The Death of Corporate Law

For decades, corporate law played a pivotal role in regulating corporations across the United States. Consequently, Delaware, the leading state of incorporation, and its courts played a central part in corporate law and governance. More than half of publicly traded firms are incorporated in Delaware, and in many law schools in the United States, Delaware corporate law has become virtually synonymous with American corporate law. While some experts have praised Delaware courts for their efficiency and sophistication in adjudicating corporate disputes, and others have accused the Delaware courts of pro-management leanings, very few would dispute that Delaware courts have played a critical role in shaping corporate law in the United States.

In a recent article, we argue that corporate law is no longer vital to the regulation of U.S. publicly traded corporations. The transformation of American equity markets from retail to institutional ownership has relocated control over corporations from courts to markets and has led to the death of corporate law. As a result, and as an illustration of this broader phenomenon, Delaware courts today play a fundamentally different–––and much less influential–––role in corporate disputes. Indeed, we show that corporate law jurisprudence originating from the Delaware courts is no longer “alive” as a substantive regulatory influence. While other scholars have argued that Delaware’s retreat reflects judicial volition, our point here is different: We argue that the transformation of U.S. equity markets has eliminated the Delaware courts’ authority to determine the extent of their own institutional centrality.

But why has the rise of institutional ownership coincided with the death of corporate law? In our article, we answer this question by unpacking the relationship between market dynamics and law, which allows us to present the core insight of our theory: The more competent shareholders become, the less important corporate law will be. By applying this general insight to the Delaware courts, we are able to explain the decline of the Delaware courts and to discuss the legal and policy implications of this insight for the future of Delaware.

Until recently, Delaware courts engaged in a high level of judicial involvement with corporate disputes. Historically, conflicts over corporate control in the United States frequently originated from hostile takeover attempts. In a series of landmark decisions beginning in the 1980s, Delaware courts played a pivotal role in the resolution of this breed of disputes. In its celebrated Unocal decision, the Delaware Supreme Court held that board-adopted defenses against hostile takeovers would receive enhanced judicial scrutiny.[1] Later decisions applying Unocal allowed boards to unilaterally adopt poison pills and then “just-say-no” to hostile takeovers, notwithstanding shareholders’ desires.

Meanwhile, the Court of Chancery’s holding in Blasius provided courts with the means to scrutinize board interference with shareholder voting rights.[2] Unocal and Blasius–––along with the court’s development of so-called “Revlon duties” that apply to board behavior in change-of-control scenarios[3]–––entrenched the Delaware courts’ position as the ultimate arbiter of corporate control disputes. This power effectively allowed the courts to dictate the allocation of control rights between boards and shareholders.

All of this, however, has changed. Delaware courts no longer wield this same level of influence. With respect to control rights,[4] here are just a few illustrations of the courts’ waning influence.[5] Consider that, while boards are free under Delaware jurisprudence to adopt a poison pill to fend off hostile takeovers, directors are hesitant to do so, fearing shareholders’ reaction. As a result, in more than half of all contemporary hostile bids, a poison pill is never implemented, even after the hostile bid launched. Similarly, although the Delaware courts permit boards to use a poison pill together with a staggered board–––a combination some consider takeover preclusive–––shareholder activists have managed nonetheless to dismantle most staggered boards via pressure exerted outside the courtroom. Sidestepping the courts, shareholder activists engaged in an extremely successful campaign, leading ultimately to an 80 percent drop in staggered boards among S&P 500 companies.

Moreover, and perhaps most strikingly, the use of hedge fund activism has become a routine method for shareholders to wield control rights outside of courts. Activist hedge funds will procure a relatively small stake in a company, issue a “white paper” detailing criticisms of the company’s management, and then campaign for other shareholders to vote against management in a proxy fight. To avoid the fiasco of a public proxy dispute, and despite the Delaware courts’ approval of anti-activist poison pills in Third Point,[6] companies often settle with activists behind the scenes, for example, by allowing the activist to appoint individuals of its choosing to the company’s board. Activists can thus sidestep judicial oversight altogether by taking advantage of the pressure generated by their threat of a proxy fight, rendering corporate law entirely irrelevant.

