Will Delaware Stay Supreme?

Elon Musk revived a century-old debate when he vowed to move Tesla out of Delaware after a state Chancery Court judge’s ruling invalidated his $56 billion compensation package. Musk was effectively asking: Who needs Delaware?

The answer is surprisingly complex, and one legal scholars have been arguing over since the tiny state started becoming America’s corporate capital. More than half of all Fortune 500 corporations are incorporated in Delaware, which derives 30 percent of its $5 billion budget from corporate fees and taxes. California, with the world’s fifth-largest economy, has a tiny share in comparison.

A Mighty Mix

The conventional explanation is that Delaware bought its way into dominance. In a race to the bottom for corporate charters, the theory goes, Delaware won by offering lower taxes and management-friendly laws.

That theory doesn’t hold up, however. If Delaware is so management-friendly, how did Musk get tagged with a pay package-erasing verdict? And don’t talk to Ronald Perelman about Delaware’s deference to corporate executives: Several key Delaware Chancery Court rulings came as rebukes to Perelman’s attempts to enrich himself at the expense of minority shareholders. Many states have tougher anti-takeover laws, which generally benefit entrenched managers over investors.

One frequently cited paper by Yale Law School Professor Roberta Romano found companies were more valuable after reincorporating in Delaware. That may be because tiny Delaware pays close attention to its court system, supplying companies and investors with relatively quick and predictable resolutions to their disputes. To paraphrase Bob Dylan, Delaware knows what corporations need, as opposed to what their managers want.

The inevitable next question is, if it’s so easy to supply what corporations need, why doesn’t every state do it? The answer involves a mix of politics, deliberate calculation and historical accident.

For most of their history under U.S. and British law, corporations were one-off creations dispensed by the king or state governments to carry out specific tasks like banking or building canals. Many had close ties to the officials who authorized them. In 1816, Pennsylvania got 40 percent of its revenue from dividends on stock it owned in state-chartered banks.

That changed with the rise of interstate commerce. In 1845, a pamphlet described Philadelphia businessmen establishing manufacturing operations in New Jersey because “a more liberal charter could be obtained from that State.” To encourage such activity, states abandoned special charters requiring individual legislation and offered general incorporation with few strings attached.

Breaching Borders

In 1888, New Jersey legislators got the idea of selling corporate charters to raise money, drawing businesses from New York with a combination of low taxes and simplified paperwork. It was no surprise when John D. Rockefeller folded his sprawling Standard Oil trust into a single New Jersey corporation in 1899.

Angry legislators elsewhere dubbed New Jersey the “Traitor State.” So it might have remained, but for the political ambitions of then-Gov. Woodrow Wilson, who pushed through state-law reforms that alienated corporate leaders after being elected president in 1913.

Delaware was waiting. Legislators there had already mimicked most of New Jersey’s corporate code, so when New Jersey tightened things up, Delaware welcomed its corporate refugees with open arms.

Will Musk trigger a similar exodus? Most legal scholars think not. Delaware has mastered balancing the needs of management and shareholders, as well as investing in a court system skilled at ironing out corporate disputes. For most companies, the second-smallest state will probably remain home sweet home.

Daniel Fisher

Daniel Fisher is a writer, financial analyst and former senior editor with Forbes magazine. He previously worked for Bloomberg Business News and newspapers in Texas and Wisconsin.

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Daniel Fisher

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