Competition between Legal Systems

by Eva-Maria Kieninger

1. Foundations and sources

The heading ‘competition between legal systems’, or ‘system competition’ or ‘institutional competition’ is meant to express the idea that legal rules (or institutions) are subject to supply and demand like goods and services. As far as competition between legislation passed by public authorities (state or federal legislatures) is concerned, the legislature is the offeror and the citizens or subjects (natural or legal persons) are the consumers of the product ‘law’. In European private law, the idea of competition between legal systems is discussed as an alternative to harmonization or standardization by the European legislature. Triggered by the European Court of Justice (ECJ) decision in Centros (ECJ Case C-212/97 [1999] ECR I-01459), European discussion has particularly focused on company law.

In the literature, the term ‘competition between legal systems’ is used with varying, often imprecise meaning. In the present author’s opinion, three levels must be distinguished (see Kieninger (2002) 8 ff): On the first level, various legal orders coexist, but the legal subjects have no choice between systems. At this level there is only competition between ideas, made fruitful through legal comparison. On the second level, legal subjects can choose between various rules without subjecting themselves to the reaction of the legislature, as supplier of rules. Reaction ensues at the third level and requires some kind of financial or idealistic motivation, which moves the legislature to act. It is only at this level that we can speak of institutional competition in the sense of a cycle of competition. The classic example for this is the development of US company law (see 2 below).

The literature on competition between legal orders is fed from a number of sources. For some authors there is a strong interest in the field of economics (see the works of Manfred E Streit, Wolfgang Kerber and Roger van den Bergh). They argue from the perspective of evolutionary economics that competition was a discovery process (Hayek) not only in relation to goods, but also to institutions, producing a continuous improvement of what is on offer. By others, the market freedoms of the Treaty on the Functioning of the European Union (TFEU) are conceived of as the foundation of a regulatory competition, since the acquisition of a foreign good or the transfer of a seat of business to another Member State is indirectly a choice of the institutions (product regulations, environmental law, labour law, companies law, tax law) of that state. The freedom of movement gives the legal subjects, therefore, the possibility to choose between the various state laws, on the one hand, in order to better satisfy their preferences and, on the other hand, to signal acceptance or rejection of the legal system of the respective Member States, thereby urging reform, if necessary.

2. The Delaware effect

An extensive body of literature exists in the United States on competition between systems in company law, where the Delaware effect has provided particular food for thought. In the United States the widely held view on incorporation says that the legal regime of a company is independent of its actual seat in the state of the union where it was founded, the laws of which were preferred by the founders (international company law). Consequently, the company’s place of registration and thereby the applicable law can be changed after incorporation by reincorporating in a different state (most frequently Delaware). This is done through the formation of a new corporation in the target state, followed by the amalgamation of old and new companies. As the states of the United States, unlike the Member States of the EU, charge yearly fees for registration in their state (franchise tax), attracting corporations to their state is a lucrative source of income, especially for small states. This led to competition between states at the end of the 19th century and the beginning of the 20th century, from which the state of Delaware emerged as winner. For a long time, this development was characterized pejoratively in the literature as a race to the bottom. Today it is seen in a positive light (see eg Roberta Romano). It is argued that management does not enrich itself at the cost of shareholders by reincorporating in Delaware, because the power of the capital markets and markets for takeovers have controlling effect. Instead of a race to the bottom the Delaware effect is much better understood as a race to the top, because the shareholders have at their disposal lawyers and judges with special expertise as well as a highly sophisticated company law in which judicial decisions already exist for almost any conceivable legal question. Furthermore, management and shareholders can trust that the legislature of Delaware will make every effort in the future to keep their corporation law attractive.

