Delaware’s Fall: The Arbitration Bylaws Scenario

Lynn M. LoPucki is Security Pacific Bank Distinguished Professor of Law at the UCLA Law School. This post is based on a recent article by Professor LoPucki, forthcoming in Delaware’s Dominance in Corporate Law (Stephen Bainbridge, ed., Cambridge University Press 2018). This post is part of the Delaware law series; links to other posts in the series are available here.

Until recently, Delaware’s dominance in the competition to sell corporation charters was considered so great as to be irreversible. Scholars assumed that if another state were to discover a method to compete effectively, Delaware could simply copy it. But the current threat to Delaware’s dominance comes not from another state, but from arbitration bylaws. Delaware cannot solve the problem by copying because the U.S. Constitution prohibits states from offering secret arbitration.

For Delaware, loss of its cases to arbitration would a crippling blow. Delaware dominates the charter competition by leveraging its unique Chancery Court. Unlike the courts of other states, the Chancery Court is significantly specialized in corporate law, publishes its opinions, has a large body of precedent, tries cases without juries, and has the resources and motivation to provide quick hearings. Other states cannot copy Delaware because they do not incorporate sufficient numbers of companies to generate sufficient litigation to support a court specialized in corporate law, because their governments are not dependent upon, and so not fully supportive of, their efforts to compete for charter sales, and because their constitutions guarantee the right to trial by jury.

Delaware has leveraged its unique judicial advantage by encouraging its judiciary to make corporate law on a case by case basis. To provide that encouragement, Delaware has made its corporation law vague, complex, and indeterminate. The advantage to Delaware was that it became possible for Delaware judges to resolve cases based largely on the interests of managers and Delaware. The litigation provided work for Delaware lawyers and enabled them to develop corporate expertise. Because they had that expertise, Delaware gave its lawyers control over the legislative process with respect to corporate law.

Delaware’s highly successful judicial strategy now appears to be unraveling. Beginning in 2001, Delaware Chancery Court cuts to the fees of plaintiffs’ attorneys began making it difficult for that Court to attract cases. In 2010, the Court changed strategies by encouraging corporations to adopt “forum selection” bylaws. Delaware corporations adopted them, but have treated the bylaws as merely options to take cases to Delaware when the Delaware courts offered strategic advantage. The effect is to pressure the Delaware courts to favor managers even more flagrantly in litigation. If the Delaware courts give in, Delaware’s and the charter competition’s legitimacy may be impaired. If they don’t, Delaware will continue to lose its cases. Either way, Delaware is at risk.

Arbitration bylaws may be Delaware’s coup de grace. Corporations have already begun adopting them, and they have been upheld in a few cases decided under Maryland law. The U.S. Supreme Court has held that the states cannot refuse to enforce contracts that provide for arbitration. The Delaware courts have held that certificates of incorporation and bylaws are contracts. It would seem to follow that Delaware cannot refuse to enforce bylaws that provide for the arbitration of shareholder litigation.

Delaware’s corporations are likely to prefer arbitration for five reasons. First, arbitrations could be secret, thus sparing the companies and their managers the embarrassment of litigating in public. Second, arbitration bylaws need not provide for class representation or fee awards to plaintiffs’ attorneys. The effect would be to prevent many, if not most, claims from being brought at all. Third, arbitrations could occur in locations convenient to the parties and their attorneys—including cyberspace. Because the arbitrations would not be in the Delaware courts, the parties could employ the counsel of their choice; they would not need to be represented by members of the Delaware bar. Fourth, the companies and their managers could write their own procedures and tailor them to different kinds of cases. Small cases could be heard by a single arbitrator without the possibility of appeal, while bet-the-company cases were heard by three arbitrators with the possibility of appeal. If shareholders objected to the procedures, the companies and their managers could negotiate the objections. Lastly, cases filed anywhere other than in the designated arbitration tribunal could be immediately dismissed, eliminating the problem of multi-district litigation.

From 2009 to 2013, Delaware attempted to provide secret arbitration through its Chancery court. The attempt was rebuffed in a 2-1 decision of the Third Circuit in 2013. After the Supreme Court denied certiorari, Delaware abandoned the strategy and prohibited arbitration bylaws.

Arbitration bylaws would not merely move the same cases to different forums. Arbitration bylaws would bar plaintiffs from proceeding in representative capacities and bar arbitrators from providing fee awards to successful plaintiffs. Because most plaintiffs who bring shareholder litigation do not individually have enough money at stake to warrant even the cost of arbitration, a shift to arbitration would sharply reduce the numbers of cases brought.

Without enough cases, Delaware’s judicial strategy would fail, leaving that state with little advantage over competing states. Competing states may seize the opportunity by adopting statutes that allow certificate of incorporation and bylaw provisions to displace all provisions of their corporation laws—to the full extent of the internal affairs doctrine. Because states need no corporate law expertise to enact such a statute and their courts need no corporate law expertise to enforce arbitration awards, Delaware’s history, familiarity, networks, and precedent would count for little. Corporate charter competition might turn solely on price and the quality of the states’ websites. No state could gain significant revenues in so competitive an environment. Delaware would be out of business, but charter competition could continue to provide a forum in which the states could demonstrate their business-friendliness, and by doing so attract economically significant business activity.

The complete article is available for download here.

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