State vs. State: The Internal Affairs Doctrine Drives a Wedge Between Delaware and California
By John A. Laco

Overview

Transactional attorneys who counsel corporations with a significant presence in California learn early in their careers that a California “long-arm” statute¹ requires certain companies incorporated outside of California, but having a substantial presence within the state, to comply with certain provisions of the California Corporations Code. Unfortunately, some of the provisions California imposes on these “foreign” corporations fundamentally conflict with the corporate statutes of the companies’ home states in key areas of corporate governance, creating genuine uncertainty about which state’s law should prevail. In a 2005 decision, VantagePoint Venture Partners 1996 v. Examen, Inc.,²  the Delaware Supreme Court further clouded this issue by declaring that California’s long-arm statute is an unconstitutional exception to the “internal affairs doctrine” and is therefore inapplicable to Delaware corporations.

This uncertainty may or may not continue for some time. Although a related lawsuit between the VantagePoint protagonists filed in California has been stayed indefinitely, the California Supreme Court now has a case on its docket that could lead to an outcome consistent with, or directly opposite, the Delaware VantagePoint decision. In late 2005, two California lower courts rendered decisions addressing the internal affairs doctrine: Grosset v. Wenaas³ and Friese v. Superior Court.⁴   However, the decisions differed wildly. Grosset cited VantagePoint and blindly applied the internal affairs doctrine; Friese distinguished Grosset and found the doctrine not applicable. On January 2, 2006, the California Supreme Court agreed to review the Grosset decision.

Until the California Supreme Court rules (and longer if that court squarely addresses and rejects the VantagePoint decision, leaving the U.S. Supreme Court as the final arbiter of this deepening dispute), it will remain unclear: which state’s laws should foreign corporations operating in California follow in conducting their day-to-day internal corporate affairs? In the interim, corporate attorneys faced with answering this question should make an informed decision based on an understanding of the differing statutes and case law, as well as the fundamental policies underlying these codes and court decisions.

The Internal Affairs Doctrine

The internal affairs doctrine is a judicially created choice of law guideline that requires the law of the incorporating state to govern disputes involving a corporation’s internal affairs.⁵ The internal affairs doctrine is based on the simple premise that a company’s state of incorporation is the only state with authority to regulate the relationships among or between the corporation and its officers, directors, and shareholders. In VantagePoint, the Delaware Supreme Court logically reasoned that because the internal affairs doctrine is a uniform system or plan of regulation and the Commerce Clause of the U.S. Constitution prohibits state regulation of subjects that require one uniform system or plan of regulation, then state exceptions to the doctrine violate the Commerce Clause.⁶

California Corporations Code Section 2115

California Corporations Code Section 2115 seeks to apply over 20 specific provisions of California corporate law to foreign corporations, regardless of whether those provisions conflict with the foreign corporation’s corporate charter or home state corporate law. Under the long-arm statute, California law is “deemed” to control a number of significant internal governance matters, including election and removal of directors, certain shareholder votes, directors’ standard of care, liability and indemnification, shareholders’ liability, and recordkeeping.⁷

Section 2115 only applies to certain of the numerous foreign corporations conducting most of their business in California. In order for Section 2115 to reach a foreign corporation, that corporation must conduct at least half of its business in California, as measured by a formula weighing assets, sales, and payroll factors.⁸ In addition, at least 50 percent of the foreign corporation’s voting securities must be held of record by persons residing in California.⁹ Section 2115 does not apply to any corporation with outstanding securities listed on the New York Stock Exchange, the American Stock Exchange, or the Nasdaq National Market.¹⁰ Likewise, associations and nonprofit corporations that are foreign to California also are exempt from the requirements of Section 2115.

The VantagePoint Decision

The facts underlying the recent VantagePoint decision were quite straightforward. Examen is a Delaware corporation headquartered in California and having other significant contacts with California. Early in 2005, Examen entered into merger discussions with a third party. VantagePoint, a venture capital fund holding 83 percent of Examen’s outstanding Series A Preferred Stock, sought to block the merger. Delaware corporate law does not impose a class-by-class vote to approve mergers, but California’s corporate law does.¹¹ VantagePoint argued that California’s long-arm statute applied to Examen, and therefore the Series A Preferred Stock had the right to vote as a class under California law.

