The Grass Isn’t Necessarily Greener: Carefully Considering the Risks of Corporate Redomiciling
7.15.2024
The State of Delaware is, and for many decades has been, the predominant jurisdiction of choice for those seeking to incorporate or form an alternative entity. Over two-thirds of the Fortune 500 are domiciled in Delaware, as are nearly 80% of companies filing for a U.S.-based initial public offering. One of the main factors contributing to Delaware’s leading position is its corporate law regime. Companies and stockholders alike place significant value on the predictability that Delaware law provides, both through its comprehensive body of established legal principles and its renowned specialized business court, the Court of Chancery.
That is not to say that Delaware’s dominance in the corporate law realm is unchallenged. Over the years a variety of factors, both internal and external to Delaware, have prompted debate about whether Delaware should remain the jurisdiction of choice for incorporation. A recent string of cases from Delaware courts that have been unfavorable to controlling stockholders has brought that debate to the forefront yet again. Indeed, these decisions have prompted more than one high-profile Delaware company to threaten to reincorporate in what they perceive to be a more “company-friendly” jurisdiction.
But reincorporation is not a simple or a cost-free endeavor. Entities contemplating redomiciling need to carefully study how their current and intended places of incorporation actually differ. And, based on a recent decision from the Court of Chancery, they also need to consider the now real legal risks that come with reincorporation.
The Recent Trend of Delaware Court Decisions Against Controlling Stockholders
Since January 2024, the Court of Chancery and Delaware Supreme Court have collectively issued several important decisions that have all gone against controlling stockholders to at least some degree. Because controlling stockholders play an outsized role in determining where their existing and future entities are formed, judicial decisions potentially increasing controller liability are likely to factor into a controller’s determination about where to establish their business.
In In re Sears Hometown & Outlet Stores, Inc. S’holder Litig.,[1] the Court of Chancery held for the first time that controlling stockholders have fiduciary duties, albeit limited ones, when they exercise their controlling voting power to alter the corporation’s “status quo.” Examples of altering the status quo include changing the entity’s governance or blocking the board’s chosen course of action.
Shortly thereafter, the Court of Chancery issued its highly anticipated decision in Tornetta v. Musk,[2] a stockholder challenge to Elon Musk’s $56 billion Tesla pay package. The court held that, because Musk controlled Tesla’s board when it came to his compensation package, the transaction needed to be reviewed under “entire fairness,” Delaware law’s most exacting standard of review.[3] The court found that Musk’s compensation package was neither the product of a fair process nor at a fair price to Telsa, and invalidated the package in its entirety.[4] For their efforts, the plaintiffs’ counsel has requested an unprecedented fee award, which would be paid by Tesla, of approximately $6 billion in Tesla stock.[5]
Less than a month later, in February 2024, the Court of Chancery invalidated a controller’s extensive veto and other rights set forth in a stockholders’ agreement with the corporation in West Palm Beach Firefighters’ Pension Fund v. Moelis & Co.[6] The court reasoned that, in combination, the controller’s rights in the stockholders’ agreement violated Delaware General Corporation Law’s Section 141, which mandates that the affairs of a corporation be managed and directed by its board of directors.
And in In re Match Grp., Inc. Derivative Litig.,[7] the Delaware Supreme Court held that entire fairness, which again is Delaware’s most stringent standard of review, applies whenever a controlling stockholder stands on both sides of a transaction, unless the controller utilizes both procedural protections contemplated by Kahn v. M&F Worldwide Corp.[8] In doing so, the Supreme Court rejected the controller’s argument that M&F Worldwide’s framework only applies in full when a controller engages in a “squeeze-out merger” that removes minority stockholders. The court further held that, for a transaction to be eligible for business judgment (rather than entire fairness) review under the framework, any special committee appointed must be entirely independent of the controller.[9]
At a minimum, these decisions collectively have made life more complicated for controlling stockholders of Delaware corporations who want to do what they wish with those entities. That, in turn, has prompted controllers like Elon Musk to consider whether there are alternatives to Delaware where they might be able to exercise their control with more freedom and less judicial oversight.[10]
Where, if Not Delaware, Is a Controller To Go?
