California Law May Determine Critical Corporate Governance Issues Even Though It’s a Delaware, Nevada or Texas Corporation

By Gerald P. Burleson, member of the California Bar and Charles Ronan, J.D., University of San Diego School of Law, and July, 2013 California bar examinee

© 2013 by Gerald P. Burleson, all rights reserved

 

 

img_lawCalifornia_540x360

 

WARNING: A potential investor should not assume merely because she buys stock in a corporation based in the Golden State, that California’s corporations laws will protect the shareholder from losses if the founders or other insiders defraud the company!

Lawyers and judges refer to corporations formed under the laws of any state outside California as “foreign” corporations.  The general rule is that the laws of the state of incorporation control issues of corporate governance.  Cal. Corp. Code §2116. This “internal affairs doctrine” is a conflict of laws principle which recognizes that only one State should have the authority to regulate a corporation’s internal affairs—matters peculiar to the relationships among or between the corporation and its current officers, directors, and shareholders—because otherwise a corporation could face conflicting demands.  Vaughn v. LJ Internat., Inc. (2009) 174 Cal.App.4th 213, 223.  However, California’s corporations laws usually offer greater protection to shareholders than do the corporations laws of Delaware, Nevada, Texas and a number of other states.

An important California exception to the “internal affairs doctrine” is found in Corporations Code §2115.  Although shareholders (and legal practitioners) find §2115 difficult to read and understand, two appellate court opinions distilled the intricacies of §2115 into the following one sentence summary, which suffices as a general overview of the statute:

After a certain period of time has elapsed, California law will govern certain internal affairs of a foreign corporation if…more than half of the corporation’s voting stock is held by California residents, and the corporation conducts a majority of its business in this state as measured by assets, payroll and sales.

Kruss v. Booth (2010) 185 Cal.App.4th 699, 716 [111 Cal.Rptr.3rd 56]; State Farm Automobile Ins. Co. v. Superior Court (2003) 114 Cal.App.4th 434, 448.  Corporations subject to §2115 are known as “quasi-foreign” corporations.

The opinion in Kruss provides a simplified explanation of the basic operation of §2115.  The opinion explains that the structure of  §2115 is somewhat convoluted, reflecting a devotion to cross-referencing worthy of the Internal Revenue Code.  California law subjects a quasi-foreign privately held corporation to §2115 if it meets the “business-voting stock” standards of §2115(a)(1) and (a)(2).  For a shareholder to determine whether the corporation’s business in California amounts to “more than 50 percent during its latest full income year”, §2115(a)(1)’s business part of the business-voting stock standard, requires one to examine the corporation’s tax returns and calculate “[t]he average of the property factor, the payroll factor and the sales factor” as defined in, respectively,  §§21529, 21532 and 21534 of the Revenue and Taxation Code.  Kruss v. Booth, supra, 185 Cal.App.4th at p. 717.

§2115(a)(2), the voting stock part of the business-voting stock standard, requires the corporation to determine if “more than one-half of its outstanding voting securities are held of record by persons having addresses in this state”.  To establish the stockholder addresses for purposes of this §2115(a)(2) analysis, one must look at the address records of stockholders on either the record date for the last shareholders meeting held during the corporation’s latest full income year or, if it held no such meeting, one looks at those same records on the last day of its latest full income year.  Id. at p. 719.  If a foreign corporation meets the “business-voting stock” standards specified by §2115(a)(1) and (a)(2), it must conduct its internal corporate affairs in conformity with the parts of the Corporations Code specified in §2115(b).

The opinion in Kruss explains that if §2115 applies, §2115(b) imposes a wide range of California Corporations Code sections to a quasi-foreign corporation’s internal governance issues.  For example, §2115(b) expressly states that California law supersedes the law of the jurisdiction of a quasi-foreign corporation’s incorporation with respect to, among others, annual elections of directors under §301; directors’ standard of care under §309; limitations on corporate distributions under §§500-506; requirements for annual shareholders’ meeting §600(b)-(c); shareholder cumulative voting under §708(a)-(c); limitations on sale of assets under §1001(d); limitations on mergers under §1101; dissenters’ rights under Chapter 13 commencing with §1300; records and reports, including the providing of an annual report to shareholders, under §§1500-1501; and, shareholder and director rights of inspection under Chapter 16 commencing with §1600.

§2115(d) determines the date when the California internal governance laws specified in §2115(b) begin to apply to the quasi-foreign corporation.  In Kruss the court recapped its detailed analysis on that point: “To recap the operation of section 2115: Take the first full [fiscal or calendar tax] year in which the out-of-state corporation meets the business-voting stock standard — year 1; then, in the next full [tax] year — year 2 — count 135 days; and then finally, the very first day of the next full [tax] year, year 3, establishes the very first day which California internal affairs law applies to that out-of-state corporation.”

