is virtually without extra-corporate law consequences; third, that corporate management is the proximate decision-maker and should be modeled as self-interestedly considering which corporate law will best promote managerial interests narrowly understood; [FN52] fourth, that states have effectively no ability to regulate management in ways that management perceives not to be in its self-interest; and fifth, that Delaware has created an effective mechanism for giving management what it seeks.

Most importantly for democratic theory, both sides of the race-to-the-bottom/top debate agree that it is effectively impossible for the voters of a particular state--or even every state--to introduce substantive regulation into corporate law. State voters cannot use corporate law, for example, to regulate friendly mergers; to limit limited liability; to make corporate managers politically answerable to line employees or customers; to demand that corporations replace or limit maximization of share value with other possible goals such as maximization of product quality or value, respect for status quo economic relations, improvement of employee quality of life or creditor or environmental protection; to require minimum capitalization; or the like (unless, of course, management finds such regulation attractive for some reason).

Only by overcoming the race to the bottom/top--generally by federalizing aspects of corporate law--has such regulation occurred. Thus, for example, ERISA changes limited liability and fiduciary duty rules; [FN53] bankruptcy law shifts fiduciary duties to non-shareholder participants; [FN54] Superfund modifies the usual rules for piercing the corporate veil; [FN55] the Wagner Act originally granted substantial employee rights in corporate governance, [FN56] and so on. Indeed, even basic protection of shares against defecting managers, more often than not, has occurred outside of the race--basic information rights necessary to any exercise of control are found in the federal securities regime rather than the state laws, and it is the Williams Act, not the state laws, that primarily structures shareholder voting rights. [FN57]

Within this broad agreement, the debate is over whether in determining where to incorporate, corporate managements seek to maximize the freedom of action corporate law will give them vis-à-vis shareholders, or rather seek to publicly renounce that freedom in order to avoid having shareholders charge them for it. Common sense, and the contingency and complexity of the assumptions necessary to generate a determinate result in a finitely repeating game, suggest the same conclusion: No doubt, both happen.

In this Part, I raise three problems with the theory of the race to the bottom/top as a whole. Each addresses, from a different angle, the quasi-empirical claim that the race theorists agree upon: that our law is a product of market-like forces leading to a largely inevitable result (at least so long as the federal government fails to intervene). Although I will not fully develop any of these objections in this Article, they point the way toward a deeper understanding of the process.

A. The Helpless States

Both of the competition-between-the-states theories portray the states as largely passive participants in a system that is beyond their control. They are price-takers in the market for law. That is, they simply offer law and then sit back and see whether corporations will accept it. But this is deeply implausible: Markets exist only within a set of legal rules, and states typically make those rules.

In the standard accounts, the states are competing for tax revenues. When Delaware wins that competition, it is supporting its internal tax requirements by funds raised from corporations that exist out of state. When a corporation pays taxes, it is not always clear which human beings ultimately bear the burden of those taxes: Depending on the relative competitiveness of the various markets in which the corporation is active, the taxes could result in lower dividends, lower wages, higher product prices, or lower payments to lenders or suppliers. What is clear is that in the case of the typical Delaware corporation, few of those people will be Delaware citizens. Accordingly, Delaware is exporting its tax burden onto non-citizens.

This country fought a revolution on the issue of taxation without representation, so there is something more than slightly surprising about a model that gives Delaware the right and ability to tax the rest of us. [FN58] The issue of whether Delaware should have that right in a geographically-based federalist system I develop elsewhere. In this Section, I wish to focus not on the right but on the ability.

The race to the bottom/top immediately raises this question: Why do the other states put up with it? Why don't they simply opt out of the race by changing the rules? For example, they could take the civil law approach, deciding that corporations headquartered domestically, or with their principal places of business located in state, will be subject to domestic law. [FN59] Or they could simply bar foreign corporations from doing business domestically, as current American law apparently permits them to do. [FN60] That might result in a system like some of the aspects of American banking law, with state-chartered subsidiaries of national parent companies, or perhaps federal incorporation for national firms. Or the states might have stuck to the early American view that a corporation has the citizenship of its shareholders and concluded that it ought to be governed by their law as well. Indeed, some states have refused to grant full recognition to foreign law with respect to corporations composed entirely of domestic citizens but incorporated elsewhere (so-called tramp corporations); [FN61] the arguments used in those cases could easily be extended to include any instance where the incorporating state has only a minimal connection with the firm.

One claim might be that states are economically too weak to impose their own law on corporations. The race to the bottom operates in many areas beyond corporate law--usually by means of capital flight or physical movement. Even in a counterfactual world without the internal affairs doctrine, corporations might still be able to choose their law by changing physical domiciles. But the tradeoff would be quite different. Under current law, a firm can determine its state of incorporation independent of such business decisions. High-tech firms may need to be in Silicon Valley or publishers in New York, but any corporation can incorporate in Delaware. Were law tied to location, most firms, most of the time, would find that legal regulation was insufficiently salient to determine their location. No doubt, if California law was vastly less attractive than Delaware's, some firms might physically move to Delaware, but in most cases, relocation would simply not be worth the costs.

