Businesses from all types of industries have long looked to Delaware as the jurisdiction in which to form their business entities. According to the Delaware Division of Corporations 2019 Annual Report, there are nearly 1.5 million active Delaware business entities.
Why do companies incorporate in Delaware or form LLCs in the state? Lawyers and business people – both nationally and internationally – assume that Delaware is one of the preferred jurisdictions for forming new business entities, corporate or otherwise. “It’s just done that way” is a common refrain.
The real answer, in short, is that the Delaware judiciary, lawyers, and state legislature work closely together to keep Delaware at the forefront of business.
Evolution of Business Entities in Delaware
Historically, the Delaware corporation was the business entity of choice for most business transactions. The case law precedents for Delaware corporations regarding director duties, shareholder rights, and creditors’ rights create certainty for the various constituents of the corporation. This is a primary driver for why so many companies are incorporated in Delaware.
The rise of the alternative business entity began in the 1980s with the use of the limited partnership (LP) in the oil and gas markets. Generally, the limited partnership vests management in a general partner and grants limited rights to investors through a limited partnership interest. For the limited partners, there is potential for an upside on investment return with perhaps little-to-no management or investment authority. Either love your general partner or gather enough votes under the limited partnership agreement to vote it out, if removal is not restricted under the terms of the partnership agreement. There is Delaware case law discussing this business entity and many important cases on the law governing the fiduciary duties owed by a general partner to its limited partners.
Created in 1988, the Delaware Business Trust legislation, now known as the Delaware Statutory Trust Act (DST), was an effort to compete with other states’ common law trusts. The act would quickly become the darling of the mutual fund industry. Delaware saw an opportunity to codify the common law trust into another alternative business entity, the business trust. The act offered the mutual fund industry some certainty based on very flexible legislation, access to the Delaware Court of Chancery for disputes (a litigation venue that other states could not match in terms of speed, sophistication and expertise), and something called a ‘series’.
The series was a unique characteristic that could allow the mutual fund industry to create fund families that were all segregated in terms of liability and assets, yet could be managed under one trust agreement. As a result, a large majority of the major mutual fund families came to Delaware, including Vanguard and Franklin Templeton.
Finally, in 1992, the limited liability company (LLC) came to Delaware with the enactment of the Limited Liability Company Act (LLC Act). Now the most popular of all the alternative business entities, LLC formations have dramatically outpaced corporate formations for the past three years. In 2019 alone, 165,910 LLCs were formed as compared to 45,405 corporations.
Advantages of Forming an LLC in Delaware
The LLC is commonly referred to as a “creature of contract” – and the operating agreement is the contract. (This offers some advantages over the LLC’s corporate cousin.) So what are Delaware LLC benefits? The LLC provides the flexibility to draft an operating agreement that sets forth the unique terms of each business deal. All types of management and membership structures can be created, including a series. There is no general liability imposed on an LLC’s member or manager, as compared with the limited partnership where the GP does have general liability on behalf of the entity. This form of entity became the preferred vehicle in the structured finance industry and for bankruptcy remote entities (BREs).
For many corporate practitioners, this is very different from the corporation entity born out of the enabling Delaware General Corporation Law (DGCL). The DGCL sets forth the law of how a corporation will operate. The case law interprets the DGCL and business takes comfort in the caliber and quality of the Delaware jurists writing these opinions.
In contrast, the LLC Act is a ‘default’ statute. If the operating agreement doesn’t expressly state the terms with respect to a particular part of the LLC’s operations, the act will provide the default language. Parties can, and often do, create business relationships that are unique to the terms of their deals. The LLC entity structure allows for these unique deals and provides a contractual entity by which to do business. One must look to the operating agreement to determine the parties’ intentions and if silent, ‘default’ to the LLC Act. (That said, there are limited sections of the act that will apply regardless of what an operating agreement states, examples include dissolution and distributions.)
Generally, the Delaware courts make a distinction between the corporate case law and the case law governing the LLC. The courts have noted that the law governing the corporation and its constituents may or may not apply to this contractual alternative business entity depending on the content of the operative agreement.
Delaware Continues to Lead
Incorporating in Delaware has definite advantages for businesses. The Delaware legislature, with the advice and comment of the Delaware Bar, continues to update the DGCL, LLC Act, the DST Act, and all the other alternative business entity laws to keep Delaware’s legislation current and responsive to the market. Many states look to Delaware not only to keep their own state’s business legislation competitive but to use Delaware’s vast body of case law to guide court decisions.
With this ongoing commitment to providing a business-forward environment, the question of “Why Delaware?” is almost an afterthought nowadays.
This content is provided for informational purposes only and should not be considered, or relied upon, as legal advice.