Two states in particular, Nevada and Texas, have made a concerted effort to attract Delaware entities to redomicile. In some instances, the two states have tried to emulate what they perceive as desirable aspects of the Delaware corporate law regime. For example, both states have created their own version of “business courts” to try and emulate the Court of Chancery’s role in resolving corporate disputes efficiently.
In other instances, the two states have deliberately departed from Delaware law to be more “company-” or “management-friendly.” Both Nevada and Texas law allow directors to consider a broader range of interests and constituencies when making decisions compared to the more stockholder-oriented approach that Delaware takes. And stockholders of Nevada and Texas corporations have more limited rights to inspect corporate books and records relative to stockholders of Delaware corporations.[11]
Perhaps a starker example of differences between the jurisdictions is that, under Nevada law, officers and directors are subject to liability in more limited circumstances than they are under Delaware law. Relative to Delaware law, Nevada directors and officers will only be liable to the corporation or its stockholders or creditors in limited circumstances where (1) the presumption of the Nevada statutory business judgment rule has been rebutted and (2) such director or officer’s conduct constitutes a breach of such person’s fiduciary duties involving intentional misconduct, fraud or a knowing violation of law.[12]
The Decision To Redomicile Now Comes With Litigation Risk
But even if a corporation is interested in switching domiciles to take advantage of more “favorable” laws, can it do so? The Court of Chancery recently answered this question in Palkon v. Maffei,[13] at least preliminarily.
Palkon involved the proposed reincorporation of travel website Tripadvisor, Inc. and a corporation that controls it, Liberty Tripadvisor Holdings, Inc., from Delaware to Nevada. Both Tripadvisor and Liberty were themselves effectively controlled by Liberty’s CEO. The Tripadvisor and Liberty boards approved the reincorporation. The reincorporation also received majority stockholder approval, but only because Liberty’s CEO, a controlling stockholder, voted in favor of the transaction.
Tripadvisor and Liberty stockholders sued, alleging that Liberty’s CEO and Tripadvisor’s and Liberty’s other directors breached their fiduciary duties in approving the reincorporation. The basis of the stockholders’ claims was that Nevada law affords fewer litigation rights to stockholders and greater litigation protections to fiduciaries such as Liberty’s CEO and the other directors. The stockholders sought injunctive relief to prevent the reincorporation from occurring and the defendants moved to dismiss the complaint in its entirety.
The Court of Chancery declined to dismiss the stockholders’ fiduciary duty claims. The court held that because the reincorporation transaction would provide the defendants with a non-ratable benefit (i.e., they would enjoy the benefit of lower litigation risk, a benefit the stockholders would not share in), the proposed transaction was subject to entire fairness.[14] And the court held that the stockholders had adequately alleged a lack of fairness given the absence of any procedural protections for the stockholders in the process and the allegedly meaningful difference in their litigation rights pre- and post-reincorporation.
Although the court did not dismiss the stockholders’ substantive claims, it did dismiss their request for an injunction enjoining the reincorporation and allowed it to proceed. The court stated that while an injunction prohibiting reincorporation might be warranted in “extreme scenarios,”[15] the case before it did not meet that criterion. Instead, the court held that stockholders could be adequately compensated with money damages, including, potentially, damages based on changes to the companies’ stock prices before and after the reincorporation.[16]
Notably, the Court of Chancery’s decision in Palkon will not be the only, or final, word on how Delaware courts will review challenges to reincorporation transactions. Despite the Court of Chancery denying the defendants’ request to certify the decision for interlocutory review, the Delaware Supreme Court nevertheless recently took the unusual step of granting the defendants such an appeal. A decision from the Delaware Supreme Court is likely before the end of the year.
