Opting Only In: The Race to the Bottom (Part 5)

We are discussing a paper recently posted on SSRN titledOpting Only In: Contractarians, Waiver of Liability, and the Race to the Bottom and examining the development and use of waiver of liability provisions.

As we noted, Section 102(b)(7), which allowed companies to amend their articles to waive liability for the breach of the duty of care, arose in a purported effort to fix the crisis in the D&O insurance crisis.  As we have noted, it did not fix the problem.  Moreover, not long after the adoption of the provision, the crisis was over.  What happened in the other states?

Two models emerged.  Delaware retained the rule that liability existed for breaches of the duty of care but allowed shareholders to "opt in" to a regime that eliminated liability by adopting the requisite amendment to the articles.  Other states, Ohio, for example, eliminated liability for breach of the duty of care but allowed companies to "opt out" of the regime. 

Most states followed the Delaware model.  By corporate law reform standards, the speed with which the other states fell in line was nothing short of remarkable.  Within a few years of the new millennium, all states had some version of waiver of liability.  A modest number chose an opt-out approach, eliminating monetary damages for breach of the duty of care but allowing companies to reinstate damages through amendments to the articles. The vast majority, however, followed the Delaware model and relied on opt-in.

What could be the reasons? Not the D&O insurance crisis; that was over. Not efficiency. Instead, it was designed to prevent companies from moving to Delaware. In other words, whatever Delaware’s motivation, other states adopted comparable provisions not because of improved governance or efficiency but because of the need to benefit management and avoid reincorporation, with some evidence suggesting harm to shareholder values.

With all states now permitting some form of waiver of liability, attention turned to the companies.  The contractarians presumably would predict that the enabling approach to regulation would result in private ordering.  Companies would adopt (or not adopt) waiver provisions that resulted in the greatest efficiency for the particular company.  Management seeking the adoption of these provisions would "negotiate" with shareholders.  In other words, they would draft the provisions most likely to win the support of shareholders.  This would suggest that waiver of liability provisions would vary from company to company, reflecting this bargaining process.  Tomorrow we will test that hypothesis.