• 28 December 2009

The Reach of State Corporate Law Beyond State Borders: Reflections Upon Federalism

Honorable Jack B. Jacobs - Justice, Delaware Supreme Court

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During their first year of law school, students are taught some eternal verities.  One of them is that America’s federal system consists of fifty states, each governed only by its own law and not by the law of any other state.  Overlying this state law tapestry is a system of federal law that operates in its own distinct sphere.  Someone from another planet viewing this structure for the first time might wonder how fifty separate state jurisdictions can operate harmoniously without getting in each other’s way.  The answer, we would tell our extraterrestrial visitor, is geographical containment:  Each state’s law extends only to that state’s border, and no further.  In theory, at least, that is how our federalist model is supposed to work.  But as with much in life, the reality is more complex than the theory.  This is particularly true in the case of corporate law because in that arena, state law will often acquire an extraterritorial reach that is at odds with the federalist theory.

This topic is of more than academic interest.  My subject—how the corporate law and governance rules of our states interact with each other in a federal system—bears importantly on the efficient operation of the American economy.  In this current economic environment, this is a subject that concerns us all.

In this short Editorial, I will cover three topics.  First, I will outline the historical background behind the current model of how state corporate laws are supposed to interact.  Second, I will discuss how reality has come to diverge from the model, as a result of attempts to give state corporate law extraterritorial reach through the internal affairs doctrine and corporate outreach statutes.  Finally, I will attempt to answer the “so what?” question:  What are the practical implications of this divergence, and what do they spell for the future?

 
I.
Historical Development of the Model

As I said earlier, our federalist model resembles a patchwork of fifty separate bodies of state corporate law, plus the corporate law of the District of Columbia, all overlaid by an additional body of federal law.  By “corporate law,” I mean state statutes and judicial decisions that regulate internal corporate matters such as the forming of a corporation, the powers and duties of officers and directors, corporate elections, the rights of stockholders, the corporate decisionmaking process, corporate mergers, sales of assets, and the like.  “Corporate law” must be distinguished from “commercial law,” which is the body of rules that governs the corporation’s external economic relationships with parties outside the corporate family, such as suppliers and customers.

A key characteristic of this corporate federalist model is that a state’s corporate law governs only those corporations that are formed under that particular state’s corporate law.  The main reason for this is historical:  Until the twentieth century, all American corporate law was local.  In fact, until the late nineteenth century, state corporate statutes did not even exist; to form a corporation in any state, a special act of that state’s legislature was required.  This regime was problematic because it tethered economic expansion to access to the political system.  Eventually, the requirement that corporations be created by special legislative acts was jettisoned, and in its place, the states adopted general corporation laws that allowed any citizen who followed the prescribed statutory rules to form a corporation privately.

A second important feature of the late nineteenth century federalist model was that the reach of state corporate law was local¾that is, each state’s law stopped at the state boarder.  Again, the reasons were historical:  Except for a few giant multistate operations such as Standard Oil, U.S. Steel, and the large railroad companies, most corporations chartered under the new state statutes—their officers, directors, stockholders, and business operations—were located in a single state. Not surprisingly, any disputes involving these corporations’ internal affairs were governed by local state corporate law, and the resolution of those disputes affected, by and large, only the citizens of that state.

During the twentieth century, however, this model changed.  In the 1930s, as we know, the New Deal added a second, overlying layer of newly enacted federal law to remedy dislocations caused by the failure or inability of state law to keep up with changes in our national economy.

This new federal scheme fundamentally altered the original legal model.  Whereas before 1934 there had been one layer of regulation, after 1934 there were two.  Each layer operated independently of the other and with different functions.  Although most internal affairs of corporations continued to be regulated by state law, now some were removed from the state law domain and transferred to the federal.  Capital raising and other interstate transactions in corporate securities became, and have continued to be, governed by a separate body of overriding and preemptive federal law.

I now turn to the second topic, which is how the corporate federalist model and reality have come to diverge over the past seventy years.  In metaphorical terms, the question is how, in defiance of the theory of federalism, it became possible for one state’s corporate law to cross over that state’s boundary line and, in unforeseen ways, influence business activity that other states arguably had an interest in regulating.