Moreover, our economy is dominated by large firms operating in many different markets, or, more accurately in a single national American market that does not respect state boundaries. With respect to these firms, at least the large commercial states would have great ability to impose law were they to reject the internal affairs doctrine. Car companies surely would not refuse to do business in New York, Illinois, or California just because their managers preferred some aspect of Delaware corporate law to the New York, Illinois, or California equivalent.

In short, capital flight no doubt would restrain a small and radical state to some degree. When Massachusetts's taxes get too high, a certain part of Boston's suburbs crosses the New Hampshire border; Utah's willingness to allow businesses to operate as they please similarly allows it to serve as a refuge from perceived excesses in California's more aggressive regulatory regimes. But this type of interstate competition operates at a vastly different level than current corporate law competition, where corporations choose their law with virtually no collateral costs at all. Even weaker states should have enough freedom of maneuver to abandon the race to Delaware without seeing significant parts of their economy decamp to Wilmington.

Alternatively, there could be some legal bar to abandoning the race to the bottom/top. This claim also seems incorrect. The doctrinal core of the race to the bottom/top is the internal affairs doctrine, which holds that a state will apply the corporate law of a corporation's state of incorporation, regardless of ordinary choice of law considerations. Under ordinary choice of law doctrine, it might be difficult to determine which state's law ought to apply to questions relating to national enterprises. [FN62] But generally it would be crystal clear that under no possible analysis would Delaware have the weightiest interest in enterprises that operate almost completely elsewhere. The issue, then, is whether the internal affairs doctrine bars states from opting out of the race. This it could do only if it were written in stone, in some sense unchangeable. It is not.

In general, modern versions of the internal affairs doctrine appeared near the turn of the twentieth century as common law, later codified. For example, the R.M.B.C.A. enacts the doctrine by defining "corporation" to exclude "foreign corporation" [FN63] and "foreign corporation" to mean "a corporation for profit incorporated under a law other than the law of this state." [FN64] The effect of these definitions is that every corporation incorporated in the enacting state is covered by that state's R.M.B.C.A. regardless of whether it is located or doing business there; conversely, all corporations incorporated elsewhere, regardless of whether they are located or doing business in the enacting state are foreign corporations not subject to the enacting state's R.M.B.C.A. In case the implications were not clear, the statute states it explicitly: "This Act does not authorize this state to regulate the organization or internal affairs of a foreign corporation authorized to transact business in this state." [FN65]

The very fact that the internal affairs doctrine is a product of statute or judge-made common law suggests that any state could reject it by simple legislation. And of course, no state can force another state to allow it to legislate extra-territorially simply by asserting that right in its corporations code. The internal affairs doctrine exists, then, only because each state enacts it, by common law or statute, and only so long as the state continues to accept it.

Some states have explicitly restated this limitation on the doctrine even as they have accepted it. Thus, for example, New York affirmatively asserts the right to legislate with respect to foreign corporations: "This chapter [i.e., the N.Y.B.C.L.] applies to every domestic corporation and to every foreign corporation which is authorized or does business in this state." [FN66] To be sure, having asserted the right to regulate, New York doesn't actually do so: Most provisions of the N.Y.B.C.L. apply only to corporations organized under the statute. Even where the language could be interpreted otherwise, New York courts consistently refer to the internal affairs doctrine. For example, section 626 of the N.Y.B.C.L. explicitly authorizes derivative actions with respect to foreign corporations, but most New York courts view this as a jurisdictional grant that does not affect the choice of law question. [FN67] The point remains: The internal affairs doctrine applies in New York to non-New York corporations only by the grace of the New York legislature and the acquiescence of the New York courts. There is nothing inevitable about New York's participation in the race to the bottom/top.

Even the more restrained language of the R.M.B.C.A. appears to recognize that the internal affairs doctrine is a matter for the host state's legislature: The statement that "this Act does not authorize the state to regulate the organization or internal affairs of a foreign corporation" [FN68] clearly acknowledges the possibility that another chapter, or a differing statutory text, might so regulate.

Delaware has asserted that the internal affairs doctrine, and thus the race to the bottom/top, is constitutionally-mandated, a necessary consequence of our federal system and the commerce clause's bar on interstate discrimination. [FN69] Dicta in some Supreme Court decisions suggests the same thing (although the older opinions located the right in a different constitutional clause). [FN70] Full discussion of the Constitutional cases would require another article. [FN71]

Here, suffice it to note that the argument requires believing that federalist principles require states to allow Delaware to legislate with regard to matters entirely outside its borders. Surely this is a deeply implausible claim.

First, ordinary notions of sovereignty, even the limited variety we give our states, begin with the territorial principle that a state has primary authority over matters of economics, politics, and law occuring within its boundaries.

