Encyclopedia of Finance Part 10 potx

Chapter 17
THE 1997 NASDAQ TRADING RULES
YAN HE, Indiana University Southeast, USA
Abstract
Several important trading rules were introduced in
NASDAQ in 1997. The trading reforms have sig-
nificantly reduced bid–ask spreads on NASDAQ.
This decrease is due to a decrease in market-making
costs and=or an increase in market competition for
order flows. In addition, in the post-reform period,
the spread difference between NASDAQ and the
NYSE becomes insignificant with the effect of
informed trading costs controlled.
Keywords: NASDAQ; trading rules; reforms; bid–
ask spread; SEC order handling rules; the six-
teenths minimum increment rule; the actual size
rule; NYSE; informed trading costs; SEC
The National Association of Securities Dealers
(NASD) was established in 1939. Its primary role
was to regulate the conduct of the over-the-counter
(OTC) segment of the securities industry. In the
middle of 1960s, the NASD developed an elec-
tronic quote dissemination system, and in 1971,
the system began formal operation as the National
Association of Securities Dealers Automated
Quotations (NASDAQ) system. By the mid-
1980s, timely last-sale price and volume informa-
tion were made available on the terminals.
Through the late 1980s and the early 1990s, more
functions were added to the system. For instance,
the Small Order Execution System (SOES) was

introduced in 1988, and the Electronic Communi-
cation Networks (ECN) was introduced in the
1990s. Services provided by the NASDAQ net-
work include quote dissemination, order routing,
automatic order execution, trade reporting, last
sale, and other general market information.
NASDAQ is a dealer market, and it is mainly
quote driven. On NASDAQ, the bid–ask quotes of
competing dealers are electronically disseminated
to brokers’ offices, and the brokers send the cus-
tomer order flow to the dealers who have the best
quotes. In comparison, the New York Stock Ex-
change (NYSE) is an auction market, and it is
mainly order driven.
Several important trading rules were introduced
in NASDAQ in 1997, including the SEC Order
Handling Rules, the Sixteenths Minimum Incre-
ment Rule, and the Actual Size Rule. The experi-
mentation of the new rules started on January 20,
1997. The SEC Order Handling Rules were applied
to all the NASDAQ stocks in October 1997. The
Actual Size Rule was applied to 50 NASDAQ
stocks on January 20, 1997 and 104 additional
stocks on November 10, 1997. The Sixteenths Min-
imum Increment Rule was applied to all the stocks
in NASDAQ on June 2, 1997. The following table
provides a detailed implementation schedule for
the new trading rules.
NASDAQ implemented the Order Handling
Rules according to a phased-in schedule. On January

20, 1997, the first group of 50 stocks became
subject to the Order Handling Rules. The SEC
Order Handling Rules include the Limit Order
Display Rule, the ECN Rule, and the Relaxation
of the Excess Spread Rule.
The Limit Order Display Rule requires display-
ing customer limit orders that are priced better
than a market maker’s quote, or adding them to
the size associated with a market maker’s quote
when it is the best price in the market. Before the
new trading rules, limit orders on NASDAQ were
only offered to the market makers. The Limit
Order Display Rule promotes and facilitates the
public availability of quotation information, fair
competition, market efficiency, the best execution
of customer orders, and the opportunity for inves-
tors’ orders to be executed without the participa-
tion of a dealer. By virtue of the Limit Order
Display Rule, investors now have the ability to
directly advertise their trading interests to the mar-
ketplace, thereby allowing them to compete with
market maker quotations, and affect bid–ask
spreads.
The ECN Rule requires market makers to dis-
play in their quotes any better-priced orders that
the market maker places into an ECN. The ECN
Rule was implemented partially because market
participants had increasingly been using ECNs to
display different prices to different market partici-
pants. In particular, NASDAQ was concerned that

the reliability and completeness of publicly avail-
able quotations were compromised because market
makers could widely disseminate prices through
ECNs superior to the quotation information they
disseminate on a general basis through NASDAQ.
Accordingly, the ECN Rule was adopted to re-
quire the public display of such better-priced or-
ders.
Prior to January 20, 1997, NASDAQ continu-
ously calculated for each stock the average of the
three narrowest individual spreads among all deal-
ers’ spreads. The Excess Spread Rule (ESR) forced
all dealers to keep their spreads within 125 percent
of this average. On January 20, 1997, the ESR was
amended for all NASDAQ stocks to stipulate that
each dealer’s average spread during the month
could not exceed 150 percent of the three lowest
average spreads over the month. The new ESR
defines compliance on a monthly basis rather
than continuously, placing no limits on the market
makers’ ability to vary their spreads during the
month as long as their monthly average is in com-
pliance.
Table 17.1. New trading rules’ implementation schedule
Date Number of stocks affected by the rules Rules implemented
01=20=1997 50 NASDAQ stocks The SEC Order Handling Rules
The Actual Size Rule
The same 50 NASDAQ stocks The Relaxation of the Excess Spread Rule

