The (Limited) Allure of Delaware
By William Foster · August 13, 2013 · 2013 Ark. L. Notes
In categories: Business Law, Corporate and In-House Counsel, Practice Tips, Securities, Snapshot, Taxation
William E. Foster 1
Delaware is known as “The First State” for its primacy in adopting the United States Constitution in 1787. 2 More recently, Delaware has become the first state of U.S. corporations, despite being the second smallest state in terms of territory and the sixth least populous state. 3 Why is Delaware the most attractive jurisdiction for incorporation? This piece will discuss the unique blend of law, institutions, and reputation that have combined to make Delaware the most sought after jurisdiction for corporate enterprise, and will consider what that means for Arkansas legal practitioners and lawmakers.
There is a common misperception among entrepreneurs and attorneys that Delaware is a “tax haven.” Tax actually has very little to do with Delaware’s allure for corporations. 4 In fact, Delaware has a relatively high state tax rate on corporate income (8.7%), 5 though corporations typically only pay that tax if they conduct business in the state. Some may consider Delaware a haven merely because of the relative ease and anonymity with which a corporation can be formed in that state. However, the true appeal of Delaware stems first, from its extraordinarily well-developed and management-friendly law of corporations; second, from the efficient court system that has unparalleled expertise resolving business disputes; and third, from the brand name it has developed along with its reputation as a uniquely favorable place to incorporate. Although these benefits are significant, they may not easily be implemented by another state and may provide limited, if any, advantages for companies owned and operated outside of Delaware, absent very narrow circumstances.
How dominant is Delaware and why does it matter?
Delaware’s dominance in the world of corporate law is well established. Its corporate primacy is accommodated by the fact that companies in the United States can choose any state to incorporate, 6 regardless of where the bulk of their actual business will occur. Incorporators of a company need only file articles of incorporation in the state whose laws they wish to govern its affairs, even if the only physical presence the corporation maintains there is through a registered agent. 7 Large companies have overwhelmingly followed this path; over 50% of all publicly-traded companies and 64% of Fortune 500 companies are incorporated in Delaware, 8 despite very few actually having any real physical presence in that state.
Other states envy Delaware’s position as the frontrunner in business incorporations, and for good reason. Filing fees can generate significant revenue for state governments. Approximately one-fourth of Delaware’s general fund comes from corporate franchise fees and corporate income taxes. 9 Moreover, in 2012, Delaware received $766 million in franchise taxes alone, which accounts for about one-fifth the state’s revenue. 10
In addition to filing fees and taxes, the incorporation business in Delaware is a huge industry unto itself. An enormous corporate legal service community has developed‒some of the largest and most prominent national and international law firms have offices in Delaware that otherwise would not. 11 Along with a sophisticated legal and business community come many high-income professionals who live and work in Delaware and accordingly, pay state income taxes, county property taxes, and local sales taxes.
Delaware Corporate Law
Perhaps the best starting point for an examination of the benefits of Delaware corporate law is the statute itself. The Delaware General Corporations Law (the “DGCL”) is so important to the state’s interests that it can only be amended or modified by a supermajority (two-thirds) vote of the legislature, whereas most other legislation requires only a majority. 12
The story of the DGCL begins in New Jersey of all places. The DGCL was enacted in 1899. 13 It mirrored the New Jersey statute, the first modern corporation law, which had been adopted three years prior and, among other things, allowed corporations to own stock in other corporations, allowed them to conduct business in other states, allowed perpetual existence of corporations, and to engage in mergers. 14 Following New Jersey’s 1896 law, many New York companies incorporated in New Jersey. 15 Concerned about potential problems in New Jersey, the New York bar wanted an alternative location for clients to incorporate and so it persuaded Delaware to enact a modern corporate code modeled after New Jersey’s law. 16 The New York bar’s concerns were soon validated when New Jersey reformed its statute under Woodrow Wilson in 1911 to add regulation of mergers, restrict stock ownership, and increase taxes. 17 As a result, large companies fled to Delaware.