3. The functions of competition of legal systems

Various functions are attributed to the competition between legal systems, which, however, contradict each other to a certain extent. First, competition is supposed, in contrast to uniform law, to make possible the fulfilment of diverging preferences. The starting point for this proposition is that the actors in the market have no uniform preferences. Consumers may, for example, prefer less rigorous consumer contract or product liability laws if this leads to lower prices. A unitary high level of protection deprives them of this choice. A second function is the reduction in the number of erroneous decisions by the legislature. If legislation is made at the Member State level rather than at the level of the European Union, mistakes in the political system or inadequate appreciation of the most efficient solution only affect the Member State concerned. Additionally, it is said that the legislative organs in Brussels are more susceptible of making mistakes than their national counterparts. In particular, the pressure to make compromises and the muddling together of factual issues with political conflicts may lead to suboptimal results. A third function is the suitability of competition for the promotion of innovation. That already happens when the efficiency of diverse legal rules on the same subject can be compared. If a strong financial incentive arises for the offeror to obtain as many customers as possible, as in the case of the Delaware effect, the legislature will even actively search for the most attractive rules and embrace them as their own. This could lead, fourthly, to a convergence of legal systems, and thus the goal of a unitary legal system would be reached ‘from below’. The proponents of competition therefore see in their theory the ideal solution for unification of European law, which even conforms to the principle of subsidiarity. The best solutions emerge over time through the process of competition and are then embraced by the other Member States.

Of course, this last function contradicts the first and third functions. If it is true that the subjects of law, either individually or collectively, have varying preferences in respect of legal rules, then the divergences between legal systems should be preserved. The same is true of the innovative function, because it is also based on coexistence and choice between different legal rules. Whoever favours the competition of legal systems in contrast to unification by supranational law will have to live with substantial legal differences inside the European internal market for a considerable time. However, a symbiosis of the competition idea with the pursuit of a uniform law for transnational legal relationships lies in the creation of additional supranational institutions for legal subjects to choose from (European Company (Societas Europaea), European Private Company (Societas Privata Europaea), European contract law (Principles of European Contract Law (PECL)) as an optional instrument).

4. Preconditions for effective competition

Discussions about competition are frequently concerned only with effects, most of all whether it should be considered as a harmful spiral of deregulation or a race to the top. However, in private law, it is unclear whether the preconditions for effective competition are or can be fulfilled. In order to judge correctly, a differentiation has to be made between the various types of competition sketched out in 1. above. Many authors already speak of competition when different legal systems coexist side by side (the second level). In this case it is true that consumers can choose between the various legal rules on offer. This can happen directly, eg in contract law where choice of law exists in private international law, or indirectly through the choice of a place of business, where particular laws are in force, or through the choice of a product or service which is produced and offered for sale under particular legal rules. The so-called ‘bundling problem’ arises where the choice is indirect. It refers to the difficulty that particular institutions can only be chosen in combination with other factual and legal circumstances. The choice of a business location, for example, is seldom determined solely by the company law of that place, but rather by a bundle of factual and legal issues, particularly tax law.

5. Institutional competition

Institutional competition as understood in economic theory as well as in the US literature on competition for corporate charters has the additional precondition, beyond coexistence of different legal systems and choice between them, that the legislature as offeror of laws must have incentives both to being successful as well as to searching for improvements. This form of competition, which functions as a cycle of competition much like the cycle for the supply of goods and services, is particularly suited to encouraging innovation and thereby preventing petrification of the legal system. Direct tax income is a strong incentive for the legislature, which, as for example in Delaware, is generated when firms choose to locate in that jurisdiction. In many areas, such direct incentives are either not conceivable, as for example in contract law, or are prohibited in the EU (see Dir 69/335 for company law). Here, other substantially weaker incentives, such as increased prestige or indirect tax income via the promotion of the legal services industry at home, are under discussion.

6. Competition in European private law

a) Company law

In European private law the existence of competition between legal systems, or rather between legislatures, is assumed most notably in the area of company law. The jurisprudence of the ECJ (Case C-212/97 – Centros [1999] ECR I-1459; Case C-208/00 – Überseering [2002] ECR I-9919; Case C-167/01 – Inspire Art [2003] ECR I-10155) obliges the Member States to apply the law of the state of incorporation to companies founded under the law of another Member State of the EU or of the EEA, insofar as the application of the law of the actual seat of the company is not, exceptionally, justified either by mandatory requirements of public interest or by the existence of an abuse of the right of establishment.

However, in Cartesio (Case C-210/06 [2008] ECR I-9641) the ECJ gave the Member States the freedom to wind up companies founded under their domestic law in those cases where only the actual seat of the company moved abroad. In obiter, the Court nevertheless hinted that it would regard the simultaneous transfer of the actual seat and the statutory seat, ie the move of the company’s headquarters together with adaptation of its legal form to the law of the new host Member State, as being protected by the freedom of establishment. The ECJ decision in Sevic (Case C-411/03 – Sevic [2005] ECRnI-10805) and the transposition of Dir 2005/56 make possible cross-border mergers and reincorporations, but only via the roundabout way of new incorporation and merger.