All the NASDAQ stocks

02=10=1998 51 NASDAQ stocks added The SEC Order Handling Rules
02=24=1997 52 NASDAQ stocks added The SEC Order Handling Rules
04=21=1997–
07=07=1997
563 NASDAQ stocks added The SEC Order Handling Rules
06=02=1997 All NASDAQ stocks with bid price not less than $10 The Sixteenths Minimum Increment Rule
08=04=1997 250 NASDAQ stocks added The SEC Order Handling Rules
08=11=1997 251 NASDAQ stocks added The SEC Order Handling Rules
09=08=1997–
10=13=1997
800 NASDAQ stocks =week added The SEC Order Handling Rules
10=13=1997 All NASDAQ stocks The SEC Order Handling Rules
11=10=1997 104 stocks added The Actual Size Rule
444 ENCYCLOPEDIA OF FINANCE
The Actual Size Rule is a by-product of the
Order Handling Rules. This rule repeals the regu-
latory minimum quote size (1000 shares). With the
implementation of the SEC’s Order Handling
Rules, the 1000 share minimum quote size require-
ments impose unnecessary regulatory burdens on
market makers. Since the investors are allowed to
display their own orders on NASDAQ according
to the Limit Order Display Rule, the regulatory
justification for the 1000 share minimum quote size
requirements is eliminated. So, it is appropriate to
treat NASDAQ market makers in a manner
equivalent to exchange specialists, and not subject
them to the 1000 share minimum quote size re-
quirements. On January 20, 1997, 50 pilot stocks
became subject to the Actual Size Rule. These 50

stocks also became subject to the SEC Order
Handling Rules. On November 10, 1997, the pilot
program was expanded to an additional 104
stocks. After 1997, the Rule was implemented to
all stocks on NASDAQ.
The Sixteenths Minimum Increment Rule re-
quires that the minimum quotation increment be
reduced from one-eighth to one-sixteenth of a dol-
lar for all securities with a bid price of $10 or
higher. On June 2, 1997, NASDAQ reduced the
minimum quotation increment from one-eighth to
one-sixteenth of a dollar for all NASDAQ secur-
ities with a bid price of $10 or higher. The reduc-
tion is expected to tighten quoted spreads and
enhance quote competition. Furthermore, it com-
plements the Order Handling Rules by allowing
orders to be displayed in increments finer than
one-eighth of a dollar. Specifically, the opportun-
ity is increasing for small customers and ECN limit
orders to drive the inside market.
Overall, all these new rules were designed to
enhance the quality of published quotation, pro-
mote competition among dealers, improve price
discovery, and increase liquidity. Under these
rules, NASDAQ is transformed from a pure
quote driven market to a more order driven market.
Successful implementation of these rules should
result in lower bid–ask spreads by either reducing
order execution costs or dealers’ profits.
Before 1997, a host of studies compared trading

costs between NASDAQ and the NYSE based on
the old trading rules. It is documented that bid–ask
spreads or execution costs are significantly higher
on NASDAQ than on the NYSE. Researchers
debate whether NASDAQ bid–ask spreads are
competitive enough to reflect market-making
costs. Christie and Schultz (1994) find that NAS-
DAQ dealers avoid odd-eighth quotes. This evi-
dence is interpreted as consistent with tacit
collusion, due to which bid–ask spreads are in-
flated above the competitive level. Moreover,
Huang and Stoll (1996) and Bessembinder and
Kaufman (1997) contend that higher spreads on
NASDAQ cannot be attributed to informed trad-
ing costs.
Since the Securities and Exchange Committee
(SEC) changed some important trading rules on
NASDAQ in 1997, studies attempt to assess the
effect of these reforms on market performance.
Barclay et al. (1999) report that the reforms have
significantly reduced bid–ask spreads on NAS-
DAQ. Bessembinder (1999) finds that trading
costs are still higher on NASDAQ than on the
NYSE even after NASDAQ implemented new
trading rules. Weston (2000) shows that the
informed trading and inventory costs on NAS-
DAQ remain unchanged after the reforms, and
that the reforms have primarily reduced dealers’
rents and improved competition among dealers on
NASDAQ. He and Wu (2003a) report further evi-

dence of the difference in execution costs between
NASDAQ and the NYSE before and after the
1997 market reforms. In the prereform period the
NASDAQ–NYSE disparity in bid–ask spreads
could not be completely attributed to the differ-
ence in informed trading costs. However, in the
postreform period the spread difference between
these two markets becomes insignificant with the
effect of informed trading costs controlled. In add-
ition, He and Wu (2003b) examine whether the
decrease in bid–ask spreads on NASDAQ after
the 1997 reforms is due to a decrease in market-
making costs and=or an increase in market compe-
tition for order flows. Their empirical results show
THE 1997 NASDAQ TRADING RULES 445
that lower market-making costs and higher com-
petition significantly reduce bid–ask spreads.
REFERENCES
Barclay, M.J., Christie W.G., Harris J.H., Kandel E.,
and Schultz P.H. (1999). ‘‘Effects of market reform
on the trading costs and depths of NASDAQ
stocks.’’ Journal of Finance, 54: 1–34.
Bessembinder, H. (1999). ‘‘Trade execution costs on
NASDAQ and the NYSE: A post-reform compari-
son.’’ Journal of Financial and Quantit ative Analysis,
34: 387– 407.
Bessembinder, H. and Kaufman H. (1997) . ‘‘A com-
parison of trade execution costs for NYSE and NAS-
DAQ-listed stocks.’’ Journal of Financial and
Quantitative Analysis, 32: 287–310.