On May 5, 2005, the Delaware Supreme Court ruled in favor of Examen and against VantagePoint, stating that, regardless of California Corporations Code Section 2115, only Delaware corporate law applied to matters involving the “internal affairs” of Delaware corporations. The Delaware Supreme Court distinguished California court precedents and relied on several U.S. Supreme Court decisions to hold that California statutes purporting to apply California law to Delaware corporations violate the U.S. Constitution.¹²

In light of this holding, a Delaware corporation may now credibly take the position that it is governed wholly by Delaware corporate law, despite its significant contacts in California. In addition to the advantages highlighted in the facts of the VantagePoint case (i.e., that one class of shares may not block a merger), the VantagePoint decision will now permit Delaware corporations to also ignore the other specific California laws imposed by Section 2115.

Relevant California Case Law

The California case law interpreting the application of California Corporations Code Section 2115 is quite limited, but the statute’s roots in California common law are deep. Well before the enactment of Section 2115, California courts had created a limited exception to the internal affairs doctrine. In 1961, in Western Airlines v. Sobieski, the California Court of Appeals broke new ground by holding that, although the issuance of capital stock and the stock structure of a corporation are customarily internal affairs governed by the law of the corporation’s state of incorporation, a foreign corporation issuing stock in California may be regulated by California for the protection of residents and citizens.¹³

In 1977, as part of a wholesale rewrite of the California Corporations Code, the Sobieski exception to the internal affairs doctrine became codified as Section 2115. At that time, the stated purpose of Section 2115 was to formalize and clarify the limited circumstances in which the internal affairs doctrine did not apply in California.

In 1982, in Wilson v. Louisiana-Pacific Resources, Inc., the California Court of Appeals first interpreted Section 2115 and held that a Utah corporation operating extensively—indeed, almost exclusively—in California was subject to the requirements of Section 2115. The court concluded that the statute was a valid exception to the internal affairs doctrine and did not violate the United States Constitution because California had substantial interests in applying Section 2115 to corporations with significant contacts or aggregation of contacts with California, and Utah had no interests that were offended by such application. ¹⁴ The court effectively amended the Utah corporation’s articles of incorporation to reflect the cumulative voting requirement imposed by California law, rationalizing that such actions were not improper or unduly burdensome because the laws at issue did not truly conflict.¹⁵

One year later, in Valtz v. Penta Investment Corp., the California Court of Appeals similarly held that the application of California Corporations Code Section 2115, and thus, California Corporations Code Section 1600, to a foreign corporation did not violate the United States Constitution. The court compelled Penta to allow the Valtz’s—potential competitors who collectively owned more than five percent of Penta’s outstanding stock and were recent officers of the corporation—to inspect Penta’s shareholder list.¹⁶ In so doing, the court made it quite clear that California may regulate foreign corporations with “significant contacts” within the state.¹⁷ However, in its reasoning, the Court of Appeals actually backed away from some of the stronger statements made in the 1982 Wilson decision in two respects. First, there was no actual conflict of laws in the Valtz case. Second, as the court explained, California Corporations Code Section 1600 does not address an internal affair, but rather deals with a right that is “incidental to the ownership of stock” and is “subject to regulation by statute where the corporation does business.”¹⁸

Wilson and Valtz have not been expressly overruled by either the California Supreme Court or the U.S. Supreme Court. In 2003, however, a different panel of the California Court of Appeals, in State Farm v. Superior Court, hinted that the model first set forth in Wilson should be overruled in light of more modern Delaware and Supreme Court precedents.¹⁹

In the recent VantagePoint decision, the Delaware Supreme Court cited the California State Farm decision, and partially relied on that opinion’s explanation of the internal affairs doctrine. However, the California Supreme Court has yet to rule on the continued validity of Wilson and Valtz. Therefore, it remains uncertain whether the California courts will continue to uphold California Corporations Code Section 2115 as a valid and constitutional limited exception to the internal affairs doctrine.²⁰

Differing Delaware Case Law

In a 1987 case, the stockholders of a Delaware corporation sought to prevent the corporation from voting shares that it owned in a Panamanian corporation.²¹ Panamanian law permitted the vote at issue, while Delaware law prohibited it.²² After distinguishing the ground-breaking 1961 California decision in Sobieski, the Delaware Supreme Court held that the vote should proceed because such action was not prohibited under Panamanian law.²³ The Delaware court also noted that: (1) the pertinent voting provision did not relate to the internal affairs of a Delaware corporation²⁴; and (2) public policy did not mandate the application of Delaware law to the internal affairs of a foreign corporation.²⁵

In the recent VantagePoint decision, the Delaware Supreme Court cited two U.S. Supreme Court decisions recognizing and applying the internal affairs doctrine²⁶ and held that California Corporations Code Section 2115 violates the Commerce Clause of the U.S. Constitution because the Commerce Clause prohibits states other than the state of incorporation from regulating the internal affairs of a corporation—particularly the voting rights of shareholders. The Delaware Supreme Court alluded to the fact that the U.S. Supreme Court decisions (which were handed down after California’s 1982 Wilson decision), in combination with the California Court of Appeals favorable citation in the 2003 State Farm case of Delaware’s 1987 McDermott decision, may have effectively overruled Wilson.

