Kim Krawiec reports:
Thanks to California, corporate board diversity or, more specifically, gender diversity, is in the news again. SB 826 which, according to news reports, Gov. Jerry Brown is expected to sign, passed the state Senate in a 23-9 vote and the Assembly in a 41-26 vote. The statute would require “publicly held domestic or foreign corporation[s] whose principal executive offices, according to the corporation’s SEC 10-K form, are located in California” to have a minimum of one female director on its board by the end of 2019. By the end of 2021, those numbers would increase for corporations with five directors, who would need to have a minimum of two female board members, and for corporations with six or more directors, who would need to have at least three female board members.
Kim goes on to review the policy arguments pro and con. Kevin Paul Bishop has a somewhat more detailed description of the bill.
In this post, I consider whether California can do this as a constitutional matter.
Opponents of the legislation are mainly focusing on equal protection arguments, claiming that neither the U.S. nor the California constitutions prohibit the sort of quotas contemplated by the bill. I think there’s another issue raised by the statute, however.
Virtually all U.S. corporations are formed (“incorporated”) under the laws of a single state by filing articles of incorporation with the appropriate state official.[1]The state in which the articles of incorporation are filed is known as the “state of incorporation.” Selecting a state of incorporation has important consequences, because of the so-called “internal affairs doctrine”—a conflicts of law rule holding that corporate governance matters are controlled by the law of the state of incorporation.
Suppose, for example, that Acme, Inc., is incorporated in Delaware, but all of Acme’s assets are located in Illinois. All of Acme’s shareholders, directors, and employees reside in Illinois. Acme’s sole place of business is located in Illinois. An Acme shareholder brings suit against the board of directors, alleging that its members violated their fiduciary duty of care. The law suit is filed in an Illinois court. Despite all these Illinois ties, the Illinois court usually nevertheless will apply Delaware law.[2]
The internal affairs doctrine developed on the premise that, in order to prevent corporations from being subjected to inconsistent legal standards, the authority to regulate a corporation's internal affairs should not rest with multiple jurisdictions. … By providing certainty and predictability, the internal affairs doctrine protects the justified expectations of the parties with interests in the corporation.[3]
The internal affairs doctrine takes on particular transactional significance when considered in conjunction with the constitutional restrictions on a state’s ability to exclude foreign corporations. With rare exceptions, states have always allowed foreign and pseudo-foreign corporations to do business within their borders. As early as 1839, for example, the U.S. Supreme Court held that federal courts should presume a state would recognize foreign corporations in the absence of an express statement to the contrary by the legislature.[4]A subsequent Supreme Court decision implied that states could not exclude foreign corporations from doing business within the state provided that the business constituted interstate commerce under the Commerce Clause of the U.S. Constitution.[5]These decisions effectively created a common market for corporate charters. If Illinois, for example, adopts a restrictive corporation law, its businesses are free to incorporate in a less restrictive state, such as Delaware, while continuing to conduct business within Illinois.
Virtually all U.S. jurisdictions follow the internal affairs doctrine, even if the corporation in question has virtually no ties to the state of incorporation other than the mere fact of incorporation. A few states make a more general exception to the internal affairs doctrine for so-called pseudo-foreign corporations. A foreign corporation is one incorporated either by a state or nation other than the state in question. A pseudo-foreign corporation that has most of its ties to the state in question rather than to the state of incorporation. Many Delaware corporations are pseudo-foreign corporations. They are incorporated in Delaware, but most of their operations are located in one or more other states. In most states, there is no significant legal difference between a foreign and a pseudo-foreign corporation, and the internal affairs doctrine will be applied to invoke the law of the state of the incorporation with respect to both. California and New York are the principal exceptions to this rule. Both states purport to apply parts of their corporate laws to pseudo-foreign corporations formed in other states but having substantial contacts with California or New York.[6]SB 826 is the latest salvo in this struggle.
In 2005, the Delaware supreme court held that the general California statute was unconstitutional under the Due Process and Commerce Clauses of the U.S. Constitution.[7]
The internal affairs doctrine is not, however, only a conflicts of law principle. Pursuant to the Fourteenth Amendment Due Process Clause, directors and officers of corporations “have a significant right ... to know what law will be applied to their actions” and “[s]tockholders ... have a right to know by what standards of accountability they may hold those managing the corporation's business and affairs.” Under the Commerce Clause, a state “has no interest in regulating the internal affairs of foreign corporations.” Therefore, this Court has held that an “application of the internal affairs doctrine is mandated by constitutional principles, except in the ‘rarest situations,’ ” e.g., when “the law of the state of incorporation is inconsistent with a national policy on foreign or interstate commerce.”[8]
Ultimately, of course, the U.S. Supreme Court will have to decide the issue.
In my view, however, the Sureme Court will come down on Delaware’s side.
… application of local internal affairs law (here California's section 2115) to a foreign corporation (here Delaware) is “apt to produce inequalities, intolerable confusion, and uncertainty, and intrude into the domain of other states that have a superior claim to regulate the same subject matter....” Professor DeMott's review of the differences and conflicts between the Delaware and California corporate statutes with regard to internal affairs, illustrates why it is imperative that only the law of the state of incorporation regulate the relationships among a corporation and its officers, directors, and shareholders. To require a factual determination to decide which of two conflicting state laws governs the internal affairs of a corporation at any point in time, completely contravenes the importance of stability within inter-corporate relationships that the United States Supreme Court recognized in CTS.[9]
Unlike 2115, SB 826 tries to finesse that holding by limiting its application to quasi-foreign corporations “whose principal executive offices, according to the corporation’s SEC 10-K form.” I doubt whether that is sufficient, however. Let’s start with general principles. The Court has emphasized that “state regulation of corporate governance is regulation of entities whose very existence and attributes are a product of state law,”[10]from which the Court extrapolated the proposition that “it . . . is an accepted part of the business landscape in this country for States to create corporations, to prescribe their powers, and to define the rights that are acquired by purchasing their shares.” In keeping with that principle, the Court emphasized that state law governs the rights and duties of corporate directors: “As we have said in the past, the first place one must look to determine the powers of corporate directors is in the relevant State’s corporation law. . . . ‘Corporations are creatures of state law’ . . . and it is state law which is the font of corporate directors’ powers.”[11]Granted, none of these cases are directly on point, but taken together they suggest the Court will recognize the constitutional status of the internal affairs doctrine.
Now let’s drill down a bit. As Jack Jacobs (former Delaware Vice Chancellor and Supreme Court Justice) has noted, a problem with the California and New York statutes is that they “have extraterritorial reach because they legislatively overrule the internal affairs doctrine and impose their own, often different, internal governance requirements upon foreign corporations having a specified level of contact with the forum state.”[12]In Edgar v. Mite, a plurality of the Supreme Court held said that an Illinois statute violated the commerce clause of the U.S. Constitution because, inter alia, of the statute’s “sweeping extraterritorial effect.”[13]“The limits on a State's power to enact substantive legislation are similar to the limits on the jurisdiction of state courts. In either case, ‘any attempt “directly” to assert extraterritorial jurisdiction over persons or property would offend sister States and exceed the inherent limits of the State's power.’”[14]
SB 826 has similar extraterritorial effect. Imagine a Delaware corporation with operations in many countries around the world, as well as numerous U.S. states. While its principal executive offices are located in California, only about 3% of the company’s operations are located in California. A sizeable majority of the company’s board of directors are domiciles of other states (and even other countries). The board routinely holds conference calls linking directors at locations around the globe. The board’s regular meetings take place in various locations throughout the United States.
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