The Delaware General Assembly is about to change the Delaware General Corporation Law (DGCL) as soon as June 30 of this year in ways that could diminsh Delaware’s status as the go-to state for incorporation.
The proposed amendments to Section 122 of the DGCL will convert Delaware’s universally accepted board-centric model to a contract-centric model, not unlike limited liability companies (LLCs) and partnerships.
At the behest of private equity firms and their Delaware lobbyists and lawyers, the Delaware legislature is fast-tracking Senate Bill 313.
SB 313 will allow boards of directors to contractually assign away their most important duties and obligations.
Bad Facts Make Bad Law
The goal behind SB 313 is to salvage contracts signed by private equity firms made partially or wholly illegal under the case West Palm Beach Firefighters’ Pension Fund v. Moelis & Co.
In law school we are told, “bad facts make bad law.”
Moelis was a case of very bad facts. The day before Moelis & Company went public, its board approved an agreement that enabled founder Ken Moelis to dominate the board and its committees. The following excerpts from Moelis summarize some of these powers:
“…the Company’s board of directors… must obtain Moelis’ prior written consent before taking eighteen different categories of action…. The Pre-Approval Requirements encompass virtually everything the Board can do. Because of the Pre-Approval Requirements, the Board can only act if Moelis signs off in advance.”
“Another set of provisions compels the Board to ensure that Moelis can select a majority of its members…. The Board is contractually obligated to maintain its size at not more than eleven seats…. Moelis is entitled to name a number of designees equal to a majority of those seats….”
“The Board must nominate Moelis’ designees as candidates for election….”
“The Board must recommend that stockholders vote in favor of Moelis’ designees….”
“The Company must use reasonable efforts to enable Moelis’ designees to be elected and continue to serve….”
“And the Board must fill any vacancy in a seat occupied by a Moelis designee with a new Moelis designee….”
“Even if Moelis holds less than a majority of the Company’s outstanding voting power, as is currently true, the Board Composition Provisions force the directors to ensure that his designees control the Board.”
“A final provision in the Stockholder Agreement forces the Board to populate any committee with a number of Moelis’ designees proportionate to the number of designees on the full Board…. Because of the Committee Composition Provision, the Board cannot create a committee with a different number of Moelis designees unless Moelis consents. The Board cannot create an independent committee without any Moelis designees unless Moelis consents.”
DE Corporations Would be No Better than LLCs
The above-listed powers given to Ken Moelis are just like those associated with many LLCs and partnerships.
The Moelis decision rejected them as contrary to Delaware law and the primacy of the board of directors.
SB 313 essentially overturns Moelis, allowing boards to give away those types of powers, which are apparently already found now in countless agreements companies have signed with PE Firms.
As I always tell my law students, and as I wrote in Startup Law and Fundraising, for Entrepreneurs and Startup Advisors, “LLCs are largely creatures of contract, while corporations are largely creatures of statute and case law.”
SB 313 would render this proposition false as to Delaware corporations. They would now be subject to contractual domination to the same extent as LLCs.
The significance of this is hard to overstate.
The current DGCL board-centric paradigm and related case law have been fine-tuned over decades to achieve a delicate balance between and among dominant shareholders and minority shareholders, serving as a check on oppression and self-dealing on the part of dominant shareholders, while still enabling boards to take substantial business risks in the pursuit of increasing enterprise value for all stakeholders.
That balance, in my view, has never been and will never be achieved by LLCs, which can be formed in a manner establishing absolute power in the hands of one or more persons.
And you know what they say about absolute power….
LLCs are so prone to exercises of raw, self-interested power and resultant litigation that I no longer form them where minority investors will be brought in. Other lawyers can deal with those headaches.
SB 313 is Moving Forward Despite Massive Opposition
It is impossible to recall any proposed amendments to the DGCL inspiring more hostility than SB 313, which was just fast-tracked out of Delaware’s Senate Judiciary Committee despite overwhelming testimony against it from a large number of leading experts on corporate law.
Written commentary on SB 313 is almost uniformly opposed and makes for interesting reading.
Here are links to four articles that articulately explain why monied interests should not be allowed to destroy the board-centric underpinnings of the DGCL:
DE Incorporation No Longer the Default?
As someone who serves as chief legal officer to numerous companies, forms five or more companies per year, and teaches corporate law at two law schools, I find the proposed changes strangely suicidal for Delaware.
Every time a founder forms a corporation, he or she has to decide whether to incorporate in their home state, in Delaware, or in some other state claiming to have the lowest taxes and fees and the strongest confidentiality protections.
While Delaware is usually the top choice for high-growth, high-tech startups due to its preference among investors and their counsel, there are definite costs and inconveniences associated with incorporation in Delaware. These include: (i) being required to maintain dual-state registration in both Delaware and the company’s home state, (ii) the risks and costs of being subject to litigation in Delaware for virtually any kind of claim, and (iii) Delaware’s significant and somewhat confusing annual franchise taxes.
Further, as noted by corporate law professor Ann Lipton in her above-linked blog post, I Write Letters, SB 313 would allow disputes involving Delaware corporations to be litigated in other states under contractual choice-of-law provisions.
If SB 313 becomes law, I and thousands of other business attorneys would need to advise founders of the new risk that their first major investor might require them to contractually sign away all control of their business. After all, overreaching contractual provisions could eventually become the norm under the new post-SB 313 paradigm.
Killing the Golden Goose
The state of Delaware derives a huge percentage of its annual budget from corporate franchise taxes.
In 2024, for example, franchise taxes are projected to provide $1,648.8 million of its total operating revenues of $6,046.8 million for Fiscal Year 2024, or 27.27% of Delaware’s entire budget. Any material diminution in those franchise taxes could be catastrophic for the state and would likely trigger increased taxes on its residents.
More than 100 years ago, New Jersey was the undisputed leader in new business formations.
And then Woodrow Wilson, as governor of New Jersey, bowed to pressures from interest groups and put a stop to those successes by outlawing holding companies. This allowed Delaware to come from behind and become the incorporation champion.
It seems we may be witnessing another paradigm shift – one spurred by Delaware’s upcoming “Woodrow Wilson” moment.
As many states have closely modeled their corporate statutes to borrow from the best parts of the DGCL, and given the tendency of many courts to look to Delaware’s body of case law for precedent, a higher percentage of founders may start opting for home state formation rather than risk losing control over their corporations due to the changes SB 313 will bring.
State, business, and bar association leaders across the country should watch carefully and think about how to capitalize on this pending blunder by the Delaware General Assembly - i.e., how to position their states as preferred corporate domiciles.
One tagline might be – “Our corporations aren’t just LLCs by a different name,” or “Our corporations still have independent boards of directors.”
Ok, those are weak, but send them off to the marketing folks. They’ll know what to do.