In this paper, Ann Lipton, an Associate Professor at Tulane Law School, contends that the “internal affairs” doctrine has gradually expanded its reach and, perhaps as a result, is now facing new challenges. As applied in Delaware—where it is applied most often—the doctrine, she argues, is “on a collision course with the legitimate regulatory interests of other states (and indeed the federal government).” Of course, many will strongly disagree with her argument, especially given the practical implications. Still, it may be worthwhile to gain some insight into her perspective. Is it time to rethink the internal affairs doctrine? The author suggests that a more balanced, targeted approach would be more appropriate and more effective.
What is the internal affairs doctrine? As described by the author, the internal affairs doctrine provides that “the law applicable to the internal governance of a business entity is that of the chartering jurisdiction.” The author loosely defines “internal affairs as “matters peculiar to the relationships among or between the corporation and its current officers, directors, and shareholders.” In essence, the founders of a business can select the state in which to incorporate, and then the “internal affairs” of the business are governed by that state’s laws, even if the company’s headquarters, operations, management and employees are located elsewhere. Consequently, she argues, the doctrine allows the state of incorporation to “regulate outside of its borders…and, more relevantly, oust the regulatory jurisdiction of states with a more tangible connection to the entity.” That is, where there is a conflict between the rules of the chartering state and the rules of state where entity is headquartered or otherwise operates, “there is no examination of which state has the greatest interest; the internal affairs doctrine is assumed to control absolutely.” In contrast, on matters outside of internal affairs, the choice of applicable law is governed by the extent of parties’ contacts or relationship with the state or, in connection with contracts, by agreement of the parties within reasonable limits.
But the times they are a-changing: “though the contours of the doctrine have never been precise, its coherence is rapidly eroding in the face of modern challenges, such as the growing impulse to use corporate governance arrangements to protect non-investor constituencies like employees and historically underrepresented groups.” Consequently, “disputes that in another era may have been handled through employment law, or securities law, or antidiscrimination law—with an individual’s rights dictated by the law of the state in which they reside—are increasingly being channeled through the law of the state that organized a party-business entity. And that state, more commonly than not, is Delaware.” For example, as advocates of ESG “use corporate law to encourage socially responsible business activity, it has become increasingly problematic that one state, Delaware, claims regulatory dominion over a huge swath of corporate behavior.” With many companies organized in Delaware but operating primarily elsewhere, the internal affairs doctrine, she suggests, erodes the ability of the states to regulate economic activity within their territory, including laws enacted to protect their residents and promote state policies. “More importantly,” she contends, “citizens who reside in the affected states—outside of Delaware—have no voice in policy choices that may directly affect their lives. And, all too often, it appears that states acquiesce in this arrangement, perhaps because it allows them to evade responsibility for difficult political choices.”
How has the extraterritorial reach of the doctrine been justified? Historically, the argument for the internal affairs doctrine was that the corporation is “created by state concession, and that it therefore exists, abstractly, in its home state, which necessarily defines the terms of its existence.” The doctrine was then justified by “the need for consistency and the constitutional demands of due process and the dormant Commerce Clause.” But then originally, the author observes, the doctrine did not mean that state regulation was extraterritorial. More recently, the “contract” theory has been in vogue, with the idea that “business entities represent a kind of contract between investors and managers, and states’ entity laws offer various templates for that contract.” Investors and managers can select the set of rules they consider most beneficial, but corporate participants then maintain that they need predictability.
SideBar
The “dormant” Commerce Clause has been “interpreted to prohibit state laws that unduly restrict interstate commerce even in the absence of congressional legislation—i.e., where Congress is dormant. This negative or dormant interpretation of the Commerce Clause prevents the States from adopting protectionist measures and thus preserves a national market for goods and services.” See https://constitution.congress.gov/browse/essay/artI-S8-C3-7-1/ALDE_00013307/.)
