Less Laissez-Faire In Delaware?

The court for most U.S. companies has been toughened up by waves of crime and reform

When shareholders sued four Oracle Corp. (ORCL ) directors in 2001 alleging insider trading, the company's board promptly appointed two outside directors to investigate. The duo cleared the directors, including Chairman and CEO Lawrence J. Ellison, and asked Delaware's Chancery Court to toss out the lawsuit.

That normally would have ended the matter in Corporate America's home court, where judges have traditionally deferred to the wisdom of board members and independent directors. But Judge Leo E. Strine Jr. was disturbed by the web of social and philanthropic ties between the investigators and the directors they were probing.

The two specially appointed outsiders were professors at Stanford University -- employer of one of the defendant directors, alma mater of another, and recipient of $300,000 in Oracle donations and a $10 million gift from Ellison's own foundation. "This was a social atmosphere painted in too much vivid Stanford Cardinal red for the [committee] members to have reasonably ignored it," Strine wrote in his June, 2003, opinion. Ruling that the outside directors weren't independent, he allowed shareholders to pursue their suit.

Clearly, aftershocks of the recent wave of corporate scandals are finally hitting Wilmington. In the wake of reforms by Congress, the Securities & Exchange Commission, and the major stock exchanges, Delaware's Chancery Court, too, is tightening the screws on Corporate America. The five-judge court, long pilloried as pro-management, is allowing shareholder suits it would have tossed out in years past. In a handful of high-profile cases over the past 18 months, Delaware judges have sided with shareholders on issues from exorbitant CEO pay to director independence. "This signals a new ball game on Delaware's part," says Charles M. Elson, a University of Delaware governance expert. "The old regime of 'management can do what it wants' is over."

A TINY STATE'S BIG CLOUT. The consequences could be profound. Internal business dealings are largely governed by state law, and tiny Delaware dominates the field. More than half of all publicly traded companies are incorporated in the state, making Delaware jurisprudence virtually the national corporate law. Rulings there demanding greater corporate accountability ultimately could do more to improve boardroom behavior than the Sarbanes-Oxley Act or many of the reforms approved by the SEC.

Traditionally, Delaware has given companies a wide berth under the so-called business judgment rule, which holds that courts won't second-guess boards as long as directors act reasonably and in good faith. That has made it hard for governance critics to successfully challenge board decisions. Now, the scope of the rule is being narrowed.

Consider the issue of CEO pay. Judge William B. Chandler III last May refused to dismiss a shareholder lawsuit that challenged Walt Disney Co.'s (DIS ) $140 million severance payment to former President Michael Ovitz. "The facts belie any assertion that [Disney directors] exercised any business judgment or made any good faith attempt to fulfill the fiduciary duties they owed to Disney and its shareholders," Chandler wrote.

In another decision in January that put independence under a microscope, Chandler ruled that certain eBay Inc. (EBAY ) outside directors weren't disinterested, because they held huge option grants that would not vest unless they were reelected. That effectively undermined their ability to decide whether to pursue shareholder claims that eBay's investment bank, Goldman Sachs & Co. (GS ), bribed company insiders with hot stock offerings. Chandler also castigated eBay officials for pocketing the initial public offerings, which could be considered a gratuity that belonged to the company.

"GIMLET-EYED SKEPTICISM". Why are Delaware judges putting boards in the hot seat? In part, they're simply reacting to the corporate crime wave. Judges insist they're not reinterpreting the law but reacting to new trends, such as the astronomical sums now lavished on CEOs. "There will continue to be gimlet-eyed skepticism by stockholders of compensation unless boards demonstrate that they're taking a businesslike approach," says Strine in an interview with BusinessWeek. "And if [stockholders] can show that there is no rational business reason for the level of pay, under traditional standards they have a claim."

So far, the shift in rulings from the bench hasn't deterred companies from flocking to Delaware. While other states have attempted to lure corporations with special business courts, they still lack the vast body of legal precedent that exists in Delaware. In 2003, 68% of the 73 companies that went public incorporated there, say state officials.

And surely, clubby Delaware -- where lawyers and judges regularly cross paths lunching at Libby's, a Wilmington greasy spoon -- is no hotbed of reform. The state's dependence on the corporate law industry is likely to deter radical moves. Franchise taxes and fees generate about a third of state revenues. But there's no mistaking the signals. "The court is sending a message that it wants boards to be more engaged," says former judge William T. Allen, director of New York University's Center for Law & Business. That's good news for shareholders in all 50 states.

By Amy Borrus in Wilmington, Del.

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