Conflicts of Laws and the Internal Affairs Doctrine
September 12, 2022
The legal concept of “conflicts of laws” is difficult, to say the least, confounding even seasoned litigators and judges, with bulky treatises and entire law school classes devoted to the subject.
Generally speaking, the term of art “conflicts of laws” refers to the question of how to determine which state’s laws provide the rules of decision to resolve a particular problem, controversy, or dispute.
For example, when a business divorce litigant sues, he or she may allege a mix of substantive claims, like breach of contract, breach of fiduciary duty, and accounting (among any number of other colorful claims in the business divorce litigant’s palette). Conflicts of laws problems arise when the entity is incorporated in one state (for example, Delaware), but the entity operated, the applicable contract was made, or the alleged tortious activity occurred, in another state (for example, New York).
To determine whether the plaintiff sufficiently alleged or proved the essential elements of a legal cause of action, the court must first determine which state’s laws govern the claim. Sometimes, a claim will be sufficient under the laws of one state, but insufficient under another, so the conflict-of-law analysis may be outcome determinative of whether the plaintiff can pursue or recover on a particular claim.
Things can get even more tricky when one state’s laws refer the court back to the other state’s laws, and vice versa. This circularity problem is called renvoi. Transactional lawyers avoid the renvoi problem by including choice-of-law provisions in their contracts containing language that disputes arising under the contract will be governed by the laws of a particular state “without regard to principles of conflicts of laws,” or words to that effect. Things can get trickier still when a lawsuit is venued in federal court based upon diversity jurisdiction, and the court must, under the “Erie doctrine,” apply state “substantive” law, but federal “procedural” law.
The Matrimonial-Turned-Business-Divorce Dispute
Recently, Manhattan Matrimonial Division Justice Douglas E. Hoffman issued an interesting decision addressing some complicated choice-of-law questions in a business divorce dispute between Italian billionaire Silvio Scaglia (“Scaglia”) and his business partner / spouse, Julia Haart (“Haart”), over Haart’s alleged misappropriation of $850,000 in cash from a Delaware entity, Freedom Holding, Inc. (“Freedom”), one day after she was informed of her imminent termination as CEO of Freedom’s wholly-owned subsidiary, high-profile modeling agency Elite World Group, Inc. (“EWG”).
In the resulting decision, Freedom Holding, Inc. v Haart (2022 NY Slip Op 22225 [Sup Ct, NY County July 20, 2022]), Justice Hoffman rejected Haart’s assertion that Delaware law applied across the board to Freedom and Scaglia’s claims simply by virtue of the entity’s incorporation in Delaware.
Before we get to the facts: how did Freedom end up in the Matrimonial Division? Freedom is yet another example among many we have written about (read here and here) where a matrimonial dispute spawned parallel business divorce litigation. In Freedom, the parties fought hard over whether the case should be venued in the Commercial Division or the Matrimonial Division, with Haart prevailing in that particular battle.
Scaglia and Haart’s matrimonial-turned-business-divorce litigation also spawned separate litigation in Delaware Chancery Court, with Haart suffering a major loss earlier this year (read here) when Vice Chancellor Morgan T. Zurn issued an exhaustive post-trial decision rejecting Haart’s claim she was an owner of Freedom’s preferred stock.
The Amended Complaint and the Dismissal Motion
According to the amended complaint in Freedom, Scaglia and Haart became equal 50% shareholders of Freedom’s common stock after Scaglia gifted Haart her shares in anticipation of their imminent (ultimately short-lived) marriage. Freedom, in turn, was the sole member of EWG. EWG was one of the plaintiffs in Freedom, though it voluntarily withdrew its claims.
Based upon Haart’s alleged misappropriation of $850,000 from Freedom, Freedom and Scaglia alleged five causes of action: conversion, breach of fiduciary duty, breach of contract, unjust enrichment, and constructive trust. Haart moved to dismiss all claims but breach of fiduciary duty. You can read the brief here, here, and here.
Haart advocated for Delaware law under the “internal affairs doctrine” except as to the breach of contract claim, which she conceded was governed by New York law because her alleged oral promise – not to withdraw money from Freedom in excess of $250,000 – was made in New York.
Freedom and Scaglia advocated for New York law except as to the breach of fiduciary duty claim, which they conceded was governed by Delaware law under the internal affairs doctrine.
