Has The “internal Affairs” Doctrine Been Stretched Too Thin? – Shareholders

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.

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.

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:

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

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.

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