California Corporations Code Section 2115 sets forth a “long-arm statute” which requires corporations incorporated outside of California, but with significant California contacts, to comply with various requirements of the California Corporations Code ordinarily only applicable to California corporations. Several of these requirements are particularly relevant to mergers and acquisitions: dissenters’ rights (Cal. Corp. Code § 1300), separate class-voting requirements (Cal. Corp. Code § 1201), and a limitation on cash-outs of minority shareholders (Cal. Corp. Code § 1101).
Section 2115 can complicate a deal involving a private target that has a significant presence in California but is incorporated in another jurisdiction, such as Delaware, because it requires the parties to comply with the potentially conflicting laws of California and the target corporation’s state of incorporation.
An out-of-state private corporation is a so-called “quasi-California corporation” and subject to Section 2115 if both:
- More than half its business during its latest full income year is conducted in California, as determined by a statutory formula weighing the corporation’s property, payroll and sales; and
- More than 50 percent of the corporation’s outstanding voting securities are held of record by California residents.
Application of Section 2115 to Mergers & Acquisitions
Particularly for private equity and venture capital-backed corporations that are deemed to be quasi-California corporations, Section 2115 has the potential to cause problems in mergers because of California’s requirement that the holders of each class of capital stock of the corporation approve the merger. For a typical private equity or venture capital-backed corporation that is a quasi-California corporation but incorporated in Delaware with outstanding shares of preferred and common stock, this means that the corporation will be required to obtain the approval of not only the holders of the preferred stock, but also of the holders of the 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 of the corporation voting together as a single class. As a result, Section 2115’s class vote requirement provides an opportunity for holders of the majority of one class of stock to block a proposed merger, even where the merger otherwise could be approved by the requisite vote pursuant to Delaware law. Section 2115 presents a mechanism for withholding approval of a merger and terminating the transaction.
VantagePoint Venture Partners 1996 v. Examen, Inc.: The Delaware Supreme Court Rejects Section 2115
In VantagePoint Venture Partners 1996 v. Examen, Inc., 871 A.2d. 1108 (Del. 2005), the Delaware Supreme Court held that Section 2115 violated “Delaware’s well-established choice of law rules and the federal constitution,” and that the internal affairs of Delaware corporations should “be adjudicated exclusively” in accordance with Delaware law.
VantagePoint Venture Partners held 83 percent of the preferred stock and no common stock in Examen, a Delaware corporation with ties to California. Examen entered into a merger agreement with another corporation which VantagePoint opposed. Under Delaware law, the merger would require the approval of Examen’s stockholders voting as a single class, and VantagePoint would lack the votes to block the merger, but under California law the preferred stockholders would be entitled to a separate class vote. Because VantagePoint controlled the vote of the preferred stock, it could vote down the merger. Examen filed a suit in Delaware and was granted summary judgment by the Chancery Court that Delaware law applied in spite of Section 2115 and that VantagePoint was not entitled to a class vote.
VantagePoint appealed and, in upholding the Chancery Court’s decision, the Delaware Supreme Court ruled that “VantagePoint’s voting rights [should] be adjudicated exclusively in accordance with the laws of its state of incorporation” and that “[t]he internal affairs doctrine is a long-standing choice of law principle which recognizes that only one state should have the authority to regulate a corporation’s internal affairs -- the state of incorporation.”
Lidow v. Superior Court: A California Court Acknowledges VantagePoint
VantagePoint provided assurance of how Delaware regarded the applicability of Section 2115 to a Delaware corporation’s internal affairs. However, it was not until May 2012, that a California court signaled that California might be unwilling to enforce Section 2115, in Lidow v. Superior Court, 141 Cal. Rptr. 3d 729 (Cal. Ct. App. 2012). In Lidow, the Second Appellate District of the California Court of Appeal, stated in dicta that matters of a corporation’s internal governance (for example, the voting rights of shareholders) are the corporation’s internal affairs, and that only the laws of its state of incorporation should govern such matters.
Among other things, Lidow involved the alleged wrongful termination of the chief executive officer of International Rectifier Corporation. In its motion for summary judgment, the company asserted that, as a Delaware corporation, the internal affairs doctrine meant that Delaware law governed the claim. Lidow, the former executive, opposed that motion and argued that thus California, and not Delaware, law governed his claim because the underlying circumstances did not constitute internal affairs of the corporation.
The California appellate court sided with Lidow and agreed with key portions of the Delaware Supreme Court’s analysis in VantagePoint, noting that “courts must apply the law of the state of incorporation to issues involving corporate internal affairs.” The appellate court further stated 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.”
Corporations potentially subject to Section 2115 may find some comfort in the Lidow decision. However, although it does accept the Delaware Supreme Court’s analysis in VantagePoint, it is not the unequivocal statement of Section 2115’s unconstitutionality that corporate lawyers have hoped for. Accordingly, the best practice for quasi-California corporations remains to comply with Section 2115 whenever possible.