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Benefits of Incorporation in Delaware
From: Columbia University
| By:
David Lukens |
EDITOR'S INTRODUCTION |
The state of Delaware has established itself as the state of choice for new businesses seeking to incorporate in the United States. David Lukens explains the draw of Delaware by explaining the three main factors that have contributed to Delaware's reputation: its well-developed corporate law; its strong legal protections limiting the financial liability of directors and officers; and its various provisions bearing on how control is shared by managers and shareholders. |
 or more than 100 years, the state of Delaware has worked hard to make itself the most desirable state for incorporation. Delaware's success in attracting companies to incorporate within its borders (approximately half of those listed on the New York Stock Exchange have done so) means that a large number of intricate corporate-law questions have surfaced in Delaware courts. |
These questions are resolved skillfully, time and again, by an equitable court (the Court of Chancery) that hears only business cases, guaranteeing their quick resolution by judges with expertise in business law. The Delaware legislature is also active and regularly revises the state's corporate statutes to clarify recurrent questions and otherwise eliminate ambiguities. |
Delaware's efforts have paid off. It now has a body of corporate law characterized by its sophistication, breadth and certainty. Attorneys representing venture capital (VC) professionals and entrepreneurs regularly cite this certainty as the reason that Delaware is the premier state for incorporation. Its status is so assured that many prestigious law firms in Silicon Valley will incorporate their high-tech clients in Delaware, even though these clients might be headquartered in California. |
The complex relationship between California and Delaware law, on this point, deserves brief mention. California treats foreign corporations (foreign only because they are incorporated elsewhere) somewhat aggressively, providing that whenever more than 50 percent of a foreign company's outstanding voting securities are owned by "persons having [California] addresses," then California law will supersede the law of the jurisdiction in which the company is incorporated (unless the foreign company trades on the New York Stock Exchange, Amex or NASDAQ). (California Corporations Code, section 2115.) The purpose of this law is to prevent foreign corporations (most of them Delaware corporations) from doing an end run around California's substantive corporate law. |
At first glance, this provision creates the impression that incorporating in California, and steering clear of Delaware and its accompanying franchise tax, is the best decision for a new, privately held company. However, for companies that will seek venture capital, or that will someday go public, this would be a mistake. Those that find themselves poised to make an initial public stock offering often reincorporate in Delaware because (1) Delaware's corporate law is so well developed; (2) Delaware affords directors and officers greater protection against liability than does California; and (3) Delaware gives those who actively manage a company more independence from shareholder interference. |
Delaware's three-tiered statutory framework
The Delaware legislature has created a three-tiered statutory framework for protecting directors from undeserved financial liability for bad business decisions. This framework embraces officers, employees and agents in addition to directors, though for convenience the term "director" will be used here. |
Delaware's three-tiered approach consists of (1) a provision limiting monetary liability for a breach of care; (2) an indemnification scheme that serves as a second line of defense; and (3) company-financed directors' and officers' insurance ("D & O insurance"), which serves as the final line of defense. |
Liability-limiting provision for directors
The technical language for a prodigiously bad business decision is a "breach of fiduciary duty [of care]" and Delaware law allows "a provision eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director" to be included in a company's certificate of incorporation |
This provision is adopted to ensure that capable people are not deterred from service on a corporation's board by the prospect of losing personal assets to disappointed shareholders who may second-guess decisions that seemed proper at the time. |
The provision allowing a company to limit its directors' liability is an enabling provision only, which means that the company's shareholders must vote to place it in the company's certificate of incorporation. In other words, shareholders can withhold the privilege. Even if the provision is in the certificate of incorporation, the immunity conferred is not absolute. |
A director is still liable if he breaches the duty of loyalty owed a corporation (the second of two fiduciary duties borne by a director). |
A director is also liable for "acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of the law." And the duty of care continues to serve as a standard in remedial contexts, so it might be invoked by shareholders seeking to rescind the board's election of a former convicted felon, for example. |
Indemnification
The inclusion of a liability-limiting provision in a company's certificate of incorporation does not, by itself, prevent directors from being sued. The financial burden of defending oneself from a suit, meritorious or not, can be onerous and it is to relieve this burden that Sections 145(a) and (b) of Delaware General Corporation Law permit the corporation to indemnify directors. These provisions, like the liability-limiting provisions reviewed above, are permissive, which means that shareholders must vote the indemnification provisions into effect. |
This said, the Delaware legislature is more solicitous of directors than to leave them at the mercy of feckless shareholders who might or might not adopt this optional provision. This solicitude surfaces in two backup plans that are available for indemnifying directors. First, Section 145(c) mandates minimal indemnification under certain conditions. But, much more important, Section 145(f) allows directors to negotiate very protective indemnification agreements through contract, and this freedom to contract is one of Delaware's selling points. |
Section 145(a) provides corporations with the chance to indemnify directors for attorneys' fees, judgments or amounts paid to settle a third-party suit. Section 145(b) does the same, only it contemplates a suit brought by the company itself, which means a derivative suit brought by a shareholder against the board. This section differs from Section 145(a) by denying indemnification for expenses incurred if the company prevails--the reason being that the real plaintiff in a derivative suit is the company itself, seeking to be made whole. The rationale behind Section 145(b) is that a company's recovery would be a hollow one if it had to reimburse the individual(s) responsible for the loss. |