Christie, W.G. and Schultz, P.H. (1994). ‘‘Why do
NASDAQ market makers avoid odd-eighth
quotes?’’ Journal of Finance, 49: 1813–1840.
He, Y. and Wu, C. (2003a). ‘‘The post-reform bid-ask
spread disparity between NASDAQ and the NYSE.’’
Journal of Financial Research, 26: 207–224.
He, Y. and Wu, C. (2003b). ‘‘What explain s the bid-ask
spread decline after NASDAQ reforms?’’ Financial
Markets, Institutions & Instruments, 12: 347–376.
Huang, R.D. and Stoll, H.R . (1996). ‘‘Dealer versus
auction markets: a paired comparison of execution
costs on NASDAQ and the NYSE.’’ Journal of Fi-
nancial Economics, 41: 313–357.
Weston, J. (2000). ‘‘Competition on the NASDAQ and
the impact of recent market reforms.’’ Journal of
Finance, 55: 2565–2598.
446 ENCYCLOPEDIA OF FINANCE
Chapter 18
REINCORPORATION
RANDALL A. HERON, Indiana University, USA
WILBUR G. LEWELLEN, Purdue University, USA
Abstract
Under the state corporate chartering system in the
U.S., managers may seek shareholder approval to
reincorporate the firm in a new state, regardless of
the firm’s physical location, whenever they perceive
that the corporate legal environment in the new state
is better for the firm. Legal scholars continue to
debate the merits of this system, with some arguing
that it promotes contractual efficiency and others

arguing that it often results in managerial entrench-
ment. We discuss the contrasting viewpoints on rein-
corporations and then summarize extant empirical
evidence on why firms reincorporate, when they re-
incorporate, and where they reincorporate to. We
conclude by discussing how the motives managers
offer for reincorporations, and the actions they
take upon reincorporating, influence how stock
prices react to reincorporation decisions.
Keywords: incorporation; reincorporation; Dela-
ware; corporate charter; director liability; antitake-
over; takeover defenses; contractual efficiency;
managerial entrenchment; corporate law; share-
holders
18.1. Introduction
Modern corporations have been described as a
‘‘nexus of contractual relationships’’ that unites
the providers and users of capital in a manner
that is superior to alternative organizational
forms. While agency costs are an inevitable conse-
quence of the separation of ownership and control
that characterizes corporations, the existence of
clearly specified contractual relationships serves
to minimize those costs. As Jensen and Meckling
(1976, p. 357) noted:
The publicly held business corporation is an
awesome social invention. Millions of individ-
uals voluntarily entrust billions of dollars,
francs, pesos, etc., of personal wealth to the
care of managers on the basis of a complex set

of contracting relationships which delineate the
rights of the parties involved. The growth in the
use of the corporate form as well as the growth
in market value of established corporations
suggests that, at least up to the present, cred-
itors and investors have by and large not been
disappointed with the results, despite the
agency costs inherent in the corporate form.
Agency costs are as real as any other costs.
The level of agency costs depends among other
things on statutory and common law and
human ingenuity in devising contracts. Both
the law and the sophistication of contracts rele-
vant to the modern corporation are the prod-
ucts of a historical process in which there were
strong incentives for individuals to minimize
agency costs. Moreover, there were alternative
organizational forms available, and opportun-
ities to invent new ones. Whatever its short-
comings, the corporation has thus far survived
the market test against potential alternatives.
Under the state corporate chartering system that
prevails in the U.S., corporate managers can affect
the contractual relationships that govern their or-
ganizations through the choice of a firm’s state of
incorporation. Each state has its own distinctive
corporate laws and established court precedents
that apply to firms incorporated in the state.
Thus, corporations effectively have a menu of
choices for the firm’s legal domicile, from which

they may select the one they believe is best for their
firm and=or themselves. The choice is not con-
strained by the physical location either of the
firm’s corporate headquarters or its operations. A
firm whose headquarters is in Texas may choose
Illinois to be its legal domicile, and vice versa.
Corporations pay fees to their chartering states,
and these fees vary significantly across states, ran-
ging up to $150,000 annually for large companies
incorporated in Delaware. State laws of course
evolve over time, and managers may change their
firm’s legal domicile – subject to shareholder ap-
proval – if they decide the rules in a new jurisdic-
tion would be better suited to the firm’s changing
circumstances. This is the process referred to as
reincorporation, and it is our topic of discussion
here.
18.2. Competition Among States for
Corporate Charters
There has been a long-running debate among legal
and financial scholars regarding the pros and cons
of competition among states for corporate char-
ters. Generally speaking, the proponents of com-
petition claim that it gives rise to a wide variety of
contractual relationships across states, which al-
lows the firm to choose the legal domicile that
serves to minimize its organizational costs and
thereby maximize its value. This ‘‘Contractual
Efficiency’’ viewpoint, put forth by Dodd and
Leftwich (1980), Easterbrook and Fischel (1983),