For the last century, Delaware has made maintaining its dominance in corporate filings a priority being responsive to the concerns of business and corporate counsel. The Delaware corporate bar is sophisticated and heavily involved, and the legislature often considers its advice in updating the DGCL. The legislature has enacted very few dramatic changes to the DGCL since 1967, 18 but it frequently makes small adjustments to respond to the bar and to cases decided by the court. 19
In addition to being time-tested and predictable, the DGCL is very deferential to managers and directors. The DGCL provides very few statutory mandates for corporate governance, and many may be overridden by shareholder veto. Thus each company is generally free to adopt company-specific negotiated provisions in its charter and bylaws. In this way, the DGCL defers to directors of corporations on things like setting acceptable consideration (the par value of shares) and valuation of assets for repurchasing stock and making dividends (the solvency of the corporation and whether there is an “excess” out of which to make distributions). 20
Moreover, the DGCL invests the members of a company’s central management team with broad discretion to make business decisions and a diverse choice of means to effect those decisions. This statutory approach facilitates creativity and risk-taking in the operation of a company, as well as flexibility in transactional planning. A “central idea of Delaware’s approach to corporate law is the social utility of an active, engaged central management,” 21 and the DGCL embodies this by allowing the business affairs of the corporation to be managed by the board of directors without unnecessary influence from the state legislature.
Delaware Court of Chancery
In addition to an enduring and favorable statutory scheme, Delaware has an extremely efficient court system with tremendous expertise in business law disputes, which gives it the ability to resolve those disputes in a fraction of the time it take other courts. This efficiency combined with management-favored statutory provisions has allowed Delaware to accumulate a distinctively massive body of corporate law over the past century.
The Delaware Court of Chancery is a special court system that operates without a jury and resolves only business disputes. 22 The Court consists of one chancellor and four vice chancellors who specialize in business law issues. The Court is widely known for being thoughtful in its rulings and expedition in processing cases.
Moreover, despite being an arm of the Delaware state court system, litigants before the Court of Chancery need not worry about a “hometown bias.” Cases before the Court involve primarily companies chartered in Delaware (usually both companies involved will be Delaware companies) but headquartered elsewhere, and so the Court does not face the pressures in other state courts to protect local industry and jobs. 23 Instead, the local industry most impacted by the Court’s decision is the industry of corporate charters, which demands‒and receives‒fair and consistent legal rulings.
Delaware has essentially become its own brand name in the world of corporate law. 24 And that status has its own inertia so that, absent an intervening event, Delaware will be known as the place to incorporate, even when other states have nearly identical laws. Kansas, for example, has adopted the DGCL nearly wholesale, but companies are not now flocking to Kansas the same way they traditionally have to Delaware. Instead, old companies are likely to stay where they have incorporated, absent compelling reason to move, and new companies are likely to follow the existing crown in Delaware. In that way, the century-old reputation that Delaware has maintained will continue to be a self-fulfilling prophecy.
In addition to the momentum of a solid reputation, as mentioned above with respect to the judiciary, Delaware is not beholden to one company or even a particular industry. In other states, it is not uncommon for a legislature to feel pressure to modify its laws to benefit a particular large employer that is based in the state out of fear the business will relocate or that a large blow to that company will harm the local economy. But because so few companies are headquartered in Delaware, it does not face that same pressure and instead can focus on the business incorporation industry and on continuing its fair and thorough corporate law structure.
Should Arkansas adopt a statutory regime similar to the DGCL?
Delaware clearly has a proven recipe for attracting corporate business. Would it behoove Arkansas to adopt similar measures? Arkansas could, for example, enact a statutory scheme substantially similar, or even identical to, the DGCL in an effort to attract businesses to the state.
