New Challenges to the Internal Affairs Doctrine

A Delaware vice chancellor recently lamented that 'Delaware should not be determining employment law for the country and for the world.'  That remarkable assertion was a reference to the gradual expansion of the internal affairs doctrine, which provides that the law applicable to the internal governance of a business entity is that of the chartering jurisdiction. The contours of the internal affairs doctrine have never been defined with precision, which is why several recent developments have placed new pressures on the doctrine’s boundaries. These fall into roughly three categories:

Corporate governance for non-investors.  Especially in the ESG era, there is an increasing call to design corporations to accommodate non-investor interests.  The most obvious example is California’s SB 826, which requires that the boards of public companies with California headquarters include a minimum number of women directors.  Though California originally justified its law using the language of profitability and shareholder value, when the law was expanded to require diversity in race, sexual orientation, and sexual identity, the state explained that its intention was to 'further the legislative goals of the Civil Rights Act of 1964.'  At least one lawsuit challenged the law on internal affairs grounds teeing up the question whether California has the authority to legislate against discrimination in board appointments for California-headquartered companies.

Shareholder inspection rights represent another burgeoning problem.  Delaware, at least, considers inspection rights to be a matter of internal affairs, but it has become common for startup companies to both pay their employees in equity and require inspection waivers as a matter of course.  Equity compensation to private company employees is regulated territorially under states’ blue sky laws, and an insistence on allowing the internal affairs doctrine to trump here would not only interfere with states’ longstanding blue sky power, but also their ability to regulate employees’ rights – and in California’s case, a major source of compensation to its workforce.

Scope of the contract.  In a pair of cases, Salzberg v. Sciabacucchi and ATP Tour Inc. v. Deutscher Tennis Bund, the Delaware Supreme Court, relying on a 'contractual' view of the corporation, held that corporations can adopt bylaws and charter provisions that limit shareholders’ ability to litigate, even for non-Delaware causes of action, such as claims arising under federal antitrust and securities laws.  Courts in other jurisdictions quickly agreed that these provisions are contractually binding, thus ceding a tremendous amount of authority to Delaware, because Delaware corporate law provides how bylaws and charters are formed, and their permissible content, as well as the fiduciary duties of directors who invoke them, regardless of where the shareholder resides, where the shares were purchased, or where the corporation does business.

The extent of the power left to chartering states – and thus Delaware in particular – was brought home with Manti Holdings v. Authentix Acquisition Co, where the Delaware Supreme Court held that, while shareholders may enter into personal agreements to waive their rights to appraisal, it is likely they may not do so via a public company charter, where shareholders’ 'rational apathy' might undermine the quality of their consent.  In other words, despite the court’s recognition that consent to a personal contract is more robust than 'consent' in the form of a corporate charter provision, the court nonetheless held that the latter form of consent was permissible for waiver of rights granted under federal law, but not state law.  And courts outside of Delaware have accepted Delaware’s lesser form of consent as sufficient to create a contract for what appears to be anything Delaware deems to be the appropriate scope of matters covered by a corporate charter or bylaw.

Noncorporate entities and shareholder agreements. Because partnerships and LLCs do not have the kind of mandatory structure of a corporation, courts must draw ever finer distinctions between aspects of the entity controlled by the chartering state and aspects controlled by ordinary choice of law principles. At the same time, even ordinary corporate governance is increasingly moving into shareholder agreements, which are usually subject to ordinary contractual choice of law rules.  These two trends, separately and in combination, create new challenges for untangling internal affairs matters from matters governed by ordinary contracts.

Delaware judges have begun to express alarm over the number of employment disputes being shoehorned into entity law via partnership and LLC agreements.  Chancellor McCormick, for example, described AlixPartners LLC v. Mori as 'one of many employment disputes to enter the Court of Chancery under the guise of an internal governance dispute,' while Vice Chancellor Laster opined on the matter in a bench ruling:

At its heart, this is an employment dispute between a New York employer and a New York employee. It’s here in Delaware because of the now widespread technology of awarding employees equity units in a Delaware entity and building into those unit grants or the constitutive document of the Delaware entity restrictive covenants and other provisions addressing quintessentially employment matters.

Untangling the mess.  Ordinarily, one looks to the policies that underlie a doctrine to determine its application to novel scenarios such as those described above, but, as I explain in my paper, the policies that underlie the internal affairs doctrine are uniquely incoherent.  Specifically, one strand of authority justifies the doctrine on the ground that entities are created by state concession and therefore exist, abstractly, in their home state, which necessarily defines the terms of their existence.  Another strand of authority holds that business entities represent a kind of contract between investors and managers, and states’ entity laws offer various templates for that contract.

The problem is, the two theories have very different implications for the scope of matters subject to the internal affairs doctrine.  The first theory – that business entities are defined by the chartering state – is necessarily inflexible.  No other state can regulate the entity’s internal affairs because the entity is an extension of the chartering state itself.  A corollary is that the matters subject to the internal affairs doctrine must be relatively limited so as to prevent the chartering state from stymieing the regulatory choices of sister states acting within their own territory, and to maintain the illusion that the matters regulated by the chartering state exist 'within' that state.

The second theory – that business entities are contracts among shareholders and managers – necessarily renders entity law solely about the preferences of investors, a theory known as shareholder primacy.  On this theory, because entity arrangements are a private matter, there is no reason to limit the subjects that investors and managers choose to include within their contracts.  Simultaneously, like any other contract, their terms should be overridden when another state has a materially greater interest in the subject matter.

Ultimately, I believe we need a less rigid approach to the internal affairs doctrine that balances the interests of the states involved.  Though I agree that states should recognize the need for stability and certainty when it comes to an entity’s internal governance, I also believe that there are scenarios where the need for certainty must be outweighed by the public policies of states with a stronger connection to the business or its constituents.

Ann M. Lipton is Associate Professor at Tulane University Law School.

This post is based on her recent article, 'Inside Out (or, One State to Rule them All): New Challenges to the Internal Affairs Doctrine,' forthcoming in the Wake Forest Law Review.

This post first appeared in Columbia Law School's Blue Sky blog (here).