Key Takeaways
With the lessons learned from the developments discussed above, in-house counsel should pay attention to two key takeaways when contemplating redomiciling.
- Don’t forget to account for the costs of reincorporation. The Palkon decision highlights two potentially significant costs of reincorporation: litigation and diminished investor confidence. Where an entity’s reincorporation decision is driven or meaningfully motivated by a desire to diminish stockholder litigation rights, Palkon suggests the entity’s stockholders will, absent use of an appropriate “cleansing mechanism,”[17] have a claim that is at least capable of surviving a motion to dismiss. And regardless of the outcome of any litigation, entities that reincorporate to jurisdictions they perceive as friendlier to officers and directors may find it difficult to maintain their stockholder base or attract new high-quality investors. The consequences could be quite significant, including a lower stock price or a higher cost of capital.
- Understand where you’re going before you get there. On the surface, competing jurisdictions may appear to have important similarities (or differences), when in fact those similarities are actually differences (and vice versa). For example, while Delaware, Nevada and Texas are “similar” in that they each have specialized business courts, there are important differences in how those courts operate. Judges on Nevada’s business court are elected, but judges on Delaware’s and Texas’s business courts are appointed by those states’ governors and confirmed by those states’ senates. In addition, while there are no juries in Delaware’s business court, jury trials are possible in both the Nevada and Texas business courts. And neither Nevada nor Texas has as extensive a body of corporate case law as Delaware or a legislature that is as responsive to changes in the law as Delaware.[18] These (and other) differences might not ultimately yield the “company/management friendly” results one hopes to achieve through reincorporation.
Josh Bloom is counsel at MoloLamken. This article appears in a forthcoming issue of Inside, the newsletter of NYSBA’s Corporate Counsel Section. For more information, please visit NYSBA.ORG/CORPORATE.
[1] 309 A.3d 474 (Del. Ch. 2024).
[2] 310 A.3d 430 (Del. Ch. 2024).
[3] Tornetta, 310 A.3d at 502-05.
[4] Id. at 546-48.
[5] Eric Mulvaney and Rebecca Elliott, Lawyers Who Got Musk Pay Struck Down Seek $5.6 Billion in Tesla Trade, Wall St. J., Mar. 2, 2024, https://www.wsj.com/finance/lawyers-who-got-musk-pay-struck-down-seek-5-6-billion-in-tesla-stock-12e85b1b.
[6] 311 A.3d 809 (Del. Ch. 2024).
[7] 2024 WL 1449815 (Del. Apr. 4, 2024).
[8] Kahn v. M&F Worldwide Corp. (Del. 2014) (MFW); In re Match Grp., 2024 WL 1449815, at *10–11.
[9] Id. at *19–20.
[10] Tesla, Inc., Preliminary Proxy Statement for 2024 Annual Meeting of Stockholders (Schedule 14A), Apr. 17, 2024, https://www.sec.gov/ix?doc=/Archives/edgar/data/0001318605/000110465924048040/tm2326076d13_pre14a.htm.
[11] Compare 8 Del. C. § 220 with Nev. Rev. Stat. § 78.257 and Tex. Bus. Orgs. Code Ann. § 21.218.
[12] Nev. Rev. Stat. § 78.138(7).
[13] 311 A.3d 255 (Del. Ch. 2024)
[14] Palkon, 311 A.3d at 261-62.
[15] Id. at 284.
[16] Id. at 286-87.
[17] “Cleansing mechanisms” under Delaware law are procedures that, when utilized, will invoke the highly deferential business judgment rule standard of review. Examples of cleansing mechanisms are when a transaction is conditioned on approval by a majority of independent directors, by a special committee of independent directors or a majority of disinterested stockholders.
[18] For example, the Delaware General Corporation Law is reviewed annually, and the Delaware State Bar Association’s Council of the Corporate Law Section has already proposed an amendment to the Delaware General Corporation Law to address the Moelis decision discussed above. In contrast, legislative sessions in Texas and Nevada are only held every other year.