Second, ordinary notions of democracy require that the people affected by a law--here, clearly all those whose economic relations are determined by the existence, boundaries, governance rules, and policies of the corporation, and only rarely Delaware voters--have the ultimate say over it. If in fact "internal affairs" affected only shareholders and managers who had contractually agreed to adopt Delaware law, perhaps this would not be a concern. But, as Jed Rubenfeld puts it, "the problem with the internal affairs doctrine is essentially the same as the problem with John Stuart Mill's doctrine of self-regarding acts: There are none. No corporate affairs are ever exclusively 'internal'; they will always have consequences of greater or lesser magnitude on the 'outside' world." [FN72]

Finally, giving constitutional status to the internal affairs doctrine requires believing that this strange understanding of federalism is so fundamental that it is enshrined in a Constitution that, in all relevant parts, pre-dates the origin of the modern corporation and, of course, is absolutely silent on the subject.

Corporate law creates the corporation as an economic and legal actor, giving it the right to hold funds and other property, enter into contracts, author intellectual property, and commit torts. It determines which human beings speak for, represent, or make decisions for the corporation, by determining the authority of the board and its electors. Perhaps most important, it determines whom corporate decision-makers should view as the corporation and whom as outsiders. When fiduciary duty law (or accounting principles) state that profits are reduced by wages, interest, or price reductions but not by dividends, the message to corporate decision-makers is clear. Employees are outsiders, to be given as little as possible in arms-length market bargaining. Shares, in contrast, are insiders; transferring corporate funds to them does not make the corporation worse off. It is corporate fiduciary duty rules, not anything in the nature of the firm, that directs managers to consider giving money to shares fulfillment of their professional duty but providing value to consumers or wages to employees merely a tool to the end of profit.

Corporate law determines the responsibilities of the people who work for the corporation and influences whether they, in their jobs, will act as citizens thinking of the good of society or will view social norms merely as restraints to be avoided whenever convenient. It thus determines the ways in which the corporation will use the great discretion granted to it under general law, for whose benefit it will act, and how it will fulfill its role in our society. Legal personality and limited liability rules, in turn, determine the extent to which property and the humans responsible for it will or will not be available to respond to claims against the corporation.

Given this broad reach, constitutional minimum contacts jurisprudence clearly would put all corporate law within the reach of any state in which a corporation has business operations. [FN73] Thus, in the case of disputes about limited liability, states clearly could impose state law any time they can impose state law regarding the underlying contract or tort dispute. More broadly, however, ordinary minimum cnontacts jurisprudence would allow a state to impose local law regarding corporate decision-making whenever local jobs, factories, environmental regulation, financial investments or other local interests are impacted.

Finally, it could be argued that abolishing the internal affairs doctine, even if legally possible, would be completely impractical. If each state were to impose its own law on corporations acting within its borders, certain complications would arise that are absent in the internal affairs system. More than under current corporate law, corporations existing and operating in different states would be subject to multiple and possibly inconsistent corporate law regulations. For example, corporate investors might be secondarily liable for corporate obligations in one state but not in another. [FN74] Similarly, one state might require that corporation decisions be made by a board elected by proportional representation of shares while others might bar such voting. [FN75] Connecticut already requires corporations to consider non-shareholder interests under some circumstances (although it provides no effective remedy for violations). [FN76] More radically, some states might decide to follow European norms and require representation of non-shareholder interests, while others no doubt would bar such systems.

But multistate businesses face such inconsistency in many areas, from state Blue Sky laws to environmental and labor laws. Dealing with the inconsistencies wouldn't be impossible. Presumably, most firms would find it possible to meet most regulatory regimes most of the time, just as they do in other regulatory areas today. For example, if one state were to limit limited liability for environmental torts in its jurisdiction, corporations would simply adjust their business plans to compensate, increasing precautions or holding larger insurance reserves in that state, for example. Or investors could adjust, holding firms that operate in the high liability state only in diversified portfolios or demanding higher compensation or greater supervisory rights due to the higher risk. Similarly, if one state followed Germany's lead and required employee representation on the corporate board, corporations doing business there could comply with that regulation without violating any provision of the generally quite flexible R.M.B.C.A. or Delaware codes.

Other types of inconsistencies might be more difficult for corporations. For example, different states in fact have had incompatible voting regimes for corporate boards. Different American states have both mandated and barred cumulative voting; a corporation would find it challenging to both have and not have cumulative voting.

But this type of inconsistent regulation is also not unknown. If compliance with differing state regimes was impossible or unduly difficult, corporations could create independently incorporated subsidiaries in each jurisdiction in which they did business (as banks did as the ban on interstate banking began to break down and as insurance companies often do to comply with disparate state regulatory regimes). This would give us the advantages of federalism without the free choice of law, leading to a lack of legal restraints on power; tax exporting; and anti-democratic aspects of the current regime.

