Choice of Law: The Internal Affairs Doctrine | Holger Spamann | November 27, 2013

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Choice of Law: The Internal Affairs Doctrine

by Holger Spamann Show/Hide

The “internal affairs doctrine” is a choice of law rule that applies the law of the state of incorporation to the corporation’s “internal affairs.”

While many in the U.S. treat the internal affairs doctrine as self-evident, other countries frequently insist on applying their corporate law to all corporations that have their headquarters in that country, or some other substantial connection to that country. Such insistence on a substantial connection is no stranger to U.S. choice of law. In fact, for most contracts, U.S. courts generally refuse to apply “[t]he law of the state chosen by the parties to govern their contractual rights and duties” if “the chosen state has no substantial relationship to the parties or the transaction and there is no other reasonable basis for the parties choice,” see Restatement of the Law (2nd) Conflict of Laws § 187(2)(a). U.S. courts will, however, enforce any chosen state's corporate law under the internal affairs doctrine.

The internal affairs doctrine allowed corporations to migrate away from states that imposed restrictions. Again, “migration” is a mere figure of speech — no people or assets need to move out of state to avoid that state's corporate law. Mere reincorporation in another state is sufficient.

Nowadays this issue is mostly discussed in connection with shareholder rights. In recent decades, commentators have been intensely debating whether Delaware’s enabling approach to shareholder rights is the result of a “race to the top” or a “race to the bottom” from the perspective of the shareholder/manager relationship. But Delaware actually became a major corporate domicile only because other states tried to protect non-shareholder constituencies through corporate law. In particular, in an attempt to combat “trusts,” a/k/a cartels, New York in the later 19th and early 20th century prohibited holding companies — it prohibited its corporations from owning stock in other corporations. In response, corporations migrated to New Jersey. When New Jersey’s governor Woodrow Wilson ran for the presidency in 1912, he advocated amendments that limited holding companies in New Jersey as well. Thus, the corporations moved on to Delaware and they have stayed there ever since. The issue of “trusts” was left to federal antitrust law.

In general, regulatory competition may work for the contracting parties writ large. As previously indicated, this group includes all those who voluntarily interact with the corporation. But regulatory competition clearly does not address the concerns of third parties, such as tort creditors or the general public. To the extent that these groups are affected by corporate law, regulatory competition is apt to generate negative externalities. Such externalities would then require federal intervention, such as the federal antitrust and securities laws. 

Are negative externalities a real problem in corporate law, or a negligible quibble? The answer depends on two related issues: First, the scope of the internal affairs doctrine. The fewer rules the doctrine covers, the less potential for externalities. As its name implies, the internal affairs doctrine covers internal organizational rules, but the details can be tricky, as Lidow illustrates.

Second, do third parties really need the protection of rules covered by the internal affairs doctrine? After all, tort victims are already protected by tort law, the environment is protected by environmental statutes and so on.  Nevertheless, additional protection through organizational law may be required. The reason is that this other law is imperfect, owing to the limits of both the political process and of law’s capacity to regulate human affairs. Hence societies must rely on non-legal norms to regulate most human interaction. However, the corporate context may interfere with the operation of non-legal norms, be it by diffusing responsibility, by suppressing internalized norms, or by some other mechanism. Do we need to insist on some mandatory internal corporate structure to avoid “sociopathic” corporate behavior? Or to take a more positive view, does organizational law provide opportunities for “mandatory betterment” that would be infeasible or unethical for individuals? For example, should we impose co-determination or affirmative action for boards? The U.S. has neither, but many European countries do.

If one concludes that externalities from corporate law are a real problem, then one should wonder why states accept the internal affairs doctrine. It is often said, especially in Delaware, that the U.S. Constitution enshrines the internal affairs doctrine; CTS is usually cited as support. See, e.g., VantagePoint below. Read CTS and judge for yourself.

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  1. 1 Show/Hide More CTS v. Dynamics (U.S. 1987)
    Original Creator: Holger Spamann

    This decision upheld Indiana’s version of DGCL 203 against constitutional challenge. In the 1980s, most states passed some form of an anti-takeover statute. They were hotly politically contested, as you might infer from the heated debate between the Justices and the various amici.

    In Edgar v. MITE (1982), a plurality of the Supreme Court struck down an Illinois law that purported to apply to any tender offer for shares of  “corporation or other issuer of securities of which shareholders located in Illinois own 10% of the class of equity securities subject to the offer, or for which any two of the following three conditions are met: the corporation (1) has its principal executive office in Illinois, (2) is organized under the laws of Illinois, or (3) has at least 10% of its stated capital and paid-in surplus represented within the State,” 457 U.S. 624, 627 (1982).

    The Indiana statute at issue here in CTS is different as it applies only to corporations chartered in Indiana. Does this fact or anything else in the decision imply that the internal affairs doctrine is enshrined in the U.S. Constitution?

  2. 2 Show/Hide More VantagePoint v. Examen Inc. (Del. 2005)
    Original Creator: Holger Spamann

    This Delaware case deals with the only sustained challenge to the internal affairs doctrine in the U.S.: section 2115 of the California Corporations Code.

    1. By its own terms, does section 2115 apply in this case?
    2. Why does the Delaware Supreme Court not apply section 2115?
    3. Does the Delaware Supreme Court hold that the internal affairs doctrine is embodied in the U.S. constitution?
    4. What is better for Delaware’s business – section 2115 or strict adherence to the internal affairs doctrine?
    5. As a policy matter, did the party arguing for application of section 2115, VantagePoint, deserve its protection in this case?



  3. 3 Show/Hide More Lidow v. Superior Court (Cal. 2012)
    Original Creator: Holger Spamann

    This California decision accepts the internal affairs doctrine in principle. Nevertheless, in this case it applies California law to a dispute between a Delaware corporation and its officer.

    1. How does the Court of Appeals of California determine the scope of the internal affairs doctrine?
    2. Looking beyond this particular case, what scope of the internal affairs doctrine increases the application of California law – a narrow scope or a broad scope?
    3. What can corporations—or rather those who control them—do to escape application of California law under section 2115 or under Lidow, and are they likely to do that? What can corporations do to escape application of Delaware law under the internal affairs doctrine, and are they likely to do that?



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