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Examining Delaware’s Role as the Preferred Corporate Jurisdiction
Why Delaware is Historically Favored as a State of Incorporation
Since the early 1900s, Delaware has been the premier home for corporations in the United States and holds the top ranking as the most corporate-friendly state. However, changes in legislation and a controversial state court decision have left many wondering whether this will still be the case moving forward. To determine whether Delaware will continue to be a preferred destination for incorporation, it is necessary to pinpoint the specific reasons for its popularity and examine why it was home to approximately 68% of Fortune 500 companies, 65% of the S&P 500, and about 79% of all American IPOs in 2022. Delaware offers companies liability protection through its highly favorable corporate legal framework. Delaware is the Incorporation Capital of the World because of its Court of Chancery structure, its corporate tax benefits, and the privacy afforded to corporations.
Delaware’s Chancery Court is the United States’ oldest business court that is optimized for efficiency and corporate acumen. Legal proceedings unfold at a faster pace without the use of juries, and experienced judges maintain the highest level of the most current corporate case law. The structure of the Delaware court has produced predictable outcomes for Delaware LLCs and their affiliates, who, until now, have not been overly concerned about taking on risk or facing legal action. Delaware also has impressive tax savings for companies that choose to incorporate there such as no state income tax, no inheritance tax on stock held by out-of-state residents, and no state sales tax on intangible personal property. If an owner of a Delaware company dies, Delaware-based companies conducting business elsewhere will save crucial funds since stock inherited by out-of-state recipients will not be taxed, and non-residents’ royalty payments and stock will not be subject to state taxes as well.
Delaware corporations conducting business out of state are not required to have a Delaware business license, and there is ample privacy given to corporation owners. Owners of Delaware corporations can file their company without listing owners’ names and without making LLC member/manager identities and addresses a matter of public record. Delaware is also valued as a location for incorporation because there is no requirement to live in the state to incorporate a company so long as the company possesses a Delaware Registered Agent. Finally, Delaware has among the lowest minimal start-up costs globally, and structurally, one person can hold all organizational positions for ultimate corporate convenience.
The reasons above detail Delaware’s renowned appeal as a state of incorporation, but recent news threatens to change that. On one hand, there is Elon Musk’s compensation package, which was approved by shareholders in 2018 but was recently struck down by the Delaware Court of Chancery on the grounds that it was not entirely fair, despite the support of a large majority of Tesla’s stockholders. On the other hand, there is Delaware’s increased scrutiny of non-compete clauses.
Legal Shifts and Interpretations Threatening Delaware’s Corporate Dominance
The Implications of Elon Musk Having to Forfeit Tesla Compensation Package
On January 30, 2023, Delaware’s Chancery Court controversially ruled that Elon Musk’s compensation package, which was approved by a 73% majority vote in 2018, could no longer stand. In reaching this decision, the court applied the entire fairness standard of review as opposed to the “business rule.” For the court to apply this standard of review, it first had to find that Elon Musk controlled Tesla when the decision was made and that Tesla’s shareholders were not sufficiently informed when they voted on Elon Musk’s compensation package.
The Chancery Court determined that Musk was in control of the particular transaction at issue despite not having a majority of Tesla’s voting power. The court’s reasoning spans over forty pages of legal analysis of several factors. Most notably, the court considered Musk’s stock ownership, his control over managerial decisions, his influence on decision-makers, and his influence on the process leading to the approval of his compensation package.
When applying the entire fairness standard of review, the burden of proof rests with the defendants. The defendants might shift this burden of proof back to the plaintiff by showing that the stockholder vote was fully informed. To do so, the defendants have to show that the stockholders were fully informed of all material information related to the transaction.
In its opinion, the Chancery Court ruled (1) that Tesla’s stockholders were not sufficiently informed of the relationships between the members of the Compensation Committee and Elon Musk in light of the Committee’s self-portrayal as “independent,” and (2) the Committee failed to disclose Musk’s involvement in the process (the timing, the terms of the compensation package and the lack of negotiations). These determinations drew criticism from businessmen and media alike, especially in light of the post-trial re-vote by the stockholders, which once again approved Musk’s compensation package with 72% of votes. Thus, the re-vote suggests that the stockholders did not consider these pieces of information as material and that the burden of proof under the entire fairness standard should have been passed to the Plaintiff.
Even with the burden of proof on the Defendants, the Chancery Court’s reasoning as to why the agreement was not entirely fair has been cause for concern in the corporate world. In determining whether a transaction was entirely fair, the court looks at “fair dealing” and “fair price,” with the latter being the preponderant consideration. In its opinion, the Chancery Court considered both.