What brought about the death of corporate law? We answer this complicated question with a theory that analyzes the relationship between market dynamics and the law. The starting point for our theory is the understanding that corporate contracts are always incomplete. The principal (the shareholders) invests in, and the agent (the board) manages, a firm, in order to create future value. But, beyond the general instruction to maximize firm value, there are few (if any) enforceable precepts as to how to manage the firm. Instead, the parties agree to a general allocation of control rights (which govern the apportionment of decision-making power over the firm) and cash-flow rights (which govern the apportionment of firm-generated value). In this incomplete contract, conflicts may arise as to the allocation and use of these two types of rights. The principal and the agent, therefore, must decide which conflicts to resolve on their own–––via discretionary control rights such as shareholder voting–––and which conflicts to resolve with the aid of a court—via the right to sue for breach of directors’ fiduciary duties.

But when will shareholders and boards prefer to engage courts in resolving corporate disputes as opposed to resolving conflicts via discretionary control rights? The exercise of corporate control rights generates control costs–––which include competence and conflict costs–––for both the principal (“principal costs”) and the agent (“agent costs”).[7] Under conventional economic assumptions, shareholders and boards will aim to minimize the sum of those costs in order to increase firm value. Critically, we observe that enlisting courts in an effort to reduce these control costs will itself impose both competence costs and conflict costs spawned by the adjudication process. Therefore, the use of courts will only be efficient when it minimizes the total control costs created by all three players–––the principal, the agent, and the courts.

Our theory shows that the relative magnitude of principal competence and court competence is a crucial determinant of whether the parties will prefer judicial intervention as opposed to the use of discretionary control rights. When the principal has relatively low competence (as with retail investors) the parties are more likely to rely on a court for dispute resolution. By contrast, when the principal has relatively high competence (as with institutional investors), the parties are more likely to resolve these issues on their own through the use of discretionary control rights. The efficiency of extra-judicial conflict resolution positively correlates with the principal’s competence. The more competent the principal, the greater the probability that actors will prefer using discretionary control rights to resolve disputes outside of the adjudication process.

As increased institutional ownership and complementary market mechanisms (such as hedge fund activism and proxy advisers) bolster the competence of U.S. investors, our theory predicts–––and reality seems to vindicate–––that judicial dispute resolution becomes a less desirable option. And as companies have grown accustomed to the ability of institutional investors to discipline management outside of the courtroom, companies have come to care more about their investors’ business opinions than about the Delaware courts’ judicial opinions. Over time, this dynamic has made corporate law marginal and has eroded the significance of the Delaware courts.

ENDNOTES

[1] Unocal Corp. v. Mesa Petroleum Co., 493 A.2d 946, at 954––55 (Del. 1985).

[2] Blasius Industries, Inc. v. Atlas Corp., 564 A.2d 651, 661––62 (Del. Ch. 1988).

[3] Revlon, Inc. v. MacAndrews & Forbes Holdings, Inc., 506 A.2d 173 (Del. 1986).

[4] For a description of the changes regarding cash-flow conflicts adopted by Delaware courts see our article.

[5] For a broader range of illustrations see our Article.

[6] Third Point LLC v. Ruprecht, C.A. No. 9469-VCP, 2014 WL 1922029 (Del. Ch. 2014).

[7] See Zohar Goshen & Richard Squire, Principal Costs: A New Theory for Corporate Law and Governance, 117 Colum. L. Rev. 767, 779 (2017).

This post comes to us from Zohar Goshen, the Alfred W. Bressler Professor of Law at Columbia Law School, and Sharon Hannes, Professor of Law and Dean of the Faculty of Law at Tel Aviv University. It is based on their recent article, “The Death of Corporate Law,” available here.

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