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Optionality is optimal: Talley, Gordon, Bainbridge et al Law Professor Letter to the Delaware Legislature Urging SB 21 be Made Optional

Eric Talley, Jeff Gordon, and I have each posted proposals that Delaware SB 21 be amended to make it optional. Over the weekend we worked up a letter to the Delaware legislature advancing just such a proposal (Eric deserves full credit for pulling the laboring oar). (Download Talley, Gordon, Bainbridge, et al SB21 Letter here.) We ended up with 25 corporate law professors cosigning the letter.

The letter argues that an opt-in approach offers several advantages:

1. Preserving Flexibility and Market Choice – Delaware’s competitive strength lies in its ability to accommodate a range of governance preferences. That strength is part of what attracts highly heterogeneous companies to incorporate in the state. Granting corporations the ability to opt into the provisions of SB21—rather than imposing them immutably and mandatorily—ensures that each company can make an informed decision about its governance structure while preserving Delaware’s reputation as the jurisdiction of choice for corporate flexibility.
2. Mitigating the Risk of Reincorporation – Providing corporations with an option to adopt SB21’s provisions circumvents the concerns over mass reincorporation out of Delaware, so-called “DExit.” Companies objecting to the common law regime will now have a ready alternative that obviates the need to explore alternatives in other states.  Moreover, corporations that opt in would still benefit from the familiar substantive law of Delaware as to other corporate attributes—one superintended by an expert and nimble court applying a rich body of precedents.  A corporation contemplating leaving Delaware could now get the model it wants without having to reincorporate.  And, providing this flexibility alleviates critics’ concerns that a rigid statutory mandate will accelerate rather than dampen an incorporation exodus. Put simply, an opt-in model would demonstrate that Delaware remains responsive to corporate needs without forcing a one-size-fits-all approach on everyone.
3. Avoiding Constitutional and Legal Challenges – A voluntary opt-in framework would also be more robust to constitutional challenges than a broad, mandatory limitation on the Chancery Court’s vested equitable powers under Delaware’s constitution. Allowing opt-in would invite Delaware corporations (and not the General Assembly) to experiment with their governance structures, obviating thorny questions about separation of powers and legal validity that are commonplace with abrupt and mandatory statutory shifts such as the one SB21 proposes.
4. Leveraging Market Forces to Settle the Debate – The competing claims about SB21’s long-term impact—whether it strengthens or weakens Delaware’s franchise—could be field tested empirically by allowing corporations to choose for themselves. Those who find the new provisions attractive can adopt them, while those who prefer the status quo can maintain their current governance structures. Over time, Delaware’s corporate governance framework will evolve based on demonstrated market preferences rather than armchair speculation.

The letter also argues that the proposal could be adopted with just a few minor tweaks to the current bill:

To take just one example, a one-sentence addition to Section 102(b) of the DGCL could provide that Delaware corporations may, through an express charter provision, opt into the new rules on conflicted transactions and inspection rights contained in SB21. Under this approach, the current versions of Sections 144 and 220 would remain intact, and SB21’s key provisions would be codified into new DGCL Sections 144A and 220A that are turnkey ready for companies to embrace through charter provisions as they see fit. This minor textual revision involves minimal legislative alteration while upholding the core strengths of Delaware’s corporate law tradition.

My coauthors and I are not unanimous in our view of SB 21. Some of us (including yours truly) think that if the legislature is unwilling to make SB 21 optional, the legislature should go ahead and pass the bill as is. Others think that unless the bill is made optional, the bill should not be passed. But all of us agree that optionalty is the optimal solution. 

Update: Ann Lipton reports that "a Delaware rep introduced a proposed amendment to SB 21 that would adopt Eric Talley's opt-in proposal (also endorsed by Jeffrey Gordon and Stephen Bainbridge)."

Lauren Pringle reports:

It got more than traction! It got pre-filed as House Amendment 1 to Senate Substitute 1 for Senate Bill 21!

You can download the proposed bill here.

Delaware Senate Bill 21: A Comprehensive Analysis and Proposals for Improvements

As regular readers know, I have been posting a lot about pending Delaware Senate Bill 21. Using Claude, I pulled all of those posts into a single document--Delaware Senate Bill 21: A Comprehensive Analysis and Proposals for Improvements--that you can download from that link.

It offers an overview of SB21. It confirms my endorsement of the bill's general framework, but proposes 9 tweaks that I believe would significantly improve the bill.

As for using AI, I think Clause did a pretty good job of boiling 12 blog posts down into a single document. 

 

Talley and Gordon on contractarian solutions to the conflicted controller debate surrounding Delaware SB 21, which I endorse

I am what is known in corporate law jurisprudence circles as a contractarian. As I explain in my essay, Community and Statism: A Conservative Contractarian Critique of Progressive Corporate Law Scholarship, “contractarians” model the firm not as an entity, but as an aggregate of various inputs acting together to produce goods or services. Employees provide labor. Creditors provide debt capital. Shareholders initially provide equity capital and subsequently bear the risk of losses and monitor the performance of management. Management monitors the performance of employees and coordinates the activities of all the firm’s inputs. The firm is simply a legal fiction representing the complex set of contractual relationships between these inputs. In other words, the firm is not a thing, but rather a nexus or web of explicit and implicit contracts establishing rights and obligations among the various inputs making up the firm.

