It is important that every corporation take time now to understand the new test for citizenship in diversity cases recently announced by the Supreme Court, rather than being surprised by application of the new rule when filing or defending a future lawsuit.

Although covered with relatively little fanfare, the Supreme Court of the United States recently published a critical decision resolving the long-standing dispute regarding how a corporation’s principal place of business is determined. Through its decision in Hertz Corp. v. Friend, No. 08–1107 (Feb. 23, 2010), the Supreme Court has definitively held that, when determining whether lawsuits may be filed in or removed to federal court, a corporation’s citizenship will be determined based on the state in which the corporation locates its “nerve center”—typically, its corporate headquarters. Although this “nerve center” test should simplify future disputes regarding the availability of federal court jurisdiction, the Hertz decision also carries with it new risks of which every company should be aware.

Federal law has long provided that suits between citizens of different states can fall within the jurisdiction of the federal courts, raising with it the question of how to determine the citizenship of a corporation. In the late 18th century, the Supreme Court determined that a corporation is treated as a citizen of the state in which it was incorporated—a rule that remains today as part of the modern diversity jurisdiction statute, 28 U.S.C. § 1332. Widespread abuses led Congress to expand the scope of corporate citizenship in 1958, by ordering that a corporation is also considered a citizen of “the State where it has its principal place of business.” Ever since, courts have fractured over the proper definition of this term, adopting at least three competing interpretations. Some circuits based a corporation’s citizenship on the location of its central decision-making authority, others focused on where a corporation’s actual business activities were located, and still others looked at the totality of a corporation’s activities to determine its citizenship. The result was chaos and inconsistency, providing corporations with little ability to predict how courts across the country would determine their citizenship.

Justice Breyer, writing for a unanimous court, ended this uncertainty by adopting the simplest of the available tests: “principal place of business” will now be read as “referring to the place where a corporation’s officers direct, control, and coordinate the corporation’s activities”—the corporation’s so-called “nerve center.” In almost all cases, application of this test will tie a corporation’s “principle place of business” to its corporate headquarters, a common-sense approach that will offer both corporations and courts better ability to determine the availability of federal jurisdiction over cases.

Adoption of this “nerve center” approach offers corporations many valuable benefits. First and foremost, the Supreme Court’s decision puts an end to the disastrous status quo, under which corporations were treated differently depending on where in the United States they were suing or being sued. Next, the “nerve center” test’s comparative clarity makes it easier for corporations to predict how the test will be applied, which will help corporations when making strategic business and investment decisions. Also, the clearer test means that corporations should spend less time and money in the future litigating over jurisdictional matters, freeing them to instead focus on the substance of a lawsuit. As any of the competing tests would have placed greater burdens on corporations, the Supreme Court’s sensible decision should be commended.

Yet even such a favorable decision also presents corporations with new challenges. First, given that most corporations have not been subjected to the “nerve center” approach in the past, it is important that every corporation take time now to calculate its citizenship under the Supreme Court’s new test, rather than being surprised by application of the new rule during some future lawsuit. For example, under the former rules a corporation with its headquarters in New York but its actual business operations in New Jersey would have been deemed a New Jersey citizen. Under the new “nerve center” test, its citizenship has moved to New York—a change better discovered now rather than after a failed attempt to assert its former New Jersey citizenship.

Second, corporations must remain mindful of the ways in which the new rule may affect the course of present and future litigation. Continuing the hypothetical raised above, for example, a corporation headquartered in New York but operating out of New Jersey may have strategically relied upon its former New Jersey citizenship, whether to steer complex cases towards New York federal courts by claiming diversity with New York plaintiffs or to take advantage of perceived “hometown” state court juries in New Jersey. The new “nerve center” test would undermine both tactics, making it critically important that corporations recognize in advance how any change in citizenship affects its historical litigation strategies.

Finally, although the “nerve center” test is the cleanest of the several options the Supreme Court considered, the Supreme Court recognized that sometimes citizenship will still be unclear. In cases where a corporation’s nominal headquarters “is nothing more than a mail drop box, a bare office with a computer, or the location of an annual executive retreat,” then courts will instead determine the true “nerve center” by evaluating where the corporation’s “direction, control, and coordination” actually occur—a potentially time-consuming and uncertain task. Advancing technology will complicate matters further, allowing corporations to distribute their traditional decision-making authority among executives in offices scattered nationwide, who hold critical meetings via teleconference rather than gathering in some “headquarters” boardroom. As corporations embrace these newer innovations, in-house counsel should remain sensitive to the impact such changes may have on future citizenship determinations.

Advance planning is the best way to ensure that your corporation both is aware of the impact of the Supreme Court’s decision in Hertz and is using it for maximum strategic benefit.