Corporate Governance

Airgas and the Management Friendly Nature of Delaware Law (Part 1)

By J Robert Brown Jr.

Delaware is a small state based upon population and area.  Yet the state is very big in the area of corporate governance.  Some 60% of the Fortune 500 are incorporated there.  Most IPOs of companies to be listed on an exchange are for Delaware companies.

Delaware benefits from this stature financially.  As we have noted, a large portion of the state's tax revenues come from these out of state corporations.  The state has no sales tax and low income tax rates.  Moreover, there are other the indirect benefits that help support the state's economy.  The small state, therefore, has every incentive to attract in more out of state companies.  Adopting a management friendly approach to corporate law is the best way to do it. 

This much is widely known and generally accepted (see the discussion in The Irrelevance of State Corporate Law in the Governance of Public Companies).  The primary defense used to be that this approach (reducing management liability and increasing management discretion, often at the expense of shareholders) was justified based upon the notion of private ordering.  Management of each company received maximum flexibility to operate the company in a manner most likely to profit maximize.  In other words, directors would use the flexibility to benefit shareholders.

The approach always contained a central analytical flaw.  Management had an incentive to use the discretion in a self interested way (say through the payment of large amounts of compensation) rather than in the best interests of shareholders.  This possibility was rationalized away in the 1980s through reference to the market for corporate control.  If management used the authority in an inefficient manner, share prices would fall and the company would be acquired, resulting in the displacement of the inefficient managers. 

The approach provided some degree of intellectual cover for the Delaware approach.  Yet the state was not adopting laws and making decisions with the goal of promoting efficiency.  Indeed, while the market for corporate control was used to justify the Delaware approach, the Delaware courts largely eliminated the market (at least with respect to hostile tender offers) through management friendly decisions such as Unocal, Moran, and Unitrin.  As a result, there is no serious credible market mechanism that will routinely penalize management if discretion is not used to promote the best interests of shareholders.  

With the intellectual venire stripped away, the management friendly nature of Delaware law has become clearer.  Moreover, the justification (beyond the pecuniary benefits earned by the state) for doing so has become increasingly more difficult to sustain.  It is because of this that Congress has, in SOX and in Dodd-Frank, increasingly intruded into areas of governance traditionally left to the states.  Delaware is treated in a less sacrosanct fashion and instead viewed as one more interest group seeking to promote a particular definition of governance.

In all of this, what is the role of the courts in Delaware?  We will pick that matter up in the next post.

Full post as published by The Race to the Bottom on November 26, 2010 (boomark / email).