As to fair dealing, the court weighed the Weinberger factors: (1) how the deal was initiated and timed; (2) how it was structured and negotiated; and (3) how it was approved. The court ruled that Musk failed to prove fair dealing due to his influence over the timeline of the process, his negotiations without a counterpart, and his relationship with the members of the compensation committee.
As to fair price, the court rejected Defendants’ arguments that Tesla merely gave 6% of $600 billion on the grounds that the cited motivations for the compensation package—to retain him and keep him properly incentivized—was unnecessary given Musk’s then-current stock ownership representing 21.9% of Tesla’s shares. In its analysis, the court repeatedly referred to Musk’s prior stock ownership as a factor that made the deal unfair. The court also focused on projections that assumed Musk’s task was not a challenge, despite it being characterized as “laughably impossible” at the time. Notably absent from the opinion was any reference to precedent where a CEO’s previous stock ownership was factored into the fairness of their compensation package.
This decision has inevitably added an element of unpredictability to cases involving the entire fairness standard of review. In addition, the legal fees requested by the Plaintiff’s lawyers in this action amount to nearly $6 billion and would come out of stockholders’ pockets who voted (twice) to approve Musk’s compensation package.
The Chancery Court expects to issue a judgment on the legal fees and the reinstatement of the compensation package by the end of the year. This judgment is expected to have significant repercussions in how executive compensation structures are evaluated going forward.
Delaware’s Increased Noncompete Clause Scrutiny
Delaware’s Chancery Court has historically held noncompete agreements to be enforceable, offering Delaware companies with a tool to safeguard their proprietary interests. Yet in light of recent litigation, Delaware is evidently applying stricter scrutiny to these covenants, requiring corporations to be more narrow and specific in their proposed provisions. Under the “reasonableness test,” Delaware courts will enforce a noncompete agreement only if it is “(1) reasonable in geographic scope and temporal duration, (2) advances a legitimate economic interest of the party seeking its enforcement, and (3) survives a balancing of the equities” between employer and employee.
While noncompetes are more leniently enforced in the context of business sales, agreements in employment contracts are more closely examined in Delaware. For example, overly broad geographic or temporal restrictions can render a noncompete unenforceable. Delaware courts also reject attempts to bypass this reasonableness analysis through the implementation of adverse contractual provisions, which cannot override judicial review. Notably, “blue penciling,” or modifying noncompetes to make them enforceable occurs less and less as courts are hesitant to adjust overbroad clauses.
This change in interpretation of noncompete agreements reflects a growing concern for the rights of employees at all levels. Additionally, it ensures that companies seeking to enforce these agreements must target specific corporate interests they wish to protect. Delaware’s new interpretation comes at a time when federal regulations seem to have stricter scrutiny, like the FTC’s proposed rule to ban the majority of noncompete agreements nationwide. In the meantime, Delaware’s evolving stance requires employers to carefully draft noncompetes that meet the state’s reasonableness standards to ensure enforceability. This may be an additional obstacle for companies that previously sought Delaware as a state of incorporation when there was greater predictability and fewer restrictions on corporate influence.
Are Other States More Corporate Friendly?
Despite the added unpredictability and changes in the law, the question remains: Are other states offering a better deal to corporations?
At the outset, the surprising decision in Tornetta v. Musk needs to be viewed in context. Any final decision will only concern a limited subset of cases concerning compensation packages of executives where courts opt for the entire fairness standard of review. The repercussions of the court’s decision regarding the legal fees in that case will similarly be limited to cases involving executive compensation packages.
However, Delaware remains the most flexible jurisdiction. For example, Delaware can quickly enact amendments to the Delaware General Corporation Law, following the Chancery Court’s decision in West Palm Beach Firefighters Pension Fund v. Moelis in February 2024. Additionally, Delaware remains the most predictable jurisdiction due to precedent providing further guidance on decisions. Finally, legal faculty and legal professionals alike maintain that Delaware remains the first choice for the majority of corporations.
Conclusion
While Delaware has historically been the top choice for corporate incorporation, recent changes in its legal landscape—such as stricter scrutiny of executive compensation and noncompete agreements—are raising questions about its future dominance. With increasing unpredictability and the potential for stricter federal regulations, companies may begin to explore other states with more favorable or predictable laws. Delaware’s status as the go-to state for incorporation could be under threat as businesses reassess their options, but this is unlikely to happen in the immediate future.
*The views expressed in this article do not represent the views of Santa Clara University.
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