The nexus of contracts model has important implications for a range of corporate law topics, the most obvious of which is the debate over the proper role of mandatory legal rules. As a positive matter, contractarians contend that corporate law in fact is generally comprised of default rules, from which shareholders are free to depart, rather than mandatory rules. As a normative matter, contractarians argue that this is just as it should be.

As a contractarian, I was very interested by a proposal in the CLS Blue Sky Blog from Professor Eric Talley that adopts a contractarian approach to the issues currently roiling Delaware corporate law. For the benefit of those who are coming in late, Delaware's proposed Senate Bill 21 (SB21) aims to restructure fiduciary duty analysis for controlling stockholders, officers, and directors in Delaware corporations. Proponents argue SB21 is necessary to prevent corporations from leaving Delaware for states like Nevada or Texas—a phenomenon dubbed "DExit." Critics counter that the bill would undermine Delaware's competitive advantage of predictable case law interpreted by skilled judges.

Professor Eric Talley identifies a crucial oversight in the debate: Delaware's historical strength lies not only in its judiciary but also in its flexible, contractarian approach to corporate law. Talley proposes a modest alteration to SB21—adding an "opt-in" feature—that would preserve Delaware's contractarian principles while addressing concerns from both sides.

This solution would create a new section (144A) offering relaxed safe harbor for transactions involving interested parties, but only for corporations whose charters expressly adopt it. A complementary provision, Section 102(b)(8), would authorize corporations to adopt this safe harbor through charter amendments. This approach draws inspiration from Delaware's successful Section 102(b)(7), which allows corporations to waive monetary liability for breaches of duty of care.

Talley argues this contractarian solution would preserve Delaware's flexibility while addressing concerns from both perspectives. Companies could choose their preferred governance framework rather than being subjected to a universal rule. This approach would also remedy SB21's most significant drawback—its mandatory nature—by making the proposed safe harbor optional, thus reaffirming Delaware's commitment to the flexible, enabling approach that has kept it at the forefront of corporate law.

In a forthcoming post at the CLS Blue Sky Blog, Professor Jeffrey Gordon offers what he calls "an additional framing and a minor modification to Talley’s proposal, a friendly amendment." Gordon's argument begins with the dual nature of controlling shareholders in corporate governance. While controllers help solve managerial agency costs through close monitoring, they also present their own agency costs through potential extraction of "private benefits of control" via diversionary transactions.

Gordon explains that the difference between U.S. law (which allows controllers to retain control premiums) and other jurisdictions (which require premium sharing through "mandatory bid" rules) stems from trust in Delaware courts to maintain effective fiduciary litigation that prevents excessive private benefit extraction by new controllers.

This judicial control is particularly crucial for dual-class stock structures, where the wedge between cash flow rights and control rights creates ongoing temptation for controllers to divert resources. Gordon provides examples showing how controllers with decreasing cash flow rights have increasing incentives to divert corporate resources.

Gordon articulates a key insight: incorporating in Delaware represents a commitment strategy by controllers to assure investors they won't extract improper private benefits. This commitment subjects controllers to Delaware's rigorous fiduciary duty regime.

Building on Professor Eric Talley's opt-in proposal, Gordon supports preserving a demanding fiduciary duty regime while allowing some controllers to opt out, with pricing consequences in capital markets. Gordon adds refinements for approval processes: for dual-class companies, requiring majority approval from each class; for single-class companies, requiring majority approval from disinterested shareholders. Without these approvals, opt-outs would be evaluated under the TripAdvisor standard.

Finally, Gordon suggests controllers should be able to lower the threshold for "facts and circumstances" control determination (e.g., from 33% to 20%) when opting into the new regime, and he proposes specific language for a new Section 102(b)(8) to implement these recommendations.

I find their general approach attractive, even if I might quibble with a few details. Delaware corporate law is generally enabling, meaning it provides corporations with broad flexibility to structure their governance and operations as they see fit, rather than imposing rigid mandatory rules. This approach allows companies to tailor their bylaws, board structures, and fiduciary obligations within the framework of statutory and common law principles. As a contractarian, I think that is as it should be.

Both Talley and Gordon propose an"opt-in" approach under which companies would have to choose to switch from current law into their proposed safe harbor, with voting structures that are designed to protect minority shareholders. I concur that an "opt-in" approach is superior here to an "opt-out approach."

First, an opt-in approach preserves Delaware's current fiduciary duty regime as the default, maintaining the predictability and established precedent that many corporations value. This avoids disrupting the existing legal framework that has been developed through decades of case law and judicial expertise.

Second, an opt-in model aligns with Delaware's contractarian tradition by allowing corporations to affirmatively choose the governance structure that best suits their needs, rather than forcing all corporations to take action to maintain the status quo. This respects corporate autonomy and the ability of firms to make deliberate governance choices.

Third, an opt-in approach better protects minority shareholders by requiring explicit action (and in Gordon's refinement, specific approval processes) to adopt the more relaxed fiduciary standards. This ensures greater transparency about the change and provides clearer notice to investors.

Finally, an opt-in structure serves as a market test for the new fiduciary regime. If the new safe harbor truly adds value and reduces unnecessary litigation without harming minority shareholders, corporations will voluntarily adopt it. If it doesn't, the market will signal this through limited adoption.

