Real Clear Markets: CA Has Hollywood, TX Has Oil, Delaware Corporations

The small coastal state known as “The First State” has been the undisputed champion of where companies choose to call home. In 2013, according to its secretary of state’s annual report, 83% of all initial public offerings, nearly half of all publicly traded companies, and 65% of Fortune 500 companies have Delaware as their state of incorporation.

But Delaware risks eroding this vaunted position and harming shareholders if its legislature passes a bill that ignores the broadly recognized scourge of abusive litigation and flies in the face of other bipartisan efforts at the state and federal level to combat the problem.

For example, litigation regarding corporate mergers and acquisitions has soared in recent years. A U.S. Chamber Institute for Legal Reform study shows that from 2011 to 2014, 93% of all corporate transactions valued above $100 million were challenged by one or more lawsuits, which are often brought in multiple states simultaneously. That is up from 39% in 2005.

Seventy percent of these lawsuits settle, and of those, only 6% result in payments to shareholders. The rest provide such trifles as coupons or supposedly augmented disclosure. Of course, the lawyers get paid royally regardless of terms of the settlement.

More than forty Delaware companies have experimented with ways for discouraging abusive lawsuits, including “fee-shifting” by-laws. These provisions, which vary from company to company, provide a mechanism for companies to recoup the costs of litigation in certain circumstances, ranging from pure “loser pays” to shifting only when a party makes objectively unreasonable claims or when the losing party’s position was “not substantially justified” in the view of the judge in the case. The goal is to reduce the burden on the vast majority of shareholders from abusive lawsuits brought by a few exploitative shareholders and their lawyers. Believe it or not, some stockholders are serial offenders, having filed up to 50 shareholder lawsuits in the past several years.

Since last year, the state’s trial lawyers have lobbied heavily to slam the door on corporate experimentation by outlawing these types of provisions. In fact, the Delaware House is about to consider a bill already adopted by the Delaware Senate that would outlaw any form of fee-shifting provisions. Unfortunately, while Delaware lawmakers seem fixated on helping the local trial bar, they are ignoring the rapidly changing federal landscape. For example, Senators Grassley, Leahy, Cornyn, Schumer, Lee, Hatch, and Klobuchar have sponsored a bill that would allow fee shifting in the exploding area of abusive patent litigation if the losing party’s position was not “objectively reasonable.” This bipartisan group of senators has realized that current federal rules (similar to Delaware’s) are simply insufficient to allow judges to police and deter abusive suits.

Instead of outlawing the tool of fee shifting, Delaware legislators should ask why companies are considering adopting this tool in the first place. The answer is because they are finding no relief from this vexing and costly litigation.

And therein lies the risk for Delaware.

Incorporations are more than a source of civic pride, they are a huge revenue stream. In 2013, corporate franchise taxes brought more than $883 million to the state’s coffers-24% of total revenue, second only to state income taxes.

In today’s world, everything is a competitive marketplace, including where companies choose to incorporate. States are constantly searching for revenues. And more than a handful, including Connecticut, South Dakota, and Oklahoma, are emerging as reasonable alternatives to Delaware. The biggest threat to Delaware could be Texas, which has a strong business climate, active new venture and technology sector, and a willingness to address tort reform. Moreover, there is an effort afoot in Texas to make Texas the most recent state to create a special business court as an analogue to Delaware’s chancery court. Given the important dollars-and-cents issue that fee-shifting represents, Delaware’s action, combined with aggressive moves by states such as Texas, could be the straw that breaks Delaware’s position as the destination of choice.

When your long-time wireless provider increases its rates, you might be nudged to look around for a better deal. If Delaware passes this change to its corporate code, many companies, especially new incorporations, might just do the same. With a new inflexible code that is unfriendly to the economic interests of shareholders, why would a Silicon Valley start-up incorporate in Delaware? Somewhere else might be more attractive in terms of real dollars.

Delaware legislators should take the advice that investors have received for decades: past performance is no guarantee of future success. If Delaware puts the interests of trial lawyers before real shareholders, other states will see opportunity and companies will respond. If that happens, it may take more than all the First State’s horses and its men to put the golden egg back together again.

Paul Atkins, a former SEC Commissioner, is Chief Executive of Patomak Global Partners, LLC.