California Supreme Court grants review of Grosset v. Wenaas ("Internal Affairs Doctrine" involved)

By: William Freeman

On October 20, 2005, the Fourth District Court of Appeal ruled in Grosset v. Wenaas. This is case is an important extension of the California courts' recognition of the "internal affairs doctrine" under which matters relating to the relationships between corporate constituents (including derivative litigation) should be decided under the laws of the state of incorporation.

In Grosset, the plaintiff was cashed out by a merger during pendency of the appeal, and the corporation moved to dismiss for lack of standing, claiming that under Delaware's "continuous ownership rule," the plaintiff could no longer prosecute the case. Plaintiff claimed that the case was controlled by Cal. Corp. Code section 800, which only required ownership at the time of the acts complained of. The Court of Appeal disagreed with plaintiff's construction of section 800, but more importantly, ruled that the standing issue had to be decided under Delaware law despite plaintiff's claim that it was merely a question of "procedure." The court made extended observations on the importance of the internal affairs doctrine and its role in intracorporate disputes:

Respondents contend that under the "internal affairs" doctrine the law of JNI's place of incorporation, Delaware, applies to the question of Huang's standing to pursue this action. The Court of Appeal in State Farm Mut. Auto. Ins. Co. v. Superior Court (2003) 114 Cal.App.4th 434, 442 (State Farm), describes the internal affairs doctrine as: "' [A] conflict of laws principle which recognizes that only one State should have the authority to regulate a corporation's internal affairsé0 matters peculiar to the relationships among or between the corporation and its current officers, directors, and shareholdersé0 because otherwise a corporation could be faced with conflicting demands.' [Citation.] States normally look to the State of a business' incorporation for the law that provides the relevant corporate governance general standard of care.' " "In general, courts in California follow this rule and apply the law of the state of incorporation in considering claims relating to internal corporate affairs." (In re Sagent Technology, Inc. (N.D.Cal. 2003) 278 F.Supp.2d 1079, 1087.)

This is so because the state of incorporation has an "overriding interest in the internal affairs of corporations domiciled there." (Nedlloyd Lines B.V. v. Superior Court (1992) 3 Cal.4th 459, 471.) Only one state should have the authority to regulate a corporation's internal affairs. (State Farm, supra, 114 Cal.App.4th at p. 442.)

Further, "[t]he internal affairs doctrine is not . . . only a conflicts of law principle. Pursuant to the Fourteenth Amendment Due Process Clause, directors and officers of corporations ' have a significant right . . . to know what law will be applied to their actions' and ' [s]tockholders . . . have a right to know by what standards of accountability they may hold those managing the corporation's business and affairs.' " (VantagePoint Venture Partners 1996 v. Examen, Inc. (Del. 2005) 871 A.2d 1108, 1113, fn. omitted (VantagePoint).) In Edgar v. MITE Corp. (1982) 457 U.S. 624, 645-646, the Supreme Court held that under the commerce clause a state "' has no interest in regulating the internal affairs of foreign corporations.' " (VantagePoint, supra, at p. 1113, fn. omitted.) Therefore, "' application of the internal affairs doctrine is mandated by constitutional principles, except in the "rarest situations," ' e.g., when ' the law of the state of incorporation is inconsistent with a national policy on foreign or interstate commerce.' " (VantagePoint, supra, 871 A.2d at p. 1113, fns.omitted.)

The question then becomes: Is the issue of a plaintiff's standing based upon share ownership a question that involves the "internal affairs" of a corporation, thus making it subject to the law of the state of incorporation? No case that we could locate has resolved this question. As we shall discuss, we conclude that it is.

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However, while these facts might be relevant in an ordinary choice of law analysis, they are irrelevant to application of the internal affairs doctrine because, as explained in State Farm, supra, 114 Cal.App.4th at pp. 445-446, "' [t]he corporate internal affairs rule is deeply ingrained in the choice-of-law culture. It has survived the conflicts resolution largely unscathed. In all but a handful of cases, the law of the state of incorporation is applied to disputes involving internal corporate affairs in spite of the various choice-of-law theories adopted from year-to-year by the individual courts.' " (See also Nedlloyd Lines B.V. v. Superior Court, supra, 3 Cal.4th at p. 471 [state of incorporation has "overriding interest in the internal affairs of corporations domiciled there" ].) Further, as discussed, ante, the internal affairs doctrine has constitutional underpinnings, requiring application of the law of the state of incorporation "' except in the "rarest situations," ' e.g., when the ' law of the state of incorporation is inconsistent with a national policy on foreign or interstate commerce.' " (VantagePoint, supra, 871 A.2d at p. 1113, fns. omitted.) We do not have that situation here.

In sum, we conclude that Delaware law controls the issue of whether a plaintiff in a derivative action must own stock in the relevant corporation throughout the litigation. Because it is not subject to dispute that Delaware requires such ownership, Huang lacks standing to pursue this matter and his appeal must be dismissed.

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Interestingly, the court also disapproved Gaillard v. Natomas, an older First District case on which derivative plaintiffs frequently rely:

However, a later California case, without citing to Heckmann, concluded that, at least under the facts presented there, there was no continuous ownership requirement in California. In that case, a shareholder filed a derivative suit challenging "golden parachute" agreements and other benefits provided for certain officers and directors of corporation as part of merger agreement. (Gaillard v. Natomas Co. (1985) 173 Cal.App.3d 410, 413 (Gaillard).) The superior court sustained defendants' demurrer to the complaint on the basis that the plaintiff no longer owned any shares in the corporation because of the merger, and therefore the plaintiff had no standing to sue. (Id. at p. 421.) The shareholder appealed, and the First District Court of Appeal reversed. It held that to have standing, a plaintiff in a derivative action need only be a shareholder (1) at the time of the transaction and (2) when the action is filed. (Id. at p. 413.)

The Gaillard court concluded that because section 800 only required a plaintiff to allege ownership at the time of the underlying transaction and at the time of filing suit, there was no continuous ownership rule in California: "The statute herein clearly states that the plaintiff must be a shareholder ' at the time' of the alleged wrongdoing. It does not have an express provision requiring a plaintiff to maintain shareholder status throughout the course of the litigation. Under the maxim that the expression of certain things in a statute necessarily precludes the inclusion of things not expressed, we cannot presume continuing shareholder status is a requirement of [section 800(b)(1)]." (Gaillard, supra, 173 Cal.App.3d at p. 414.)

The Gaillard court also declined to follow federal cases holding that continuous ownership was required, even in the event of a merger, as opposed to a voluntary sale of stock. The court first noted that federal cases holding that there was a continuous ownership requirement relied upon federal rule 23.1. The Gaillard court opined that federal rule 23.1 "has an implied continuous ownership requirement. [Citation.] We are certainly not concerned here with the federal rules or their interpretations." (Gaillard, supra, 173 Cal.App.3d at p. 417.) The court distinguished a federal merger case because in the cited case the merged corporation ceased to exist, while in the Gaillard action the corporation in which the plaintiff owned shares was still a viable entity after the merger. (Id. at pp. 417-418.) The Gaillard court also distinguished that case because in Gaillard the plaintiff was attacking the merger itself. (Id.at p. 418.) As noted above, the derivative suit in Gaillard attacked the golden parachute agreements and other benefits certain officers and directors received for their agreement to the merger. (Id. at p. 413.)

The First District also rejected the Delaware Supreme Court's holding in Lewis, supra, 453 A.2d 474, stating: "Although we note with interest the holding in that case, we are not bound thereby." (Gaillard, supra, 173 Cal.App.3d at p. 420.)

We find the reasoning in Gaillard unpersuasive and the case itself distinguishable….

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