Delaware Supreme Court Says “Quasi‐California Corporation” Statute

Violates U.S. Constitution

By Kevin Spreng, Robins, Kaplan, Miller & Ceresi L.L.P.

For years corporate attorneys have maneuvered cautiously through the complexities created by section 2115 of the California Corporations Code (the quasi‐corporations law) to attempt to comply with conflicting laws of two states (often Delaware and California), all the while thinking section 2115 is probably unconstitutional. Well, the Delaware Supreme Court agrees. On May 5, 2005 the Delaware Supreme Court in VantagePoint Venture Partners 1996 v. Examen, Inc.1 said section 2115 violates “well established choice of law rules and the federal constitution.”2

Section 2115 imposes certain provisions of California corporate law upon a foreign corporation, “to the exclusion of the law of the jurisdiction in which it is incorporated”, if the corporation has significant shareholders and operations in California.3 Section 2115 purportedly overrides the laws of other states with respect to some pretty fundamental issues, like:

• annual election of directors,

• directors standard of care,

• indemnification of officers and directors,

• distributions to shareholders,

• cumulative voting, and

• class voting for mergers.

The VantagePoint case arose from a dispute over whether or not to merge Examen, Inc., a Delaware corporation with stockholders and operations in California, into a subsidiary of Reed Elsevier. In February 2005, Examen and Reed Elsevier entered into a merger agreement approved by Examen’s board, which was to expire on April 15, 2005 if the transaction had not closed. The board and common stockholders wanted to complete the merger, but VantagePoint, a very sophisticated venture capital firm, did not. The parties agreed that Examen’s Certificate of Incorporation (including the Series A Certificate of Designation) and Delaware General Corporate Law required only the affirmative vote of a majority of all stockholders, voting together as a single class, and did not require a separate class vote of the Series A Preferred stockholders. VantagePoint, which owned 83% of the Series A Preferred Stock, however, asserted that under section 2115 approval of the merger required a separate vote of the holders of each of the common stock and Series A Preferred Stock. This would have, in effect, given VantagePoint a veto over the transaction. The Certificate of Designation, which created the Series A Preferred held by VantagePoint, did not provide for a separate class vote in connection with a merger.

Examen sought declaratory relief from the Delaware Chancery Court on an expedited basis so it could close the merger before the agreement expired. VantagePoint claimed that a judgment on the pleadings was not possible because discovery was needed to determine whether Examen had enough contact with California to require application of section 2115. Chancellor Lamb, without specifically addressing the constitutionality of section 2115, applied the internal affairs doctrine and determined Delaware law must govern internal matters of Delaware corporations. He noted that section 2115 “expressly states that it operates to the exclusion of the law of (Del.the jurisdiction in which [the company] is incorporated,” and therefore both Delaware and California law could not be enforced. 4

VantagePoint appealed. The Delaware Supreme Court affirmed the judgment of the Court of Chancery determining that the internal affairs doctrine and the federal constitution require the voting rights of Examen’s stockholders be based exclusively on Delaware General Corporation Law.5 The Court reasoned that there is need for stability and uniformity in determining the internal affairs of a corporation and that applying the law of one state over the laws of another state depending upon the ever‐changing circumstances of the company would likely result in unacceptable confusion and uncertainty in corporate affairs.6 Concluding that the laws of only one state can properly govern corporate internal affairs, the Court cited the United States Supreme Court’s decision in CTS Corp. v. Dynamics Corp of Am., for the proposition that the Commerce Clause prohibits a state from regulating the internal affairs of a corporation created by another state.7 As such, the Court determined, VantagePoint’s voting rights must be based exclusively on Delaware law.8

VantagePoint attempted to persuade the Court that a decision to apply Delaware law to Examen’s internal affairs notwithstanding section 2115 would result in “forum shopping races to the courthouse.” It argued that the California courts, following the precedent set in Wilson v. Louisiana‐Pacific Resources, Inc., will continue to enforce section 2115 “to the exclusion” of the law of the state of incorporation.9 The Court disagreed with VantagePoint’s argument, saying that it has no doubt “the California courts would ‘apply Delaware [demand] law [to the internal affairs of a Delaware corporation], given the vitality and constitutional underpinning of the internal affairs doctrine.” 10

While the California courts are not bound by the precedent set in VantagePoint, it is quite likely they will follow the Delaware Supreme Court’s persuasive reasoning. Until that actually happens, it’s probably business as usual, except when there is no choice. In a merger situation, like that in VantagePoint, if the company can obtain the votes required under section 2115, the cautious approach would be to attempt to comply with section 2115 rather than ignore it, despite the fact it may not actually be enforceable. If the company clearly will not be able to get the required class votes, the company would need to chose between proceeding under Delaware law to the exclusion of section 2115 or terminating the transaction. In such cases, it will probably be common now to proceed based exclusively on Delaware law.

The VantagePoint decision also seems to have a strong undercurrent reiterating the rulings in the well publicized Watchmark11 and Benchmark12 decisions. Specifically, special stockholder rights (such as a separate class vote on a merger) must be very clearly granted in the certificate of incorporation or other operative document. Delaware courts will not imply or assume a right not expressly provided for in the operative documents or under Delaware law, particularly if the party asserting the right is a sophisticated investor. It doesn’t matter if the asserted right is ambiguously alluded to in the investment documents13 or is purportedly imposed by the laws of another state, as in the VantagePoint case. Delaware courts won’t enforce a right that is not expressly and clearly granted.

1 VantagePoint Venture Partners 1996 v. Examen, Inc., 2005 WL 1047285 (Del. Supr. May 5, 2005).

2 Id. at *6, citing McDermott Inc. v. Lewis, 531 A.2d 206 (Dl. 1987) and CTS Corp. v. Dynamics Cor. of Am., 481 U.S. 69 (1987).

3 Cal. Corp. Code § 2115.

4 Examen, Inc. v. VantagePoint Venture Partners 1996, Not Reported in A.2d, 2005 WL 790812 Ch., Mar. 31, 2005).

5 VantagePoint, 2005 WL 1047285

6 Id. at *6 citing McDermott Inc. v. Lewis, 5341 A.2d 206 (Del. 1987); Deborah A. DeMott, Perspective on Choice of Law fro Corporate Internal Affairs, 48 Law & Contemp. Probs. 161,166 (1985); CTS Corp v. Dynamics Corp of Am., 481 U.S. 69 (1987); and Kamen v. Kemper Fin. Serv., 500 U.S. 90 (1991).

7 VantagePoint, 2005 WL 1047285 at *6, citing CTS Corp v. Dynamics Corp of Am., 481 U.S. 69 (1987)

8 Id.

10 VantagePoint,2005 WL 104728 5at *7, citing Draper v. Gradner, 625 A.2d 859, 867(Del. 1993)

11 Watchmark Corp. v. Argo Global Capital, LLC, Del. Ch. C.A. No. 711‐N Chandler, C (Nov. 4, 2004) 12 Benchmark Capital Partners IV, L.P. v. Vague, et. al., No. Civ. A. 19719, 2002 WL 1732423 (Del. Ch. July 15, 2002).

13 See Watchmark Corp. v. Argo Global Capital, LLC, Del. Ch. C.A. No. 711‐N Chandler, C (Nov. 4, 2004).

http://www.abanet.org/buslaw/committees/CL930000pub/newsletter/200507/DelawareSupremeCourt.pdf