Two weeks ago, Delaware, the legal home of a substantial majority of U.S. public companies, self-destructed with serious consequences for investors worldwide. At the behest of a coalition of lawyers representing private equity firms, hedge funds and controlling investors, Delaware’s General Assembly passed legislation that jettisoned the State’s traditional investor-protective approach. The bill will permit secret agreements with controllers dictating governance questions previously reserved for directors. The tale is a sad one for shareholders everywhere and invites calls for the federal government to intervene, with all the political agenda that would entail.
Through an accident in financial history over 100 years ago, Delaware became the legal home and primary regulator of the internal affairs of corporate America. Delaware law, enforced by its world-renowned judiciary, defines the important relationships between stockholders, boards and corporate management. The goal was ultimately to protect investors.
For many years, Delaware courts were highly deferential to corporate management, trusting managers over small investors — seen as unsophisticated “widows and orphans” — who were best protected by executives whose acumen and probity was unquestioned.
Starting 40 years ago, however, large institutional investors equal in sophistication to corporate managers began to play a significant role. And thanks to vivid examples of management entrenchment in response to takeover bids and executive compensation scandals in the late 1990s, corporate managers were no longer universally viewed as reliable fiduciaries for their shareholders.
Delaware slowly but decisively changed its approach and shifted to a more balanced model of investor protection. Shareholder power became equally valued with the protection of management prerogative. Sometimes the courts favored management in shareholder disputes, but they also increasingly recognized shareholder authority as the animating force of corporate direction.
The substance of Delaware law is central to its success. But more important is the universal respect for its judiciary. The judges are acclaimed as experts in their corporate law domain, brilliant and fair. With no major local industry in the state to influence or compromise their objectivity, Delaware judges are trusted as neutral arbiters. Judges and policymakers worldwide look to the Delaware bench for guidance.
This was a winning formula. Delaware’s corporate franchise was the envy of its sister states, many of which tried — and failed — to imitate its model. Delaware’s only true rival was the federal government. Following the corporate scandals of the early 2000s, the SEC took on regulating public company audit and compensation practices, until then the domain of the Delaware legal regime. Still, Delaware dominated the rest of corporate law. Until now.
Earlier this year, the Delaware Court of Chancery, the state’s highly respected corporate trial court, handed down two rulings enforcing statutory protections of minority shareholder rights. In an unprecedented step, the Corporate Law Council of the Delaware State Bar Association, supported by lawyers representing the interests of the disappointed litigants, hastily lobbied for a legislative override of these decisions before an appeal could be taken to the state’s Supreme Court.
Stonewalling significant opposition from the chancellor and a vice chancellor of the Chancery Court; many in the national corporate, academic and practitioner community; and those representing large institutional investors, the General Assembly rubber-stamped the bill. Never before had the bar and legislature moved so hastily in the face of such strident opposition. Major revisions to Delaware law historically took years of debate, discussion and compromise. The resulting changes were thus almost uniformly respected.
Not this time.
The change in Delaware law is significant. The bill favors controllers over public investors, upending the historic equipoise between management and public investors. Independent directors, central to effective governance, will now find themselves hamstrung by secret agreements with large, powerful shareholders, undermining their ability to protect all investors.
Worse still, throughout the process, the judiciary was unfairly attacked, maligned and ignored by the bill’s proponents. These attacks aimed at crippling the authority of these judges to effectively protect investors, striking at the core of Delaware law and the state’s brand. Powerful special interest groups now have a model for legislatively circumventing the celebrated judicial process.
Sadly, Delaware’s cherished neutrality and circumspection have been sacrificed. Investors will turn elsewhere for protection — whether to other states or, more likely, to the federal government. It’s a terrible ending to a brilliant regime.
