United States: Will The California Courts Enforce A Delaware Exclusive Federal Forum Provision?

In  Salzberg v. Sciabacucchi (pronounced Shabacookie), the Delaware Supreme Court unanimously held that charter provisions designating the federal courts as the exclusive forum for '33 Act claims are "facially valid." (See this PubCo post.) Given that Sciabacucchi involved a facial challenge, the Court had viewed the question of enforceability as a "separate, subsequent analysis" that depended "on the manner in which it was adopted and the circumstances under which it [is] invoked." With regard to the question of enforceability of exclusive federal forum provisions if challenged in the courts of other states, the Court said that there were "persuasive arguments," such as due process and the need for uniformity and predictability, that "could be made to our sister states that a provision in a Delaware corporation's certificate of incorporation requiring Section 11 claims to be brought in a federal court does not offend principles of horizontal sovereignty," and should be enforced. But would they be? Following Sciabacucchi, many Delaware companies that did not have FFPs adopted them, and companies with FFPs involved in current '33 Act litigation tried to enforce them by moving to dismiss state court actions. One such case is currently being fought in California state court involving '33 Act claims against Dropbox, and, as noted in this column in Reuters, a group of former Delaware jurists and a former SEC Commissioner have filed an amicus brief in support of the company's effort to enforce the FFP in that case.

Background. You might recall that Sciabacucchi took on heightened significance when, in March 2018, SCOTUS held, in Cyan Inc. v. Beaver County Employees Retirement Fund, that state courts continue to have concurrent jurisdiction over class actions alleging only '33 Act violations and that defendants cannot remove these actions from state court to federal court. (See  this PubCo post.) Both before and especially after Cyan, many companies adopted FFPs in their charters or bylaws to avoid state court litigation of '33 Act claims (and forum shopping by plaintiffs for the most favorable state court forum). Section 115 of the Delaware General Corporation Law (DGCL) expressly permits the adoption of a charter or bylaw provision designating Delaware as the exclusive forum for adjudicating "internal corporate claims." The statute defines "internal corporate claims" as those claims "(i) that are based upon a violation of a duty by a current or former director or officer or stockholder in such capacity, or (ii) as to which this title confers jurisdiction upon the Court of Chancery." Claims under the '33 Act, however, are not expressly included. (See this PubCo post.) 

In Sciabacucchi, the Chancery Court had previously invalidated the FFPs in the charters of three Delaware companies because, among other reasons, Delaware's enabling statute (Section 102(b)(1))—which provides general authority for non-mandatory charter provisions—was, in the lower court's view, inherently limited to "internal affairs," while FFPs were "external" matters. On de novo review, the Delaware Supreme Court rejected this binary analysis.  The Court reasoned that '33 Act claims, although governed by federal law, can involve aspects of internal matters and are often brought together with state fiduciary duty and disclosure claims based on the same facts. Accordingly, "Section 11 claims are 'internal' in the sense that they arise from internal corporate conduct on the part of the Board and, therefore, fall within Section 102(b)(1)." For purposes of the enabling statute, the Court characterized FFPs as intra-corporate matters, located in a new territory—the "outer band" between internal and external matters—which fell within the statutory scope of Section 102(b)(1) and were, therefore, valid on their face.

The Court then considered the question of the application of the "internal affairs doctrine," established by SCOTUS under  Edgar v. MITE Corp. and the Court's parallel definition in McDermott v. Lewis. Those cases defined the "internal affairs doctrine" as a conflict of laws principle recognizing that, to avoid conflicting demands on a corporation, only one state should have the authority to regulate the "corporation's internal affairs—matters peculiar to the relationships among or between the corporation and its current officers, directors, and shareholders."  The trial court, however, had departed from "the established definition" of "internal affairs" set forth in those cases by unduly narrowing the doctrine to apply only to claims involving "the rights, powers, or preferences of the shares, language in the corporation's charter or bylaws, a provision in the DGCL, or the equitable relationships that flow from the internal structure of the corporation." In McDermott, the Court reiterated that the "umbilical tie of the foreign corporation to the state of its charter is usually still religiously regarded as conclusive in determining the law to be applied in intracorporate disputes," and that the doctrine has serious constitutional implications. By unduly narrowing the definition, the trial court was in effect severing that tie.