 
II.
The Model and the Reality Diverge

This divergence between the model and reality has taken three quite different forms.  The first form of divergence resulted from what some refer to as the “first generation” of anti-takeover statutes; the second resulted from the widespread application of the internal affairs doctrine, which for generations has been a central feature of American corporate law; and the third resulted from the so-called “corporate outreach” statutes, which are exemplified by legislation adopted in California and New York.  I will discuss the second and third forms here.1

 
A.     The Internal Affairs Doctrine

The internal affairs doctrine is a judge-made choice-of-law rule that mandates that disputes regarding “internal affairs”—“those matters which are peculiar to the relationships among or between the corporation and its . . . directors, officers and shareholders”2—are governed by the laws of the state of incorporation.  Illustrative examples of internal affairs include the mechanics of incorporating, the election or appointment of officers and directors, the adoption of bylaws, the issuance of shares and bonds, voting, mergers, the reclassification of shares, and the declaration and payment of dividends.

Extraterritoriality is an unavoidable consequence of the internal affairs doctrine.  As an example, imagine a company that is incorporated in Iowa.  A lawsuit involving that corporation’s internal affairs (say, a breach of fiduciary duty action) is filed in a New York state court.  In that lawsuit, the New York court will apply the internal affairs doctrine and decide the case under Iowa corporate law, even if the director-defendants all live in Illinois, or the plaintiff-shareholder lives in Wisconsin, or both.  By virtue of this choice-of-law principle, the corporate law of the state of incorporation has extraterritorial effect.

At first blush, this fact may appear to have only theoretical interest and no real-world importance; however, this is not the case, because the internal affairs doctrine does not exist in a vacuum.  It operates conjointly with two real-world facts.  First, internal affairs disputes frequently involve large corporations that have far-flung operations.  Second, a majority of those firms are incorporated in one state, namely, Delaware.  In practice, because of these facts, mega-disputes involving the internal affairs of America’s largest companies are often resolved under Delaware law.  And because of the large number of Delaware corporate law cases, Delaware corporate jurisprudence has become more widespread and more developed than the corporate jurisprudence of other states.  As a result, Delaware corporate law has come to have significant extraterritorial effect.

 
B.     The Corporate Outreach Statutes

The corporate outreach statutes adopted by California and New York have extraterritorial reach because they legislatively overrule the internal affairs doctrine and impose their own, often different, internal governance requirements upon foreign corporations having a specified level of contact with the forum state.3 I will focus on the California outreach statute, not only because it is the most illustrative, but also because it has actually been a subject of litigation.  Section 2115 of the California Corporations Code requires certain foreign corporations to conform to a broad range of California internal affairs requirements.  It provides that in cases where it applies, California corporate law will govern a host of internal governance matters.  These include the annual election of directors, the removal of directors, the filling of director vacancies in specified circumstances, the directors’ standard of care, the directors’ liability for unlawful distributions, the indemnification of directors and officers, and many others.  Lest there be any doubt about its intended purpose, the statute specifically provides that in cases where it applies, “the foreign corporation’s articles of incorporation are deemed amended to the exclusion of the law of the state of incorporation.”4

These outreach statutes are an effort, through legislation, by one state to give its corporate law extraterritorial reach.  Foreign corporations that are subject to these statutes risk being caught in a crossfire between two conflicting sets of governance requirements¾one imposed by the outreach statute of the forum state and the other mandated by the corporate law of the state of incorporation.  Because a corporation cannot obey two conflicting legal commands at the same time, the “hot button” question is which state’s corporate law will take precedence.

That issue has been litigated in both California and Delaware, and the results thus far have been a mixed bag.  In California, some court decisions have upheld the application of California governance requirements to corporations that had major California contacts but were incorporated elsewhere.5 In Delaware, the courts have held that by virtue of the internal affairs doctrine, Delaware corporate law trumped the conflicting California statutory rules.6 The question is ultimately one of constitutional law.  As the law currently stands, there is no single answer because the answer in any particular case depends upon which state’s jurisprudence¾Delaware’s or California’s¾a court looks to when deciding that question.