Baysinger and Butler (1985), and Romano (1985),
implies the existence of a determinate relationship
between a company’s attributes and its choice of
legal residency. Such attributes may include: (1)
the nature of the firm’s operations, (2) its owner-
ship structure, and (3) its size. The hypothesis fol-
lowing from this viewpoint is that firms that decide
to reincorporate do so when the firm’s character-
istics are such that a change in legal jurisdiction
increases shareholder wealth by lowering the col-
lection of legal, transactional, and capital-market-
related costs it incurs.
Other scholars, however, argue that agency
conflicts play a significant role in the decision
to reincorporate, and that these conflicts are ex-
acerbated by the competition among states for
the revenues generated by corporate charters
and the economic side effects that may accom-
pany chartering (e.g. fees earned in the state for
legal services). This position, first enunciated by
Cary (1974), is referred to as the ‘‘Race-to-the-
Bottom’’ phenomenon in the market for corpor-
ate charters. The crux of the Race-to-the-Bottom
argument is that states that wish to compete for
corporate chartering revenues will have to do so
along dimensions that appeal to corporate man-
agement.
Hence, states will allegedly distinguish them-
selves by tailoring their corporate laws to serve
the self-interest of managers at the expense of cor-

porate shareholders. This process could involve
creating a variety of legal provisions that would
enable management to increase its control of the
corporation, and thus to minimize the threats
posed by outside sources. Examples of the latter
would include shareholder groups seeking to influ-
ence company policies, the threat of holding man-
agers personally liable for ill-advised corporate
decisions, and – perhaps most important of all –
the threat of displacement by an alternative man-
agement team. These threats, considered by many
to be necessary elements in an effective system of
corporate governance, can impose substantial per-
sonal costs on senior managers. That may cause
managers to act in ways consistent with protecting
their own interests – through job preservation and
corporate risk reduction – rather than serving the
interests of shareholders. If so, competition in the
market for corporate charters will diminish share-
holder wealth as states adopt laws that place re-
strictions on the disciplinary force of the market
448 ENCYCLOPEDIA OF FINANCE
for corporate control (see Bebchuk, 1992; Bebchuk
and Ferrell, 1999; Bebchuk and Cohen, 2003).
Here, we examine the research done on reincor-
poration and discuss the support that exists for the
contrasting views of both the Contractual Effi-
ciency and Race-to-the-Bottom proponents. In
the process, we shall highlight the various factors
that appear to play an influential role in the cor-

porate chartering decision.
18.3. Why, When, and Where to Reincorporate
To begin to understand reincorporation decisions,
it is useful to review the theory that relates a firm’s
choice of chartering jurisdiction to the firm’s attri-
butes, the evidence as to what managers say when
they propose reincorporations to their share-
holders, and what managers actually do when
they reincorporate their firms.
Central to the Contractual Efficiency view of
competition in the market for corporate charters
is the notion that the optimal chartering jurisdic-
tion is a function of the firm’s attributes. Reincor-
poration decisions therefore should be driven
by changes in a firm’s attributes that make the
new state of incorporation a more cost-effective
legal jurisdiction. Baysinger and Butler (1985)
and Romano (1985) provide perhaps the most
convincing arguments for this view.
Baysinger and Butler theorize that the choice
of a strict vs. a liberal incorporation jurisdiction
depends on the nature of a firm’s ownership struc-
ture. The contention is that states with strict cor-
porate laws (i.e. those that provide strong
protections for shareholder rights) are better suited
for firms with concentrated share ownership,
whereas liberal jurisdictions promote efficiency
when ownership is widely dispersed. According to
this theory, holders of large blocks of common
shares will prefer the pro-shareholder laws of strict

states, since these give shareholders the explicit
legal remedies needed to make themselves heard
by management and allow them actively to influ-
ence corporate affairs. Thus, firms chartered in
strict states are likely to remain there until owner-
ship concentration decreases to the point that legal
controls may be replaced by market-based govern-
ance mechanisms.
Baysinger and Butler test their hypothesis by
comparing several measures of ownership concen-
tration in a matched sample of 302 manufacturing
firms, half of whom were incorporated in several
strict states (California, Illinois, New York, and
Texas) while the other half had reincorporated
out of these states. In support of their hypothesis,
Baysinger and Butler found that the firms that
stayed in the strict jurisdictions exhibited signifi-
cantly higher proportions of voting stock held by
major blockholders than was true of the matched
firms who elected to reincorporate elsewhere. Im-
portantly, there were no differences between the
two groups in financial performance that could
explain why some left and others did not. Collect-
ively, the results were interpreted as evidence that
the corporate chartering decision is affected by
ownership structure rather than by firm perfor-
mance.
Romano (1985) arrived at a similar conclusion
from what she refers to as a ‘‘transaction explan-
ation’’ for reincorporation. Romano suggests that