Alternatively, firms could seek a uniform state corporation code through the usual mechanisms. This is the regime under which multi-state law firms and other large partnerships exist; each state applies its own law, but most states apply something quite close to the Uniform Partnership Act or the Revised Uniform Partnership Act. We might then end up with a single state corporate law, but with the critical difference that every state legislature, not just Delaware's, would have the opportunity to vote on it.

Finally, multi-state corporations unwilling to operate through state-based subsidiaries could pressure for a federal incorporation law (as early railroads did, and as is the German model, where incorporation is considered a federal rather than a state responsibility). [FN77] We already have federal chartering for banks, so this would not be a radical innovation.

In short, neither economics, the nature of law, nor inconsistency problems prevent states from simply opting out of the race to the bottom/top and reclaiming both their sovereignty over difficult issues of social planning and over taxation of their citizens. A fuller account of the race to the bottom/top, then, must explain why states have not fought harder to retain their right to legislate. This Article does not explore that historical question, but it does argue that the time has come for states to reassert the rights they have abandoned. The race is not some inevitable aspect of federalism but rather an accidental byproduct of particular contingent facts. Were the major industrial states to conclude that the race is no longer in their interests or not in accord with their political or moral beliefs, they could simply and unilaterally put an end to it. Indeed, as we see in the next section, at the margins they have ignored it.

B. The Inevitable Internal Affairs Doctrine

If the first problem with the race to the bottom/top is that it is hard to understand why states don't simply opt out, the second is that the doctrinal basis for the race is extremely peculiar. Given that states have choice, the question here is the coherence of state law. The choice of law rule for corporations--that corporations choose their law by determining where to incorporate--is anomalous. Under ordinary doctrine, a forum state applying a comparative interests analysis would be hard pressed to conclude that Delaware had a stronger interest than the forum state in corporate actions taking place in the forum or affecting the citizens of the forum state. Courts and legislatures interested in making the law a consistent whole ought to question why we abandon the usual rules for corporations.

1. An Anomalous Choice of Law Rule

Ordinary choice of law doctrine presumes that the law of the forum state applies unless the weight of interests is clearly elsewhere. [FN78] In the usual course, courts would consider factors such as where the dispute arose, where the relevant agreements were made or carried out, which state's citizens would be most impacted by the adjudication or rule of law, where the parties are domiciled, and so on. In a case where the corporation's only contact with Delaware is its incorporation (with the statutorily required registered office and agent), none of these factors points to Delaware.

Conflicts analysis generally begins with the legal issue at stake. Were corporate "internal affairs" considered under the usual doctrine, the first issue would be characterizing particular disputes as tort, contract, or status--a difficult task, considering that corporate law partakes of all of these while borrowing most heavily from the law of limited sovereignty and self-government.

Some corporate law disputes seem to be obviously in the tort category: The most common "internal affairs" litigations probably are derivative actions for breach of duty of care or duty of loyalty, which are clearly negligence-type actions. Similarly, the "internal affairs" matter of limited liability also affects, at least implicitly, every tort action involving a corporation.

In a tort action, courts will look first to the interests of the states involved. The tort law of conflicts focuses on which state "has the most significant relationship to the occurrence and the parties," by looking to "(a) the place where the injury occurred, (b) the place where the conduct causing the injury occurred, (c) the domicil, residence, nationality, place of incorporation and place of business of the parties, and (d) the place where the relationship, if any, between the parties is centered." [FN79] Courts ask such questions as where the allegedly tortious conduct occurred--in most cases the state where the tort occurred is the state that will have the strongest interest in deterring such conduct or balancing deterrence against other values--or where the victim is domiciled or was injured--that state, or those states, will have the strongest interest in compensating the injured party or balancing the interests of compensation against competing interests of furthering economic activity. [FN80] Since these torts involve a relationship between the parties at least formally, the location or center of that relationship will also be important under ordinary tort conflict of law principles. [FN81] When a corporation doing business in New York injures a New Yorker, whether as a shareholder or in any other role, Delaware has no obvious interest in whether New York concludes that accurate pricing, compensating victims, deterring wrongdoers, or subsidizing accident-causing entrepreneurs is the most important tort value. Those are issues for the citizens of New York to decide, not Delaware (or the firm's managers).

Other corporate law internal affairs actions might be analyzed as contract disputes. For example, contract conflicts principles would apply when limited liability affects the performance of a contract. Disputes among shareholders or between shareholders and directors over the election of the board, for example, might be analyzed as closer to contract than tort, on the theory that corporate governance, at least as to shareholders and managers, can be analogized to a consensual, negotiated contractual agreement. Like many contracts, this agreement implicates both individuals and policies beyond its four corners, including the effects it has on corporate participants who are not participants in the "agreement." Usually, then, if corporate law were analyzed as contract, it would be analyzed as contract imbued with social significance. Contract conflict rules are more complicated than tort rules but again ultimately rest on the relative interests of the states involved.

