Is Delaware Still Business-friendly?

Delaware has been hailed as the country’s incorporation capital for years due to its pro-business corporate laws and dedicated business court. Nearly 1.4 million business entities are registered in the First State, over two-thirds of which are Fortune 500 companies. 

However, experts are starting to notice a shift in the corporate landscape. Other states, like Nevada and Texas, are starting to attract the attention of high-profile entrepreneurs.

Prominent figures like Tesla CEO Elon Musk are also leaving Delaware, raising questions about whether the state is still as business-friendly as it claims. 

In this blog, we’ll discuss the scrutiny that Delaware has faced in recent years and explore which states might be emerging as new contenders for the title of incorporation capital.

Delaware’s Business Court: The Good & The Bad

Delaware is known for its extensive case law on corporate conflicts, fiduciary disputes, and other similar affairs. Its Court of Chancery has been commended for hearing these cases with “institutionalized fairness” and experienced judges. 

But despite all the praise, the business court is facing scrutiny for some of its rulings. One case that comes to mind is Tesla CEO Elon Musk’s high-profile pay package lawsuit. 

In 2018, Tesla shareholder Richard J. Tornetta sued Elon Musk and the company’s other senior executives after Musk’s $55 billion compensation package was approved. The package will allow Musk to get a large payout and stock options in the company if it hits a specific performance target. 

The lawsuit argued that the package’s approval was unfair, alleging that Tesla’s senior executives acted with Musk’s interests in mind, which goes against their fiduciary duty. 

Unfortunately for Musk, Delaware Chancery Court Judge Kathaleen McCormick ruled against him.

Last January 30, McCormick released a judgment ordering that Musk’s pay package be voided and that he return any benefits he received from it. In a 200-page opinion, she wrote, “Musk launched a self-driving process recalibrating the speed and direction along the way the way he saw fit.”

Musk was the first to express his disappointment with McCormick’s ruling. On X, the social media platform formerly known as Twitter, he told his followers to “never incorporate your company in the state of Delaware.” and that he “recommends incorporating in Texas and Nevada if you prefer shareholders to decide on matters.” 

Legal experts also pointed out how rigid Delaware’s laws on conflicting transactions have become. 

Decisions on compensation packages are typically subject to the board of directors’ decision. But things change when there are controlling shareholders or controllers.

Controlling shareholders own more than 50% of the company’s voting power. These shareholders can easily persuade other executives to follow their will. 

If a controlling shareholder engages in a conflicting transaction, an independent decision-maker should step in. The independent decision-maker can either be an independent board member or a disinterested shareholder who can maintain an objective stance. If not, the court will examine whether the transaction is fair.

However, Delaware’s courts agree that independent decision-makers could still be intimidated if a controller is on the other side of a conflicting transaction. They said a conflicting deal would only be valid if independent board members and disinterested shareholders approved it. 

Since Musk’s pay package had no independent decision-maker, McCormick had to turn to the state’s fairness analysis. Based on her findings, Musk’s close ties with Tesla’s other executives, his 21% stake, and his “superstar CEO” status tainted the shareholder vote. 

Another instance that highlights the flaws of Delaware’s Chancery Court is its Caremark claims. Caremark claims are lawsuits filed against the board of directors who breach their fiduciary duties. 

According to Delaware’s law, there are three criteria that a Caremark claim must satisfy for it to be deemed futile: 

• The director received a material personal benefit from the alleged misconduct.
• The director would face a substantial likelihood of liability on the claims subject to the demand. 
• The director lacks independence from another person who received a material, personal benefit or would face a substantial likelihood of liability. 

The test may seem procedural, but the court’s decision on demand futility will be significant in derivative lawsuits. If the demand is not excused, the lawsuit will be barred. But if it is excused, it implies that the court believes that at least half of the board is compromised. 

The Delaware court has recognized the importance of their court’s decision on demand futility, claiming that the “demand requirement is not excused lightly.” 

Yet, there have been multiple instances where the court allowed derivative lawsuits to be filed against corporate boards that did not engage in fraudulent dealings but only failed to maintain sufficient oversight of the company. 

Ultimately, the state’s rigorous standard on corporations caused prominent entrepreneurs to rethink their locations. 

A Race For The Title

Since high-profile entrepreneurs like Musk leave Delaware, other states like Texas and Nevada are gunning for its title. But the Silver State is the strongest contender to be the next corporate haven. 

While Delaware courts were focused on preserving shareholder value, Nevada turned its attention to offering directors stronger protections. 

According to Las Vegas shareholder Michael Bonner, “What Nevada did is we went further than Delaware, and it’s one of those reasons why people are actively considering Nevada over Delaware these days.”

How did Nevada do it? In her paper entitled “Market Segmentation: The Rise of Nevada as a Liability-Free Jurisdiction,” University of Virginia School of Law Professor Michal Barzuza explained that the state is deliberately creating a legal Wild West to attract more companies. 

She says that in 2001, Nevada made “no liability” the default rule for exculpation clauses, which means a valid exculpatory clause in a contract can now protect directors and executives from negligence liability.

It’s also worth noting that the state has no corporate or individual income taxes. Businesses that will incorporate in Nevada will be able to enjoy far more tax savings than in any other state. 

With all these benefits in mind, it’s no surprise that entrepreneurs like Musk are moving to the Silver State. 

Although experts like Barzuza believe that Delaware will still be the number one destination for businesses, she thinks that we will likely see more billionaire entrepreneurs migrating to the shores of Nevada. 

Discover The Nevada Edge

Discover Nevada’s edge with NCH’s help. NCH is one of the state’s leading business formation service providers. 

Our experienced team of business specialists is here to assist and guide you throughout the incorporation process. From filing your formation documents to finding a trusted registered agent, NCH is here to help you and your business succeed. 

To learn more about our formation services, visit our website here or call us at 1-800-508-1729 to schedule a consultation.

Disclaimer: The above material has been prepared for informational purposes only, containing opinions of the provider, and is not intended to provide, and should not be relied on for, tax, legal, or accounting advice. Please consider consulting tax, legal, and accounting advisors before engaging in any transaction.