firms change their state of incorporation ‘‘at the
same time they undertake, or anticipate engaging
in, discrete transactions involving changes in firm
operation and=or organization’’ (p. 226). In this
view, firms alter their legal domiciles at key times
to destination states where the laws allow new
corporate policies or activities to be pursued in a
more cost-efficient manner. Romano suggests that,
due to the expertise of Delaware’s judicial system
and its well-established body of corporate law, the
state is the most favored destination when com-
panies anticipate legal impediments in their exist-
ing jurisdictions. As evidence, she cites the high
frequency of reincorporations to Delaware coin-
ciding with specific corporate events such as initial
public offerings (IPOs), mergers and acquisitions,
and the adoption of antitakeover measures.
In their research on reincorporations, Heron
and Lewellen (1998) also discovered that a sub-
stantial portion (45 percent) of the firms that
REINCORPORATION 449
reincorporated in the U.S. between 1980 and 1992
did so immediately prior to their IPOs. Clearly, the
process of becoming a public corporation repre-
sents a substantial transition in several respects:
ownership structure, disclosure requirements, and
exposure to the market for corporate control. Ac-
cordingly, the easiest time to implement a change
in the firm’s corporate governance structure to
parallel the upcoming change in its ownership

structure would logically be just before the com-
pany becomes a public corporation, while control
is still in the hands of management and other
original investors. Other recent studies also report
that the majority of firms in their samples who
undertook IPOs reincorporated in Delaware in
advance of their stock offerings (Daines and
Klausner, 2001; Field and Karpoff, 2002).
Perhaps the best insights into why managers
choose to reincorporate their firms come from the
proxy statements of publicly traded companies,
when the motivations for reincorporation are
reported to shareholders. In the process of the
reincorporations of U.S. public companies that
occurred during the period from 1980 through
1992, six major rationales were proclaimed by
management (Heron and Lewellen, 1998): (1) take-
over defenses; (2) director liability reduction; (3)
improved flexibility and predictability of corporate
laws; (4) tax and=or franchise fee savings; (5) con-
forming legal and operating domicile; and (6) fa-
cilitating future acquisitions.
A tabulation of the relative frequencies is pro-
vided in Figure 18.1. As is evident, the two dom-
inant motives offered by management were to
create takeover defenses and to reduce directors’
legal liability for their decisions. In addition, man-
agers often cited multiple reasons for reincorpor-
ation. The mean number of stated motives was 1.6
and the median was 2. In instances where multiple

motives were offered, each is counted once in the
compilation in Figure 18.1.
18.4. What Management Says
It is instructive to consider the stated reincorpor-
ation motives in further detail and look at ex-
amples of the statements by management that are
contained in various proposals, especially those
involving the erection of takeover defenses and
the reduction of director liability. These, of course,
0% 10% 20% 30% 40% 50% 60%
% of sample
Takeover defenses
Director liability
reduction
Flexibility or
predictability
Tax or franchise fee
savings
Conform legal and
operating domicile
Facilitate acquisitions
Stated motives for reincorporation
One of multiple
motives cited
Sole motive cited
Figure 18.1. Stated motives for reincorporation
450 ENCYCLOPEDIA OF FINANCE
represent provisions that may not be in the best
interests of stockholders, as a number of re-
searchers have argued. The other motives listed

are both less controversial and more neutral in
their likely impact on stockholders, and can be
viewed as consistent with Contractual Efficiency
arguments for reincorporations. Indeed, reincor-
porations undertaken for these reasons appear
not to give rise to material changes in firms’ stock
prices (Heron and Lewellen, 1998).
18.4.1. Reincorporations that Strengthen
Takeover Defenses
Proponents of the Race-to-the-Bottom theory con-
tend that the competition for corporate chartering
may be detrimental if states compete by crafting
laws that provide managers with excessive protec-
tion from the market for corporate control – i.e.
from pressures from current owners and possible
acquirers to perform their managerial duties so as
to maximize shareholder wealth. Although take-
over defenses might benefit shareholders if they
allow management to negotiate for higher takeover
premiums, they harm shareholders if their effect is
to entrench poorly performing incumbent man-
agers.
The following excerpts from the proxy state-
ment of Unocal in 1983 provides an example of a
proposal to reincorporate for antitakeover
reasons:
In addition, incorporation of the proposed
holding company under the laws of Delaware
will provide an opportunity for inclusion in its
certificate of incorporation provisions to dis-