Note that neither Talley nor Gordon address the provisions of SB21 amending the shareholder inspection rights under DGCL section 220. The logic of allowing companies to opt-into those provisions seems equally compelling.

The Badly Drafted Books and Records Provisions of Delaware SB 21: What Documents Can Shareholders Inspect?

As regular readers know, I have been blogging regularly about the SB 21 bill currently pending before the Delaware legislature. I've focused solely on the provisions amending DGCL section 144 as it relates to conflicted interest transactions by directors, officers, and controlling shareholders. In this post, I turn to the provisions of SB 21 governing inspections of books and records.

I should make clear here that the version of SB 21 I am working with here is the one from the DSBA Corporation Law Council not the original text. 

As I explain in my book, Corporate Law (Concepts and Insights):

DGCL § 220 provides that shareholders have the right to inspect a corporation’s books and records, subject to a variety of limitations:

(b) Any stockholder, in person or by attorney or other agent, shall, upon written demand under oath stating the purpose thereof, have the right during the usual hours for business to inspect for any proper purpose, and to make copies and extracts from:

(1) The corporation's stock ledger, a list of its stockholders, and its other books and records; ....

A proper purpose shall mean a purpose reasonably related to such person's interest as a stockholder. ...

As the Delaware Supreme Court has explained, for example, inspection rights can be very useful in a variety of contexts:

Section 220 provides stockholders of Delaware corporations with a “powerful right.” By properly asserting that right under section 220, stockholders are able to obtain information that can be used in a variety of contexts. Stockholders may use information about corporate mismanagement, waste or wrongdoing in several ways. For example, they may: institute derivative litigation; “seek an audience with the board [of directors] to discuss proposed reform or, failing in that, they may prepare a stockholder resolution for the next annual meeting, or mount a proxy fight to elect new directors.”

More than a decade ago, we noted that “[s]urprisingly, little use has been made of section 220 as an information-gathering tool in the derivative [suit] context.” Today, however, stockholders who have concerns about corporate governance are increasingly making a broad array of section 220 demands. The rise in books and records litigation is directly attributable to this Court’s encouragement of stockholders, who can show a proper purpose, to use the “tools at hand” to obtain the necessary information before filing a derivative action. Section 220 is now recognized as “an important part of the corporate governance landscape.”

SB 21 makes a number of significant changes to Section 220 that will substantially limit or even eliminate its utility for such purposes.

Perhaps most importantly, SB 21 adopts a much narrower definition of the books and records that are subject to inspection. Under current law, where a shareholder seeks to prove director or officer mismanagement in connection with a particular transaction or event, the shareholder is entitled to inspect relevant contracts, correspondence, and the like. See, e.g., Amalgamated Bank v. Yahoo! Inc., 132 A.3d 752, 791 (Del. Ch. 2016) ("This court has the power to order production of documents prepared by officers and employees as part of a Section 220 inspection."); see also KT4 Partners LLC v. Palantir Techs. Inc., 203 A.3d 738, 752–53 (Del. 2019) (holding “that the Court of Chancery should not order emails to be produced when other materials (e.g., traditional board-level materials, such as minutes) would accomplish the petitioner’s proper purpose, but if non-email books and records are insufficient, then the court should order emails to be produced”).

In contrast, SB 21 creates a new statutory definition of books and records that largely limits the materials a shareholder may inspect to board-level materials. Emails and other correspondence between managers, contracts, and similar materials seemingly are not subject to inspection under the new provisions.

But then we come to new section 220(b)(4), which provides that "This section does not affect: ... b. The power of a court, independently of this chapter, to compel the production of corporate records for inspection and to impose reasonable restrictions as provided in paragraph (b)(3) of this section, provided that, in the case of production of books and records described in paragraph (a)(1) of this section at the request of a stockholder, the stockholder has met the requirements of this subsection." The bill's synopsis cryptically explains that "preserves whatever independent rights of inspection exist under the referenced sources and does not create any rights, either expressly or by implication." It's unclear what the "referenced sources are," but under existing law a shareholder may have inspection rights granted by the corporation’s certificate of incorporation, its bylaws, or a shareholder agreement. In addition, under pre-DGCL Delaware law, shareholders had a common law right to inspect books and records. Shareholders have sometimes argued that those common law rights continue to exist independently of section 220. But the law here is not clear. See, e.g., King v. DAG SPE Managing Member, Inc., No. CIV.A. 7770-VCP, 2013 WL 6870348, at *7 (Del. Ch. Dec. 23, 2013) ("Section 220(d) at least arguably preempts a director's common law right to inspect corporate books and records. As the relevant authorities demonstrate, Delaware courts enforced this right at common law only until 1981, when the General Assembly enacted 8 Del. C. § 220(d).").

In sum, it is unclear what work new Section 220(b)(4) is intended to do.

But now we come to new section 220(g). (Note that the original version of SB 21 lacked this provision, which would leave access to below board level documents to the tender mercies of (b)(4).) It provides that:

(g) In any proceeding brought by a stockholder under subsection (c) of this section to compel the inspection of book and records, the Court of Chancery may order the corporation to produce, in addition to any books and records or other records ordered to be produced pursuant to subsection (e) of this section, other specific records of the corporation only if and to the extent: (1) such stockholder has met the requirements of subsection (b) of this section; (2) such stockholder has made a showing of a compelling need for an inspection of such records to further the stockholder’s proper purpose; and (3) such stockholder has demonstrated by clear and convincing evidence that such specific records are necessary and essential to further such purpose.

