Contract Design, Default Rules, and Delaware Corporate Law

Incomplete contract theory recognizes that parties have neither the interest, nor the time, nor the ability to anticipate and address every contingency in contracts. The more complex and time-sensitive the transaction, the more practical constraints force lawyers to limit the scope of drafting and broadly rely on legal defaults and open‑ended terms to plug holes and address contingencies.  In theory, this should explain why practitioners broadly choose Delaware as the preferred jurisdiction and forum for merger and acquisition (M&A) transactions and other high‑end corporate deals.  Lawyers appear to perceive Delaware as superior to other states both for its default rules for corporate law and its judiciary’s expertise in discerning the “hypothetical bargain” of the parties.

In a new paper, we examine whether lawyers’ professed confidence in Delaware defaults actually shows up in the drafting of merger and acquisition agreements. Our premise is that the best proxy for examining lawyers’ reliance on a jurisdiction’s defaults is the extent of brevity in legal drafting, which is closely related to reliance on standards rather than rules. Incomplete contract theory predicts that reliance on defaults should broadly translate into implicit (and explicit) references to existing defaults that conserve time and space in drafting, especially through the use of parsimonious standards rather than prolix rules. To the extent to which comparable contracts grounded in different jurisdictions have systematic differences in length, this finding would serve as evidence that lawyers are placing greater substantive reliance on the defaults of one jurisdiction compared with another.

In an earlier work, The Delaware Delusion, 93 N.C. L. Rev. 1049 (2015), we showed empirically that both the “race to the top” and “race to the bottom” schools of thought may rest on a flawed premise because the decision to incorporate in Delaware does not appear to affect how financial markets value publicly traded companies. We leveraged the fact that every merger of companies in different states constitutes an “acquisition reincorporation” because the target corporation’s assets are redeployed from the target corporation’s regime of corporate law into the surviving corporation’s regime of corporate law. By comparing the reaction of capital markets to mergers that reincorporated companies into and out of Delaware, we were able to show that the financial world places no apparent value on the alleged superiority of the Delaware legal system.

Our previous work left an important issue unresolved: whether lawyers themselves perceive value associated with Delaware law and courts. This question is particularly important because lawyers choose Delaware as the locus of jurisdiction and chosen forum for a large percentage of merger and acquisition agreements. But that fact in itself does not reveal the extent of reliance on Delaware defaults (as it could be explained by path dependence, familiarity with Delaware law, or other non-substantive factors). In our article we analyze the confidence, or lack thereof, that lawyers appear to place in Delaware law in drafting merger and acquisition agreements.

Our premise is that the best proxy for reliance on defaults and open‑ended terms is brevity in legal drafting. Contracts will vary in length due to deal‑specific differences, but incomplete contract theory predicts that reliance on defaults should translate into implicit (and explicit) references to existing defaults that conserve time and space in drafting. To the extent comparable contracts grounded in different jurisdictions have statistically significant differences in length, this finding would serve as evidence that lawyers are placing greater reliance on the defaults of one jurisdiction compared with another.

In our paper we compare the length of public company M&A agreements for Delaware transactions with those governed by the law of other jurisdictions. To the extent practitioners regard Delaware law as more comprehensive, more precise, or more settled (due to the Delaware General Corporation law, case law, or the judicial system) compared with other jurisdictions, we would expect that Delaware M&A agreements would be more concise because of greater reliance on defaults and open‑ended terms.

Our results show that agreements governed by Delaware law are no shorter, and are in fact systematically longer, than agreements governed by the law of other states even when we accounted for a spectrum of control variables including the deal structure, the quality of law firms, deal complexity, and the size of the transaction. This finding held true even when we identified and excluded the Delaware (and other states’) jurisdiction‑specific language. In fact, the most predictive variable for the length of an agreement turned out to be the length of the precedent agreement from which counsel copied the original draft. This fact suggests that lawyers place little reliance on the statutory and judicial defaults and that Delaware law matters little as an “off‑the‑rack” default to economize on the costs of drafting.

Our findings suggest that there is a gap between lawyers’ professed and actual confidence in Delaware law and courts. Lawyers may simply give lip service to the reputation of Delaware law and its judiciary, but in the context of M&A contract design, lawyers appear to pay less attention to the statutory and judicial defaults than they would to the defaults of any other jurisdiction. These results have important implications for both Delaware corporate law and for contract design, where the tradeoff between ex ante drafting costs and ex post enforcement costs is paramount.

Our finding that lawyers rely on the defaults of Delaware no more (and possibly less) than those of other jurisdictions also suggests that Delaware is living off its reputation and that the Delaware legislature and courts may need to address the comprehensiveness and precision of Delaware contract law to maintain Delaware’s reputation in the long run.

This post comes to us from professors Jeffrey Manns at George Washington University Law School and Robert Anderson at Pepperdine Caruso University School of Law. It is based on their recent article, “Contract Design, Default Rules, and Delaware Corporate Law,” available here.

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