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Delaware: The Black Hole of Corporate Reform


By C. Peter R. Gossels


Corporate reform is the mantra of policymakers in the wake of the massive corporate scandals of the past couple of years. Numerous proposals have been discussed in Congress and the media to address the widespread corruption perpetrated by corporate managers to enrich themselves at the expense of their company, its shareholder s, retirees and employees. (See "Will Reforms With Few Teeth Be Able To Bite?" in the Business Section of the Sept. 22, 2002 issue of the New York Times)

That's all well and good, but no one seems to have noticed the fundamental anomaly in our federal system , which allows the government and judges of Delaware to undermine all attempts to reform corporate governance in the United States.

As counsel for shareholders of Polaroid in its Chapter 11 bankruptcy case in Delaware, I have seen firsthand how Delaware protects corrupt corporate officers and directors from their shareholders and federal regulators in two ways: By enforcing its "business judgment presumption" and by the way its judges conduct proceedings in the U.S. Bankruptcy Court.

The Business Judgment Presumption

To encourage corporations to organize and continue to do business in Delaware, the legislature and judges of that state have diluted the fiduciary duties that corporate officers and directors in most other states owe to their corporation, its shareholders, employees and retirees.

By adopting the "business judgment rule" Delaware created the presumption that officers and directors of Delaware corporations (unlike the officers and directors of corporations organized in most other states) have made all their business decisions "on an informed basis (i.e., with due care), in good faith and in the honest belief that the action taken was in the best interests of the(ir) corporation". Citron v. Fairchild Camera & Instrument, Del. Supr.569 A.2d 53, 64 (1989)

In order to overcome that presumption, a plaintiff must prove that the officer or director has engaged in fraud, acted in bad faith or made the business decision for his or her profit or betterment. This is very hard for plaintiffs to do, because the courts will usually allow motions for summary judgment in favor of corporate defendants before plaintiffs can obtain needed corporate documents through discovery to prove their cases.

 

The business judgment presumption has spread across the country, because state and federal courts generally apply the law of the state of incorporation in matters relating to the internal affairs of a corporation, including the fiduciary duty that officers and directors owe to shareholders, even when the laws governing their domestic corporations contain no such presumption. Harrison v. NetCentric Corp., 433 Mass.465 (2001). As a result, it is almost impossible for shareholders to prove wrongdoing by officers and directors of Delaware corporations.

No Wonder so many corporate officers elect to organize their corporations in Delaware, even though they do little or none of their business there.

The Bankruptcy Code And Its Interpreters

The second major flaw in our system is the U.S. Bankruptcy Code, which was designed to protect debtors from their creditors while giving creditors every opportunity to participate in the bankruptcy proceedings and to uncover the financial affairs of the debtor at company expense.

Although the Code also grants legal standing to the employees, retirees and shareholders of a bankrupt corporation to participate in the bankruptcy proceeding, they must do so at their own expense, unless the bankruptcy judge authorizes the appointment of an official committee to represent them.

Bankruptcy judges in Delaware rarely appoint such official committees, however. As a result, numerous prepackaged restructuring agreements between bankrupt corporations and their creditors have recently been created.

These agreements allow the creditors to be paid and the management that ran the debtor in to bankruptcy to survive handsomely enriched at the head of the reorganized company, all at the expense of their former employees, retirees and stockholders.

As counsel to the shareholders of Polaroid, I have learned some additional lessons about the way that judges sitting in the U.S. Bankruptcy Court in Delaware strip corporate shareholders, retirees and employees of their savings, pensions and jobs at the request of management.

  • Delaware judges routinely authorize the managers, who have driven their company into bankruptcy, to pay themselves handsome "retention bonuses" in addition to their inflated salaries and other benefits. They also allow these managers to protect themselves from liability by drawing millions of dollars from the bankrupt company's limited resources to hire lawyers, accountants and consultants of all kinds at rates as high as $675 per hour for lawyers and $150 per hour for their secretaries.
  • Delaware judges rarely appoint official committees to represent the shareholders of bankrupt corporations at company expense, saying that they are adequately represented by the official creditors' committees, despite the fact there is a fundamental conflict between interests of a corporation's creditors and the interests of its employees, retirees and shareholders, who can not recover until the creditors have been satisfied. As a result, it is prohibitively expensive for these victims of corporate corruption to challenge such wrongdoing in Delaware.
  • Delaware judges routinely ignore the interests of shareholders, retirees and employees of the bankrupt companies in favor of the interests of the companies' managers and creditors, who are often represented in court by a squadron of attorneys, all handsomely paid by the company to protect its managers.
  • The judgment of Delaware courts can be used by corrupt managers to defend themselves in the civil courts throughout the United States under the full faith and credit clause of the Constitution as well as the doctrine res judicata.
  • Federal agencies, such as the United States Attorneys and the Securities and Exchange Commission, are often discouraged from pursuing allegations of wrongdoing by corporate managers, when they note that the Bankruptcy Court has approved debtor proposals for reorganizing the company they had raped.
  • In order to challenge the orders of Bankruptcy Court judge in Delaware, one must prove that the judge abused his or her discretion in entering n order or judgment. That is extraordinarily difficult standard for an individual to meet, especially if one must rely on one's own funds to finance such an appeal

A Proposal

So, while Congress has enacted legislation designed to protect employees, retirees and shareholders of publicly traded corporations from corruption in the board room, the state of Delaware and its judges continue to pander to the managers of corporate America by protecting them from liability and allowing them to enrich themselves wrongfully in more ways than we can imagine.

To address these fundamental problems, I recommend that Congress:

  1. Enact a national corporation statute that would govern all corporations that engage in interstate commerce and would abolish Delaware's business judgment presumption; and
  2. Amend the Bankruptcy Code to:
    1. Give retirees and shareholders of publicly traded corporations with assets in excess of $2 million the right to be represented before the Bankruptcy Court by an official committee financed by the debtor so that they will have the resources to participate fully in the bankruptcy process; and
    2. Compel the management of all companies with assets in excess of $2 million, who have sought the protection of the Bankruptcy Code, to make full and continuing disclosure of their financial condition to its retirees and shareholders without further order of the court.

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