courage efforts to acquire control of Unocal in
transactions not approved by its Board of Dir-
ectors, and for the elimination of shareholder’s
preemptive rights and the elimination of cumu-
lative voting in the election of directors.
The proposed changes do not result from
any present knowledge on the part of the
Board of Directors of any proposed tender
offer or other attempt to change the control
of the Company, and no tender offer or other
type of shift of control is presently pending or
has occurred within the past two years.
Management believes that attempts to acquire
control of corporations such as the Company
without approval by the Board may be unfair
and=or disadvantageous to the corporation and
its shareholders. In management’s opinion, dis-
advantages may include the following:
a nonnegotiated takeover bid may be timed
to take advantage of temporarily depressed
stock prices;
a nonnegotiated takeover bid may be
designed to foreclose or minimize the possibil-
ity of more favorable competing bids;
recent nonnegotiated takeover bids have
often involved so-called ‘‘two-tier’’ pricing, in
which cash is offered for a controlling interest in
a company and the remaining shares are ac-
quired in exchange for securities of lesser
value. Management believes that ‘‘two-tier’’ pri-

cing tends to stampede shareholders into mak-
ing hasty decisions and can be seriously unfair
to those shareholders whose shares are not pur-
chased in the first stage of the acquisition;
nonnegotiated takeover bids are most fre-
quently fully taxable to shareholders of the
acquired corporation.
By contrast, in a transaction subject to ap-
proval of the Board of Directors, the Board can
and should take account of the underlying and
long-term value of assets, the possibilities for
alternative transactions on more favorable
terms, possible advantages from a tax-free re-
organization, anticipated favorable develop-
ments in the Company’s business not yet
reflected in stock prices, and equality of treat-
ment for all shareholders.
The reincorporation of Unocal into Delaware
allowed the firm’s management to add several anti-
takeover provisions to Unocal’s corporate charter
that were not available under the corporate laws of
California, where Unocal was previously incorpor-
ated. These provisions included the establishment
of a Board of Directors whose terms were stag-
gered (only one-third of the Board elected each
year), the elimination of cumulative voting
(whereby investors could concentrate their votes
on a small number of Directors rather than spread
them over the entire slate up for election), and the
requirement of a ‘‘supermajority’’ shareholder vote

to approve any reorganizations or mergers not
REINCORPORATION 451
approved by at least 75 percent of the Directors
then in office. Two years after its move to Dela-
ware, Unocal was the beneficiary of a court ruling
in the Unocal vs. Mesa case [493 A.2d 946 (Del.
1985)], in which the Delaware Court upheld Uno-
cal’s discriminatory stock repurchase plan as a
legitimate response to Mesa Petroleum’s hostile
takeover attempt.
The Unocal case is fairly representative of the
broader set of reincorporations that erected take-
over defenses. Most included antitakeover charter
amendments that were either part of the reincor-
poration proposal or were made possible by the
move to a more liberal jurisdiction and put to a
shareholder vote simultaneously with the plan of
reincorporation. In fact, 78 percent of the firms
that reincorporated between 1980 and 1992 imple-
mented changes in their corporate charters or
other measures that were takeover deterrents
(Heron and Lewellen, 1998). These included elim-
inating cumulative voting, initiating staggered
Board terms, adopting supermajority voting pro-
visions for mergers, and establishing so-called
‘‘poison pill’’ plans (which allowed the firm to
issue new shares to existing stockholders in order
to dilute the voting rights of an outsider who was
accumulating company stock as part of a takeover
attempt).

Additionally, Unocal reincorporated from a
strict state known for promoting shareholder
rights (California) to a more liberal state (Dela-
ware) whose laws were more friendly to manage-
ment. In fact, over half of the firms in the sample
studied by Heron and Lewellen (1998), that cited
antitakeover motives for their reincorporations,
migrated from California, and 93 percent migrated
to Delaware. A recent study by Bebchuk and
Cohen (2003) that investigates how companies
choose their state of incorporation reports that
strict shareholder-right states that have weak anti-
takeover statutes continue to do poorly in attract-
ing firms to charter in their jurisdictions.
Evidence on how stock prices react to reincor-
porations conducted for antitakeover reasons sug-
gests that investors perceive them to have a value-
reducing management entrenchment effect. Heron
and Lewellen (1998) report statistically significant
(at the 95 percent confidence level) abnormal stock
returns of À1.69 percent on and around the dates
of the announcement and approval of reincorpora-
tions when management cites only antitakeover
motives. In the case of firms that actually gained
additional takeover protection in their reincor-
porations (either by erecting specific new takeover
defenses or by adopting coverage under the anti-
takeover laws of the new state of incorporation),
the abnormal stock returns averaged a statistically
significant À1.62 percent. For firms whose new

takeover protection included poison pill provi-
sions, the average abnormal returns were fully À
3.03 percent and only one-sixth were positive (both
figures statistically significant). Taken together
with similar findings in other studies, the empirical
evidence therefore supports a conclusion that ‘‘de-
fensive’’ reincorporations diminish shareholder
wealth.
18.4.2. Reincorporations that Reduce
Director Liability
The level of scrutiny placed on directors and of-
ficers of public corporations was greatly intensified
as a result of the Delaware Supreme Court’s ruling
in the 1985 Smith vs. Van Gorkom case [488 A.2d
858 (Del. 1985)]. Prior to that case, the Delaware
Court had demonstrated its unwillingness to use
the benefit of hindsight to question decisions made
by corporate directors that turned out after the
fact to have been unwise for shareholders. The
court provided officers and directors with liability
protection under the ‘‘business judgment’’ rule, as
long as it could be shown that they had acted in
good faith and had not violated their fiduciary
duties to shareholders. However, in Smith vs. Van
Gorkom, the Court held that the directors of
Trans-Union Corporation breached their duty of
care by approving a merger agreement without
sufficient deliberation. This unexpected ruling had
an immediate impact since it indicated that the
Delaware Court would entertain the possibility of