This brings me to my third and last topic.  We now know that a state’s corporate law may reach beyond its borders even though under the corporate federalist model it should not.  We also know that two of the three ways under which this can happen could set, at least potentially, a collision course that may affect more than just the two states whose corporate laws are in conflict.  The question becomes:  how will this uncertain state of affairs unfold in the future?

 
III.
What Will the Future Look Like?

In guessing what the future may hold, there are several possibilities, but they all turn on one question:  whether the internal affairs doctrine is only a choice-of-law rule or whether it is also a rule of constitutional law.  If the doctrine is only a choice-of-law rule, then any state is free to adopt or reject it.  If it is a principle of constitutional law, then no state is free to reject it.  The only court that can decide that question with finality is the United States Supreme Court, and thus far, the question has not percolated up to that level.

Language in some earlier Supreme Court decisions suggest that the Supreme Court has already recognized the constitutional dimension of the internal affairs doctrine.7 In addition, I personally subscribe to the view that the stability and certainty afforded by the internal affairs doctrine justifies according that doctrine constitutional status.  But my personal view is of minimal relevance.  The question is debatable, and legal commentators have lined up on both sides of the debate.8 So, any prediction about how the nation’s highest court might rule would be hazardous.  It is more productive, in my opinion, to tease out what might happen under both scenarios.

 
A.     The Internal Affairs Doctrine as a Choice-of-Law Rule

Let us first assume that the Supreme Court decides that outreach statutes such as California’s are constitutional.  Should this occur, I predict that the legislatures of other states will adopt their own outreach statutes, at the behest of shareholder activists and other interest groups.  Those statutes would likely impose various, perhaps highly idiosyncratic, kinds of corporate governance requirements upon foreign corporations that do business in those states.

Were that to happen, what would the landscape look like?  I suspect it would resemble a corporate law version of the “Gunfight at the O.K. Corral.”  Companies that do business in several states could find themselves subject to inconsistent internal governance requirements.  Were these conflicts to become widespread and frequent, it could become economically disruptive.  Corporations facing the impossibility of complying with two or more inconsistent governance requirements might simply choose not to do business in the states having inconsistent rules—a choice that could distort economic incentives and seriously inhibit economic growth.  Or, corporations might instead choose to create separate subsidiaries to operate in each state in which they do business.  Creating new levels of corporate ownership may solve the inconsistency problem, but it would inflict other costs such as (not limited to) additional taxes and increased cost of capital.

Were this state of affairs to become sufficiently disruptive, it could create pressure for Congress to eliminate the conflict by enacting some kind of preemptive uniform legislation.  The least intrusive form of such legislation—that is, the kind that would preserve the states’ authority to regulate corporations chartered under state law—would just mandate the internal affairs doctrine on a nationwide basis, in effect overturning our hypothetical Supreme Court decision upholding outreach statutes.  The most intrusive¾that is, the kind that would be least protective of state sovereignty¾would be a federal corporation law that would displace the corporation law of all fifty states.  For those of us who have devoted our professional lifetimes to shaping and improving corporate governance law at the state level, that would be a most unfortunate development, if only because it would create rigidity and retard experimental (and, hopefully, beneficial) change.  Experience shows that laws enacted by Congress, even if flawed, are politically difficult, if not impossible, to change.  In contrast, imperfect laws that are enacted by state legislatures or imperfect rules crafted by judges as part of the common law adjudication process tend to be more easily correctible.

 
B.     The Internal Affairs Doctrine as a Rule of Constitutional Law

Now, assume the alternative scenario:  The Supreme Court decides that the internal affairs doctrine is also a rule of constitutional law.  In that event, the corporate outreach statutes would be invalid, at least as applied to a foreign corporation whose state of incorporation imposes inconsistent requirements.  There would be a clear, easily applied rule that regardless of where a lawsuit involving the corporation’s internal affairs is filed, only the law of the state of incorporation governs the case.  That would essentially preserve the status quo, but it is important to keep in mind that the status quo is not necessarily static or quiescent.  Far from it.  For years, other states have been competing with Delaware, and with each other, to encourage firms either to incorporate or to reincorporate in their jurisdictions. If the internal affairs doctrine were to become the universal rule, that competition could well intensify.

