Incorporation Issues Why Delaware

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Oct 1999

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It is common knowledge that many of the largest public companies are incorporated in Delaware. What is not so well known are the reasons why we, as California attorneys, might seek to

incorporate an entity that is about to go public in the state of Delaware. The first part of this

article is a summary of some of the differences between the corporate law in California and

Delaware. The second part of this article deals with why so many companies that are

incorporated in Delaware, but have their principal places of business elsewhere, choose

Delaware as the place to file a bankruptcy petition.

As a matter of history, Delaware was not always the leading state of incorporation. New Jersey

was once the leader until 1918, when its new governor, Woodrow Wilson, tightened its laws.

Several states then vied to have the most favorable incorporation and corporate governance

statutes, but it did not take long for Delaware to come out on top. From its business-friendly

corporate laws to its Division of Corporations that keeps some employees until 11 p.m to

permit a three-day incorporation approval process and its Chancery Court, which handles only

business cases and has no backlog, Delaware is now the clear incorporation leader. The

incorporation industry in Delaware employs about 1,000 people and yields more than $400

million in taxes and fees, which represent about one quarter of the state's budget.

But Delaware's role as the incorporation leader is not based solely on its business-friendly

reputation and its ease of access. The corporation law of Delaware is widely regarded as the most

extensive and well-defined body of corporate law in the United States. Both the legislature and

the courts in Delaware have demonstrated an ability and a willingness to act quickly and

effectively to meet changing business needs. The Delaware judiciary has acquired considerable

expertise in dealing with complex corporate issues. There is an anticipation that the Delaware

General Corporation Law will continue to be interpreted and construed in significant court

decisions, lending predictability to the corporate legal affairs of all corporations that are

domiciled in Delaware.

<h3>Delaware vs. California</h3>

Certain provisions described in greater detail below are permitted under Delaware law but not

under California law. These provisions, generally called "anti-takeover provisions," include:

classified boards of directors; the elimination of the right of stockholders to call special

meetings of stockholders; the granting of authority to the board of directors, without

stockholder approval, to establish and change the authorized number of directors; and the

limitation of director liability for certain breaches of fiduciary duties.

Delaware law allows all corporations to have classified boards of directors, with each class

having a term of longer than one year. In California, only stock listed on stock exchanges or

widely held NASDAQ stocks may have classified stock. This provision prevents a third party

from arbitrarily removing a director midterm and acts as an anti-takeover provision.

Delaware law allows cumulative voting for directors. Actually, in this instance, Delaware law is

more restrictive than California law in that in order to have cumulative voting in Delaware,

such a provision must be included in the certificate of incorporation. We generally recommend

that cumulative voting provisions be inserted in Delaware certificates of incorporation.

Under California law, a director may be removed without cause by a shareholder vote,

provided that the shares voted against such removal would not be sufficient to elect the director

under cumulative voting rules. Under Delaware law, a director of a corporation that does not

have a classified board of directors may be removed with or without cause by a stockholder vote,

provided that in the case of a corporation having cumulative voting, if less than the entire board

is to be removed, the shares voted against removal would not be sufficient to elect the director

under cumulative voting rules at an election of the board of directors.

Under California law, a director may be removed for cause only (i) by order of a court sought

by shareholders holding at least 10 percent of the outstanding shares of any class, if a director

is found to have committed fraudulent or dishonest acts or gross abuse of authority or discretion

or (ii) by the board if a director has been declared of unsound mind by order of a court or has

been convicted of a felony. Under Delaware law, a director of a corporation with a classified

board of directors can be removed only for cause, unless the certificate of incorporation

otherwise provides.

Under California law, a special meeting of shareholders may be called by the holders of 10

percent or more of the voting stock of the corporation and this right may not be eliminated in

the articles of incorporation or by-laws. Under Delaware law, a special meeting of stockholders

may only be called by the board of directors or any other person authorized to do so in the

company's certificate of incorporation or by-laws. The principal effect of this provision is to

prevent stockholders, including majority stockholders, from forcing a special meeting of

stockholders to consider a proposal opposed by the board of directors.