Section 145(a), then, presents shareholders with an opportunity to indemnify directors who lose on the merits, but this opportunity is permissive and can be withheld. Section 145(c), on the other hand, mandates indemnification of directors who prevail on the merits. "To the extent that a director, officer, employee or agent of a corporation has been successful on the merits or otherwise in defense of any action, suit or proceeding referred to in subsections (a) and (b) of this section ... he shall be indemnified against expenses (including attorneys' fees actually and reasonably incurred by him in connection therewith)." |
On its face, this provision says that success on the merits leads to automatic indemnification. Yet Section 145(d) of the Delaware statute, in a strange twist, requires the company to vouch that the director complied with Sections 145 (a) and (b), which condition indemnity on (i) actions made in good faith and (ii) actions made in the company's best interest. Section 145(d) specifies that this quasi-judicial determination is the responsibility either of the board (by majority vote of those not party to the action, even though less than a quorum), an independent legal counsel or the stockholders. |
Cautious directors will seek contractual assurance that if Section 145(d) ever sets them before an ad hoc tribunal, favorable procedures and presumptions will take effect. Procedural advantages include the right to choose the decision maker, the right to declaratory judgment if the determination is not made within a specified time, or the right to an "appeal" in case of an adverse decision. An indemnification agreement, which is a separate contract allowed by Section 145(f), is the best way to ensure that these favorable mechanisms will be available. Another protective measure that might be drafted into the indemnification agreement is a contractual provision requiring the shareholders to adopt the indemnification provisions of Sections 145(a) and (b). |
Directors' and officers' insurance
Directors' and officers' insurance ("D & O insurance") is the final protective measure, the third tier, and is intended to plug up the holes where a director remains vulnerable under the statute's indemnification framework. This is accomplished by letting a company pay the premiums on a policy that benefits its directors and officers. |
The necessity of this third protective layer is best seen by recalling that a Section 145(b) derivative suit, if it results in a judgment against a director, does not entitle him to recover the expenses incurred defending himself. D & O insurance covers those expenses, though this is its only true role; the other kinds of liabilities against which a director might be insured are somewhat limited by public policy, so a director convicted of embezzlement, say, cannot collect insurance proceeds to mount a top-tier defense. |
Provisions giving autonomy from shareholder interference
In every corporation, there is a balance of power between, on one side, the directors and officers who make decisions about how to run a business and, on the other side, the shareholders. Under Delaware law, a number of optional provisions may be incorporated into a company's charter, and these provisions then determine how control will be distributed among the corporate players. Directors who choose to incorporate in Delaware for its "permissive" laws often defend their choice by noting that Delaware companies can capably deter takeover attempts. However, self-interested motives can sometimes be inferred from the choice of Delaware, too, as the state makes it harder for minority shareholders to elect directors but easier for managers to maintain control by limiting the opportunities for shareholder intervention. |
First, Delaware never forced companies within its borders to adopt cumulative voting provisions. Its flexibility on this point allowed it to attract defecting companies from states where these provisions were mandatory. The rationale for cumulative voting--in those states that did mandate it--is best illustrated by the following anecdote: A newspaperman, asked about the shares in his company, said that "there are 51 shares worth $1 million and 49 shares that aren't worth a damn." Cumulative voting is a technique that restores some value to those 49 shares, by giving minority shareholders (at least, those who meet a specified percentage interest, determined by formula) the ability to elect at least one board member. Again, this is not mandatory in Delaware and will not apply to any company unless the company's certificate of incorporation says it does. |
Delaware also affords companies the chance to create up to three classes of directors. Classified directors enjoy the equivalent of limited tenure because of a default provision that says they can be removed "only for cause." The effect of this is to prevent a classified director from being removed midterm for political reasons. |
There is also a statutory provision giving a corporation the right to abolish the shareholders' ability to convene ad hoc meetings. In California, by contrast, a shareholder owning more than 10 percent of the corporation's outstanding voting shares may convene a special shareholder meeting at any time. From the viewpoint of directors and officers, special meetings pose a threat because, within hours of hatching an insurgency plan, an alliance of activist shareholders, collectively owning a controlling block of voting shares, could oust a director. |
Another shareholder privilege that often goes hand in hand with the right to call shareholder meetings is the right to execute an action by written consent, in lieu of a shareholder meeting. Delaware law permits a corporation to eliminate this right, too. Stripped of these two rights, insurgent shareholders can engineer a transfer of control only at the annual shareholders' meeting. However, it would be a mistake to assume that incumbent directors entrench themselves within the firm once they learn that their removal is imminent. It is much more common for directors to simply resign at this point, largely because last-ditch defensive maneuvers will only tempt shareholders to retaliate with lawsuits. |
Delaware law benefits directors and officers in a more subtle respect by making it more difficult than it is in other states for shareholders to bring derivative suits. A derivative suit is a lawsuit brought against management by one shareholder, on behalf of all other shareholders, seeking redress for the mishandling of statutory, contractual or common-law duties owed the corporation. In Delaware, such suits are harder to bring than in other states (like California), because of a rule that the stockholder bringing the suit must have owned shares at the time of the controversial transaction. |
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