At Last, a California Court Acknowledges Delaware Supreme Court Decision Holding that the State's "Quasi-California Corporation" Statute Violates Internal Affairs Doctrine
August 30, 2012
Companies incorporated outside of California but with significant California contacts (so-called "quasi-California corporations") have struggled with exactly how to comply with the long-arm statute found in Section 2115 of the California Corporations Code. The statute purports to impose a number of provisions of the California Corporations Code on quasi-California corporations, including the state's requirement to obtain separate approval from holders of each class of capital stock on a merger "to the exclusion of the law of the jurisdiction in which [the quasi-California corporation] is incorporated." Section 2115 has been thought to be legally infirm for some time, particularly after a decision by the Delaware Supreme Court in 2005. However, there never has been an acknowledgement by a California court that Section 2115 reaches too far. That changed earlier this year, when a California Court of Appeal stated in dicta that certain matters of internal corporate governance fall within a corporation's internal affairs and should be governed by the laws of the corporation's state of incorporation.
Relevance of Section 2115 to Venture-Backed Companies in M&A Transactions
Especially for venture-backed companies that are deemed to be quasi-California corporations, Section 2115 issues often arise in the context of a merger because of California's requirement that the holders of each class of capital stock of the corporation approve the merger. For a typical venture-backed corporation that is a quasi-California corporation but incorporated in Delaware with outstanding shares of preferred and common stock, this means that it must obtain the approval of not only the holders of preferred stock, but also of the holders of common stock, each voting as a separate class. This approval requirement goes beyond the statutory requirement for the approval of a merger in Delaware, which only requires the approval of holders of a majority of the outstanding stock. As a result, Section 2115's class vote requirement provides an opportunity for a shareholder or group of shareholders holding the majority of one class of stock to block a proposed merger, even where the merger otherwise has been approved by the requisite vote pursuant to the laws of the corporation's state of incorporation. In a situation where shareholders are not aligned on the right strategic direction for the company (e.g., some favor a merger while others prefer continuing to operate the business independently), this can raise significant certainty of closing concerns for all involved.
Rejection of Section 2115 by Delaware Supreme Court and Subsequent Practice
In 2005, the Delaware Supreme Court in VantagePoint Venture Partners 1996 v. Examen, Inc.1 held that Section 2115 violated "Delaware's well-established choice of law rules and the federal constitution," and found that the internal affairs of Delaware corporations (and, in particular, the voting rights of shareholders) are to "be adjudicated exclusively" in accordance with Delaware law. Plaintiff Examen, a Delaware corporation doing business in California, filed a complaint in Delaware seeking a judicial declaration that defendant VantagePoint Venture Partners was not entitled pursuant to Delaware law to a separate class vote on a proposed merger in which Examen was to be acquired by another corporation. VantagePoint owned approximately 83 percent of Examen's Series A preferred stock and, if Examen was deemed to be a quasi-California corporation, held sufficient votes to block the approval of the merger pursuant to California's separate class vote requirement. However, if Examen was not deemed to be a quasi-California corporation, VantagePoint did not have sufficient votes to block the merger.
In upholding the Delaware Chancery Court's earlier decision, the Delaware Supreme Court explicitly found that "VantagePoint's voting rights [should] be adjudicated exclusively in accordance with the laws of its state of incorporation" (in this case, Delaware). Going a step beyond the Chancery Court, the Supreme Court found that the internal affairs doctrine was rooted in constitutional principles, with a state having no interest in regulating the internal affairs (that is, "those matters that pertain to the relationships among and between the corporation and its officers, directors and shareholders") of a foreign corporation, other than in rare instances where the law of the state of incorporation is inconsistent with national policy on foreign or interstate commerce.
VantagePoint provided welcome assurance regarding the applicability of Delaware law to a Delaware corporation's internal affairs. However, Section 2115 remained on the statute books and no California court had adopted the Delaware Supreme Court's reasoning in a published decision. As a result, out of an abundance of caution many practitioners continued to recommend that, whenever possible, a quasi-California corporation comply with Section 2115, including by obtaining the necessary class votes in connection with a merger, in addition to complying with any other applicable provisions of the laws of its state of incorporation to the extent that they are different from those provisions of California law that purport to apply by operation of Section 2115.
At Last, a California Court Acknowledges VantagePoint
In late May 2012, for the first time, a California court signaled that it likely was unwilling to enforce Section 2115. In that case, Lidow v. Superior Court,2 the Second Appellate District of the California Court of Appeal, in the published portion of an opinion, stated in dicta that matters of internal corporate governance (such as the voting rights of shareholders) fall within a corporation's internal affairs, and that only its state of incorporation's laws should govern such matters.
Lidow involves, among other things, the purported wrongful termination of the chief executive officer of International Rectifier Corporation. In moving for summary judgment, International Rectifier asserted that, because it was a Delaware corporation, the internal affairs doctrine meant that Delaware law governed the claim. Lidow, the former chief executive officer, opposed the motion, arguing that the circumstances underlying his claim did not constitute an internal affair of the corporation and thus California (and not Delaware) law governed.
The court ultimately sided with Lidow on his claim, and in so doing agreed with key portions of the analysis of the Delaware Supreme Court in VantagePoint. Noting that "courts must apply the law of the state of incorporation to issues involving corporate internal affairs," the court stated its belief 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."
Although Lidow does not involve an explicit application of Section 2115, the court's belief, consistent with VantagePoint, that certain issues, including the voting rights of shareholders and possibly other corporate matters currently covered by Section 2115, involve matters of internal corporate affairs likely signals an unwillingness to enforce Section 2115.3
Lidow is not the unequivocal statement of Section 2115's unconstitutionality that many hoped for in the wake of VantagePoint, but it does accept the Delaware Supreme Court's analysis and should give practitioners and the companies they advise some comfort that VantagePoint will be persuasive to a California court tasked with reviewing Section 2115. That said, the best course for quasi-California corporations remains to comply with Section 2115 whenever possible.
For more information about quasi-California corporations and the implications of the decisions in VantagePoint and Lidow, please contact any member of Wilson Sonsini Goodrich & Rosati's corporate and securities or mergers and acquisitions practices.
3 Efforts to repeal Section 2115 have arisen from time to time, with the most recent coming in February 2012 through Assembly Bill 2260. AB 2260 sought to repeal Section 2115 and explicitly provide that nothing in the California Corporations Code should be construed to authorize California to regulate the organization or internal affairs of a foreign corporation. The sole exception to this would be existing Section 2116 of the California Corporations Code, which provides for the liability of directors of a foreign corporation transacting intrastate business in certain circumstances. According to the bill's author, AB 2260 "takes the proactive step of repealing Section 2115 before the federal courts strike it down" and would reduce uncertainty for foreign corporations operating in California.
On May 7, 2012, the California Assembly passed AB 2260 in a floor vote of 75 to 0. After being referred to the Senate Judiciary Committee, the bill failed passage by the committee by a vote of 1 to 3. The analysis prepared for the Judiciary Committee focuses on the lack of California authority finding Section 2115 unconstitutional. The analysis questions the wisdom of exempting foreign corporations from regulation in California, noting that prohibiting the state "from taking even reasonable steps to require certain acts from . . . foreign corporations, as [AB 2260] might arguably do, could lead to an uneven playing field among corporations that do business in California and provide yet another incentive for corporations to incorporate outside of California." Finally, the analysis also notes that only a limited number and type of California laws are applicable to foreign corporations as a result of Section 2115, and the exact number of corporations affected by Section 2115 is unknown.