However, the author suggests, “the two theories have very different implications for the scope of matters subject to the internal affairs doctrine”: the first theory is inflexible and limits the reach of the doctrine beyond the state and the second focuses on the preferences of investors (shareholder primacy) with few limitations on the subjects covered by the “contract,” such as federal securities law or employment arrangements between investors and the firm. However, she contends, “if entities are simply contracts among investors and managers, there is no reason why (like any other contract), their terms should not be overridden when another state has a materially greater interest in the subject matter.…The balance would be particularly likely to tilt in favor of the state that substantively hosts the entity’s activities when rules are intended to prevent externalities that affect nonparties to the contract, like employees and consumers.” In Edgar v. MITE and CTS Corp. v. Dynamics Corp. of America, SCOTUS merged both theories, which the author viewed as an “awkward combination” that “create[s] an additional set of problems: They give the organizing state complete sovereignty over internal affairs, but—by endorsing the logic of the contractarian theory—they do not admit of any natural limits on the scope of the matters in which the organizing state has unfettered authority.”
In the author’s view, currently, the scope of the doctrine is “increasingly in dispute,” with Delaware expanding the doctrine to apply to charter and bylaw provisions related to litigation under federal law (see, e.g., Salzberg v. Sciabacucchi in which the Delaware Supreme Court held that charter provisions designating the federal courts as the exclusive forum for ’33 Act claims were “facially valid,” see this PubCo post) and California seeking to limit the doctrine by adopting legislation (SB 826) mandating that boards of public companies achieve specified levels of board diversity.
SideBar
SB 826 required that, by December 31, 2021, all public companies listed on a major exchange and headquartered in California, no matter where they were incorporated, include at least two women on their boards if the corporation had five directors, and three women directors if the corporation had six or more directors. A minimum of one woman director was required if the board had four or fewer directors. The statute also required that the office of the California Secretary of State post on its website reports on the status of compliance with the law. To provide those reports, the Secretary sought to collect pertinent data from subject companies. Under the statute, the Secretary could impose fines for violations, ranging from $100,000 to $300,000 per violation. No fines for violations or regulations regarding fines had been proposed or adopted. (See this PubCo post.)
AB 979, California’s board diversity statute for “underrepresented communities,” patterned after the board gender diversity statute, was signed into law in 2020. That law required boards of public companies, including foreign corporations with principal executive offices located in California, to have a minimum of one director from an underrepresented community by the end of 2021. No later than the close of 2022, a corporation with more than four but fewer than nine directors was required to have a minimum of two directors from underrepresented communities, and a corporation with nine or more directors was required to have a minimum of three directors from underrepresented communities. A director from an “underrepresented community” means a director who self-identifies as Black, African American, Hispanic, Latino, Asian, Pacific Islander, Native American, Native Hawaiian, Alaska Native, gay, lesbian, bisexual or transgender.
A corporation could increase the number of directors on its board to comply with these laws. In both cases, the laws were expected to lead companies to look outside their traditional channels to find new diverse directors. (See this PubCo post.)
The author addresses a number of areas where she views the edges of the internal affairs doctrine to be a bit frayed, such as the use of charter and bylaw provisions to limit litigation. In this post, I’ll just cover the author’s discussion of the California board diversity statutes. Here, the author points out that director qualifications are typically a matter of corporate governance, which she says are now tied to shareholder interests or primacy. Accordingly, the findings in the legislation sought to justify the statute on the basis that companies with diverse boards were more profitable companies, a justification that she viewed as somewhat flimsy in light of mixed evidence. Still, in the author’s view, this seems to be a prime example of the need to revisit the internal affairs doctrine:
“This is precisely the territory that the internal affairs doctrine, viewed through a contractual lens, should cover. Managers and investors select a chartering jurisdiction that offers them the law that will maximize corporate profits; if they select a state with no diversity requirement for corporate boards, it is because such a requirement will not contribute to their wealth. California certainly has no reason to override that choice, especially for public companies, with their sophisticated shareholder base. Thus, it is hardly surprising that one of the challenges to California’s law was rooted in the internal affairs doctrine. But, as a court later determined, California’s law was almost certainly not intended to benefit California’s investors or even California’s economy; the far more likely motivation was to benefit the women who are dramatically underrepresented on corporate boards. So, if the internal affairs doctrine is rooted in a contractual arrangement between shareholders and managers, we might reasonably ask whether California’s interest in promoting gender equity supersedes the rights of these contracting parties, just as it clearly would in the case of employment law, public accommodations law, and the like. This is the point made by Jill Fisch and Steven Davidoff Solomon: That laws designed to benefit non-investor constituencies are categorically removed from the internal affairs doctrine, and therefore may be regulated by non-chartering states. Or, to put it another way, ‘the use of legal rules for purposes other than increasing the value of the firm is the boundary separating corporate from other areas of law.’ Given that argument, it is not surprising that when California expanded its law in 2020 to require the same companies to include directors of ‘underrepresented communities,’…it articulated a broader set of goals beyond advancement of shareholder value. In addition to mentioning that diverse boards might pay CEOs less, commit less fraud, and that diversification might increase the wealth of the tech industry, the Legislature extensively documented the underrepresentation of racial minorities in the tech sector generally, and highlighted how affirmative action plans would ‘further the legislative goals of the Civil Rights Act of 1964.’”