Under Delaware law, the certificate of incorporation may require that any action taken by the

stockholders of the company must be effected at an annual or special meeting of stockholders and

may not be taken by written consent.

Delaware law also insulates directors from monetary liability for breach of fiduciary duty

except in circumstances where a stockholder can demonstrate a breach of the duty of loyalty, a

failure to act in good faith, intentional misconduct, a knowing violation of law, an improper

personal benefit, or an illegal dividend or stock purchase. California law does not contain any

such limitation of monetary liability upon the finding of a breach of fiduciary duty.

In Delaware, the laws governing the payment of dividends are less restrictive than in California.

Delaware corporation law also makes it more difficult for a stockholder to bring a derivative

action on behalf of the corporation. In most circumstances, Delaware law requires a stockholder

bringing a derivative action against the corporation to have been a stockholder of the

corporation at the time of the transaction in question. California law contains no such

restriction.

It is also more difficult to dissolve a corporation in Delaware, where 100 percent of the total

voting power must approve dissolution unless the board of directors approves the proposal to

dissolve. In California, shareholders with 50 percent or more of the total voting power may

authorize a corporation's dissolution with or without the approval of the corporation's board of

directors.

There are numerous other differences between the corporate law of Delaware and California,

some of which are subtle and some of which are not. We regularly advise clients concerning all

of these issues.

<hr>

Since forum shopping appears as though it is here

to stay, creditors should be prepared to pursue

collection remedies in a forum located far from an

obligor's principal place of business.

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<h3>Filing in Delaware</h3>

Now that we know why companies incorporate in Delaware, why are so many of them filing for

bankruptcy in Delaware? Although it seems logical that the creditors of a company based on the

West Coast ought to be able to pursue their collection rights in a local venue, the spate of

bankruptcy filings in Delaware by large high-profile debtors has left many financial

institutions and credit managers with the daunting task of pursuing their legal remedies in a

court located on the other side the country. The reasons for the forum shopping phenomenon and

the impact of efforts to curtail it is the focus of the balance of this article.

The reason that so many large public corporations end up filing in Delaware is due in part to

bankruptcy venue provisions, which permit a bankruptcy case to "be commenced in the

district court for the district in which the [debtor] is domicile[d]." In 1988, Hon. Helen

Balick, then the only bankruptcy judge in Delaware, held that a corporation's "residence or

domicile" for venue purposes was its place of incorporation. As a result, any corporation that

had been incorporated in Delaware could file a bankruptcy petition there, even if its place of

business or principal assets were located elsewhere.

Since the vast majority of large, publicly traded corporations had been incorporated in

Delaware, Judge Balick's decision added Delaware to the list of venue sights for nearly every

corporation contemplating a bankruptcy filing. The impact of Judge Balick's interpretation of

the venue provisions was not immediate, but, according to a recent study by Cornell law

professors Theodore Eisenberg and Lynn LoPucki, the tendency of debtors to file in Delaware

began to gather momentum in the early 1990s. By 1993 the rate of forum shopping in large

cases rose to about 40 percent, then climbed sharply to 86 percent by 1996, when 12 of 14

large public companies filing for bankruptcy did so in Delaware. Not surprisingly, the

alarmingly high tendency of debtors to file in Delaware did not go unnoticed.

Soon much of the bankruptcy bench and bar (outside of Delaware and possibly New York) began

to express their concern that many large corporations were filing chapter 11 in Delaware even

though most or all of their operations were located elsewhere. In response to the controversy,

the National Bankruptcy Review Commission, which had been formed at the behest of Congress to

review possible revisions to the Bankruptcy Code, recommended revisions that would stop

forum shopping by preventing debtors from choosing a venue based solely on the state of its

incorporation.

But before the proposed statutory revisions could gather much support (and after two of the

first three large cases filed in Delaware in early 1997), Hon. Joseph Farnan, Chief Judge of the

Delaware District Court, took the unprecedented step of withdrawing the reference in all

chapter 11 cases. In order to comprehend the significance of Judge Farnan's action, one needs to

understand the interaction of a couple of other statutory provisions governing the allocation of

bankruptcy cases within a district. <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… U.S.C. §1334</a> provides that the district courts "shall

have original and exclusive jurisdiction of all cases under title 11 [the portion of the United

States Code known as the Bankruptcy Code]." As a result, all bankruptcy cases are filed in

district court and could be heard by any of the district judges of a particular district.