By way of example, beginning in the 1980s, thirty-one states, including Pennsylvania, Virginia, and Rhode Island, adopted so-called “other constituency” statutes.  These statutes did two things.  First, they relieved target company boards responding to takeover bids from any obligation to treat the interests of shareholders as paramount over all others.  Second, they permitted those boards to consider the effects of a hostile takeover on other constituency groups, such as employees, suppliers, customers, creditors, and local communities. Essentially, these statutes were a legislative rejection of Delaware case law, specifically the Unocal9 and Revlon10 decisions, which imposed greater limitations upon how directors may respond defensively to hostile takeover bids.

If the Supreme Court were to constitutionalize the internal affairs doctrine, absent preemptive federal legislation, we could expect more and different forms of this kind of competition among states for incorporation business and the franchise tax income it generates.  That is, in an internal affairs doctrine world, there would be competition among state legislatures, but there would be no irreconcilable direct conflicts imposed on individual firms.  Different states would offer different arrays of legal choices, and corporations would choose whatever legal regime they preferred, just as they do now.dingbat

 

Acknowledgments:

Copyright © New York University Law Review.

The Honorable Jack B. Jacobs is a Justice of the Delaware Supreme Court.

This Legal Workshop Editorial is an abbreviated version of the following Lecture: Jack B. Jacobs, The Reach of State Corporate Law Beyond State Borders: Reflections Upon Federalism, 84 N.Y.U. L. REV. 1149 (2009). The original Lecture was delivered on February 26, 2009 at the New York University School of Law as the 15th Annual William J. Brennan, Jr., Lecture on State Courts and Social Justice.

  1. For my discussion of the first-generation anti-takeover statutes, see 84 N.Y.U. L. REV. 1149, 1155–59.
  2. McDermott Inc. v. Lewis, 531 A.2d 206, 214–15 (Del. 1987).
  3. See CAL. CORP. CODE § 2115 (West Supp. 2009); N.Y. BUS. CORP. LAW § 1320 (McKinney 2003 & Supp. 2009).
  4. VantagePoint Venture Partners 1996 v. Examen, Inc., 871 A.2d 1108, 1114 (Del. 2005) (emphasis in original) (citing CAL. CORP. CODE § 2115(b) (West 1997 & Supp. 1984)).
  5. See, e.g., Wilson v. Louisiana-Pacific Resources, Inc., 187 Cal. Rptr. 852, 857–58 (Cal. App. 3d 1982); Western Air Lines, Inc. v. Sobieski, 12 Cal. Rptr. 719, 728 (Cal. App. 2d 1961). But see State Farm Mut. Auto. Ins. Co. v. Super. Ct., 8 Cal. Rptr. 3d 56, 67–68 & n.3 (Cal. App. 2d Dist. 2003) (questioning continued vitality of Wilson, given broad acceptance of internal affairs doctrine over intervening period).
  6. See, e.g., VantagePoint, 871 A.2d 1108; Draper v. Gardner Defined Plan Trust, 625 A.2d 859 (Del. 1993).
  7. See Kamen v. Kemper Fin. Servs., Inc., 500 U.S. 90 (1991); CTS Corp. v. Dynamics Corp. of America, 481 U.S. 69 (1987); Edgar v. MITE Corp., 457 U.S. 624 (1982).
  8. See, e.g., Norwood P. Beveridge, Jr., The Internal Affairs Doctrine: The Proper Law of a Corporation, 44 BUS. LAW. 693, 719 (1989) (arguing that internal affairs doctrine should not be “blindly adopted”); P. John Kozyris, Corporate Wars and Choice of Law, 1985 DUKE L.J. 1, 96 (suggesting that anti-takeover statutes “fall within the ambit” of state powers to regulate foreign corporations); Continued Primacy, supra note 28, at 1501 (arguing that costs of state legislatures’ overruling internal affairs doctrine may outweigh benefits).
  9. 493 A.2d 946 (Del. 1985).
  10. 506 A.2d 173 (Del. 1986).

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