Derivative Standing and the Internal Affairs Doctrine
June 05, 2023
Choice-of-law questions in shareholder derivative lawsuits venued in New York courts involving out-of-state or international entities can be confoundingly difficult, even for appeals court judges.
Last Friday, Manhattan’s Appellate Division – First Department issued an important decision in which it was forced to reconcile two conflicting decisions of prior panels of the same Court with divergent rulings about whether New York’s “internal affairs doctrine” mandates application of New York law, or the law of the state or nation of incorporation, to the threshold question of standing to sue in shareholder derivative actions.
Lerner was a shareholder derivative suit involving a Delaware entity. The plaintiff requested, and the Court denied, discovery on the threshold question of pre-suit demand or demand futility, ruling that Delaware law, not New York law, governed whether plaintiff was entitled to discovery to attempt to plead standing.
Under the internal affairs doctrine, explained the Court, “New York choice-of-law rules provide that substantive issues such as issues of corporate governance, including the threshold demand issue, are governed by the law of the state in which the corporation is chartered—here, Delaware.”
The Court ruled that although “New York courts have applied the law of the forum when deciding matters, such as discovery,” the fact that “this case is a purported derivative action places it into a different context.” Holding that Delaware law prohibits discovery to assist pleading pre-suit demand, the Lerner Court affirmed dismissal of the complaint.
Lerner is consistent with a long line of prior appellate case law holding that, under New York choice-of-law rules, the issue of shareholder derivative standing is “substantive,” not “procedural,” and therefore, determined by the laws of the state of incorporation, not the law of the forum:
Culligan was a shareholder derivative suit involving a Bermuda entity. I wrote about a much later decision in the Culligan litigation here. In Culligan, the Court reversed dismissal for lack of standing of a shareholder derivative suit, ruling that New York law, not Bermuda law, governed standing because the plaintiffs in that particular case pled reliance upon Sections 1317 and 1319 of the Business Corporation Law (the “BCL”).
BCL § 1317 provides that “directors and officers of a foreign corporation doing business in this state are subject, to the same extent as directors and officers of a domestic corporation” to statutory liability under BCL §§ 719 and 720, and such liability “may be enforced in, and such relief granted by, the courts in this state, in the same manner as in the case of a domestic corporation.”
BCL § 1319 provides that BCL § 626, the statute governing shareholder derivative actions, “shall apply to a foreign corporation doing business in this state, its directors, officers and shareholders.”
Suggesting that BCL §§ 1317 and 1319 displace or supplant the common-law internal affairs analysis, the Court ruled that “the issue of plaintiffs’ standing to bring a shareholder derivative action is governed by New York law, not Bermuda law.”
Acknowledging its apparent conflict with prior rulings, the Culligan Court wrote: “We note that Matter of CPF Acquisition . . . held that the plaintiff’s standing to sue was governed by Delaware law because Delaware was the state of the corporation’s incorporation. However, there is no indication that the plaintiff in that case raised BCL § 1319.”
Uncertainty After Culligan
In a number of post-Culligan decisions, plaintiffs often argued, and lower courts generally rejected, the notion that Culligan impliedly overruled prior case law applying the laws of the state of incorporation to shareholder derivative standing:
City of Aventura Police Officers’ Retirement Fund v Arison, 70 Misc 3d 234 [Sup Ct, NY County 2020, Cohen, J.] [“New York’s Business Corporation Law . . . does not, as Plaintiff argues, override the internal affairs doctrine on the issue of standing to bring a derivative claim. BCL § 1319 is considered a mere statutory predicate to jurisdiction, which simply confers jurisdiction upon New York courts over derivative suits on behalf of out-of-state corporations but does not require application of New York law in such suits”] [quotations omitted].
The Ezrasons Decision
Until Ezrasons, no New York appeals court had occasion to revisit Culligan‘s holding that BCL § 1319 in effect supplants the internal affairs doctrine’s choice-of-law rules for shareholder derivative standing.
Justice Reed dismissed plaintiff’s complaint, ruling that it lacked standing because it was not a registered “member” of the entity, a standing requirement in derivative lawsuits under the U.K. Companies Act.
The appeal briefs in Ezrasons are available here, here, and here.
On appeal, the First Department held that Justice Reed “correctly dismissed the complaint based on plaintiff’s lack of standing.” “The internal affairs doctrine,” explained the Court, “has been consistently invoked by this Court in derivative actions to apply foreign law on substantive issues, including those affecting a party’s right to sue” (citing Hart and Lerner).
Expressly “adopt[ing] the rationale” of Justice Cohen in City of Aventura, the Court wrote that “Business Corporation Law § 1319 merely confers jurisdiction upon New York courts over derivative suits on behalf of a foreign corporation,” but “does not override the internal affairs doctrine” (quotations omitted).
Attempting to reconcile its ruling with Culligan, the Court “reject[ed]” plaintiff’s argument that Culligan “silently overruled the longstanding principle regarding the applicability of the internal affairs doctrine in derivative actions.”
Instead, wrote the Court, “Culligan addressed only the rare situation in which a foreign entity nevertheless had such presence in our State as would, irrespective of other considerations, call for the application of New York law” (quotations omitted).
Commentary on Ezrasons
Culligan, as it turns out, was on shaky stare decisis footing even before Ezrasons.
In another portion of Culligan, the Court ruled that “the internal affairs doctrine does not apply to those defendants who are not current officers, directors, and shareholders” at the time of the lawsuit’s filing.
Over time, this holding led to bizarre outcomes where New York law would apply to former officers, directors, or shareholders, but not current ones, meaning that the choice-of-law analysis might vary depending upon when the plaintiff happened to file the lawsuit.
Troubled by this lack of “uniformity and predictability of outcome,” the First Department eight months ago overruled this aspect of Culligan, holding in Eccles v Shamrock Capital Advisors, LLC (209 AD3d 486 [1st Dept 2022]), “We reject plaintiff’s argument that the internal affairs doctrine applies only to officers and directors at the time of the lawsuit. . . . To the extent our past decisions could be interpreted as suggesting otherwise, we clarify that the internal affairs doctrine applies to an officer or director at the time of the conduct at issue.”
Notwithstanding Eccles, the Ezrasons Court declined to explicitly overrule Culligan’s treatment of BCL § 1319 as a choice-of-law, rather than a jurisdiction-conferring, statute. Instead, Ezrasons characterized Culligan as a rare instance, limited to its facts, where the Court found New York law applicable because of the entity’s heavy New York contacts (i.e., “presence” in the forum state).
This seems to me a distinction without a difference, one not supported by the language of Culligan itself. There are countless entities operating predominantly or exclusively in New York, but incorporated in Delaware or elsewhere. Should the choice-of-law analysis be different for them just because of their “presence” in New York? Under traditional internal affairs doctrine analysis, it should make no difference how strong an entity’s contacts are with the forum state; the laws of the state of incorporation should apply to issues of “substantive law,” including standing, regardless of the entity’s presence in, or contacts with, New York.