United States: Delaware - Small State Big Business

At the turn of the 20^th century, the quiet state of Delaware ratified a new state Constitution, and the lawyers in the state (all eleven of them) began to form a state bar association.

One hundred years later, heading into the 21^st century, Delaware is a leading player on the national business stage, and is poised to have a significant impact on the world of international commerce. How did this happen?

In the 19^th century, New Jersey was the preferred state of incorporation, known for having the most liberal business laws in the country. Delaware modeled its first corporate laws on those of New Jersey. In 1913, however, then-Governor of New Jersey Woodrow Wilson began signing antitrust and other laws greatly restricting the freedom with which business trusts and corporations had previously operated. These new restrictions did not sit well with the business community, and the business trusts and corporations fled the state.

Delaware, still holding on to New Jersey’s former liberal statutory scheme, was conveniently close by. It was also conveniently situated, approximately halfway between New York and Washington, D.C. Delaware’s small size also provided, and still provides, greater access to state political figures, which business leaders consider important.

Delaware, naturally, welcomed the new incorporations, as they added to the tax base. Unlike New Jersey, however, Delaware worked to appear inviting to businesses.

Over the next fifty years, as corporations continued to incorporate in Delaware, other states took notice of the potential for corporate franchise and other tax revenues, and adopted laws similar to those of Delaware. In the 1960s Delaware responded by engaging in a review and overhaul of its corporate code. The resulting revision simplified the mechanics of operating a corporation to meet the needs of modern times. The revision put Delaware well ahead of the pack, and cemented its reputation as a leader in corporate law. Subsequently, other states have copied Delaware’s statutes in whole or part. But as the Delaware legislature, with the assistance of the highly-sophisticated corporate bar, frequently amends and updates the law to anticipate and meet new needs, other states find themselves in a constant state of "catch up," and behind Delaware’s leadership.

Some scholars have criticized Delaware’s efforts to attract corporations, suggesting that the state is willing to emphasize pro-management laws, since the management usually determines the state of incorporation, at the expense of the shareholders. Such criticism, however, lacks empirical support. In fact, Delaware has declined to adopt pro-management statutes adopted in other states that it deemed to be incompatible with the long-term interests of shareholders. Further, such criticism fails to recognize that if investors were to view Delaware’s laws unfavorably, they would hesitate to invest in Delaware companies, to the disadvantage of all. The fact that this has not occurred lends credence to the proposition that the Delaware corporate laws, statutory and judge-made, strike a reasonable balance between the interests of the investors and capital markets and the interests of management.

Delaware has also been in the forefront of the burgeoning demand for new business entities, by adopting laws creating and governing limited partnerships, limited liability partnerships and limited liability companies, along with the more traditional entities such as general partnerships and business trusts.

This history helps explain how Delaware developed such pre-eminence in the field of business law. But how does one explain the continuing popularity of Delaware? Currently, approximately one-third of all American corporations are incorporated in Delaware, including half of the companies making up the Fortune 500.

Companies promoting Delaware as the preferred forum for incorporation point to favorable aspects of Delaware law such as: low franchise taxes; no sales, state or property tax or state corporate income tax for corporations that are formed in Delaware but do not transact business there; no taxes on stock in Delaware corporations that are owned by people or entities outside the state; the absence of a requirement to hold meetings or have any physical presence in Delaware (other than a registered agent for service of process); no minimum required amount of capital; the right to issue dividends out of profits as well as surplus; etc.

But other states can adopt similar laws, and many have. So why do businesses continue to incorporate in Delaware?

The answer is predictability and stability, and the reason is Delaware’s judicial system. Delaware’s courts, specifically the Court of Chancery (the trial court) and the Supreme Court of Delaware (the appellate court) have spent the last hundred years interpreting Delaware corporate law, not only the statutory law, but the common law applicable to corporations and their directors, in particular the fiduciary obligations imposed upon corporate directors.

As a result, Delaware has a large body of precedent upon which lawyers can rely in addressing questions regarding the legality of proposed corporate transactions. Indeed, Delaware corporate lawyers are routinely called upon by corporations to give formal opinions about whether a given transaction can occur consistent with the Delaware General Corporation Law. In answering those questions, the lawyers have at their disposal pronouncements of the Delaware judiciary interpreting Delaware’s corporate statutes, which precedent helps lawyers and corporations understand how such laws might be applied in interpreting the transaction at issue and future transactions.

Delaware’s unequalled body of judicial precedent provides a higher degree of predictability, and hence comfort, about corporate activity. This benefits corporations by reducing transaction costs, including the risk of litigation. By contrast, in states with a lesser body of precedent, corporations face an increased risk that in the event of litigation a court may interpret the law in a manner adverse to the corporation’s interests.

Thus, the Delaware judiciary plays a pronounced role in maintaining Delaware’s attractiveness to corporations. That attractiveness is not limited to precedent. If a lawsuit is brought challenging a corporate transaction, most corporations want the matter heard in Delaware’s Court of Chancery. That court, which does not hear criminal or domestic matters and has no jury trials, focuses on corporate matters. Approximately 75% of its docket consists of corporate disputes, including shareholder suits, director election contests, takeovers, etc. The judges (one Chancellor and four Vice Chancellors) have developed special expertise in complex commercial issues, and have a well-deserved international reputation for excellence. Such expertise helps streamline and expedite the litigation process. The Court of Chancery has been known to hear and resolve difficult corporate issues in weeks or, in extreme cases, days, with thoughtful rulings.