In contract disputes, courts will give substantial weight to the law chosen by the parties (although never the dispositive weight of the internal affairs doctrine) to the extent that the parties could have determined the issue explicitly in their private agreement. [FN82] This is clearly the point where the internal affairs doctrine looks most like normal conflicts law: If corporate law were purely private contract law, the only relevant parties were shareholders and managers, and incorporation were equivalent to a private agreement with no public-policy implications, ordinary choice of law would reach a conclusion not unlike the internal affairs doctrine. But those qualifications are critical.

Absent the internal affairs doctrine, parties could not privately agree to grant themselves limited liability or to create a corporate enterprise with governance centered in an elected board and transferable voting rights. (At a minimum, that would require consent of each shareholder or perhaps each corporate participant, converting a corporation into something much more like a partnership.) The very creation of a corporation, then, should take corporate law out of the purely private sphere in which parties are allowed to choose their own law without regard for state sovereignty or policies.

Beyond that fundamental limit on the right of the disputants to choose their own law, other conflicts principles significantly limit contracting parties' right to specify their own law outside of normal political processes. First, contracting parties may not specify a state that "lacks a substantial relationship to the parties or the transaction," which would exclude Delaware in most instances of Delaware corporations. Second, the forum state should ignore the parties' specification if "application of the law of the chosen state would be contrary to a fundamental policy of a state which has a materially greater interest." [FN83] As in tort, courts place great weight on location in determining the interests of the various states. The Restatement lists such factors as place of contracting, negotiation, and performance; location of the subject matter of the contract; and the same domicil-related factors important in tort. [FN84]

A court might also understand the issue not as a dispute between human beings located in specific places but as an issue of the existence or status of the corporation itself. Corporate law, then, would be closely analagous to other status relationships, and corporate choice of law might look like family choice of law. Like families, corporations are semi-autonomous, internally governed units in our law, where the state overtly intervenes mainly when something has gone seriously wrong or the usual internal dispute resolution mechanisms (operating in the shadow of state-created background rules) are malfunctioning.

Status relationships--principally divorce--have yet a third set of conflicts rules; here, the most important jurisdictional factor is domicil, but states may choose to hear disputes involving mere residents as well. Importantly for the corporate analogy, it is accepted that the "the fact that the spouses were married in the state should not of itself provide an adequate jurisdictional basis." [FN85] Moreover, a domiciliary state will apply its own local law to determine the right to a divorce. [FN86] The net result is that the key factor is domicil--which in the corporate context would more naturally mean the real location of the actual organization, rather than the legal formality of incorporation, which would be more analogous to the state that created the marriage.

Neither in tort nor in contract do these principles lead automatically to an obvious result in all corporate law disputes. But they point in a consistent direction away from Delaware. Disputes about how the company is run ought to be subject to the law of a state where the company is run, or a state that is affected by how the company is run, or a state where the people who run the company are located, or a state where the disputants' relationship is centered. In the ordinary course, the choice under these principles would be among states where the corporation is headquartered (presumably the location of any breach by its managers or directors) or where its principal activities are located. Sometimes, the key factor arguably might be the state where the relationships were commenced--for disputes involving shareholders of publicly held corporations, presumably either New York where the stock exchange is located or the shareholders' home state where they initiated the relationship, or, again, the headquarters of the corporation where the relationship was consummated and centered. In any event, the state of incorporation is nearly irrelevant to any of these issues. If the corporate law issue is seen as a dispute between managers and shareholders (or indeed any other corporate participants), the key point ought to be where the human parties are located.

Similarly, a court applying status rules in the absence of the internal affairs doctrine to determine what law should apply to an issue of corporate existence or internal corporate decision-making (for example, who has the power to act on behalf of the corporation) might ask (as European courts do) where the corporation or its headquarters is physically located. [FN87] It might explore where the relevant agreements were made or were intended to be performed--where, for example, the relevant by-laws or corporate resolutions were negotiated or enacted. Presumably, it would ask which states' citizens were likely to be affected by the dispute or its resolution. It would then inquire whether fundamental policies of those states--including values of self-governance, employee protection and self-determination, economic growth and quality, responsibility for legal liabilities under tort, environmental protection law and (with a rather different set of issues) contract law, and so on--are implicated.

In short, under standard conflicts law, there might not be a single, clear answer to where the weight of the interests might be in disputes involving a national corporation. But usually it would be clear that Delaware has no interest at all because so few of the relevant human beings live in Delaware. When Delaware determines to whom corporate managers owe fiduciary duties, what the scope of limited liability is, whether shareholders should be imagined to be diversified portfolios as interested in a company's competitors' success as in its own, or whether Delaware corporations may vote their own stock, the humans affected by the decision--shareholders, managers, bondholders, employees, customers, suppliers, competitors, downwinders, or economic neighbors affected by the corporation--are almost certain to be located elsewhere.

