Delaware is jettisoning its traditional approach of protecting investors

The writer is the founding director of the John L. Weinberg Center for Corporate Governance at the University of Delaware

Delaware, the legal home of a substantial majority of US public companies, last month passed legislation that would lead, in effect, to the self-destruction of its corporate role — with serious consequences for investors worldwide.

The bill passed by Delaware’s general assembly jettisons the state’s traditional approach of protecting investors. Now sent to Delaware Governor John Carney for approval, it would allow the management of companies to strike secret side deals with big shareholders, bypassing the board on governance questions previously reserved for directors. For example, the bill would allow agreements giving a single shareholder veto power over the hiring or firing of a chief executive.

The tale is a sad one for shareholders everywhere and invites calls for the federal government to intervene. Through an accident in financial history more than 100 years ago, Delaware became the legal home and primary regulator of the internal affairs of corporate America.

Delaware law, enforced by its world-renowned judiciary, defines the important relationships between stockholders, boards and corporate management. The goal was ultimately to protect investors.

For many years, the state’s courts were highly deferential to corporate management, trusting managers over small investors. Starting 40 years ago, however, large institutional investors began to play a significant role, gaining influence. Delaware slowly but decisively changed its approach and shifted to a more balanced model of investor protection. Sometimes the courts favoured management in shareholder disputes, but they also increasingly recognised shareholder authority as the animating force of corporate direction.

The substance of Delaware law is central to its success. But more important is the universal respect for its judiciary. The judges are acclaimed as experts in their corporate law domain, brilliant and fair. Judges and policymakers worldwide look to the Delaware bench for guidance.

Delaware’s corporate franchise was the envy of its sister states, many of which tried, and failed, to imitate its model. Delaware’s only true rival was the federal government.

Still, Delaware dominated the rest of corporate law. Until now. Earlier this year, the Delaware Court of Chancery, the state’s highly respected corporate trial court, handed down two rulings enforcing statutory protections of minority shareholder rights. One involved limits on the board’s ability to give away its core powers through contract. The other interpreted statutory requirements for board and stockholder approval of mergers.

In an unprecedented step, the Corporation Law Council of the Delaware State Bar Association hastily lobbied for a legislative override of these decisions before an appeal could be taken to the state’s Supreme Court.

The move drew significant criticism, including from the chancellor and a vice-chancellor of the chancery court as well as representatives of large institutional shareholders. But the General Assembly of Delaware rubber-stamped the bill.

Never before had the bar and legislature moved so hastily in the face of such strident opposition. Major revisions to Delaware law historically took years of debate, discussion and compromise. The resulting changes were thus almost uniformly respected. Not this time.

The change in Delaware law is significant. The bill favours controlling shareholders over public investors. It also upends the historic equipoise between management and public investors. Independent directors, central to effective governance, could now find themselves hamstrung by secret agreements with large, powerful shareholders, undermining their ability to protect all investors.

And throughout the process, the judiciary was unfairly attacked and maligned by the bill’s proponents. These attacks seemed aimed at diminishing the authority of these judges to effectively protect investors, striking at the core of Delaware law and the state’s brand.

Powerful special interest groups now have a model for legislatively circumventing the celebrated judicial process. Sadly, Delaware’s cherished neutrality and circumspection have been sacrificed. Investors will turn elsewhere for protection — whether to other states or, more likely, to the federal government. It’s a terrible ending to a brilliant regime.