In fact, some states have done exactly this. Arkansas’s neighbors, Kansas and Oklahoma, for example, have adopted statutory regimes nearly identical to the DGCL. That legislative decision has some advantages, certainly, because those states then inherit the robust body of case law that Delaware has developed. Adopting the DGCL brings an element of predictability and provides a convenient resource for state courts to rely on when considering difficult business law questions that perhaps do not arise in that state very frequently. 25 However, there is no evidence to suggest that Kansas and Oklahoma have seen a huge migration of businesses from other states. 26
Legislatures cannot replicate the corporation-friendly environment in Delaware merely by adopting the DGCL because a large part of Delaware’s efficient and business-friendly legal system is the Court of Chancery. That court is incredibly well-versed in dealing with business issues, in contrast to Kansas or Oklahoma, or even Arkansas, state courts that hear a wide range of cases on a daily basis. Unlike an Arkansas circuit court judge who may hear a shareholder dispute between a child custody hearing and the probate of an estate, the chancellors in Delaware review only corporate litigation. Delaware’s chancellors are widely considered some of the finest corporate minds in the country, and in addition to the legal expertise they have developed, they have refined and nearly perfected expedited procedures in business cases.
The importance of timing cannot be overemphasized. Take, for example, In re IBP, Inc. Shareholders Litigation, 27 a case involving a venerated poultry company headquartered in Arkansas but incorporated in Delaware. In that case, Tyson Foods attempted to back out of its merger agreement with IBP after certain accounting improprieties in one of IBP’s subsidiaries came to light. IBP sought specific performance of the merger agreement in Delaware’s Court of Chancery, and the entire case was litigated and resolved in IBP’s favor (including a two-week trial) in less than three months. The Delaware court was even applying New York law to contractual claims. That same case would likely have so much longer in a state court in Arkansas that the equitable relief IBP sought would not be practical.
Aside from the benefit of extensive case law, then, adopting the DGCL in Arkansas would likely not trigger an influx of corporations and the corresponding economic benefits to the state.
Further, some scholars have challenged the notion that Delaware’s statutory regime and case law are superior to alternative regimes, including the Model Business Corporation Act, which Arkansas has in place. 28 William J. Carney and George B. Shepherd have argued that in terms of transactional costs in major transactions, the Delaware system is less attractive than others. They further suggest that over the last several decades, Delaware law has become “increasingly complex and uncertain,” in large part because of shortsighted judicial decisions that require lawyers to cobble together piecemeal precedence to formalistically structure transactions.
Regardless of whether Carney and Shepherd are absolutely correct, their arguments further erode the incentive for Arkansas or other states to adopt a Delaware-modeled statutory regime.
Should Arkansas attorneys encourage clients to incorporate in Delaware?
A more immediate and practical question for Arkansas practitioners is whether they should advise their clients to incorporate in Delaware. In the vast majority of cases, the answer is probably not. For a company that is headquartered in Arkansas and primarily does business in Arkansas, the benefits of Delaware are likely not going to be worth the hassle of incorporating there. As noted, Delaware does have a well-developed body of case law and an ever-evolving, yet incremental, statutory scheme to govern its corporations. But it also has the expertise of the Court of Chancery, the benefits of which an Arkansas company would miss unless it had the time and resources to litigate disputes in Delaware.
However, startup companies looking to eventually make a public offering or seeking institutional investors may find a benefit to incorporating in Delaware, based primarily on those investors’ familiarity with Delaware corporate law. Large-scale investors understand Delaware law given its primacy in the corporate world generally. They see 1,000 offerings from Delaware corporations for every one they see from an Arkansas corporation. This familiarity with the law and procedures of Delaware adds a level of comfort for investors who will be less likely to feel the need to employ separate counsel to review the particular aspects of Arkansas law that might expose them to unforeseen liabilities or hassles with respect to the investment. Beyond companies engaged in serious national or international business and who can afford to pay to litigate in Delaware, or those seeking institutional investors, the benefits of incorporating there are likely not worth the trouble for an otherwise Arkansas-based operation.
Delaware’s status as the foremost state of corporate law is unlikely to be challenged any time soon. That state’s emphasis on attracting corporate business by developing and maintaining a director-centered statutory regime and efficient and expert chancery court system distinguish it from all other corporate venues. These results are not replicable in Arkansas or other states with relatively underdeveloped case law, and the benefits of adopting a similar legal regime are questionable. Further, Arkansas practitioners should use Delaware incorporations sparingly. Aside from companies that are seeking to raise significant capital from out-of-state sources or those that expect to be frequently engaged in complex business litigation, the upside to incorporating in Delaware is far outweighed by the costs.