Subsection (e) provides in pertinent part that "the Court of Chancery may not order the corporation to produce any records of the corporation other than the books and records set forth in paragraph (a)(1) of this section." It's not clear why subsection (g) doesn't simply jump straight to (a)(1), but let's pass over that issue.

Although subsection (g) preserves a limited right to access materials like emails, contracts, and other below board level documents, it imposes quite high burdens on the shareholder to get access to such documents. The shareholder must identify specific documents.

Consider, for example, the documents at issue in Yahoo Amalgamated Bank v. Yahoo! Inc., 132 A.3d 752, 791 (Del. Ch. 2016), where the stockholder was using a Section 220 inspection to gather the information necessary to bring a derivative suit challenging the hiring and compensation of Yahoo's COO. Those documents included "emails to and from the directors from management or the compensation consultant, emails among the directors themselves, and documents and communications prepared by Yahoo officers and employees about the Board's deliberations." Id. The court limited the documents subject to inspection to documents possessed by the members of the Compensation Committee "including their email communications."

Will it be enough under subsection (g) for the stockholder to say "I want all emails related to the hiring of the COO"? Or would the stockholder have to specify "the email from CEO Jane Smith" to Compensation Committee Chair Helen Doe on February 28, 2025"? Or something in between?

Once the stockholder achieves the required--albeit uncertain--level of specificity, the stockholder must prove that it has a "compelling need" for the documents. How does the stockholder do that?

Last, the stockholder must demonstrate "by clear and convincing evidence that such specific records are necessary and essential to further such purpose." "Clear and convincing evidence is evidence that produces an abiding conviction that the truth of the contention is 'highly probable.'” Matter of Koyste, 111 A.3d 581, 588 (Del. 2015). This "is a much more difficult standard of proof than the ordinary preponderance of the evidence standard applied in most civil contexts." Miranda v. Delaware State Lottery Commn., No. CIV.A. K10A10008 WLW, 2011 WL 3329282, at *2 n.8 (Del. Super. Aug. 1, 2011).

In addition, one wonders whether a plaintiff who shows a "compelling need" for purposes of (g)(2) has shown that such records "are necessary and essential to further such purpose"?

To sum up, the amendments to Section 220 substantially undermine the Delaware Supreme Court's repeated insistence that shareholder books and records inspections be used routinely as a way of satisfying the requirement that derivative suits be plead with particularity. Worse yet, the new provisions contain multiple ambiguities that are going to require much litigation to resolve.

Andrew Verstein's new article "The Corporate Census" gets a nice shout out from corporate governance guru Evan Epstein

I am a huge fan of Evan Epstein's newsletter. In the latest post, he offers up a good summary of the state of play in Delaware's current corporate law debate about the fiduciary duties of controlling shareholders. https://lnkd.in/ghgDW-WE
In the post, Evan gives a nice shout out to my friend and colleague Andrew Verstein's new article, which Evan (correctly IMHO) praises for its "remarkable findings." I concur. It's an important article. https://lnkd.in/gxM4ZpR4

Courts are not omniscient and/or sacrosanct. Not even Delaware courts. The law governing conflicted controller transactions needs a legislative fix.

Lucian Bebchuk has posted a critique of Delaware SB 21, which raises several objections to the bill. As a supporter of the bill, I disagree with much of it. But I want to speak here to an aspect that I have seen among a lot of SB 21's opponents, which is a sort of patrician view that courts should not be subject to legislative correction:

Delaware officials have long taken pride in the role played by these courts and have put forward the caselaw developed by these courts as a major asset that favors Delaware incorporation. ...

By contrast, passing the legislation would communicate a judgment by the Delaware legislature that (a) the Delaware courts have gotten their work wrong and developed inferior doctrines with respect to important subjects, and (b) the courts nonetheless applied these doctrines for a substantial period of time. Furthermore, enacting the proposal would also communicate the legislature’s judgment that corporate planners would be better off without the guidance and predictability provided by the body of caselaw developed on these important subjects.

Problem 1: As Justice Sotomayor has acknowledged, "All judges make mistakes. (Even us.) See Brown v. Allen, 344 U.S. 443, 540, 73 S.Ct. 397, 97 L.Ed. 469 (1953) (Jackson, J., concurring in judgment) ('We are not final because we are infallible, but we are infallible only because we are final')." Dietz v. Bouldin., 579 U.S. 40, 53 (2016). 

