Delaware's Preeminence and the Internal Affairs Doctrine (Part 1)

Delaware ’s fear of a federal takeover of corporate law is once again in thenews and in the blogs (seehere, here, andhere). In a related series of posts, this Blog has explored the temperament of Delaware judges and their efforts to promote the state’s chartering franchise. As I argue in a recent article,Delaware's VantagePoint:  The Empire Strikes Back in the Post-Post-Enron Era, there is another aspect of the Delaware judiciary’s strategy to protect and expand the state’s domination that has been largely overlooked. And this strategy offers further support for the contention that Delaware’s jurists are willing to go beyond the traditional norms of judicial behavior to advance Delaware’s interests.

Despite its advantages in attracting entity charters, Delaware is vulnerable to other states' choosing not to adhere to the internal affairs doctrine – the choice-of-law rule that mandates application of the law of the state of incorporation to disputes among directors, officers, and shareholders. Some might downplay this risk, observing (correctly) that other states have shown little interest in regulating directly the internal affairs of most types of Delaware entities, including the publicly traded firms from which Delaware receives the bulk of its direct revenues and litigation business.

But this threat remains important to Delaware for two reasons. First, Delaware's domination in the market for publicly traded firms is failing to produce the benefits it once did. Delaware's corporate franchise tax revenues have been relatively flat in recent years and have declined as a percentage of the state's overall revenue. 

The state is now filling the gap through explosive growth in chartering of closely held firms. Yet it is in this context that the benefits of chartering in Delaware are the least pronounced, and the risks of foreign regulation of internal affairs are at their greatest, making this new revenue stream vulnerable. As I will discuss in more detail in the next post, the Delaware Supreme Court’s 2005 decision in VantagePoint Venture Partners 1996 v. Examen, Inc., 871 A.2d 1108 (Del. 2005) – which addresses a California statute purporting to apply domestic law to a shareholder dispute within a closely held Delaware corporation – suggests the court is very much aware of these conditions and of this burgeoning market's particular susceptibility to outside regulation.

Second, in times of market or more general economic distress, other states – unsatisfied with the regime maintained by Delaware and the federal government -- might decide to play a more active role in regulating the internal workings of publicly traded firms. There has been recent litigation over what constitutes “internal affairs” in such firms, included in two cases out of California, Friese v. Superior Court, 36 Cal. Rptr. 3d 558 (Ct. App. 2005), review denied, No. S141028, 2006 Cal. LEXIS 3559 (March 15, 2006), cert. denied, Moores v. Friese, 127 S. Ct. 138 (2006) (insider trading), and Grosset v. Wenaas, 175 P.3d 1184 (Cal. 2008) (standing).

More importantly, following Enron, state regulators in New York (yes, AG Spitzer before the fall) and elsewhere showed heightened interest in enforcing legal norms governing entities and the markets, although they stopped short of regulating corporate internal affairs directly. Such regulatory activity is dangerous to Delaware not only because it would make application of Delaware law less certain, but also because, as we have seen, aggressive and popular state-level enforcement can prod or shame federal actors into action.

Delaware ’s dilemma is that it cannot stop other states from doing this – at least not directly. Certainly, Delaware Chancellors have made clear that they will act aggressively in individual cases to ensure they retain jurisdiction over disputes involving Delaware entities. But they do not have the ability to ensure application of Delaware law in many cases litigated elsewhere. Nor can Delaware prevent regulatory officials in other states from taking action.

Thus, the Delaware Supreme Court has had to try something else. Delaware is powerless to prevent legal innovation elsewhere, but federal lawmakers are not. In the next post, I will explore how the court drafted its VantagePoint decision to preempt other states from regulating Delaware firms by creating the very conditions that might induce federal judicial or legislative actors to act in its favor.