- Visiting Assistant Professor, University of Arkansas School of Law; Associate Professor, Washburn University School of Law. The author would like to thank Kerri Russ for her research assistance. ↩
- Thomas R. Carper, Tiny Delaware as Corporate and Legal Powerhouse, 13-WTR Del. Law. 6, 6 (1995). ↩
- Delaware Health and Social Services: Division of Substance Abuse and Mental Health, Residency Program: Delaware Area: Information about the State of Delaware, State of Delaware, http://dhss.delaware.gov/dhss/dsamh/residency/delawarearea.html (last updated June 1, 2010). ↩
- There is a notable exception to the general comment that tax plays a small role in the choice to incorporate in Delaware. Firms with significant intellectual property rights may be able employ multi-tiered structures that take advantage of Delaware’s favorable taxation of intangible assets. Basically, some companies incorporate subsidiaries in Delaware, transfer intangible assets to the Delaware subsidiary, and have another related entity pay a royalty to the Delaware subsidiary for the use of the intangible assets. This type of planning is extremely expensive, but may yield tax savings relative to other jurisdictions. ↩
- Scott D. Dyreng, Bradley P. Lindsey, & Jacob R. Thornock, Exploring the Role Delaware Plays as a Domestic Tax Haven, 108 J. Fin. Econ. 751, 760 (2013). ↩
- The “internal affairs doctrine” recognizes that only one state should have the authority to regulate a corporation’s internal affairs – the state of incorporation. Vantagepoint Venture Partners v. Examen, Inc., 871 A.2d 1108, 1112 (Del. 2005). It is “an accepted part of the business landscape in this country for States to create corporations, to prescribe their powers, and to define the rights that are acquired by purchasing shares.” CTS Corp. v. Dynamics Corp. of America, 481 U.S. 69, 91 (1987). ↩
- CT Corporation, headquartered in an unassuming office building in Wilmington, Delaware, services as the registered agent for over 285,000 entities that are formed under Delaware law. Leslie Wayne, How Delaware Thrives as a Corporate Tax Haven, NY Times (June 30, 2012), http://www.nytimes.com/2012/07/01/business/how-delaware-thrives-as-a-corporate-tax-haven.html?pagewanted=all&_r=0. Although most Delaware corporations are not headquartered in the state, Delaware corporations have begun enacting bylaws that require any intra-corporate litigation to occur in Delaware, some even require litigation in the Court of Chancery. See Ashley Post, Shareholders Sue Over Exclusive-Forum Bylaws, InsideCounsel (May 30, 2012), http://www.insidecounsel.com/2012/05/30/shareholders-sue-over-exclusive-forum-bylaws. This trend could further secure Delaware’s future dominance in corporate law. ↩
- Jeffrey W. Bullock, Delaware Division of Corporations 2012 Annual Report, State of Delaware 1 (2013), http://corp.delaware.gov/pdfs/2012CorpAR.pdf. ↩
- Id. at 2. One significant factor contributing to this revenue stream is the number of newly incorporated public companies choosing Delaware. Id. Ninety percent of 2012 Initial Public Offerings incorporated in Delaware. Id. ↩
- Id. ↩
- For example, Skadden, Arps, Slate, Meagher & Flom LLP, http://www.skadden.com/the-firm/offices/wilmington; DLA Piper http://www.dlapiper.com/us/offices/office.aspx?office=111; and Greenberg Traurig http://www.gtlaw.com/Locations/Delaware all have offices in Wilmington, which might at first glace seem out of place among Hong Kong, London, Frankfurt, Moscow, Paris, Los Angeles, and New York. ↩
- Del. Const. art. 9, § 1. The Delaware General Corporations Law is reviewed annually to ensure it meets the needs of the companies incorporated there. Leo E. Strine, Jr., The Delaware Way: How We Do Corporate Law and Some of the New Challenges We (and Europe) Face, 30 Del. J. Corp. L. 673, 681 (2005). ↩
- William J. Carney & George B. Shepherd, The Mystery of Delaware Law’s Continuing Success, 2009 U. Ill. L. Rev. 1, 3 (2009). ↩
- Id. ↩
- Id. ↩
- Id. ↩
- Id. ↩