Delaware courts have gotten the law of conflicted controller transactions wrong. Egregiously so. I refer you to my article, A Course Correction for Controlling Shareholder Transactions, in which I identify three problems with the caselaw in this area:

    A.    Overly Broad Definition of "Controller"

1. 1. Delaware courts have significantly expanded who qualifies as a "controlling shareholder" beyond those with majority voting power
   2. Courts increasingly find control in shareholders with significantly less than 50% ownership
   3. The "superstar CEO" doctrine from Tornetta v. Musk allows finding control based on managerial rather than voting power
   4. Courts now emphasize "soft control" through contractual rights, commercial relationships, and other non-voting mechanisms
   5. The expanded definition creates uncertainty and may eventually lead to finding someone a controller even without stock ownership

    B.    Problems with the Standard for Reviewing Conflicted Transactions

1. Delaware courts have departed from the *Sinclair Oil* threshold test, which required showing that a controller received a benefit at both the expense of and to the exclusion of minority shareholders
2. Courts now apply the exacting "entire fairness" standard whenever a controller: Stands on both sides of a transaction or Receives a unique or non-ratable benefit, even without harm to minority shareholders
3. This expansion has led to treating many ordinary commercial transactions between controllers and controlled entities as inherently suspect

    C.    Excessive Scrutiny of Director Independence

1. Courts have made cleansing conflicted transactions increasingly difficult through heightened scrutiny of director independence
2. The definition of independence has expanded to emphasize personal relationships that might influence objectivity
3. The inquiry has become highly subjective, contextual, and fact-specific, creating uncertainty
4. Courts have shown growing skepticism of independent directors in controlled companies
5. The indeterminate standard allows judges to find bias in an increasing variety of relationships

These trends have led to significant consequences, including increased litigation, uncertainty in transaction planning, deterrence of potentially beneficial transactions, and controllers threatening to reincorporate outside Delaware (as with Elon Musk and Tesla). A course correction is needed to restore balance between preventing abusive controller conduct and allowing legitimate transactions with proper safeguards. There being no signs that the Delaware courts would do the job, it was necessary for the legislature to step in.

Problem 2: Lucian worries that "corporate planners" will lack "the guidance and predictability provided by the body of caselaw" governing conflicted controller transactions. But therein lies the problem. It is not just that the recent Delaware judicial decisions in this area have made serious doctrinal errors, it is not just that those decisions are premised on unsound public policy norms, but it is precisely that those decisions have resulted in a lack of guidance and predictability. My article notes Chancellor McCormick's acknowledgment that it's now "impossible to identify or foresee all of the possible sources of influence that could contribute to a finding of actual control." This creates significant uncertainty for legal advisors and transaction planners. My article describes uncertainty about whether Delaware courts apply different standards for determining controller status at different procedural stages (motion to dismiss versus trial), which increases litigation costs. My article notes that various Delaware jurists split 4-2 on a director independence question in Sandys v. Pincus, demonstrating that "Delaware decisions regarding independence are characterized by a lack of consistency."

Problem 3: Now we come to my most fundamental disagreement with what I take to be the import of Lucian's argument. If I am reading him correctly, Lucian seems to suggest that there is something wrong with a legislature passing a bill that some might see as calling out the courts for having made bad law. But what would Lucian have the legislature do when courts make bad law? To the contrary, in this era of common lawmaking in statutory contexts, it is precisely the province of the legislature to correct judicial errors. It is also perfectly legitimate for the legislature to send the courts signals when the courts overstep their bounds. We are not talking about constitutional rights here, which the courts must defend against legislative intrusion, after all, but ordinary laws that rest on a statutory foundation. 

DExit is a trickle not a flood and is unlikely to become a cascade

A cascade effect (a.k.a. domino effect or snowball effect) occurs when a change triggers a chain of events in which one state of the world rapidly transforms into a new state. 

Many commentators on the DExit phenomenon appear to assume that we are on the verge of a cascade event in which huge numbers of Delaware corporations decide to change their state of incorporation to some other state.

As I explain in my article, DExit Drivers: Is Delaware's Dominance Threatened?, the number of firms that have moved from Delaware is tiny. It barely amounts to a trickle. As I also explain therein, for most firms, Delaware remains the preferred choice. The only plausible exception is the small number of publicly traded firms having a controlling shareholder, who have faced a greater risk of liability as a result of recent Delware court decisions (discussed in my A Course Correction for Controlling Shareholder Transactions). Assuming SB 21 passes the Delaware legislature, those decisions will be overturned and the incentive driving DExit will be significantly reduced.

But let's assume I'm wrong. Would DExit become a cascade?

This brings us to my friend and UCLAW colleague Andrew Verstein's new article, The Corporate Census. This is a really important new article in which Andrew presents:

... the first database of all entity formations in the United States, going back to the founding. All previous studies were based on tiny subsets of corporations, such as only large public corporations. Looking at the broader sample destabilizes core empirical assumptions in the field. For example, while Delaware is commonly thought to be the leader for incorporations, its law is not even in the top five.

Of particular import for present purposes is Andrew's finding that, although "Delaware is thought to have taken New Jersey's leading role in the early 20th century, New Jersey actually continues to beat Delaware until the late 1980s." Contrary to conventional wisdom there was no cascade in which massive numbers of corporations decamped from New Jersey to Delaware. 

To my mind, Andrew's findings suggest that there will not be a domino effect. If DExit becomes a real phenomenon rather than clickbait, it will still take decades for Delaware to be overtaken. 

This doesn't mean SB 21 is unnecessary. To the contrary, as I discuss in Course Correction, Delaware common law has gone seriously awry in this area. Both as a matter of doctrinal consistency and sound policy, the law needed to be changed. It does, however, suggest that Delaware can take its time and do it right. 

In any case, go read Andrew's article. 

A Bibliography of my Delaware SB 21 Posts

• A Comment on Larry Cunningham's Weinberg Center Program on SB 21: Would Tornetta Come Out the Same Way?

