Delaware Law Mid-Century: Far From Perfect but Probably Not Leaving for Las Vegas

Stopping controlling shareholders from taking actions that benefit themselves at the expense of non-controlling (minority) shareholders is an incredibly valuable and worthwhile thing for courts to do. Delaware historically excelled at this. Incorporating in Delaware long was considered to be wise (and efficient) for companies for the very reason that Delaware was steadfast in protecting minority investors in its corporations.

Incorporating in a jurisdiction that protects minority investors is not an act of altruism for controllers. Protecting minority investors does not benefit only the minority. Controllers also benefit when minorities are protected because such protection enables the controllers to attract investment dollars from non-controlling minority investors on better terms than would have been possible if investors lacked judicially enforced legal rights and protection against controller opportunism. In economic terms, protecting minority shareholders is pareto efficient because such protections make both controllers and minority investors better off.

On the other hand, prohibiting controlling shareholders from taking actions that benefit themselves, but do not harm non-controlling (minority) shareholders in any way shape or form lacks social value and is wasteful and inefficient.  In a free market economy, controlling shareholders should be able to retain control rights after selling their shares to public shareholders if they compensate the minority shareholders sufficiently for allowing them to retain such rights. Recently, certain Delaware judges appear unduly suspicious about controlling shareholders and unwilling to accept even benign deals that both controllers and minorities strongly favor.

A couple of notorious Delaware cases, Tornetta v. Musk  and West Palm Beach Firefighters’ Pension Fund v. Moelis ignore the important distinction between controllers’ actions that harm minority shareholders and controllers’ actions that benefit minority shareholders. These decisions impose costs on controllers without providing any offsetting benefits to minority investors. The commitment to “protecting” minority shareholders from controllers goes too far in these cases because it protects minority investors who neither want or need the “protection” that is being foisted on them.

In West Palm Beach Firefighters’ Pension Fund v. Moelis & Company, decided in early 2024, the Delaware Court of Chancery invalidated a stockholder agreement between the investment bank Moelis & Company and Ken Moelis, its founding and controlling shareholder. The challenged agreement gave Mr. Moelis control over a wide range of corporate governance matters, allowing him to retain significant control and influence over the company. Even though Mr. Moelis was not alleged to have made a single decision or taken a single action that actually harmed his company’s minority investors, his contract with the company was invalidated on the grounds that allocating control rights to him illegally intruded on the governance authority of the company’s board of directors.

From an economic perspective, however, the central issue was whether the minority shareholders who allocated control rights to Ken Moelis were compensated for doing so. And clearly they were.  We know this because the controlling stockholder agreement that was invalidated in Moelis was put in place years before the litigation and before the company had sold a single share of stock to the public in its IPO. As Vice Chancellor Later acknowledged: “[i]n the prospectus for the IPO, the Company disclosed that Moelis and the Company would enter into the Stockholder Agreement.” And as Larry Hamermesh observed in a letter supporting proposed amendments to the Delaware General Corporation law overturning the Moelis decision, “the invalidated provisions were fully disclosed when the company went public ten years ago, and went unchallenged.” The fact that the provisions were fully disclosed is conclusive proof that non-controlling shareholders were not harmed because such disclosure enabled Mr. Moelis’ retention of control rights to be priced. Prospective non-controlling shareholder/ investors with concerns about being disadvantaged or harmed by the fact that Mr. Moelis was retaining control could decline to invest unless they received a purchase price low enough to compensate them for the risk.

The Chancery decision in Moelis also ignored the important, ongoing consideration Ken Moelis gave in exchange for his control rights.  Unlike many other controlling stockholder CEOs (e.g., Elon Musk, Larry Ellison, and Jack Dorsey), Ken Moelis was specifically required to devote himself to serving the company as CEO as long as he remained in office and was subject to the forfeiture of his voting and other rights if he pursued side ventures.   This alignment of interests protected Moelis’s minority stockholders by requiring Ken Moelis to focus his entrepreneurial talents on making the company as profitable as possible.

Thus, far from protecting minority shareholders, invalidating controller agreements like the one in Moelis actually makes minority shareholders worse off by forcing them to accept protections they do not want or need and preventing them from making investments in companies like Moelis at the lower stock prices that the controller would obtain for shares sold in the IPO.

The insult to minority shareholders was even more egregious in Tornetta v. Musk, and related cases challenging Elon Musk’s compensation from Tesla.  The Delaware Chancery Court repeatedly invalidated Musk’s compensation package even after minority shareholders overwhelmingly voted, on two separate occasions, to approve the pay package.

There is empirical support for the proposition developed here that Delaware’s harsh treatment of transactions involving controlling shareholders often harms the minority shareholders it ostensibly benefits.  Studies have found that Delaware firms with a controlling shareholder “are actually slightly less valuable than similar companies incorporated elsewhere” and the scholars doing this research have found that “Delaware provides little value for controlled firms.” These results that Delaware law has indeed gone too far, as reflected in the fall in Tesla’s share price immediately after the decision on a day when broader equity indexes rose appreciably.

One reasonably could take the position that the situation in Delaware is not nearly as bad as many are claiming. After all, no legal regime is perfect, and it probably is better to provide too much legal protection to minority shareholders than too little. On the other hand, the emerging judicial hostility toward the legitimacy of private ordering, which is reflected not only in the substance, but also in the hostile and condescending tone of these recent opinions, is a significant break from the traditional approach to corporate law on which Delaware’s well-deserved reputation for jurisprudential excellence is based.  But the controllers also have gone way too far in the tone and substance of their response. The judge who wrote the opinions invalidating Elon Musk’s compensation was unfairly and unjustly attacked as corrupt.  Attacking misguided decisions as corrupt does is not only wrong, it is inaccurate. It also is counterproductive because it diverts attention and energy away from what is important, which is moving Delaware corporate jurisprudence back to its roots in concepts of consent and contract, and restoring its respected place as the world’s most respected authority for principles of corporate law and corporate governance.

Delaware has gone off-track before. But it has always course corrected and righted the ship. I predict that it will do so again.