- In 1967, the legislature modified the DGCL to eliminate shareholder preemptive rights except when explicitly adopted by the stockholders, validate interested director transactions that do not injure the corporation, broaden the power of corporations to indemnify wrongfully accused directors, and facilitate various merger transactions. Stanley A. Kaplan, Foreign Corporations and Local Corporate Policy, 21 Vand. L. Rev. 433, 436 (1968). ↩
- For example, following Smith v. Van Gorkom, 488 A.2d 858 (Del. 1985), the legislature added § 102(b)(7) raincoat amendments, which allows indemnification of directors for breaches of their duty of care except for intentional misconduct or knowing violation of the law. Dale A. Oesterle, The Law of Mergers and Acquisitions, 351 (4th Ed. 2012). More currently, Delaware is currently considering proposed elimination of the shareholder vote requirement in certain back-end mergers. The proposed amendments (which would apply, on an opt-in basis only to target’s listed on a national securities exchange or whose voting stock is held by more than 2,000 holders) would add a new provision to Section 251 of the Delaware General Corporation Law (i.e., subsection (h)) to permit the consummation of a second-step merger (following completion of the front-end tender or exchange offer) if certain structural and disclosure conditions are satisfied. In other words, the need to seek and obtain stockholder approval for the merger would be eliminated even though the purchaser did not (whether directly in the initial tender offer period, as extended, or subsequently by means of exercising a “top up” option or using a Rule 14d-11 “subsequent offer period”) acquire the 90% or more of the target’s outstanding voting stock necessary to effect a “short-form” merger under Section 253 of the DGCL. Bruce E. Jameson, Proposed Amendments to the Delaware General Corporation Law, Bus. L. Today (June 2013), http://www.americanbar.org/publications/blt/2013/06/delaware_insider.html. ↩
- See Strine supra note 12, at 674–75 (the DGCL is a “broad, enabling statute”); Kaplan, supra note 20, at 436. ↩
- Id. at 675. ↩
- From the English tradition of having separate courts of law and equity – chancellors had jurisdiction over fiduciary matters (including trustees), which is similar to the director’s role. Strine, supra note 12, at 681. ↩
- Strine, supra note 12, at 683. ↩
- Lewis S. Black, Jr., Why Corporations Choose Delaware 1 (2007). ↩
- A few quick Westlaw searches demonstrate the disparity in reported case law. For example, a search of the phrase “business judgment rule” yielded 663 results in Delaware state courts and 7 results in Arkansas state courts. The phrase “shareholder rights” yielded 153 results in Delaware and 3 results in Arkansas. While these issues likely arise more often in Arkansas than these results indicate, they are not appealed often enough to have a robust and reliable body of case law. That said, Delaware’s corporate law precedence is not without its critics. See generally William J. Carney, George B. Shepherd, & Joanna Shepherd Bailey, Lawyers, Ignorance, and the Dominance of Delaware “Corporate Law (Emory Pub. L. & Legal Theory Res. Paper Series, Research Paper No. 11-171, 2011) (Emory L. & Econ. Res. Paper Series, Research Paper No. 11-118, 2011) (suggesting Delaware’s continued dominance is due to ignorance about other states’ corporate law). – DE law on a few things is kind of muddled…. Great expertise but some really fine lines being drawn that may not be a wholesale victory for those looking for clarification on these issues]. ↩
- Although, if states adopt similar statutory regimes and begin attracting in-state companies to incorporate there, states will begin receiving more franchise fees, corporate taxes, and may begin increasing their business and corporate case law. See Wayne, supra note 7 (stating that “the Delaware loophole has enabled corporations to reduce the taxes paid to other states by an estimated .5 billion”) ↩
- 789 A.2d 14 ↩
- See generally Carney & Shepherd, supra note 13 (examining different aspects of Delaware’s corporate law and the Model Business Corporation Act). ↩