• A Question About Delaware SB 21 and Fairness

• Another Delaware SB 21 drafting problem

• Could the Chancery Court End-Run SB 21?

• Is Delaware SB 21 the Start of a Race to the Bottom?

• Delaware SB 21 and Director and Officer Conflict of Interest Transactions: The Good, the Bad, and the Missed Opportunities

• Preliminary Reaction to Delaware SB 21 and Comparison to the Proposals I Made in A Course Correction for Conflicted Controller Transactions

• Professor Talley Poses a SB 21 Question: I resort to AI

Another Delaware SB 21 drafting problem

The draft statute defines controlling shareholder as someone who, among other things, owns at least 1/3 of the issuer's voting power. Presumably the drafters intend that someone who owns less than 1/3 of the voting stock is not a controlling shareholder and accordingly owes no fiduciary duties to the entity or the other shareholders. But why not say so? What is to stop a court from saying that somebody who owns 20% of the stock and is a superstar CEO is a controller with fiduciary duties? Granted, a fair reading of the statute suggests that the legislative intent is to preclude such cases. But I'm a belts and suspenders guy. So why not explicitly say somebody who owns less than 1/3 is not a controlling shareholder and owes no fiduciary duties to the entity or the other shareholders?

Is Delaware SB 21 the Start of a Race to the Bottom?

Over on LinkedIn, the invaluable  Lauren Pringle of the estimable Chancery Daily wrote of Delaware SB 21:

Make no mistake — this is regressive legislation that races us to the bottom. If you told someone forty years ago in all the “race to the bottom” debates that Delaware would be cribbing from the MBCA and that was nearly the least-bad aspect of proposed DGCL changes that had skipped out on the CLC process and were getting slammed through the legislature in a matter of weeks, no one ever would have believed you. And yet. Here we are.

I'm sort of ambivalent about the process by which SB 21 came to life. On the one hand, I get the argument that Delaware has a historic process that has served it well and has been bypassed here. On the other hand, Delaware's historic process consists of the state bar's corporation law council drafting legislation that the legislature then rubber-stamps. It's not exactly a paragon of democratic virtue. 

In any case, I seriously doubt whether SB 21 is starting a race to the bottom. Let's assume that the bottom is Nevada (no offense to my Nevada friends, but it's true). Serious scholars like Michal Barzuza and Ofer Edlar have closely scrutinized Nevada law and come away concluding that it is "lax." See Michal Barzuza, Market Segmentation: The Rise of Nevada As A Liability-Free Jurisdiction, 98 Va. L. Rev. 935, 942 (2012) (“Nevada leverages its own competitive advantage by offering lax law.”); Ofer Eldar, Can Lax Corporate Law Increase Shareholder Value? Evidence from Nevada, 61 J.L. & Econs. 555, 556 (2018) (“The migration of firms to Nevada seems to be driven by the laxity of its corporate law with respect to managers . . ..”). 

In 2001, for example, Nevada launched an especially aggressive attack on Delaware’s dominance, “as part of a plan to significantly raise franchise taxes for Nevada corporations,” by amending its corporation statute to offer substantially increased protection for managers against liability risk. Bruce H. Kobayashi & Larry E. Ribstein, Nevada and the Market for Corporate Law, 35 Seattle U.L. Rev. 1165, 1170 (2012). 

At the time the amendments were adopted, one Nevada legislator objected that they would “protect some corporate crooks” and come “at a terrible price.”  Dain C. Donelson & Christopher G. Yust, Litigation Risk and Agency Costs: Evidence from Nevada Corporate Law, 57 J.L. & Econs. 747, 753 (2014). Another complained that if the amendments were adopted “corporate officers and directors would be able to ‘commit virtually any act and get away with it and waste your money .... Scoundrels can move here.’”  Id. Overall, critics predicted, the legislation would “impair shareholder litigation rights significantly, and facilitate self-dealing transactions, poor corporate governance practices, and managerial misconduct.” Michal Barzuza, Nevada v. Delaware: The New Market for Corporate Law 6 (Mar. 2024), https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4746878. 

Delaware has strong incentives not to race Nevada to the bottom. Unlike Nevada’s focus on a small firm market segment, Delaware caters to “larger firms that pay higher franchise fees.”  Ofer Eldar & Lorenzo Magnolfi, Regulatory Competition and the Market for Corporate Law, 12(2) Am. Econ. J.: Microecon. 60, 81 (2020). Those firms face substantial pressure from large institutional investors who generally dislike Nevada-style liability protection for directors and officers. See Eldar & Magnolfi, supra, at 64 (“Nevada firms tend to be relatively small with low institutional shareholdings, and that Delaware firms tend to be larger and have significant institutional ownership”).

In addition to the constraining influence of institutional investors, venture capitalists reportedly prefer founders to incorporate in Delaware.  See Jennifer Kay, Musk’s Tesla Threats Unlikely to Shake Delaware’s Dominance, Bloomberg News (Apr. 2, 2024), https://news.bloomberglaw.com/litigation/musks-tesla-threats-unlikely-to-shake-delawares-dominance (“Often it’s venture capital firms and other investors who push for Delaware incorporation . . ..”). Likewise, activist investors pressuring incumbent directors to improve firm performance reportedly often include reincorporation into Delaware among their demands.  Eldar & Magnolfi, supra, at 65.