Under the internal affairs doctrine as currently understood, of course, none of this is relevant. Choice of law is not an issue for courts to determine by comparing the interests of the forum state with that of other possible sovereign claimants. Instead, courts simply defer to the choices made by corporate decision-makers. Without that deference, the race to the bottom/top would not exist in its current form: States, no longer passive but active participants in a regulatory enterprise, would have to make decisions about which state is entitled to regulate which business enterprises (or, in the case of regional or national ones, which parts of them). Corporations unhappy with the corporate law of their host states would be forced to respond just as ordinary citizens respond to law they are unhappy with--by attempting to mobilize political forces to change the rules, by relocating to a different state, or by convincing the federal government to impose a uniform national standard.

2. Defining "Internal"

The gap between ordinary choice of law rules--which would not lead to the race--and the internal affairs doctrine means that the race to the bottom/top as we know it in corporate law depends intimately on the line created by the internal affairs doctrine. The boundary between internal affairs and ordinary choice of law is the boundary between ordinary politics and the "market for law" that distinguishes the race-to-the-bottom/top theories. If the distinction collapses, then either the race must turn into ordinary politics or vice versa. For without the internal/external distinction, any state could opt out of the race by declaring a particular regulation "external," or corporations could argue that any regulation was "internal" and ought to be binding only if chosen. Thus, the race to the bottom/top relies on strong agreement on which matters are "internal" and which are not.

Legal boundaries are places of conflict and dispute as a rule; maintaining distinctions, tweaking, pushing, and destroying them is most of what lawyers do. The internal affairs/conflict of law distinction is no different than the other famous distinctions around which legal debate centers: It is not only essential but debatable, contestable, and ultimately quite fragile. Current law cannot live without it, but it cannot depend on it either.

At first glance, there appears to be general agreement on what is covered by the internal affairs doctrine--the sorts of things that appear in the Revised Model Business Corporations Law, matters relating to the internal power relationships between shareholders, directors and managers. The R.M.B.C.A., for example, invokes this understanding of the doctrine in its reference to "organization or internal affairs of a foreign corporation." It then effectively defines internal affairs as "whatever matters are covered in the R.M.B.C.A." [FN88] by excluding foreign corporations from the scope of its regulation. But, appearances notwithstanding, there is no principled line that explains what is or is not part of corporations law nor what is or is not internal. [FN89]

If, as this Subsection demonstrates, the boundary of the internal affairs doctrine is contested and, ultimately, political, then it follows that the race to the bottom/top is not a natural feature of American law but rather a hidden political decision. Covert action is generally not a healthy way to make law in a democracy. The decision to abandon the task of determining the content of corporate law to corporate managers and Delaware voters is an intensely political decision that, to be justifiable, requires strong arguments against normal law, as we have seen in several areas. That decision ought to be made, if at all, only after a true political debate. But first we must establish that there is something to debate about--that the internal affairs doctrine is not simply a background fact of life.

a. Internal Corporate Law/External Securities Law

Many issues that seemingly relate to the relationship between shareholders and managers have been taken out of the race to the bottom/top by being declared something other than corporate law. Most importantly, perhaps, is the unusual American distinction between corporate and securities law. In most countries, securities regulation is considered part of companies law, and of course our corporations laws regulate many aspects of the rights and duties associated with corporate securities. However, we have removed large parts of securities law from the race to the bottom/top by simple reclassification. On the one hand, the federal government, through securities law, regulates most issues of shareholder rights to learn about internal corporate affairs ("disclosure") [FN90] including minimum accounting standards, [FN91] as well as many aspects of rights to sell the corporation or change the composition of its board of directors (tender offer and proxy solicitations). [FN92] On the other hand, states simultaneously regulate disclosure and other sale of securities issues without concern for the internal affairs rules by declaring Blue Sky law subject to ordinary choice of law doctrine.

Corporate law and federal securities law conceptualize the regulatory problem in largely distinct ways. In general, federal securities law conceives of shareholders as outsiders to the corporation. In effect, under federal law, shareholders are consumers of a product (securities) that is seen as particularly difficult to evaluate, so that consumers need a special type of truth-in-labeling protection. In contrast, state law more often treats shares as insiders--voter-citizens of a peculiar kind of limited republic.

Both regimes use the rhetoric of ownership, but in the federal regime, what shareholders own are shares, while in the state regime, they are sometimes spoken of as owning the corporation itself (although they generally have political rights rather than the rights normally associated with ownership). But even this distinction is not entirely clear. The federal Williams Act, for example, regulates that most-political of shareholder rights, the proxy contest to overthrow incumbent governors, in ways that go well beyond the usual federal conception of shareholders as benighted consumers in need of elaborate warning labels. [FN93]

Notwithstanding the differing rhetoric and metaphors of state and federal law, the line between corporate and securities law is basically arbitrary. Nothing in the nature of the corporation determines when public shareholders will be seen as consumers, entitled to protection without races to the bottom/top, or when as voters and owners under a state regime of voluntary law.