Finally, §2115(e) determines the date when the California laws specified in §2115(b) cease to apply to the internal governance of an out-of-state corporation.  The California internal affairs law ceases to apply “at the end of the first income year of the corporation immediately following the latest income year with respect to which at least one of the tests referred to in subdivision (a) is not met.”

Shareholders who get confused by the rule can use §2115(f) to their advantage.  §2115(f) requires a quasi-foreign corporation to inform its shareholders, officers, employees, and creditors of whether it is subject to §2115(b) within 30 days of receiving a written request for that information.  Providing incorrect information, or failing to provide the information as requested, may render the corporation liable for court costs and attorneys’ fees in an action to enforce this requirement.  Moreover, failing to provide the information to a shareholder may result in a penalty of $25 for each day the failure continues, to a maximum of $1,500.  The corporation pays the penalty to the shareholder, and it begins to accrue 30 days from the corporation’s receipt of the request for the information.  Cal. Corp. Code §2200.

Kruss presents an excellent example of the application of §2115 to the facts of a specific case.  That case was a shareholder derivative action brought on behalf of a Nevada corporation doing business in California.  The corporation used the calendar year as its tax year.  The plaintiff alleged in his first amended complaint that the corporation’s directors breached their fiduciary duties under California law.  However, the trial court found that Nevada law controlled under the internal affairs doctrine and the trial court required the plaintiff to re-plead his case.

The appellate court held that under §2115, California law governed the adequacy of the performance of the directors’ duties.  The alleged wrongdoing on the part of the directors described occurred in connection with a February 2004 reverse merger and certain actions taken by the directors in the months following the merger.  In its §2115 analysis, the appellate court observed that the first amended complaint alleged that in 2002, more than half of the Nevada corporation’s voting shareholders and all of its business were in California, thus the corporation met the §2115(a) business-voting stock standard in 2002.  Under the §2115 formula articulated by the appellate court, as summarized above, “. . . 2002 was year 1; the 135 days expired in May of 2003 (year 2); and therefore January 1, 2004 (first day of year 3) was the date of first applicability of California law to the internal affairs of the [Nevada] corporation.”  The court thus concluded that California law applied to the reverse merger.

The appellate court in Kruss then analyzed the facts to determine when §2115 ceased to apply to the internal affairs of the Nevada corporation.  The appellate court noted that the plaintiffs admitted in their brief that by 2003, the voting stock part of the business-voting stock standard could not be met, so the court concluded that under §2115(e), December 31, 2004 established the date of the end of the applicability to the Nevada corporation of the California internal affairs law.  In summary, the appellate court in Kruss, after analyzing the facts presented by the case under the §2115 formula, concluded that California law applied to the internal affairs of the Nevada corporation specified in that statute, §2115(b), throughout 2004.

Nevertheless, shareholders must note that courts in other states may not follow California’s courts’ logic.  In VantagePoint v. Examen, the Delaware Supreme Court held that the internal affairs doctrine trumps §2115.  VantagePoint v. Examen, Inc. (Del. 2005) 871 A. 2d 1108.  The Supreme Court of Delaware held Delaware’s well-established choice of law rules mandated that Delaware corporation’s internal affairs, and in particular, the issue of whether a corporation’s preferred shareholder possessed the right, under the corporation’s certificate of designations, to class vote on a proposed merger, must be determined exclusively in accordance with Delaware law, as the state of incorporation, rather than under §2115; despite the claim that the action involved a quasi-California corporation, the Delaware court concluded that the legal issue involved the relationship between the Delaware corporation and its shareholders, and thus was controlled by the internal affairs doctrine.

In late May 2012, for the first time, a California court acknowledged VantagePoint and signaled that it might not enforce all of §2115. In that case, the Second Appellate District of the California Court of Appeal, agreed that the voting rights of shareholders, just like the payment of dividends to shareholders and the procedural requirements of shareholder derivative suits, involve matters of internal corporate governance and thus, fall within a corporation’s internal affairs and the laws of the state of incorporation.  See Lidow v. Superior Court (2012) 206 Cal. App. 4th 351, 363, 141 Cal. Rptr. 3d 729, 737, review denied (Aug. 15, 2012).  However, since the court determined the case on factors deemed outside the scope of internal corporate governance, and therefore outside the purview of §2115, California courts continue to uphold the “pseudo-foreign corporation” statute against challenges.

California often goes further to protect minority shareholders with its laws than many other states.  Through §2115 California tries to exert its public policies on corporations which establish a sufficient business “presence” in California even if the corporation has attempted to avoid California law by incorporating elsewhere.  Minority shareholders can use §2115 as a tool to protect their rights if they know the requirements and limitation of §2115.

Speak Your Mind

*