Delaware: The Empire Strikes Back

A proposal to make broad and major changes to Delaware’s corporate law code, the DGCL, was made public last week. I understand that an effort will be made to enact the proposal, which is backed by the governor, by the end of this month. Prominent law firms have already commended the proposed legislation as “salutary” and “balancing.” As discussed below, however, this proposal raises serious concerns, and its adoption would have considerable detrimental effects on public company shareholders.

I plan to say more about the proposed legislation later on. In the meantime, however, I would like to flag several issues that discussions of the legislation should carefully consider.

1. Pushing the Delaware Courts Under the Bus?

The legislation overturns and replaces a substantial body of Delaware caselaw, including court decisions that have developed the doctrines governing conflicts by controlling shareholders, the “facts and circumstances” analysis of director independence, and the use of inspection rights to facilitate shareholder litigation. (For an account of the proposal and its background, see this recent post from Morris Nichols).

This approach deviates from Delaware’s traditional attitude toward the work of the state’s corporate law courts. Delaware officials have long taken pride in the role played by these courts and have put forward the caselaw developed by these courts as a major asset that favors Delaware incorporation. The Morris Nichols memo states that “[t]he crown jewel of the Delaware franchise is our court system and its jurisprudence” and that the “depth and breadth of judicial caselaw is a benefit to corporate planners.” Similarly, in describing the benefits of Delaware incorporation, the State of Delaware indicates on an official website that “[f]or many experienced lawyers throughout the world, the principal reasons to recommend organizing in Delaware are the Delaware courts and the body of case law developed by those courts” and that “[t]he quantity and quality of the Court of Chancery’s opinions confer a substantive advantage on Delaware business entities by providing them with a thorough and predictable body of interpretive case law.”

By contrast, passing the legislation would communicate a judgment by the Delaware legislature that (a) the Delaware courts have gotten their work wrong and developed inferior doctrines with respect to important subjects, and (b) the courts nonetheless applied these doctrines for a substantial period of time. Furthermore, enacting the proposal would also communicate the legislature’s judgment that corporate planners would be better off without the guidance and predictability provided by the body of caselaw developed on these important subjects.

Delaware players should recognize that the above attitude toward Delaware’s corporate law courts would have significant long-term costs to its ability to compete for incorporations. This is important to note because the proposal seems to be motivated by fears of an exodus by Delaware companies and a desire to induce such companies to retain their in-state incorporations. However, even from the perspective of Delaware’s interest in maintaining its leading position in the market for incorporations, in the long term, this legislation could backfire and operate to undermine Delaware’s position.

The proposed legislation could do so by sending a clear signal that Delaware’s unique system for adjudicating corporate disputes and the caselaw produced by it are, in the legislators’ eyes, are significantly less valuable than has been earlier believed. This signal will likely affect how market participants perceive the value of Delaware incorporation going forward. Ultimately, the proposed legislation might erode the value of an advantage that Delaware has long claimed to have in the market for incorporations.

2. Preventing the Courts from Offering Equitable Relief

Delaware law has for decades been especially respectful and deferential to the key corporate law courts’ “equity role.” As former Chief Justice Strine stressed: “[T]here is no question that the Delaware system of corporate law cannot function with credibility or efficiency if the judiciary does not use its equitable powers when fiduciaries have failed to act with fidelity or care. If we blanche at finding misconduct when that is warranted, then we, as judges, do not fulfill the promise of our law.” Similarly, in describing the value of Delaware incorporation, the State of Delaware indicates that the Delaware courts’ “commitment to settling cases that come before them in an equitable manner is unrivaled.” Accordingly, fiduciary duties have been developed by the courts, not by the corporate code, as an extra layer of protection, coming to the rescue when equity so demands.

