For more than a century, executives have flocked to Delaware, the First State, to incorporate their businesses. It’s not for the beaches or even the taxes — Delaware’s 8.7 percent corporate rate, in fact, ranks near the highest in the country.
Delaware’s secret sauce has long been its corporate jurisprudence. But recently, activist judges in the state have set out to padlock Delaware’s main attraction. They are sending companies packing for states like Texas, which for its part is doubling down on its efforts to recruit businesses to the Lone Star State.
Exhibit A in Delaware’s self-sabotage effort was February’s ruling by Chancery Court judge Kathleen McCormick voiding Elon Musk’s compensation package. Perhaps Judge McCormick knows something more than Tesla’s directors and shareholders, who were to profit enormously from the 2018 deal. At the time they approved the deal, Tesla’s market value stood at $53 billion, roughly what General Motors was worth. Musk needed the company’s market value to soar to $650 billion over 10 years for all of his options to vest. Tesla’s market cap hit $1 trillion in 2021, and its stock is up 570 percent since the pay package was approved.
Tesla’s investors were betting on Musk — and so was Musk. Both were right.
Judge McCormick, however, threw out the package earlier this year. This left management teams and shareholders wondering what else could be undone by a single Delaware judge.
As Musk biographer and former CEO Walter Isaacson told CNBC, the ruling is “going to hurt Delaware.”
“People will say, ‘Wait, wait, you mean five years after something happens, eight years after something happens, you’ll go back and undo it?’” he asked. Yes, they will.
Telsa investors should send a message to the Elon haters and approve his compensation package again when they vote Thursday.
But Delaware’s problems run much deeper than Musk’s payday. Its judiciary is already a bit behind the times with its new embrace of the value-destroying combination of aggressive plaintiffs’ attorneys and Environmental, Social, and Governance (or ESG) activism.
According to the law firm Wilson Sonsini, Delaware’s plaintiffs’ bar is “increasingly active” and “successful.” As a result, companies incorporated in Delaware now need to plan for “gotcha” litigation, often “driven by plaintiffs’ lawyers more than those lawyers’ individual clients.”
The plaintiffs’ lawyers in Musk’s case are seeking fees of $5.6 billion. If they get it, the windfall will go to them and their firms. It’s a “a strange world,” to quote law professors Jonathan Macey and M. Todd Henderson, “in which lawyers who sue companies propose to be paid like superstars, while executives who build them can’t.”
At least when public company CEOs get filthy rich through value creation, pensioners and individual stockholders also benefit.
Over the last few years, Delaware courts have also been increasingly receptive to cases alleging breaches of oversight by directors. Investors should beware. Corporate lawfare is an expensive distraction from business growth. And as former Attorney General William Barr and Labor Department official Jonathan Berry have observed, Delaware’s corporate-law elder statesmen “today advocate that the state should adopt a more assertive and explicitly pro-ESG corporate law.” The upshot: executives could be liable for failing to manage so-called “risks” that “correspond to du jour ESG issues like climate change, [diversity, equity and inclusion], and #MeToo — or even the 2020 presidential election.”
Delaware’s courts also affect tort law claims, because plaintiffs can file claims in the state of incorporation. Dominion, for example, filed against Fox News in Delaware. The judge imposed burdensome discovery on Fox and rejected the network’s libel defenses. According to Fox’s former general counsel, Viet Dinh, these pretrial rulings “called into question the fundamental fairness and integrity of the Delaware civil justice system.” This left the network with a Hobson’s choice between a trial that would have been “months of utter pain” and a jaw-dropping $787 million settlement.
Other states are offering businesses less regulatory and litigation risk. Tripadvisor recently said sayonara to Delaware and reincorporated in Nevada. The travel platform explained that the move would save about $250,000 a year in taxes and “provide potentially greater protection from unmeritorious litigation for directors and officers.”
It’s not the only company bailing on Delaware’s deal-killing litigation environment. Since April, reports Nevada’s Democratic Secretary of State Francisco Aguilar, “three more publicly traded companies have announced plans to shift to Nevada, and these sort of legal shenanigans are a big reason why.”
Texas shows that states can become more business-friendly through policy choices. As recently as the early 2000s, trial lawyers were one of the most powerful political forces in Texas. This was before Texans for Lawsuit Reform worked with lawmakers from both political parties and pushed through historic tort reform that energized the state’s business climate.
In the time since, Texas has continued to build on its reputation as a place where companies can count on a fair and transparent regulatory system. This September, the state’s dedicated business court, which handles derivative, corporate governance and securities claims to rival Delaware’s Chancery Court, will begin taking cases.
Texas is now coming for Wall Street, too. Just last week, the TXSE Group announced it had raised $120 million for a new stock exchange based in Texas. The backers of the new exchange are saying that “corporate issuers and exchange-traded product sponsors are demanding more stability and predictability around listing standards and associated costs.” Does that sound familiar? It’s the same reason why businesses are fleeing Delaware — the listing standards in other jurisdictions keep shifting based on political winds rather than business judgment.
Critics have called Texas, Nevada and other states’ attempts to attract corporations with favorable laws a “race to the bottom.” Don’t buy it.
Delaware originally became the hub for incorporation after New Jersey Governor Woodrow Wilson (D) instituted anti-corporate measures in the early 20th Century. Nevada’s effort to attract new businesses has bipartisan support, and major asset managers BlackRock and Citadel Securities are among the early investors in the TXSE.
The truth is that Delaware and other increasingly anti-business states, by accommodating anti-shareholder activists, are leading a new race to the bottom that is forcing companies to set out in search of safer homes.
Michael Toth is a founding partner of PNT Law Firm based in Austin, Texas.
