One feature of the U.S. corporate law environment that always strikes outside observers and new initiates as odd is the predominance on the legal landscape of the law of Delaware. The tiny Eastern seaboard state is the second smallest U.S. state by size; only five states are smaller by population, yet its corporate laws outweigh those of any other state. Over half of the U.S. listed companies are incorporated in Delaware. Nearly two thirds of Fortune 500 companies are organized under the laws of Delaware.
Questions about Delaware’s outsized role in the corporate legal world are nothing new. But when the Wall Street Journal runs a front page article questioning Delaware’s role, it might be time to start wondering of Delaware’s predominance might actually be under challenge.
Emblazoned across the front page of the August 3, 2015 Wall Street Journal was Liz Hoffman’s article entitled “Firms Sour on Delaware as Corporate Haven” (here), the gist of which is that some corporate officials and representatives are questioning Delaware’s special status because, the naysayers assert, the state is among other things not doing enough to protect against shareholder lawsuits. Among the factors the commentators cite is the state’s legislature’s recent legislative enactment prohibiting fee-shifting bylaws (about which refer here).
As the Journal article notes, Delaware’s status as presumptive corporate headquarters is very important to the state. Corporate fees account for 26% of the state’s budget. Corporate litigation is a big business in the state as well, producing millions in fees for the state’s law firms. But other states are angling for this lucrative business. Among other things, Michigan and Texas have established dedicated business courts with judges steeped in corporate law, in a bid to challenge the often-cited superiority of Delaware’s Chancery courts.
All of this highlights the more basic question of why companies are drawn to Delaware in the first place. Clearly there is a perception that there is an advantage to incorporating there. But what are those perceived advantages, and is the perception of an advantage valid?
Those are the questions asked in a recent paper by Pepperdine University Law Professor Robert Anderson IV and George Washington University Law Professor Jeffrey Manns in their paper, “The Delaware Delusion” (here). The longer paper is summarized in a short August 3, 2015 post, also entitled “The Delaware Delusion,” on The CLS Blue Sky Blog (here).
In their paper, the authors set out “to empirically assess whether there is an economic basis for Delaware’s appeal in the market for company incorporations.” In making their assessment, the authors considered the two leading schools of thought about Delaware’s appeal, which are, first, that Delaware has a superior legal regime that enhances shareholder value better than other states, and, second, that Delaware has a protectionist appeal in adding “managerial value” by entrenching corporate management at shareholders’ expense.
The authors assessed the economic value of these Delaware factors by looking at the way the market reacted to corporate mergers when the new, merged entity proceeded as a Delaware company. They looked at the pre- and post-acquisition value of acquirers and targets in a cross-section of intra- and inter-state mergers.
After reviewing data for the period 2001 to 2011, the authors found that “the financial markets place no economically consequential value on Delaware relative to other states,” which, the authors say, “contradicts both leading schools of thought.” The authors interpret this result to mean that “lawyers are engaging in default decision-making based on Delaware’s past preeminence, rather than actively weighing the value-added Delaware and other states offer to their clients.” The authors suggest this default decision making does not necessarily serve the interests of corporate clients.
The authors argue in favor of “shareholder say” on incorporation, in order to subject the decision “to greater scrutiny and to give shareholders the opportunity to address this principal-agent failure.” The need to justify the incorporation decisions “would force lawyers to actively assess the value-added by Delaware law and the law of other states,” — which, in turn, “would make it more likely that corporate lawyers will spearhead change in a proactive way to extract value for companies.” This, in turn, would “create market pressures for Delaware and other states to compete to assess and enhance the quality of their corporate governance law.”
The debate about Delaware’s predominance is likely to continue. Because there is, as the authors note, a default-to-Delaware mentality, it is unlikely that Delaware’s predominance will disappear any time soon. But it is clear that questions about Delaware’s role are growing, as the appearance of a front page Wall Street Journal article on the issue attests. There is some irony that the Delaware legislature’s enactment of the statute prohibiting fee-shifting bylaws is being cited as an example of the state’s supposed shortcomings, since all that did was preserve the continuation in the state of the so-called American rule pursuant to which each party bears their own costs.
If there is one area where the state’s court undoubtedly could and should do more it is with respect to merger objection litigation. The fact that virtually every merger transaction now attracts a lawsuit is curse on the system. The Delaware courts are only now evidencing a willingness to crack down on the type of disclosure-only settlement that produces no benefit except for the fee-garnering plaintiffs’ lawyers. The Delaware courts need to do more to crack down on these kinds of lawsuits. The lawsuits bring the entire system into disrepute and cast a pall over the cases that are meritorious.
That said, however, it probably is a good thing for questions about the default assumptions on the state of incorporation to be asked. In many cases, there may be no particular reason for Delaware to be the domicile for many companies. Just the same, I am not sure a state of incorporation competition is necessarily the best thing for the contemporary business environment. If state competition leads to a race to loosen corporate governance requirements and reduce shareholder protections, the ultimately impact could be negative. The business leaders and legal authorities in the competing states need to take into account the needs of a healthy business environment, rather than just the desire to capture incorporation fees, in building the best corporate law regime.
ABA Top 100 Law Blogs List: Once again, it is time for nominations to the American Bar Association’s annual list of the Top 100 Law Blogs. I certainly am going to nominate my favorite law blogs for inclusion in the list. I would be very grateful to any reader who would be willing to nominate The D&O Diary for inclusion in the ABA’s annual list. You can nominate your favorite law blogs on the ABA website, here. When you make your nominations be sure to provide the reasons why you like the blogs you nominate. Nominations are due no later than 11:59 p.m. CDT on Friday, Aug. 16, 2015. Thank you for your support.