Who is Right?

Apparently lost in all of this high-level legal analysis is the undisputed fact that Wilson has not yet been expressly overruled by the California courts. Despite some negative treatment, Wilson may continue to be cited and relied upon in California. Unlike Delaware, for many years California courts have permitted limited exceptions to the internal affairs doctrine. California judges have consistently maintained that when the local interest in regulation is high and the burden on interstate commerce is comparatively low, the state may legitimately regulate the internal affairs of foreign corporations. Because California Corporations Code Section 2115 only applies to a limited subset of foreign corporations operating within California, and because by definition those corporations cannot have more substantial contacts in any other interested state (including even their own state of incorporation), it is plausible that California Corporations Code Section 2115 may ultimately be found to pass constitutional muster as a permissible limited exception to the internal affairs doctrine.

Conclusion

The twenty-year-old California decisions and the recent Delaware decision in VantagePoint clearly conflict with respect to the permissible scope of the internal affairs doctrine, and the courts in each state disagree about whether California Corporations Code Section 2115 violates the United States Constitution. While the Delaware Supreme Court has made it clear that it believes Delaware corporations no longer need comply with California corporate law governing internal affairs, the California Supreme Court has not yet definitively ruled.

Until this split of state court decisions is resolved, the provisions imposed on a “foreign” corporation by California law may continue to fundamentally conflict with the corporate statutes of its home state, creating genuine uncertainty about which state’s laws govern with respect to key areas of corporate governance. Accordingly, for the time being, directors and officers of Delaware and other foreign corporations doing the majority of their business in California must decide whether, notwithstanding the VantagePoint decision, the most predictable and risk-free path is continued compliance with California Corporations Code Section 2115 and the relevant associated provisions of California law.

Notes

1. California Corporations Code § 2115.

2. 871 A.2d 1108 (Del. Supr., 2005).

3. 133 Cal.App. 4th 710 (Cal. App., 2005).

4. 134 Cal. App. 4th 693 (Cal. Superior, 2005).

5. McDermott Inc. v. Lewis, 531 A.2d 206 (Del. Supr., 1987).

6. 871 A.2d at 1115-1116.

7. Section 2115(b) lists all implicated provisions.

8. Cal. Corp. Code § 2115(a) (1977 & Supp. 1984).

9. Id.

10. Cal. Corp. Code § 2115(c) (1977 & Supp. 1984).

11. Cal. Corp. Code § 1101 (1977 & Supp. 1984). While most of the California regulatory provisions that Section 2115 imposes on foreign corporations will have little effect on the corporate governance of non-California corporations, Section 1101 is controversial and problematic. This rule requires the approval of each class of stock, including common stock, in order for a merger to proceed, effectively permitting holders of more than 50 percent of any particular class of stock to block a boardapproved merger, despite approval of the merger by a majority of all outstanding shares entitled to vote.

12. 871 A.2d at 1112-14.

13. 191 Cal.App. 2d 399, 410 (1961).

14. 138 Cal.App.3d 216, 222-31 (Cal.App., 1982).

15. Utah’s law allowed for cumulative voting.

16. 139 Cal.App. 3d 803, 808 (Cal.App., 1983).

17. Id. at 809-10.

18. Id. at 807.

19. 114 Cal.App.4th 434 (Cal.App. 2 Dist., 2003).

20. The recent Grosset and Friese decisions in California did not involve California Corporations Code Section 2115.

21. McDermott Inc. v. Lewis, 531 A.2d 206 (Del. Supr., 1987).

22. Id. at 209-11.

23. Id. at 211.

24. Id. at 214-17.

25. Id. at 219.

26. Edgar v. MITE Corp., 457 U.S. 624 (1988); CTS Corp. v. Dynamics Corp. of Am., 481 U.S. 69 (1987).

About the Author

Mr. Laco (JLaco@OMM.com) is a Corporate Partner of O’Melveny & Myers LLP resident in the Los Angeles office. This article is derived from an article originally published by Mr. Laco in THE BUSINESS LAW NEWS (Issue 3-2005), a publication of the State Bar of California.