By contrast, the proposed legislation would not respect the courts’ freedom to provide equitable relief when equity warrants. To the contrary, the legislation indicates that transactions between a company and its controller “may not be the subject of equitable relief” regardless of whether the court would provide such relief if it were warranted by equity. Thus, for transactions between companies and controllers, the legislation would guide courts to abandon their long-praised “unrivaled commitment” to providing equitable relief when equity warrants. This effect will further contribute in the long term to eroding the perceived value of a Delaware incorporation, and thus possibly also to hurting Delaware in the market for incorporations.

3. Worse than the Moelis Legislation?

Last year, at the urging of the Delaware corporate bar, the Delaware legislature adopted a bill that overturned a Chancery Court decision in the Moelis case. This legislation, which was passed quickly before the Delaware Supreme Court had an opportunity to consider an appeal of the Chancery Court decision, was criticized as an unwarranted intrusion into the court’s territory by many academics, including myself (see my posts here and here). Against this recent history, it is worth noting that, compared to the Moelis legislation, the proposed legislation would be worse in terms of its treatment of Delaware’s corporate law courts.

To begin with, the Moelis legislation sought to overturn one recent decision by a single Chancery Court judge. By contrast, the proposed legislation would overturn many court decisions made by different judges over a substantial period of time (including both Chancery Court and Delaware Supreme Court decisions).

Furthermore, even though the Moelis legislation sought to overturn a Chancery Court decision, the Moelis legislation, unlike the proposed legislation currently being considered, was careful to retain the courts’ key equity role. In particular, the Moelis legislation was designed to “not affect the case law empowering a court to grant equitable relief.” The proposed legislation thus stands out in the way it undermines the courts’ key equity role.

4. In a Hurry, Without Substantive Engagement with Expected Costs

The legislative process in this case seems intended to be even speedier, and to involve even less substantive analysis, than the flawed process that produced the Moelis legislation.

Supporters of the legislation elected to skip even the standard stage of having proposed legislation, before its presentation, be first approved by the Delaware Bar’s Council on Corporation Law after adequate consideration. The Morris Nichols memo praises the value of this standard stage as follows: “The Council, comprised of a diverse representation of twenty-six plaintiff- and defense-side lawyers, including litigators and transaction planners, as well as a representative of the Secretary of State’s office, will consider such amendments, often through the assistance of focused committees comprising an even broader cross-section of the Delaware bar. Any such proposed amendments are presented to the General Assembly only if they are approved by the Corporation Law Section and the executive committee of the DSBA.” Given the broad scope and significance of the considered legislation, the choice to skip this stage and present the proposal to the General Assembly without the above approval is, at the very least, surprising.

Importantly, the brief synopsis accompanying the proposal submitted to legislature, and the various law firm memos issued in its support, provide little substantive engagement with the reasons that led courts to develop the doctrines the proposal seeks to drop, as well as with the costs that could be expected to result from adopting the proposal.

Here are some significant concerns with which supporters of the proposed legislation should have engaged substantively before designing and putting it forward: (1) Because the proposal would allow non-freezeout transactions with a controller to be fully cleansed by independent directors, supporters could have been expected to seriously consider concerns that directors appointed by the controller and serving at its pleasure cannot generally be relied on to provide effective oversight of conflicted controller transactions. (2) Because the proposal would allow transactions approved by independent directors even if these directors were not involved in the negotiations of these transactions from the start, it raises concerns that such transactions would be produced by a process that does not even attempt to resemble an arm’s length process. (3) Because Delaware law does not allow any shareholder derivative litigation to get to the post-complaint discovery stage if the complaint does not already include particularized facts that would be sufficient for obtaining a remedy if true, the proposal raises concerns, which supporters have thus far not attempted to address substantively, that the proposed curtailing of access to company books and records would severely impede litigation when insider opportunism is suspected.

In my view, the above concerns and others raised by the proposal provide a strong basis for believing that the proposed legislation would be severely detrimental to shareholder protection. At a minimum, however, the proposal should not have been brought to the legislature, with a plan to adopt it by the end of this month, without supporters providing a detailed and substantive analysis addressing these concerns. It is surprising, and disconcerting, that this has not been (yet) done for a major legislation presented to the General Assembly and planned to be enacted by the end of this month.