452 ENCYCLOPEDIA OF FINANCE
monetary damages against directors in situations
where such damages were previously not thought
to be applicable. The ruling contributed to a 34
percent increase in shareholder lawsuits in 1985
and an immediate escalation in liability insurance
premiums for officers and directors (Wyatt, 1988).
In response, in June of 1986, Delaware amended
its corporate law to allow firms to enter into indem-
nification agreements with, and establish provisions
to limit the personal liability of, their officers and
directors. Numerous corporations rapidly took ad-
vantage of these provisions by reincorporating into
Delaware. Although 32 other states had established
similar statutes by 1988 (Pamepinto, 1988), Dela-
ware’s quick action enabled it to capture 98 percent
of the reincorporations, which were cited by man-
agement as being undertaken to reduce directors’
liability, with more than half the reincorporating
firms leaving California.
The 1987 proxy statement of Optical Coatings
Laboratories is a good illustration of a proposal
either to change its corporate charter in California
or to reincorporate – to Delaware – for liability
reasons, and documents the seriousness of the im-
pact of liability insurance concerns on liability in-
surance premiums:
During 1986, the Company’s annual premium
for its directors’ and officers’ liability insurance
was increased from $17,500 to $250,000 while

the coverage was reduced from $50,000,000 to
$5,000,000 in spite of the Company’s impec-
cable record of never having had a claim. This
is a result of the so-called directors’ and of-
ficers’ liability insurance crisis which has
caused many corporations to lose coverage al-
together and forced many directors to resign
rather than risk financial ruin as a result of
their good faith actions taken on behalf of
their corporations.
This year at OCLI, we intend to do some-
thing about this problem. You will see included
in the proxy materials a proposal to amend the
Company’s Articles of Incorporation, if Cali-
fornia enacts the necessary legislation, to pro-
vide the Company’s officers and directors with
significantly greater protection from personal
liability for their good faith actions on behalf of
the Company. If California does not enact the
necessary legislation by the date of the annual
meeting, or any adjournment, a different pro-
posal would provide for the Company to
change its legal domicile to the State of Dela-
ware, where the corporation law was recently
amended to provide for such protection.
Although it was a Delaware Court decision
that prompted the crisis in the director and officer
liability insurance market, Delaware’s quick action
in remedying the situation by modifying its corpor-
ate laws reflects the general tendency for Delaware

to be attentive to the changing needs of corpor-
ations. Romano (1985) contends that, because
Delaware relies heavily upon corporate charter
revenues, it has obligated itself to be an early
mover in modifying its corporate laws to fit evolv-
ing business needs. It is clear that this tendency has
proven beneficial in enhancing the efficiency of
contracting for firms incorporating in Delaware.
In contrast to the reaction to the adoption of
antitakeover measures, investors have responded
positively to reincorporations that were under-
taken to gain improved director liability protec-
tion. Observed abnormal stock returns averaging
approximately þ2.25 percent (again, at the 95 per-
cent confidence level) are reported by Heron and
Lewellen (1998). In a supplemental analysis,
changes in the proportions of outside directors on
the Boards of firms that reincorporated for dir-
ector liability reasons were monitored for two
years subsequent to the reincorporations, as a test
of the claim that weak liability protection would
make it more difficult for firms to attract outsiders
to their Boards. The finding was that firms that
achieved director liability reduction via reincorpor-
ation did in fact increase their outside director
proportions by statistically significant extents,
whereas there was no such change for firms that
reincorporated for other reasons.
18.4.3. Other Motives for Reincorporations
Reincorporations conducted solely to gain access

to more flexible and predictable corporate laws, to
REINCORPORATION 453
save on taxes, to reconcile the firm’s physical and
legal domicile, and to facilitate acquisitions fall
into the Contractual Efficiency category. Re-
searchers have been unable to detect abnormal
stock returns on the part of firms that have re-
incorporated for these reasons. The bulk of the
reincorporations where managers cite the flexibil-
ity and predictability of the corporate laws of the
destination state as motivation have been into
Delaware. Romano (1985) argues that Delaware’s
responsive corporate code and its well-established
set of court decisions have allowed the state to
achieve a dominant position in the corporate char-
tering market. This argument would be consistent
with the evidence that a substantial fraction of
companies that reincorporate to Delaware do so
just prior to an IPO of their stock. Indeed, Dela-
ware has regularly chartered the lion’s share of
out-of-state corporations undergoing an IPO: 71
percent of firms that went public before 1991, 84
percent that went public between 1991 and 1995,
and 87 percent of those that have gone public from
1996 (Bebchuk and Cohen, 2002).
The language in the 1984 proxy statement of
Computercraft provides an example of a typical
proposal by management to reincorporate in
order to have the firm take advantage of a more
flexible corporate code:

