Incorporation in Delaware

This chapter will examine why many companies choose Delaware as their state of incorporation and review central issues of the Delaware Corporation Law.

Background

The state of Delaware is known in the United States as one of the most attractive states for the purpose of incorporation. Since the Delaware General Corporation Law (DGCL) was enacted in 1899, the State of Delaware has offered a stable legislative framework that, on the one hand, allows broad flexibility and managerial discretion and, on the other hand, balances the interests of the various organs within the corporate world. The registration of corporations is performed by the Delaware Secretary of State automatically and quickly, with no bureaucratic delays. Business disputes are heard in Delaware in a special professional court (the Delaware Court of Chancery) that specializes in resolving complex business disputes without a jury. These principal considerations, in addition to further factors described below, are the reason that despite its small geographic size, Delaware has become the state in which most Fortune 500 corporations are incorporated, along with more than 50% of the companies listed for trade on the New York Stock Exchange (NYSE).

Organizing and Managing a Delaware Corporation

A Delaware corporation is organized by filing a Certificate of Incorporation with the Secretary of State. The organization of the corporation is performed by filing the certificate by fax or online, and in both cases the process is completed within minutes from the incorporator's filing of the signed Certificate of Incorporation. The registration of the corporation that is conducted by the Secretary of State, as aforesaid, includes only the name of the person or entity organizing the new corporation, and the corporation's registered agent in Delaware. According to Delaware law, the public information on the corporation need not include the names of the shareholders, the directors, or the officers.

The details that must be included in the Certificate of Incorporation are:

• The name of the corporation

• The name and address of the corporation's registered agent in Delaware

• The name and address of the incorporator

• The purpose of incorporation (it is sufficient to state that the corporation intends to engage in lawful activities undertaken by corporations)

• The registered share capital and the par value per share

Although Delaware law does not require any minimum number of shares, the consideration for the shares has to be at least their par value. It is therefore recommended to fix the par value of the shares in the Certificate of Incorporation at no more than $0.01, in order to give the Board of Directors the most flexibility in determining the consideration for the shares.

Delaware law provides considerable flexibility in determining the balance of power and the priorities among shareholders, in order to enable the broad variety of business and financial activities required during the course of the corporation's lifetime. The Certificate of Incorporation may also authorize the allotment of preferred shares, whose qualities may be determined by the Board of Directors from time to time.

Since the DGCL regards the Certificate of Incorporation as an agreement between the corporation and its shareholders, it may contain managerial provisions and directives, such as the limitation of the directors' liability and the granting of a preemptive right. The Certificate of Incorporation may be modified only by a resolution of the Board of Directors and a majority vote of the shareholders.

After the corporation is organized, the incorporator has to adopt bylaws that set out rules for the corporation's management and to appoint the first members of the Board of Directors. The first directors may also be named in the Certificate of Incorporation. Once the first Board of Directors is appointed, the incorporator's function is concluded, and its authorities over the corporation expire. The bylaws are not filed with any public authority and are consequently not a publicly available document. In order to complete the process of organization (or establishment) of the corporation, the elected Board of Directors has to appoint officers. Although the law does not set out pre-defined offices that need to be filled, the corporation has to appoint according to common practice and an interpretation of the DGCL at least a President and a Secretary, both of which may be occupied by one person.

Share Capital and the Shareholders

After its appointment, the Board of Directors has to allot the preliminary share capital. Subject to several exceptions, Delaware law prohibits shareholders from participating in the management of the corporation's business (which function is entrusted to the Board of Directors), and removes from them any personal liability for its debts. "Piercing the corporate veil" (i.e., attributing the company's debts to its shareholders personally) is a rare act in Delaware that requires an allegation of fraud or deceit.

The shareholders can function in annual and special meetings or through written resolutions. Written resolutions require the same majority required for the adoption of resolutions at a General Meeting, and become effective immediately upon the adoption of the written resolution by the required majority. According to an amendment made to the DGCL in 2000, the Board of Directors may approve the convening of General Meetings on the Internet.