In order to placate such investors, firms with such investors are unlikely to opt for a Nevada-like regime. In turn, to placate such firms, Delaware is unlikely to increase the laxity of its laws to match Nevada. 

Another important constraint on Delaware’s ability to pursue Nevada-style laxity is the risk of federal intervention. There is an emerging consensus that Delaware’s chief competition is no longer other states but rather the federal government.  Although the federal government typically intervenes in corporate governance only in response to financial crises,  Delaware is nevertheless highly aware of the threat of federal preemption.  Former Delaware Chief Justice Norman Veasey, for example, has repeatedly warned that Congress may preempt Delaware law if Delaware courts fail to uphold its fiduciary duty standards.

Noting these developments, Professor Barzuza argues an effort by Delaware to compete with Nevada by weakening shareholder protections might trigger federal intervention. Barzuza, supra, at 967. Given Delaware’s reliance on maintaining its franchise tax revenue, Delaware cannot risk federal preemption.  In contrast, because Nevada corporate law does receive the same level of attention as paid to Delaware law, Nevada’s laxity poses a much lower risk of triggering federal intervention.

This post draws on Bainbridge, Stephen Mark,  DExit Drivers: Is Delaware's Dominance Threatened? (July 29, 2024). UCLA School of Law, Law-Econ Research Paper No. 24-04, Available at SSRN: https://ssrn.com/abstract=4909689

A Comment on Larry Cunningham's Weinberg Center Program on SB 21: Would Tornetta Come Out the Same Way?

Larry Cunningham held a program on Delaware SB 21 yesterday at the University of Delaware's Weinberg Center. He summarized the speakers on Linkedin.

One speaker was Ed Rock (regular readers will recall he is the Chief Reporter of the ALI's pending Restatement of Corporate Governance). 

Professor Rock highlighted that the Musk pay cases (Tornetta I and II) would come out the same way under a pending bill in the Delaware legislature aimed at altering the state's approach to assessing controlling stockholder transactions since the bill doesn't address conflicted CEO transactions, while also observing that the bill seems to respond to pressures from other non-majority controlling stockholders seeking to weaken constraints on their control.

Yale law professor Jon Macey called this summation to my attention and kindly allowed me to take it up on the blog. We're trying to figure out why Professor Rock thinks the cases would come out the same way under SB 21. 

I think it's possible that it would come out the same way, but I think it is far from certain and that a strong argument can be made it would come out differently.

I start with the premise that Tornetta v. Musk was the decision that triggered SB 21. After his $50 billion-plus compensation plan was struck down by the Delaware Chancery Court,  Musk fired off a now notorious social media post recommending that one should “[n]ever incorporate your company in the state of Delaware.”  Tesla subsequently reincorporated in Texas. Subsequently, other controllers started making noises about moving, which triggered Delaware to respond with SB 21 to provide controllers with greater insulation from liability. Presumably the drafters would have ensured that the triggering case would be covered by the statute.

Let's look at SB 21. The first question raised under the statute is whether Musk would be deemed a controlling shareholder. SB 21 defines a controlling shareholder as

any person that, together with such person’s affiliates and associates:

a. Owns or controls a majority in voting power of the outstanding stock of the corporation entitled to vote generally in the election of directors; or

b. Has the power functionally equivalent to that of a stockholder that owns or controls a majority in voting power of the outstanding stock of the corporation entitled to vote generally in the election of directors by virtue of ownership or control of at least one-third in voting power of the outstanding stock of the corporation entitled to vote generally in the election of directors or for the election of directors who have a majority in voting power of the votes of all directors on the board of directors and power to exercise managerial authority over the business and affairs of the corporation.

According to the Tornetta decision, at the relevant point in time, Musk owned "approximately 21.9% of Tesla's outstanding common stock." Tornetta v. Musk, 310 A.3d 430, 502 (Del. Ch. 2024). As I read SB 21, it is not enough for Musk to exercise de facto "managerial authority over the business and affairs of the corporation," he must also own at least 1/3 of the stock. As the MNAT memorandum on SB 21 explains:

... for non-majority stockholders to be considered controlling stockholders, the functionally-equivalent-to-majority power must be by virtue of ownership or control of at least one-third in voting power of the outstanding stock of the corporation entitled to vote (i) generally in the election of directors or (ii) for the election of directors who have a majority in voting power of the votes of all directors on the board of directors. This change would prevent the existence of controlling stockholder status from being found if the alleged controller does not own a minimum level of stock.

And Musk does not meet that minimum.

Of course, Musk is a CEO. As such, his pay package could be viewed as a related party transaction of the sort traditionally subject to review under DGCL 144. Contrary to what Professor Cunningham reports Professor Rock as stating, it is incorrect to say the bill does not address conflicted CEO transactions. It makes some important changes in former section 144(a) as applied to conflict of interest transactions involving directors and officers. 

As revised by SB 21 (assuming it passes), a transaction between the corporation and one of its officers:

may not be the subject of equitable relief, or give rise to an award of damages or other sanction against a director or officer of the corporation if: (1) The material facts as to the director’s or officer’s relationship or interest and as to the contract act or transaction transaction, including any involvement in the initiation, negotiation, or approval of the act or transaction, are disclosed or are known to the board of directors or the committee, and the board or committee in good faith authorizes the contract act or transaction by the affirmative votes of a majority of the disinterested directors, even though the disinterested directors be less than a quorum ....