The Board of Directors believes that the best
interests of the Company and its shareholders
will be served by changing its place of incorp-
oration from the State of Texas to the State of
Delaware. The Company was incorporated in
the State of Texas in November 1977 because
the laws of that state were deemed to be ad-
equate for the conduct of its business. The
Board of Directors believes that there is needed
a greater flexibility in conducting the affairs of
the Company since it became a publicly owned
company in 1983.
The General Corporation Law of the State
of Delaware affords a flexible and modern
basis for a corporation action, and because a
large number of corporations are incorporated
in that state, there is a substantial body of case
law, decided by a judiciary of corporate spe-
cialists, interpreting and applying the Delaware
statutes. For the foregoing reasons, the Board
of Directors believes that the activities of the
Company can be carried on to better advantage
if the Company is able to operate under
the favorable corporate climate offered by the
laws of the State of Delaware.
The majority of reincorporations which are done
to realize tax savings or to reconcile the firm’s legal
domicile with its headquarters involve reincorpora-
tions out of Delaware – not surprisingly, since Dela-
ware is not only a very small state with few

headquartered firms but also has annual chartering
fees which are among the nation’s highest. The
following excerpt from the 1989 proxy statement
of the Longview Fibre Company illustrates the ra-
tionale for such a reincorporation:
Through the Change in Domicile, the Com-
pany intends to further its identification with
the state in which the Company’s business ori-
ginated, its principal business is conducted, and
over 64% of its employees are located. Since
the Company’s incorporation in the State
of Delaware in 1926, the laws of the State of
Washington have developed into a system
of comprehensive and flexible corporate laws
that are currently more responsive to the needs
of businesses in the state.
After considering the advantages and disad-
vantages of the proposed Change in Domicile,
the Board of Directors concluded that the
benefits of moving to Washington outweighed
the benefits and detriments of remaining in
Delaware, including the continuing expense of
Delaware’s annual franchise tax (the Company
paid $56,000 in franchise taxes in fiscal year
1988, whereas the ‘‘annual renewal fee’’ for all
Washington corporations is $50.00). In light of
these facts, the Board of Directors believes it is
in the best interests of the Company and its
stockholders to change its domicile from Dela-
ware to Washington.

Note in particular the issue raised about the
annual franchise tax. Revenues from that source
currently account for approximately $400 million
of Delaware’s state budget (Bebchuk and Cohen,
2002).
454 ENCYCLOPEDIA OF FINANCE
18.5. Summary and Conclusions
Distinctive among major industrialized countries,
incorporation in the U.S. is a state rather than a
federal process. Hence, there are a wide variety of
legal domiciles that an American firm can choose
from, and the corporation laws of those domiciles
vary widely as well – in areas such as the ability of
shareholders to hold a firm’s managers account-
able for their job performance, the personal liabil-
ity protection afforded to corporate officers and
directors, and the extent to which management can
resist attempts by outsiders to take over the firm.
The resulting array of choices of chartering juris-
dictions has been characterized by two competing
views: (1) the diversity is desirable because it en-
ables a firm to select a legal domicile whose laws
provide the most suitable and most efficient set of
contracting opportunities for the firm’s particular
circumstances; (2) the diversity is undesirable be-
cause it encourages states to compete for incorp-
orations – and reincorporations – by passing laws
that appeal to a firm’s managers by insulating
them from shareholder pressures and legal actions,
and making it difficult for the firm to be taken over

without management’s concurrence. Thus, the
choice of legal domicile can become an important
element in the governance of the firm, and a change
of domicile can be a significant event for the firm.
As for many other aspects of corporate decision-
making, a natural test as to which of the two
characterizations are correct is to observe what
happens to the stock prices of companies who
reincorporate, on and around the time they do
so. The available evidence indicates that reincor-
porations which result in the firm gaining add-
itional takeover defenses have negative impacts
on its stock price – apparently, because investors
believe that a takeover and its associated premium
price for the firm’s shares will thereby become less
likely. Conversely, reincorporations that occasion
an increase in the personal liability protection of
officers and directors have positive stock price
effects. The inference is that such protection
makes it easier for the firm to attract qualified
directors who can then help management improve
the firm’s financial performance. These effects are
accentuated when the reincorporation is accom-
panied by a clear statement from management to
the firm’s shareholders about the reasons for the
proposed change. There is, therefore, some sup-
port for both views of the opportunity for firms
to ‘‘shop’’ for a legal domicile, depending on the
associated objective. Other motives for reincorpor-
ation seem to have little if any impact on a firm’s

stock price, presumably because they are not
regarded by investors as material influences on
the firm’s performance.
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