The Board of Directors

A corporation's Board of Directors may comprise one member or more, as provided in the corporation's bylaws or Certificate of Incorporation. The Board of Directors may be classified into different groups of directors with different voting powers and terms of office (Classified Board). It is also possible to determine that one-third of the members of the Board stand for election every year, so that every member is elected for three years (Staggered Board). A simple majority of the directors constitutes the legal quorum, unless a different quorum is fixed in the corporation's Certificate of Incorporation or bylaws. In any case, the minimum majority for the Board of Directors' resolutions cannot be smaller than one-third of the Board. The Board of Directors' resolutions may be adopted at board meetings or by written unanimous resolutions.

The Board of Directors is authorized to establish committees for various matters, and certain committees are authorized to perform any act which the Board of Directors is authorized to perform, unless the Board of Directors or the corporation's bylaws provide otherwise. In any case, the committees are not authorized to perform acts that are expressly required by law to be approved by the shareholders in addition to the Board of Directors (mergers, sale of assets, and liquidation of the corporation). Nor are they authorized to change the corporation's bylaws.

Directors in a corporation owe special fiduciary duties to the corporation and to its shareholders, but not to creditors or third parties (except for cases in which the corporation is in the process of dissolution or is insolvent). These special duties include the duty of care, the duty of loyalty, and the duty of acting in good faith. The directors enjoy the presumption that they had acted properly and fulfilled their duties while managing the corporation's affairs, and the courts will not intervene in their actions, unless it is proven otherwise (the business judgment rule). In addition, Delaware law makes it possible to determine in the Certificate of Incorporation that the directors be exempt from the payment of damages for breaching their duty of care, unless they acted wrongfully or with bad intent. The law does not, however, allow directors to be exempted from the payment of damages for actions in which they had a personal interest that compromised their duty of loyalty. The law also awards corporations wide discretion with respect to retroactive indemnification for acts performed by the directors.

Mergers and Consolidations

Delaware corporations may merge with (or into) any company, whether registered in the United States or elsewhere. Usually, a merger of a Delaware corporation requires the approval of the Board of Directors and the affirmative vote of a majority of the outstanding shares. In triangular mergers, a vote by the acquiring company's shareholders is not required, since the acquiring company is not directly involved in the merger (see Chapter 17 for a discussion on triangular mergers). In addition, Delaware law provides a simple mechanism for mergers between affiliated companies (parent companies and subsidiaries). The fact that the merger of companies requires no regulatory approval or judicial intervention under the DGCL confers a significant advantage on the many companies that choose to incorporate in Delaware.

In order to avoid ordinary merger proceedings, Delaware corporations may change the legal entity they had decided to organize into a converted legal entity. The advantage of conversions over ordinary mergers is that in contrast with ordinary mergers, in which the target ceases to exist and is consumed by the acquirer, in conversions the target retains its legal entity, while modifying the legal form of its incorporation. This process is useful, and at times even necessary, when a company wants to merge but is bound by contracts or other undertakings prohibiting the assignment of rights or obligations.

Taxation of Partnerships, S Corporations, and Limited Liability Companies (LLCs)

Partnerships, S Corporations, and Limited Liability Companies (LLCs) are pass-through entities for tax purposes in the United States. In other words, these entities are not taxed at their own level, and their income and losses are attributed to the partners in the partnership or to the shareholders of the S Corporation or the LLC, according to their respective shares in the corporation.

S Corporations and LLCs are companies for all intents and purposes, and their shareholders can enjoy limited liability like any limited liability company. The tax treatment of S Corporations and LLCs is essentially similar, but S Corporations are subject to certain restrictions, such as a maximum of 75 shareholders, all of whom need to be local and non-incorporated residents. A similar consequence having the income and losses attributed to the shareholders and the company regarded as a pass-through entity for tax purposes (including a company not organized in the United States) may be achieved through the "Check the Box" rules in the Federal Internal Revenue Code.

From January 1997, the United States has allowed certain corporations to choose whether to be taxed as a company or as a partnership (each corporation marks its choice by checking the appropriate box on its annual income tax return). In other words, a company may choose whether to be a pass-through entity for tax purposes, so that its income and expenses will be attributed to its shareholders like a partnership, or to have its income taxed at the company level.