Delaware Supreme Court Holds “Quasi-California Corporation” Statute Violates Delaware’s Internal Affairs Doctrine

September 1, 2005

By Ara A. Babaian, Esq., Encore Law Group LLP

The Delaware Supreme Court recently held that privately-held corporations incorporated in Delaware are not subject to Section 2115 of the California Corporations Code, which requires non-California corporations with substantial California contacts to adhere to certain California corporate law requirements. This “quasi-California corporation” statute, the Court found, violates Delaware’s internal affairs doctrine and the U.S. Constitution. The Court’s decision emphasizes the need for venture capital and private equity firms to (i) understand the significance of the jurisdiction of incorporation of the private companies in which they invest and (ii) negotiate and draft corporate charters and stock instruments to give themselves certain rights that are clearly spelled out. Taking these actions will later avoid the choice of law problems that may arise when an investor tries to exercise its rights as a shareholder.

 

VantagePoint Venture Partners 1996 v. Examen, Inc.

 

In VantagePoint Venture Partners 1996 v. Examen, Inc., decided on May 5, 2005, Examen, a Delaware corporation, had signed a merger agreement with another Delaware corporation, which agreement was subject to shareholder approval. 871 A.2d 1108 (Del. May 5, 2005) (unpublished opinion). Examen had outstanding over 9,700,000 shares of its capital stock, which included approximately 8,600,000 shares of common stock and 1,100,000 shares of preferred stock. VantagePoint, a major venture capital firm, held a large majority of the outstanding preferred stock but did not hold any shares of common stock. Under Delaware corporate law, as well as the Certificate of Designations of Examen’s preferred stock filed with the Delaware Secretary of State, adoption of the merger agreement required the affirmative vote of the holders of a majority of the issued and outstanding shares of the common and preferred stock, voting together as a single class. Since each share of Examen’s common and preferred stock was entitled to one vote, under this rule, VantagePoint would not have sufficient shares to block the merger.

 

For California corporations or “quasi-California corporations” under Section 2115, regardless of the provisions contained in the corporate charter or the certificate of designations, each class of stock votes separately on a merger. Therefore, if the shareholders were to vote by class as required by California law, VantagePoint would be able to block the merger since it held 83.4 percent of the preferred stock. In an attempt to block the merger, VantagePoint argued that, because Examen has substantial California contacts (as set forth in Section 2115 of the California Corporations Code), the provisions of this “long-arm” statute apply to some of Examen’s internal affairs, and would require shareholder approval on a class-by-class basis. Section 2115 would also govern other important affairs of a “quasi-California corporation,” such as the annual election of directors, removal of directors without cause or by court proceedings, the director’s standard of care, director and shareholder liability for unlawful distributions, indemnification, limitations on corporate distributions in cash or property, the requirement for annual shareholder’s meetings and remedies for the same if not timely held, cumulative voting for shareholders, and others. So, if California’s Section 2115 applied, then VantagePoint effectively would have a veto power over Examen’s proposed merger due to its majority preferred stock holding.

 

Examen first brought this case to the Delaware Court of Chancery on March 3, 2005, seeking a judicial declaration that pursuant to Delaware law and the Certificate of Designations of its preferred stock, VantagePoint was not entitled to a class vote of the preferred stock on Examen’s proposed merger. Days later, VantagePoint filed an action in the California Superior Court seeking, among other things, a declaration that Examen was a “quasi-California corporation” under Section 2115 and, for that reason, VantagePoint was entitled to a class vote on the proposed merger pursuant to California Corporations Code Section 1201(a). Thereafter, the California Superior Court stayed its action pending the ruling of the Court of Chancery. Then, on March 29, 2005, the Court of Chancery ruled that the case was governed by the internal affairs doctrine and, therefore, Delaware law governed the vote that was required to approve a merger between two Delaware entities. VantagePoint subsequently appealed the case to the Delaware Supreme Court.

 

In holding that Delaware corporations are not subject to California’s Section 2115, the Delaware Supreme Court declared that Section 2115 violates Delaware’s internal affairs doctrine, as well as the Fourth Amendment Due Process Clause and the Commerce Clause of the U.S. Constitution. The Court pointed to a 1987 U.S. Supreme Court decision which recognized that a “State has an interest in promoting stable relationships among parties involved in the corporation it charters, as well as ensuring that investors in such corporations have an effective voice in corporate affairs.” CTS Corp. v. Dynamics Corp. of Am., 481 U.S. 69, 91 (1987). The internal affairs doctrine “recognizes that only one state should have the authority to regulate a corporation’s internal affairs – the state of incorporation.” VantagePoint, 871 A.2d at 1112. Therefore, the internal affairs of a corporation, including voting requirements as to a proposed merger, can be governed only by the laws of its state of incorporation. In this manner, the internal affairs protects the “justifiable expectations of the parties and ease in the application of the law to be applied.” Restatement (Second) of Conflict of Laws § 301.

 

Section 2115 is particularly problematic because its applicability depends on the existence of certain factual predicates. For Section 2115 to apply, (i) a corporation must transact a certain amount of its business in California (as determined by property, payroll, and sales factor tests set forth in the statute) and (ii) more than half of the corporations’ outstanding securities must be held by holders with a California address. Since these determinants for Section 2115’s applicability vary from time to time, Section 2115 may apply at certain times and not at others. This inconsistency contravenes long-standing principles of certainty and predictability that are fundamental to the internal affairs doctrine, which is intended to facilitate the transaction of corporate governance and business.

 

According to the Delaware Supreme Court, the internal affairs doctrine is also supported by federal constitutional principles that support consistency and predictability. The Court found that California’s long-arm statute violated the Fourth Amendment Due Process Class since corporate directors and officers “have a significant right . . . to know what law will be applied to their actions” and shareholders “have a right to know by what standards of accountability they may hold” officers and directors. VantagePoint, 871 A.2d at 1113 (quoting McDermott Inc. v. Lewis, 531 A.2d 206, 216 (Del. 1987)). Further, under the Commerce Clause, states do not have an interest in regulating the internal affairs of corporations incorporated in other states. Id.

 

Implications for Investors in Privately-Held Corporations

 

Because a Delaware court cannot determine the constitutionality of the law of another state, the Delaware Supreme Court decided VantagePoint applying a choice of law analysis (relying somewhat on federal constitutional principles). In refusing to apply California’s long-arm statute to a Delaware corporation, the Court reaffirmed the application of the internal affairs doctrine. However, since VantagePoint is a Delaware decision, it is not binding on a California court when presented with a similar case. Still, if a similar case is presented to a California court, VantagePoint would be persuasive and it is possible, though not certain, that California might reach a conclusion similar to the one in VantagePoint. In addition, because of this apparent tension between the laws of two states, the U.S. Supreme Court may become interested in reviewing the internal affairs doctrine and California’s long-arm statute under the U.S. Constitution. Until then, there remains a risk of inconsistent outcomes. Investors are therefore well-advised to fully understand the implications of the jurisdiction of incorporation of the companies in which they invest. Investors should also negotiate and draft corporate charters and preferred stock instruments to help avoid an unpredictable outcome.

Please contact the author at ara@encorelaw.com.

 

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