The pronouncements of Delaware’s courts have a long-term impact on corporate conduct, and can also have a short-term effect on capital markets. During the heyday of hostile takeovers, arbitrageurs were regular fixtures at court hearings, attempting to divine how the courts would rule, and how it would affect their portfolios. In some high-profile cases, rulings have been withheld until after trading on Wall Street had closed for the day, to allow time for the rulings to be properly analyzed and understood by the markets. CNN broadcast live the oral argument before the Delaware Supreme Court in the Time-Warner merger case, and a graphic on the side of the screen tracked contemporaneously the movement of each company’s stock.

In addition to the effect of Delaware’s courts, members of Delaware’s government and corporate bar have actively promoted Delaware throughout the world. Members of Delaware’s executive branch have traveled to foreign countries to promote Delaware as a forum for incorporation. Delaware corporate lawyers have lectured abroad, particularly to emerging democracies, about the significance and utility of commercial laws.

These actions have had an impact. Incorporators are receiving requests from such diverse countries as Russia, Israel and Nepal. Delaware courts are addressing disputes between Delaware corporations and entities from foreign nations. This author has represented a Russian business suing a Delaware corporation, as well as a Delaware corporation suing over a Hungarian business opportunity. As American business expands to new international markets, business will continue to look to Delaware for guidance.

In the late 1980’s-early 1990’s, as the trend of hostile takeovers financed with junk bonds and other risky investments subsided, and the economy took a turn for the worse, the United States Bankruptcy Court for the District of Delaware saw the beginnings of what would become a meteoric rise in commercial bankruptcy filings.

Businesses that were incorporated in Delaware now turned to the Delaware Bankruptcy Court for assistance with financial restructurings, which might include issues of corporate governance and ownership. Businesses sought the same consistency, expertise and efficiency they had come to expect in the state Court of Chancery, and the Bankruptcy Court rose to the challenge.

The Bankruptcy Court developed procedures to streamline the process, including establishing omnibus hearing dates months in advance so that the parties and their counsel know when they need to be in Delaware; ease of access to the judges for emergency hearings; prompt responses to questions; easy access to court documents online and offline; and flexibility in scheduling to permit delicate negotiations amongst the parties to proceed. Further, the small number of bankruptcy judges helped ensure consistency and predictability.

As a result, debtor, creditors, lawyers and lending institutions have all become comfortable with the Delaware Bankruptcy Court, and promote Delaware as a site for filing bankruptcy petitions. Companies as diverse as TWA, Lernout & Hauspie (Dictaphone), Continental Airlines, Columbia Gas, Days Inn, Fruit of the Loom, Montgomery Ward, Vlasic Pickles, and many others have sought Chapter 11 protection in Delaware.

The tremendous growth of commercial bankruptcy filings in Delaware has had two side effects. The first has been an effort by some in Congress to limit the ability of corporations to file for bankruptcy in Delaware. That effort has proven unsuccessful. The second has been an influx of non-Delaware law firms opening offices in Delaware, taking a "if you can’t beat ‘em, join ‘em" approach, to benefit from the large amount of bankruptcy work available.

Delaware has also played a significant role in the development and protection of intellectual property.

Because it is home to such major science and technology companies as Dupont, Hercules and AstraZenica, Delaware has one of the highest concentrations of scientists and engineers in the United States. Not coincidentally, Delaware also has one of the highest concentrations of patents in the United States.

To encourage start-up companies to commercialize new technologies and to promote job growth, Delaware is a limited partner in a venture capital fund called Delaware Venture Partners. This fund is designed to provide money, ranging from $100,000 to $2,000,000 to startups and later-stage companies in the areas of high technology, biotechnology, environmental, medical and communications technology.

Additionally, the Delaware Innovation Fund provides limited early-stage funding for high-tech enterprises to assist with obtaining patents and commercial promotion.

Delaware also plays a significant role in patent protection. Since the 1950’s, the United States District Court for the District of Delaware has been a popular venue for litigating patent infringement disputes. The Delaware District Court was recently cited as the 9^th most popular venue out of 92 potential venues for litigating patent infringement cases.

The Delaware District Court judges have developed a reputation over the past fifty years for expertise in intellectual property issues. Just as the Court of Chancery has developed a body of precedent on corporate law matters, the District Court judges have created a body of law covering the spectrum of patent issues, which cases have been cited as influential authority in other jurisdictions.

The judges have also developed modern, pragmatic approaches to litigating these complex cases, creating procedures designed to move trials along in an efficient manner and limit the burden on juries. The Court also has a highly effective mediator, who provides a cost-effective mechanism to resolve disputes.

It is perhaps these reasons that have drawn companies such as Honeywell International, Union Carbide, United Technologies, L’Oreal, AT&T, Motorola, Dow Chemical and Proctor & Gamble, amid scores of others, to prosecute their patent infringement actions in Delaware.