As I read that statute, Musk's pay package would have been insulated from review if a single member of the Tesla board of directors qualified as "disinterested."

SB 21 defines a disinterested director as "a director who is not a party to the act or transaction and does not have a material interest in the act or transaction or a material relationship with a person that has a material interest in the act or transaction." In turn, material relationship is defined as "a familial, financial, professional, employment, or other relationship that (i) in the case of a director, would reasonably be expected to impair the objectivity of the director’s judgment when participating in the authorization or approval of the act or transaction at issue ...."

Hence, disinterested includes independence. Granted, McCormick found that all of the Tesla directors had relationships with Musk. She basically said none of them were independent, albeit to varying degrees. 

But SB 21 adds a wrinkle to the analysis. It provides that: 

Any director of a corporation that has a class of stock listed on a national securities exchange shall be presumed to be a disinterested director with respect to an act or transaction to which such director is not a party if the board of directors shall have determined that such director is an independent director or satisfies the relevant criteria for determining director independence under any rules promulgated by such exchange, which presumption shall be heightened and may only be rebutted by substantial and particularized facts that such director has a material interest in such act or transaction or has a material relationship with a person with a material interest in such act or transaction.

Assuming NASDAQ qualifies as a national securities exchange, the directors would get the benefit of this "heightened" presumption. McCormick would have to find "substantial and particularized facts" to rebut that presumption. Obviously, her opinion did not have to resolve that issue, so we have to speculate as to how the analysis would come out under the new presumption.

As to at least two directors--Denholm and Buss--"Plaintiff does not argue that Musk established Buss and Denholm's compensation so as to render them beholden." Tornetta v. Musk, 310 A.3d 430, 510 (Del. Ch. 2024). That's a key factor. After all, if you're not beholden, you're generally regarded as independent. 

McCormick nevertheless claimed that Denholm and Buss's lack of independence could be shown by examining how they "acted when negotiating the Grant." Id. There are two problems with that argument, however. First, the part of her opinion analyzing the negotiations makes virtually no mention of Denhold and Buss. Second, McCormick's analysis is premised on her view that establishing Musk was a controller with respect to the transaction at issue is sufficient. See id. at 511 ("There is no greater evidence of Musk's status as a transaction-specific controller than the Board's posture toward Musk during the process that led to the Grant."). It is true that transaction specific control was sufficient under the pre-SB 21 common law. But as we have seen SB 21 says that a minority stockholder can only be deemed a controller if it owns 1/3 of the stock and "power to exercise managerial authority over the business and affairs of the corporation." I read that language as precluding transaction specific control.

In sum, so long as at least one Tesla director qualifies as disinterested, Musk's transaction is cleansed. Given the "heightened" presumption and the narrowed definition of material relationship, I suspect that at least Denholm or Buss would so qualify if the case were tried under the new standard. 

Update: Professor Rock sent along some comments, which he kindly allowed me to post:

Larry’s one sentence summary, not reviewed by me, missed a bit of the nuance but was mostly accurate.  I’m glad to see that you (mostly) agree with me. While you are right that new 144 would allow a single disinterested & independent director to approve an officer/director conflict transaction (which is weird), surely there was enough evidence in KSJM’s post trial opinion to give her the grist, should she have wanted to use it, to conclude that none of the directors was disinterested.  In the litigation context, as you pointed out, she didn’t have to, but it was there.  I am enough of a legal realist to think that how a judge justifies his/her decision is not necessarily how he/she arrived at it!

A Question About Delaware SB 21 and Fairness

As I have been doing, my friend Yale law professor Jon Macey has been following developments with respect to Delaware SB 21 closely. He posed a question that I found quite interesting and kindly gave me permission to pass it along to my readers.

SB 21 defines "fair to the corporation" as:

... the act or transaction at issue, as a whole, is beneficial to the corporation, or its stockholders in their capacity, as such given the consideration paid to or received by the corporation or its stockholders or other benefit conferred on the corporation or its stockholders and taking into appropriate account whether the act or transaction meets both of the following:

a. It is fair in terms of the fiduciary’s dealings with the corporation.

b. It is comparable to what might have been obtained in an arm’s length transaction available to the corporation.

It's not clear to me what work this provision does. As I explain in my article on SB 21, A Course Correction for Controlling Shareholder Transactions available at SSRN: https://ssrn.com/abstract=5022685, the common law defines fairness as having two components: fair dealing and fair price.  The former goes to the process by which the transaction was proposed, approved, and consummated.  The latter goes to the economics of the transaction.  The review is not neatly bifurcated; rather, all aspects of the transaction must be considered together. 

Accordingly, it seems as though SB 21 essentially tracks the existing common law. So why include it in the statute? What did the drafters intend?

One guess is that they don't want courts changing the definition of fairness so as to end run the statutory intent to insulate conflicted controlled transactions. But that doesn't make sense because SB 21 allows cleansing by disinterested directors or shareholders without regard to whether the transaction is fair. Fairness only comes into play as an alternative way of cleansing a conflicted transaction.

So I'm puzzled.