Similarly, some states have unilaterally declared particular issues not "internal." Thus, for example, California has mandated (while other states have banned) cumulative voting for directors without closely following the internal affairs doctrine. [FN94] New York and other states impose domestic rules regarding disclosure of the shareholders list--important mainly for the purely internal purpose of contesting the control of the corporation's decision-making machinery--on foreign corporations using ordinary choice of law analysis. [FN95] New Jersey, in a famous case read in many introductory business organizations courses, imposed its own law of fiduciary obligation on a New York corporation existing in New Jersey. [FN96] New York did the same in a Cardozo decision. [FN97] Other states have also ignored the internal affairs doctrine from time to time. [FN98] Finally, nearly every state determines most managerial (as opposed to directorial) duties at least in part by agency law, following ordinary choice of law rules rather than the internal affairs doctrine.

b. Externalizing Internal Law

Conversely, some parts of the R.M.B.C.A. are "internal" only by the wispiest of legal fictions.

i. Limited Liability: Determining When There Is a "There" There

The law of limited liability, usually found in business corporations laws, determines whether and to what extent the people associated with a corporation will be personally responsible for the contracts they enter into or the damages they cause while operating as a firm. In turn, that determines whether other "external" regulatory law has any meaning at all. If a corporation can be set up with no capital and only the corporation is liable for "its" contracts, torts, or environmental disasters, then nobody is liable at all. Limited liability, that is, determines if there is a "there" there, and thus whether the host state (not the incorporating state) will be able to effectively control its economic and other actors. For this reason, no doubt, both ERISA and Superfund ignore the internal affairs doctrine--to be effective, those statutes had to have their own rules of limited liability. [FN99] California, similarly, for many years refused to recognize full limited liability even when it was granted by the incorporating state. [FN100] Most states impose minimum capitalization rules on insurance companies operating domestically without regard to the internal affairs doctrine (which would leave that decision to the incorporating state); this too is a clear limitation of limited liability.

In general, the states have abandoned limited liability law to Delaware under the banner of the internal affairs doctrine, but there is nothing in the doctrine itself that explains why limited liability is an internal affair. After all, Delaware law generally treats corporate creditors as external, outsiders to a corporation conceived of as consisting, at least in the first instance, of its shareholders. Why should Delaware be allowed to determine the conditions under which investors in a business operating outside of the state should be allowed to decline responsibility for its torts and contracts?

ii. The External Reach of Fiduciary Duty

Similarly, fiduciary duty is hardly an "internal affair." Everyone, not just shareholders, is affected by how national businesses are run. The law of fiduciary obligation (and the rules of voting) determine to whom directors owe loyalty and for whom they manage the corporation. This "internal" rule determines how the corporation relates to its various participants-- whether, for example, employees are seen as part of the enterprise or as outsiders to be exploited. [FN101]

Delaware corporate law instructs managers that their duty is to act in the best interests of the corporation and its shareholders but offers little guidance as to what interests the corporation might have apart from share value maximization. [FN102] However, Delaware law is quite clear that no non-shareholder has a claim on the loyalty of directors, since it grants no non-shareholder either standing or votes to influence those actions or represent those interests. Moreover, when the company is for sale, shareholders have an enforceable claim to exclusive loyalty. [FN103]

While we call these matters "internal," they hardly affect only shareholder/manager relations. Whether or not what is good for General Motors is good for America, it is definitely the case that what General Motors views as good for General Motors will affect every American. Fiduciary duty law tells General Motors decision-makers what they should view as "General Motors" and what they should view as "good" for General Motors. If it directed them to view global weather patterns as part of General Motors, or if it directed them to consider General Motors customers as constituents (as shareholders are) rather than outsiders (as employees are), perhaps General Motors would take a different view of mass transit. If it directed Wal-Mart to view its employees (or the employees of the factories that produce the products it sells) as as much a part of Wal-Mart as its shareholders are, surely the company would be quite different. The point is not that these changes in fiduciary duty would be sensible; some would not be. The point is that fiduciary duty affects the citizenry--it is not an "internal" affair.

At the margins, the law accepts the claim it ignores at the core. Thus, recognizing the arbitrariness of the claim that fiduciary duty is "internal" and private, of concern only to those who chose the applicable state law, federal bankruptcy law ignores the internal affairs doctrine and constructs its own, rather different, view of fiduciary obligation, in which bondholders-- explicitly excluded from the corporation under Revlon--may demand that directors of insolvent or almost-insolvent corporations run the firm in their interests. [FN104]

Fiduciary duty, in short, determines what a corporation's managers should view as "its" interests. That, in turn, should affect how it acts in the world--not merely relation to shares "internally" but in every aspect of its operations. External regulatory laws--such as environmental, civil rights, consumer protection, labor, tort or criminal law, or even contract rules requiring contracting parties to fulfill their promises--impose more-effective or less-effective external constraints on corporate decision-makers. Corporate law, in contrast, charges the decision-makers with a duty to use their freedom of action within those constraints to a particular end.