But it is <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… U.S.C. §157</a> that permits the district court judges to automatically "refer"

bankruptcy cases to the bankruptcy judges in that district: "[E]ach district court may provide

that any or all cases under title 11 and any or all proceedings arising under title 11 or arising

in or related to a case under title 11 shall be referred to the bankruptcy judges for the

district." By withdrawing the reference, Judge Farnan prevented bankruptcy cases from

automatically being referred to the two bankruptcy judges (Judge Balick and Judge Walsh) that

were then presiding in Delaware. Three district judges (Farnan, Roderick R. McKelvie and Sue

Robinson), none of whom were experienced in bankruptcy, were thus immediately thrown into

the pool of judges that could be assigned to a bankruptcy filing in Delaware.

The impact of withdrawing the reference was immediate. Instead of the "certainty" that debtors

had come to expect from Delaware's bankruptcy judges, the specter of a presiding judge

unfamiliar with the intricacies of bankruptcy brought bankruptcy filings in Delaware to a

screeching halt. In fact, according to professors Eisenberg and LoPucki, for five months, not a

single large public company filed a bankruptcy petition in Delaware.

Over time, bankruptcy practitioners became more comfortable with the district judges and

their ability to handle the intricacies of large cases. In early July 1998, First Merchants, a

large automobile financing business, filed in Delaware and was assigned to Judge Farnan.

Shortly thereafter, Montgomery Ward Holding Corp. filed in Delaware and was assigned to Judge

Walsh. That filing was soon followed by Avoca Natural Gas Co., which was assigned to District

Judge Robinson, and in early September 1998, Levitz Furniture Inc. filed in Delaware and was

assigned to Judge Farnan.

Recent statistics compiled by LoPucki demonstrate that Delaware's near monopoly on large cases

has dropped to about 50 percent since the withdrawal of the reference by Judge Farnan.

According to LoPucki, that decline is due to the lack of "certainty" in the treatment of large

public bankruptcy cases that has been engendered by the addition of the three district judges to

the pool of judges that could be assigned to a case filed in Delaware. LoPucki is of the opinion

that, given the decline in filings in Delaware, there is an opportunity for other bankruptcy

courts to step up and demonstrate that they can handle major cases just as well as the courts in

Delaware.

But others suggest that large districts, like the huge Central District of California, which

encompasses 21 judges in five different locations (including 10 in Los Angeles), are at a

distinct disadvantage when debtors shop for the best location for a bankruptcy filing.

Predictability, often considered the single most important factor in the decision of where to file,

tends to suffer when there are more than a few judges that can be assigned to a particular case.

As a result, the Central District of California will be hard-pressed to compete with Delaware as

the preferred venue choice for large publicly traded corporations.

In the meantime, while the National Bankruptcy Review Commission's recommendation to

exclude the state of incorporation as a venue choice has been included in the House version of

bankruptcy reform pending before Congress, its adoption is considered highly unlikely.<a href="#1" name="1a">1</a> Since

forum shopping appears as though it is here to stay, creditors should be prepared to pursue

collection remedies in a forum located far from an obligor's principal place of business.

In conclusion, it is clear that from the birth of the idea of forming a corporation for the

transaction of business to perhaps the termination of the corporate existence of a business,

those conducting business in California must be acutely aware of what is going on in Delaware.

<hr>

<h3>Footnotes</h3>

<a name="1">1</a> Section 304 of H.R. 833 would amend <a href="http://www.westdoc.com/find/default.asp?rs=CLWP1.1&vr=1.0&cite=… U.S.C. 1408</a> to provide that "if the debtor is a corporation, the domicile and residence of the debtor are conclusively presumed to be where the principal place of business in the United States is located." <a href="#1a">Return to article</a>

Journal Authors

Bernard D. Bollinger

William Jarblum

Journal Date

Friday, October 1, 1999 - 12:00