Businesses That Incorporate in Nevada Face Little Liability, Barzuza's Research Shows
Every corporate law student learns that in America, directors and officers face liability for breaching their fiduciary duties — duty of loyalty, good faith and care — to their shareholders.
But for a while now that hasn't been entirely true in Nevada, according to University of Virginia law professor Michal Barzuza.
"Over time the state of Nevada designed its corporate law with almost no liability for breaches of fiduciary duties, which have been the staples of American corporate law," Barzuza said. "Shareholders of companies incorporated in Nevada should realize they may not have as much protection if or when there is malfeasance at the top."
If a firm incorporates in Nevada, by default its directors and officers are protected from liability for breaches of duty of care, loyalty and good faith, and even for improper personal benefits. The only category that they could face liability for is intentional misconduct, fraud or a knowing violation of law.
These kinds of legal protections for corporate leaders are markedly different from the law in Delaware, where more than half of publicly traded companies are now incorporated.
In Delaware, directors and officers face mandatory liability for breaches of duties of loyalty and of good faith. Delaware has allowed corporations to protect directors only from liability for negligence (breaches of duty of care). But in Nevada, directors are protected even for self-dealing transactions or other situations involving conflicts of interest from which they derived personal benefits.
Furthermore, while Delaware conditions its protection on shareholder approval, Nevada applies all of its protections as a default.
Finally, "Delaware law allows protection from liability only to directors, while Nevada provides it to officers too," Barzuza said.
Barzuza's paper on the subject, "Market Segmentation: The Rise of Nevada as a Liability-Free Jurisdiction," was published recently in the Virginia Law Review and was selected to be reprinted in the Corporate Practice Commentator.
Barzuza also examined the dynamics of incorporations in Nevada and the kinds of companies the state attracts in a concurrent paper co-authored with David Smith from the University of Virginia's McIntire School of Business, "What Happens in Nevada: Self-Selecting into Lax Law?" One of their main findings is that these companies have a high ratio of accounting restatements.
Is setting itself apart from Delaware a strategy that Nevada takes publicly?
Absolutely, Nevada is marketing itself as a state with lax corporate law.
The website of Nevada's secretary of state explains that companies should choose Nevada because the state provides stronger personal liability protection to officers and directors than the one Delaware provides. And because Nevada grants directors more flexibility when they face takeovers.
This is very different from what you see on Delaware's website, which stresses Delaware's experienced judiciary and the large number of corporations incorporated there.
Nevada is unique also in aggressively marketing itself as a low-liability corporate regime.
Were there signs that Nevada's legislators were actively pushing to attract businesses to incorporate in their state? What does Nevada gain from it?
In 2001, Nevada legislature adopted amendments to the state's law with a clear intention to strengthen insiders' protection. It was part of a plan to increase the incorporation tax that Nevada charges, which until then has been almost negligible. As the paper details, in the hearings on the proposed bill, a local lawyer explained to the senate committee on the judiciary that in order to derive revenues from incorporation, Nevada has to provide something that Delaware does not — more protection from liability to directors and officers. Otherwise everyone will choose Delaware.
Some initially opposed the change, expressing concerns that only crooks will come to Nevada, and Nevada will become the hole in the wall. Yet, they finally supported it because they were promised the proceeds will be used to increase teachers' salaries.
You suggest in the paper that Nevada's strategy is one of market segmentation. Why? Does that help explain Nevada's success?
Given Delaware's dominant position in this market, Nevada could not derive revenues from competing head-to-head with Delaware by offering the same law.
So instead Nevada chose to offer a different product than Delaware. Nevada offers exactly what Delaware does not. Delaware law is flexible and allows variations, but not of the kind that Nevada offers. Duty of loyalty and duty of good faith are mandatory in Delaware.
This product caters to a subset of firms that are interested in lax law. Vis-á-vis these firms, Nevada has market power and thus can charge a price that reflects this market power. While the Nevada incorporation tax is lower than the Delaware tax, it is higher than the tax the firms could pay if they stayed in their home state.
Nevada also has some competitive advantage in offering lax law — it has been a provider of lax law in other fields, such as gambling and marriage. It is politically feasible for the state to adopt lax law and maintain it.
Lastly, this strategy benefits Nevada also because Delaware would not respond to Nevada by offering similar lax law. Degrading its law so far as to match Nevada's would run against Delaware's judicial philosophy, may trigger federal intervention and could significantly harm the Delaware brand.
What are the consequences for Nevada having lax laws that don't hold business leaders liable?
The paper suggests that in the U.S., firms can choose to operate with almost no liability. It is too early to know what exactly the consequences are, but there could be reasons for concern.
First, duty of loyalty covers significant issues, most notably conflicts of interests and self-dealing transactions. Not scrutinizing these transactions could result in significant harm to shareholders. Second, since firms choose where to incorporate, the concern is that this law attracts some bad apples. This does not meant that only crooks choose Nevada, but rather that Nevada may disproportionally attract problematic firms. Put differently, if there are insiders that are interested in extracting significant value from shareholders, they have a place to go now.
If, as you suggest, the variance in Delaware and Nevada laws causes market segmentation, with different kinds of businesses choosing the state best for their needs, could this be helpful to shareholders and the public in the long run, as it may help them better understand the company they are investing in?
This is indeed a potential advantage from market segmentation. In theory, investors could learn from these choices. Having said that, it is not clear that the markets accurately assess Nevada law and the companies that go there.
David and I find that Nevada firms are not traded at a discount relative to firms that remain in their home state. At the same time, when firms in Nevada restate their accounts, David and I find that they are being penalized more than firms that restate in Delaware or other states. This could be consistent with an interpretation that when firms go to Nevada, investors are not sure what their reason was, but if the firm restates its earnings investors take it as a sign of the firm's motives in choosing Nevada. It is also possible that it will take time for the markets to learn the implications of incorporating in Nevada.
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