As a result, the court was required to determine the applicable law for three claims: conversion, unjust enrichment, and constructive trust.
An outsized portion of the briefing focused on the conversion claim. In Haart’s view, “Delaware law provides that a cause of action for conversion is improper where, as here, a claim for the payment of money is involved.” In the resulting decision, Justice Hoffman provided a nuanced treatment of the choice-of-law question, analyzing each claim independently.
The Choice of Law Framework
Under New York’s choice of law framework, wrote Justice Hoffman, “the initial question is whether there is a difference between the laws of Delaware or New York for the claims, and if no conflict exists between the laws of the jurisdictions involved, there is no reason to engage in a choice of law analysis” (quotation omitted).
If there is an actual conflict between the two state’s laws, the next question becomes which state, New York or Delaware, has the “greatest interest” in the application of its laws to the particular dispute, usually determined by which state has the “most significant contacts” to the matter in the controversy.
The Internal Affairs Doctrine
According to Haart, Delaware had the greatest interest in the dispute under the internal affairs doctrine because of Freedom’s incorporation in Delaware.
Justice Hoffman took a far more narrow view of the doctrine, writing that “the conflict-of-laws internal affairs doctrine could apply (and result in application of Delaware choice of law) only if the claims are regarding the internal affairs of a Delaware entity and its officers, directors, or shareholders as such.”
Justice Hoffman wrote that the internal affairs doctrine “only governs the choice of law determinations involving matters peculiar to corporations, that is, those activities concerning the relationships inter se of the corporation, its directors, officers and shareholders,” not to all claims automatically simply because they relate to a business entity (quotations omitted).
The Court ruled: “Haart is not alleged to be an officer or director” of Freedom, and “[a]lthough she is alleged to hold 50% of the common (but not preferred) shares of Freedom, she is not alleged to be its controlling shareholder for fiduciary duty purposes.” Therefore, held the court, the complaint “does not allege sufficient facts . . . to require application of Delaware law to these three claims” (quotations omitted).
Presumably to protect itself on appeal, the Court noted that it would nonetheless “where appropriate” consider Delaware law “out of abundance of caution.”
Disposition of the Claims
The Court applied both New York and Delaware law to the conversion claim, ruling that the claim was insufficient under either state’s laws. The Court held, “The tort of conversion (whether in Delaware or New York) has roots in common law, and New York would take a similar view of alleged conversion of non-specific monies: claims for conversion of monies are allowed only if the funds in question were separate, distinct, separately identifiable and not commingled with other monies.” The Court ruled that under either state’s laws, the cash Haart allegedly misappropriated was not “separately identifiable,” and dismissed the claim “as currently alleged, without prejudice to Plaintiff’s remaining claims or, if so advised, appropriate amended allegations if they were to sufficiently allege a conversion claim.”
Haart challenged the unjust enrichment claim as “duplicative” of others, particularly the breach of contract claim. The Court applied New York law to the unjust enrichment claim, but also wrote, “There does not appear to be a substantive difference, however, between the laws of New York and Delaware on the issue of whether potentially duplicative claims may be allowed at this stage of the proceeding. Under each, pleading in the alternative at this stage may be allowed.” In other words, the court declined to dismiss the unjust enrichment claim as duplicative on the grounds that a plaintiff is entitled to plead alterative or inconsistent legal theories, but signaled that it might later consider doing so at the appropriate time.
In a final paragraph, Justice Hoffman disposed of the constructive trust claim as alleged by Scaglia only for lack of standing, leaving the claim to survive as alleged by Freedom, and the applicable law being that of New York.
If there’s any takeaway from Freedom, it’s that business divorce litigants and their counsel should devote careful attention to the conflict-of-laws analysis when litigating claims in New York relating to foreign-incorporated entities. Wooden reliance on the internal affairs doctrine may be shortsighted where the claims relate to a discrete transaction or conduct not directly related to or dependent upon the parties’ unique roles as directors, officers, shareholders, managers, or members.
That said, I could see other thoughtful judges disagreeing with the court’s internal affairs doctrine holding for the simple reason that it is hard to see in what capacity, other than as a fiduciary of Freedom, Haart allegedly misappropriated money from the business. Perhaps we will eventually get clarification on this difficult issue from the appeals court.