[co-author: Katie McKitterick]
A recent decision in the Delaware Supreme Court, in conjunction with the broad California exceptions to the internal affairs doctrine, may dictate the legal landscape of shareholder litigation in California in the near future.
In ATP Tour Inc. et al v. Deutscher Tennis Bund, 91 A.3d 554 (Del. 2014), the Delaware Supreme Court upheld a Delaware corporation’s ability to amend its bylaws without the consent of its shareholders to include a provision that shifts litigation expenses to shareholders who unsuccessfully bring derivative suits. Predictably, this decision has been met with some hostility by shareholders and plaintiff’s bars in many states, including California, who argue that mandatory fee-shifting provisions discourage (or even preclude) shareholders from bringing derivative suits for fear of shouldering the prohibitive costs of being unsuccessful. On the other hand, corporations’ management teams generally praise the decision as curbing the legal cost imposed on a corporation defending from shareholders lawsuits, with a number of corporations amending their bylaws to include this fee-shifting provision.
What does it mean for shareholder litigation in California, especially considering the broad exceptions by California Corporations Code Section 2115 from the internal affairs doctrine? Per this doctrine, the internal affairs of a corporation are governed by the state in which it is incorporated. In California, however, there are significant and broad exceptions to this doctrine. According to Section 2115, if more than half of a foreign corporation’s shares are held by California residents, a majority of its business is done in California and the corporation’s shares are not listed on a national exchange, the applicable provisions of the California Corporations Code, rather than the corporation’s state of incorporation, would apply in many instances of such corporation’s internal affairs. For example, if ABC, Inc. is incorporated in Delaware, but half of its shares are held by California residents, the majority of the ABC, Inc.’s business is done in California and ABC, Inc.’s shares are not listed on a national exchange, Section 2115 states that California law will apply to a significant number of internal governance decisions of such entity. With respect to shareholder derivative suits, one of the notable areas of internal affairs to which California law would apply is directors’ standard of care.
California courts have justified these significant exceptions to the internal affairs doctrine by arguing that certain issues corporations face extend beyond the internal affairs of the corporation and involve important state interests. However, California has not consistently applied the internal affairs doctrine, making it difficult for foreign corporations to anticipate whether California law or the law of its state of incorporation will govern their internal matters. Further, in VantagePoint Venture Partners 1996 v. Examen, Inc.,1 the Delaware Supreme Court held that California Corporations Code Section 2115 was unconstitutional, and therefore, that Delaware law was to be applied to a Delaware corporation’s internal affairs. A California court addressed this decision in Lidow v. Superior Court.2 In dicta, the Lidow court discussed that a corporation’s state of incorporation should govern internal matters of a corporation, such as the rights of shareholders. Notably, the court in Lidow stated, also in dicta, that the voting rights of shareholders, the payment of dividends to shareholders and the procedural requirements for shareholder derivative suits “involve matters of internal corporate governance and thus, fall within a corporation’s internal affairs.”3 It still remains to be seen whether the fee-shifting provisions upheld by the Delaware Supreme Court in ATP Tour Inc. will be deemed procedural (which would be governed by Delaware law) or substantive (which could be governed by California law or the law of the corporation’s state of incorporation—see discussion below) for purposes of shareholder derivative suits.
The effects of the Delaware decision in ATP Tour Inc. et al v. Deutscher Tennis Bund on derivative shareholder actions in California against the corporations incorporated in Delaware are yet to be determined. Of course, there are a great many Delaware corporations operating in California. Equally important, California has one of the biggest investment communities (including prominent investment and pension funds) in the nation. With the broad exceptions to the internal affairs doctrine in mind, California could potentially take one of two approaches: invalidate fee-shifting provisions even if they are validly adopted in a corporation’s bylaws, or, alternatively, make fee-shifting provisions mandatory (as was done in Oklahoma with respect to the derivative actions filed in that state).
If fee-shifting provisions are universally invalidated in California, by either the California legislature or the California judiciary, it would broaden the areas of internal affairs to which California law would apply, rather than the law of the state of incorporation, thus making California a popular state for shareholders for forum selection purposes. As a result of such a shareholder-friendly provision, shareholder litigation would presumably increase in California. But would it drive businesses away from California?
On the other hand, upholding mandatory fee-shifting provisions in California would presumably cause shareholders to litigate elsewhere, thus reducing California courts’ caseload. Clearly, this direction would be attractive to corporate management and would presumably make California perceived as more management-friendly (the image that Delaware has been fostering for many years).
Corporate management and shareholders will want to remain abreast of when and if California takes any position with respect to fee-shifting. We will update our readers on any development.
[1]871 A.2d 1108 (Del. 2005)
[2]141 Cal. Rptr. 3d 729 (Cal. Ct. App. 2012)
[3]141 Cal. Rptr. 3d 729, 737
