Before Competition: Origins of the Internal Affairs Doctrine

Abstract

To the modern corporate scholar and lawyer, the internal affairs doctrine seems in the natural order of things. Corporate law is state law. Each corporation is formed under the law of its chosen state of incorporation. To ensure consistency and predictability, that law must govern the corporation's internal affairs. Yet the origin of such a doctrine is puzzling. Respecting the firm's choice of corporate law, the doctrine forces state legislatures into competition to attract incorporations. But how did legislatures come to concede their traditional territorial regulatory authority, and instead agree to compete? This Article solves this puzzle, offering the first account of the doctrine's surprising origins. In so doing, it also raises an important challenge to regulatory competition proposals generally, which are all the rage today, and which rely on U.S. corporate law as their prototype. Widespread acceptance of the internal affairs doctrine among U.S. states assures that a firm's choice of corporate law will be respected outside the incorporating state. According to the dominant paradigm, this respect for firm choice creates a common market for corporate law, enabling regulatory competition. Both proponents and critics of competition agree that state legislatures compete - or at least have competed - to sell corporate charters to raise state revenues. In the debate over state competition, all sides take the internal affairs doctrine as a given. But if legislators compete to maximize private benefits in the form of state revenues, why do states recognize foreign corporation law at all? How did state legislatures ever come to surrender their traditional territorial jurisdiction, and instead agree to a choice of law convention forcing them into direct competition? To date, the puzzle of the internal affairs doctrine has been overlooked. The doctrine's existence has been taken for granted, requiring little in the way of comment, criticism, or explanation. I explain the unexpected origins of the doctrine and its persistence through the early years of modern charter competition in the early part of the twentieth century. This historical analysis shows that the doctrine's origin had nothing to do with regulatory competition. Instead, it emerged before state charter competition, at a time when firms had little choice about where to incorporate. Competition came later, under circumstances radically different from those under which the doctrine was first articulated. That the earlier-crafted doctrine later facilitated regulatory competition was hardly by design. Instead, its path to facilitating modern charter competition depended on a fortuitous sequence of events, driven by ideology, interest group influences, and institutional inertia. This story of historical contingency debunks common assumptions about the emergence of the doctrine, which modern corporate scholars implicitly view to have been inevitable. Solving the puzzle of the internal affairs doctrine has important implications for regulatory competition generally. Law-as-a-product competition proposals abound in other regulatory areas and often rely on charter competition as their prototype. These public choice constructions of regulatory behavior depend on regulators' assumed pursuit of private benefits to realize the advantages of competition, yet they ignore critical questions of institutional design and evolution. Competition proponents seem content to assume that rational regulators would happily surrender their traditional territorial authority - their regulatory monopolies. The story of the internal affairs doctrine, however, suggests that markets for law may not emerge spontaneously. Instead, regulatory competition may require a perfect historical storm.