Therefore, it is safe to conclude that insofar as company law is not yet harmonized, competition exists in the form of coexistence of various legal systems and freedom of choice. Furthermore, a fundamental precondition for true institutional competition, namely freedom of choice of law, is fulfilled in the EU and EEA just as in the United States. It is, however, under debate, whether institutional competition (ie competitive behaviour by legislatures as offerors of company law) actually exists in Europe or whether it can still develop. Many consider the recent legislation on limited liability companies in France, Spain, Italy, and finally Germany (see new German Gesetz zur Modernisierung des GmbH-Rechts und zur Bekämpfung von Missbräuchen (MoMiG)) as the result of such competition. Other authors emphasize the absence of financial incentives for the legislatures to participate in competition, as incorporation fees are prohibited in the EU, and therefore consider the legal reform to be motivated mostly by internal needs.

b) General contract law

Freedom of choice of law is an integral principle of the general law of contract (see Art 3 Rome I Regulation (Reg 593/2008)) so that market participants as ‘consumers of contract law’ may freely choose from the various contract law systems of Member States and third party states. Whether the parties’ actual choice in practice is really oriented towards criteria based on content, like the suitability of the chosen law for the transaction at hand, can be doubted. An empirical study of European contract law (see Stefan Vogenauer, Steven Weatherill) has shown that contracting parties almost always prefer their own law because that is what they and their advisers know best. Interestingly, the vast majority of people interviewed thought their own law was, on the whole, the best.

If one considers the chances for competitive behaviour by legislatures as offerors of contract law, only indirect incentives can be made out. Only in exceptional circumstances is it conceivable that such indirect incentives be marked enough to trigger innovative behaviour. For example, a contract law considered particularly suitable internationally, like English law, may contribute to increased income of legal advisers, whereby the state indirectly benefits through the creation of jobs and the increase in income tax paid. Where there is no freedom of choice of law, namely in consumer contracts, only indirect competition can take place. Because of the bundling problem it is certainly difficult to interpret the choice of a particular marketplace as a choice of the consumer protection law prevailing there. Numerous other factors such as sales opportunities, prices, taxes and transport costs will play a dominant role. The so-called competition in consumer law, which is promoted by Roger van den Bergh, is thus reduced to the coexistence of various levels of consumer protection in the Member States, which would make possible a comparison of the effectiveness of various consumer protection theories but which does not tally with the term ‘institutional competition’ as used in the writings of Manfred Streit or the American competition for corporate charter literature.

Literature

Lucian Arye Bebchuk, ‘Federalism and the Corporation: The Desirable Limits on State Competition in Corporate Law’ (1992) 105 Harvard LR 1435; Roberta Romano, The Genius of American Corporate Law (1993); Roger van den Bergh, ‘Subsidiarity as an Economic Demarcation Principle and the Emergence of European Private Law’ (1998) 5 MJ 129; Manfred E Streit and Daniel Kiwit, ‘Zur Theorie des Systemwettbewerbs’ in Manfred E Streit and Michael Wohlgemuth (eds), Systemwettbewerb als Herausforderung an Politik und Theorie (1999) 13; Anthony Ogus, ‘Competition between National Legal Systems: A Contribution of Economic Analysis to Comparative Law’ (1999) 48 ICLQ 405; Wolfgang Kerber, ‘Interjurisdictional Competition within the European Union’ (2000) 23 Fordham Int’l LJ 217; Eva-Maria Kieninger, Wettbewerb der Privatrechtsordnungen im Europäischen Binnenmarkt (2002); Stefan Vogenauer and Steve Weatherill, ‘The European Community’s Competence to Pursue the Harmonisation of Contract Law—an Empirical Contribution to the Debate’ in Stefan Vogenauer and Steve Weatherill (eds), Harmonisation of European Contract Law: Implications for European Private Laws, Business and Legal Practice (2006) 105; Eva-Maria Kieninger, ‘Aktuelle Entwicklungen des Wettbewerbs der Gesellschaftsrechte’ in Hans-Bernd Schäfer and Thomas Eger (eds), Ökonomische Analyse der europäischen Zivilrechtsentwicklung (2007) 170; William W Bratton, Joseph A McCahery and Erik PM Vermeulen, ‘How Does Corporate Mobility Affect Lawmaking? A Comparative Analysis’ (2009) 57 Am J Comp L 347.