SideBar
There’s not a smidgen of equivocation about the constitutionality of SB 826 under the internal affairs doctrine in this article from Stanford’s Rock Center for Corporate Governance. In the article, Professor Joseph Grundfest contended that SB 826 violates the Commerce Clause “because it purports to apply to corporations headquartered in California that are chartered outside of California. As the United States Supreme Court has explained, a corporation’s internal affairs, such as rules regulating the composition of its board of directors and shareholder elections, are governed by the corporation’s state of incorporation, and not by the state in which it is headquartered.”
Citing Mite and CTS, Grundfest argued that the “composition [of] a corporation’s board of directors is a prototypical example of a matter ‘among or between the corporation and its current … directors’ that must be governed by a single jurisdiction ‘lest a corporation be faced with conflicting demands.’” Accordingly, he maintained, a
“board’s gender diversity is a matter of internal corporate governance, as is shareholder voting, and SB 826 interferes with both. SB 826 would establish the first and only demographic test for board membership. It thereby constrains a board’s ability to designate directors in the event of a vacancy and interferes with the shareholder franchise by imposing a financial penalty if shareholders refuse to elect the minimum number of women directors mandated by SB 826. California therefore cannot require that corporations headquartered in California but chartered in Delaware have a minimum number of women directors while Delaware simultaneously permits its chartered corporations to have any number of women directors that is consistent with the board’s business judgment, subject to shareholder approval and constraints imposed by the corporation’s charter and bylaws. The conflict between California law and Delaware law is apparent. Indeed, because SB 826 would be the first and only mandatory board diversity requirement in the United States, the bill creates a conflict between California and the chartering laws of every other state in the nation.”
Further, Section 2115, California’s long-arm statute, “cannot over-ride the internal affairs doctrine, which is of constitutional dimension.”
In addition, he observed that
“[w]hile well intentioned, this legislation will not achieve its intended effect because it is unconstitutional as applied to the vast majority, if not all, of publicly held corporations headquartered in California. The internal affairs doctrine will limit the law’s application to only 72 corporations headquartered and chartered in California, or 1.59 percent of all publicly traded corporations. The bill will increase the number of board seats occupied by women by trivial amounts, if at all. These trivial changes will, however, come at great risk to the evolution of affirmative action jurisprudence. California’s own legislative analysis concludes that ‘the use of a quota-like system, as proposed by this bill … may be difficult to defend.’ A successful equal rights challenge means that SB 826 will have no effect at all. The legislation thus offers a poor bargain for diversity advocates: gain a trivial number of board seats, if any, but increase the risk of judicial rulings inimical to broader affirmative action initiatives.”
Instead, the professor advocated shareholder activism as a more effective, less perilous route to achieving board gender diversity.
To be sure, the legislation was struck down in California, but on equal protection grounds (see this PubCo post), and is currently on appeal. The author suggests that perhaps the law would have been on stronger ground had it required, rather than an affirmative obligation to select women as directors, that boards “simply not discriminate against women and racial minorities when considering candidates for board service. A California court suggested that such a law would have been on stronger constitutional ground, and currently, no law actually requires nondiscrimination in board selection, because nondiscrimination is not an aspect of the duties of loyalty and care, and directors—whose relationship with the company is not usually close enough to be deemed employees—are not covered by typical antidiscrimination laws.”