One key justification of the internal affairs doctrine is that it is simply a convenient rule of interpretation of a private contract--by incorporating in a particular state, shareholders and managers clearly signal their intent to be governed by the law of that state, and other states have little reason not to respect their choice. But that justification only works if the internal affairs are in fact internal in the sense of being important primarily to shareholders and managers. Because it determines these role obligations, fiduciary duty is not "internal" in that way. Rather, changes in corporate law change the basic decision-making process itself, a potentially far more powerful tool than changing the "external" regulatory constraints within which it functions.

iii. Harnessing Fiduciary Duty: Who Is a Means and What Is an End?

Under current norms, conscientious managers are likely to see a conflict between their role responsibilities and larger social duties: To be a good professional, one must set aside one's views as a citizen. The role of manager currently requires professionals to maximize share returns even at the expense of social good (although it probably does not require the manager to adopt any particular view of how best to maximize shareholder value and certainly does not require adopting the false view that share value is always best pursued by disregarding everyone else's interests). Indeed, Delaware norms suggest that managers "ought" to exploit loopholes, take advantage of non-shareholder corporate participants, and evade or perhaps even violate the law whenever doing so is profit-maximizing.

Within the professional managerial role, the argument must be about whether criminality or excessive decency is profit maximizing, not over whether Kantian imperatives require one to act morally even if the result is going to hurt the firm. Thus, corporate ethics debates center on whether it might not be profit enhancing to treat employees better or whether pollution is costly. [FN105] Optimistic theorists suggest that consumers might be able to overcome the limits of constrained rationality to purchase products based on their politics. [FN106] Less persuasively, ethicists even argue that shareholders might avoid the stock of companies that act contrary to their values, although most shareholders are institutions that would be in violation of their own fiduciary duties if they chose stock on any basis other than potential profit, and even a few such shareholders should be enough to ensure that stock prices reflect only perceived profit potential.

All these approaches accept the basic premise of current fiduciary law: Doing good is permitted only when profitable. Conversely, the share-centered profit norm of corporate law demands that managers cause the corporation to free-ride whenever profitable, even if they see and agree that it is wrong to do so. [FN107] Delaware corporate law, that is, encourages decent managers to act indecently. [FN108]

Thus, for example, under current corporate law, corporate funds expended to help the environment or the employees are classified as costs to the corporation. Conscientious managers are directed to minimize such costs. Corporate law tells them to do no more for the environment or employees than regulatory law (interpreted narrowly) requires, unless benefiting those outsiders would effectively increase gains for shares. In contrast, current corporate law counts a gain to the value of shares as a gain to the corporation: Corporate law directs managers to maximize, not minimize, this share value within regulatory constraints. If corporate law has any effect at all, it must be to urge managers to use their discretion to increase shareholder gains at the expense of environmental or other values whenever they conflict. Share value is an end, while all other participants and values are merely means to that end or legally imposed constraints on pursuing it.

Accordingly, a state serious about its environmental, consumer protection, tort, or contract law--or indeed any value that potentially conflicts with maximum returns to shares--might consider making one or more of those corporate claimants into beneficiaries of a corporate fiduciary duty or voting constituents of a corporate governing board. This change would dramatically change the decision-making process of conscientious professional managers. Fulfilling the spirit, not just the letter, of non-corporate law would now be their duty, rather than an arguable violation of fiduciary responsibilities to fictional shareholders. Conscientious managers, under this alternate corporate law regime, would seek to maximize, rather than minimize, the corporate resources going to these constituents. If the beneficiaries of this new duty had the right to enforce it in court or to politically oust directors who ignored it, even non-conscientious managers might find their role-demands radically changed. One cannot simply exploit a party who has a right to sue for breach of duty or an effective power to remove the exploiter from office. Thus, by opting out of the race to the bottom/top, states could harness the powerful incentives of corporate law to work for, rather than against, other legal norms.

iv. The Limits of Law

To be clear, it is important to note the limits of corporate law, including radically different corporate law that states might consider. In the end, the market constrains every firm. At equilibrium, where there is no firm surplus and firms must sell precisely at cost, corporate law fiduciary duties are largely irrelevant, for the simple reason that there is no difference between maximizing and minimizing: To sell anything at all, managers must sell at the lowest cost they can, which means they must minimize resources given to all corporate claimants, including shares or any alternative object of their fiduciary duty. Even when a corporation has some flexibility--where there is a corporate surplus to argue about--the basic market constraint limits any attempt to obey corporate law's mandate that managers exercise their discretion in the interests of one corporate claimant rather than another. If, under current law, a corporation gives too much to shares in the short run, its expenses will be too high for it to continue in existence in the long run.

Even were the object of corporate fiduciary duty to change, this constraint would not. Managers directed to maximize (for example) environmental values co