Freakonomics – 539. Why Does One Tiny State Set the Rules for Everyone?

Intro

In this episode of the Freakonomics podcast, the hosts explore why Delaware, the second smallest US state by area and the sixth smallest by population, sets the rules for everyone. They delve into the reasons behind Delaware’s dominance in corporate law and the implications it has on tax dodging, money laundering, and trafficking. They also discuss the role of the Delaware legal industry and the Court of Chancery in shaping the state’s corporate laws.

Main Takeaways

Delaware’s Dominance in Corporate Incorporation

• Delaware has established its own rules for how corporations incorporate, attracting businesses with its special business court, tax haven status, and ease of incorporation.
• Approximately 95% of corporations incorporated in Delaware do not do significant business there.
• Delaware has more companies than people, with roughly two-thirds of Fortune 500 companies being legally registered there.

The Implications of Delaware’s Tax Policy

• Delaware’s tax policy has caused state corporate income tax receipts to collapse, and companies have used the Delaware Loophole to avoid paying taxes in other states.
• The state’s ease of setting up a company makes it easier to set up a company in Delaware than to get a library card there.
• Anonymity in Delaware makes it easier to hide illegal activity, such as money laundering.
• Delaware is known for anonymous LLCs and shell companies, frustrating criminal investigators who often find that they don’t know who’s actually behind a company.

The Influence of the Delaware Legal Industry

• The Delaware bar operates in what is known as the “Delaware way” and is influential in shaping corporate laws.
• The Delaware Bar’s corporation law council, made up of 27 working lawyers, writes proposed changes to the law and presents them to the state legislature without explanation or justification.
• Delaware has perfected regulatory capture, where lawyers write the corporate code themselves and it gets rubber-stamped without checks and balances.
• Only unelected lawyers have the right to make laws in Delaware, and they inevitably make laws that protect and promote the Delaware franchise.

The Role of the Court of Chancery

• The Court of Chancery is one of the three constitutional courts of Delaware and is the preeminent venue for deciding business disputes.
• The court of chancery is a separate court system in Delaware that deals with fiduciary relationships, such as trustees and directors of a corporation.
• Delaware’s reputation as a haven for anonymous LLCs and shell companies is a concern, but requiring disclosure could harm Delaware’s franchise.

Summary

Delaware’s Dominance in Corporate Incorporation

Delaware’s appeal to businesses lies in its special business court, tax haven status, and ease of incorporation. Companies choose to incorporate in Delaware for various reasons, including the chance to record in a special business court, tax advantages, and the simplified incorporation process. Delaware’s tax policy has led to a collapse in state corporate income tax receipts and the use of the Delaware Loophole to avoid taxes in other states. The state’s reputation for anonymity and the ease of setting up a company contribute to its attractiveness for businesses.

The Implications of Delaware’s Tax Policy

Delaware’s tax policy has enabled tax dodging and money laundering, as companies can easily hide their activities behind anonymous LLCs and shell companies. The state’s focus on efficiency and ease of incorporation has created an environment where illegal activities can thrive. The US has made efforts to combat money laundering through international standards set by the Financial Action Task Force, but Delaware’s anonymous registration process undermines transparency efforts. While the US passed the Corporate Transparency Act in 2020, Delaware was heavily involved in lobbying around the law and still allows anonymous registration.

The Influence of the Delaware Legal Industry

The Delaware legal industry plays a significant role in shaping corporate laws and protecting the Delaware franchise. The Delaware bar’s corporation law council, composed of working lawyers, has the power to propose changes to the law without explanation or justification. This system of unelected lawyers making laws without democratic oversight has led to a clubby system that promotes and protects Delaware’s corporate interests. The legal industry is valuable to both legitimate and illegitimate corporations, generating billions of dollars for the state and providing employment opportunities.

The Role of the Court of Chancery

The Court of Chancery, as one of Delaware’s constitutional courts, holds significant influence in deciding business disputes. It operates as a separate court system that specializes in fiduciary relationships, such as those between trustees and directors of a corporation. The court’s detailed opinions not only resolve individual cases but also provide guidance for future situations. Delaware’s reputation as a haven for anonymous LLCs and shell companies raises concerns, but imposing disclosure requirements could jeopardize the state’s franchise.

Conclusion

Delaware’s dominance in corporate law and incorporation has created a system that attracts businesses with its special business court, tax advantages, and ease of incorporation. However, this system also enables tax dodging, money laundering, and corporate anonymity. The Delaware legal industry and the Court of Chancery play crucial roles in shaping corporate laws and protecting the Delaware franchise. While there are concerns about transparency and democracy in Delaware’s legal system, the state’s reputation and revenue generation make it difficult to challenge its position as the go-to destination for businesses.