Equal protection notwithstanding, the author contends that California may still have had difficulty in the event of an internal affairs challenge because California’s interest may not have been sufficiently strong; “the board members of publicly traded companies do not necessarily reside in the state where the company has operations, and there is no certainty that a substantial amount of board-level activity would occur in that state.” If, theoretically, California had argued that board discrimination “contributes to a hostile climate throughout the organization,” the law might have been read as a mechanism for protecting California employees. She posited instead a theoretical California law that applied to private companies operating in the state: “At that point, a nondiscrimination requirement would look much like an expansion of employment law, with a new, more capacious definition of what it means to be an employee—bolstered by the explicit reference in California’s 2020 amendments to Title VII of the Civil Rights Act. And this is where the internal affairs doctrine has real bite: it could give Delaware the power to block California from legislating against discrimination within its own territory.” Another example the author suggested is the status of corporate officers as employees—how does the internal affairs doctrine affect California’s ability to protect officers from discrimination in their capacity as employees? Should Delaware have the power to block California from legislating against discrimination within its own territory?
The analysis has a bipartisan impact. The author notes that the same analysis could apply to proposed state regulation regulating health benefit reimbursements to employees for interstate travel for abortion-related care. Members of the Texas legislature “threatened to declare such payments to be a per se violation of directors’ fiduciary duties to shareholders, and to permit any Texas shareholder of a public corporation to sue for a violation of those duties, regardless of where the corporation was organized, conducted business, or the states involved in the travel…. The proposed legislation would also criminalize such payments unless they received unanimous shareholder approval (a reference to the traditional standard for corporate waste, which can only be cleansed with a unanimous shareholder vote….” The author contends that this legislation was
“obviously unnecessary to protect the actual interests of public corporation shareholders, who are more than adequately positioned to police against wasteful corporate spending. That said, the proposed legislation, just like SB 826, is transparently less about protecting shareholders than about protecting Texas’s interests in limiting women’s ability to obtain abortions. Viewed through that lens, it suffers from the same defects of SB 826, namely, a lack of Texas-specific connection. Texas’s legitimate interests could be advanced by banning specific actions taken within its territory. The only reason it threatened to redefine corporate fiduciary obligations is, apparently, to extend its regulatory reach beyond its borders, to actions taken in other states.”
In practice, she suggests, states have been reluctant to adopt “aggressive interventions,”—long-arm statutes like California’s Section 2115 notwithstanding—perhaps, she speculates, to avoid the risk of “offending powerful constituencies who, if pressed, may relocate to more accommodating jurisdictions. In a sense, then, the internal affairs doctrine may not so much constrain states’ regulatory options as serve as a convenient scapegoat; so long as companies routinely incorporate in Delaware while doing business outside of it, host states can offload thorny political choices.” In some of the cases cited in the article, when faced with a Delaware challenge, California courts have simply ceded authority. Perhaps, as another author suggested, Delaware’s “aggressive defense” of the doctrine has cowed other states into giving up.
In conclusion, the author attributes the hazy scope of the internal affairs doctrine to the conflict in its “doctrinal underpinnings”: “if it represents an exercise of state sovereignty, it should be absolute but operate along a narrow set of dimensions; if it represents a respect for privately ordered arrangements among investors and managers, it should be porous but broad. Delaware, however, with the intermittent acquiescence of other states, has adopted both a broad and absolute interpretation, which cannot be justified theoretically and puts it on a collision course with the legitimate regulatory interests of other states (and indeed the federal government).” In her view, states frequently have no substantive ties to their chartered businesses and, accordingly, it doesn’t make sense for these organizing states to “claim complete regulatory dominion over an entity’s form solely on the basis of the state’s status as the organizing jurisdiction.”
Rather, she advocates a balancing of interests for a more targeted approach. While it may be appropriate to respect the choices of shareholders and management about the state-created structure of the entity and its judicial oversight, “other states should be able to override the law of the chartering state when their own interests are strong enough….” She suggests a few principles that should apply in determining the ambit of the chartering state’s regulation, including determining the role of the chartering state’s law based on the issue at stake, providing for compliance with multiple applicable states’ laws if compatible and states’ interests are legitimate, ensuring that non-chartering states’ seeking to regulate governance matters have legitimate interests in the subject, making the role of chartering states more significant for public companies with dispersed shareholders and operations (where the need for predictability and stability is more significant), and encouraging Delaware to “assume more modesty when it comes to matters that even it concedes are governed by non-Delaware law,” while other states be less deferential to Delaware law