Dropbox. After Sciabacucchi held that Delaware FFPs were facially valid, Dropbox, with a similar action under the '33 Act arising out of its IPO already proceeding in federal court in the Northern District of California, filed a motion to dismiss the '33 Act litigation that had been filed in state court.  Dropbox contended that its FFP was valid and "constitutes a binding and enforceable contractual obligation between it and its shareholders" that should be enforced: "[u]nder California law, a forum selection clause will be enforced unless the party challenging the clause shows that its enforcement would be unreasonable under the circumstances of the case."  Under these circumstances, Dropbox asserted, "'unreasonable' means that the 'selected forum would be unavailable or unable to accomplish substantial justice or that no rational basis exists for the choice of forum.'" That is a substantial burden that the plaintiffs cannot meet, Dropbox contended, making enforcement of the FFP mandatory: there is a rational basis for selecting federal courts as the proper forum to litigate federal '33 Act  claims, and to do so would not "substantially diminish the rights of California residents in a way that violates a statute or public policy of the state."  Anticipating plaintiffs' argument, Dropbox also contended that "Cyan merely confirmed that state courts have concurrent jurisdiction over Securities Act claims"; it did not establish "some inviolate right to assert Securities Act claims in state courts."

The plaintiffs (who distinctively refer to Dropbox as a "California-headquartered company") contended that the court should not allow Delaware law to regulate whether a California court has jurisdiction over a federal law claim—that would violate not only the '33 Act, but also the Commerce Clause and the Supremacy Clause and would be impermissible under California law. FFPs (which they referred to as "Grundfest clauses," after one of the amici, Joseph Grundfest), they argued, are contrary to Cyan, which mandated concurrent jurisdiction. In addition, while bylaws have been held to create contracts under Delaware law, under California law, this FFP did not result in the formation of a contract because, they maintained, there was no consent and no consideration, and, even if a contract had been formed, it would be unenforceable as void and unconscionable. Not to mention that they believed Sciabacucchi's concept of "intra-corporate claims" was an "aggressive expansion of Delaware's asserted authority" that  "departed from conventional wisdom."

In reply, Dropbox argued that, because they "define and regulate the relationship between the corporation and its directors, officers, and shareholders," corporate bylaws are "a matter of internal affairs," the validity of which should be determined by the state of incorporation under the internal affairs doctrine as established in Edgar. That is true, Dropbox maintained, regardless of the subject matter of the bylaws—even if they relate to intra-corporate matters. The FFP was held valid under Sciabacucchi, and, under the internal affairs doctrine, should therefore be valid in California. The plaintiffs, Dropbox contended, could not cite "a single case in which a court—in California or elsewhere—has ever held that the validity of a bylaw is governed by the law of a state other than the state of incorporation."  What's more, Dropbox argued, even under California law, the bylaws would be viewed to establish a contract with the shareholders. Nor does the FFP violate the Commerce or Supremacy Clauses in light of the absence in this instance of state action. With regard to enforceability, Dropbox reiterated that the plaintiffs had not satisfied their burden of showing the diminution of an unwaivable substantive right. Nothing in Cyan, they argue, "suggests that the existence of concurrent jurisdiction creates an unwaivable right that prevents parties from agreeing ex ante to an exclusive federal forum."

The amicus brief, filed on behalf of two former Chancery Court judges, four former Delaware Supreme Court justices and a former SEC commissioner, citing Edgar and McDermott, also focused on the internal affairs doctrine, but from a different angle.  First, they maintained that, on a facial claim, applying Delaware law to FFPs does not "necessarily impinge on the authority of any other state, and the [FFP] of a Delaware corporation is, on a facial challenge, governed by Delaware law." In Sciabacucchi, the Court had concluded that "'FFPs, as a facial matter, do not violate principles of horizontal sovereignty'...—that is, principles reserving authority to each state to apply its own law to its own chartered corporations as described by the internal affairs doctrine."  With regard to enforceability, they contended, the very allegations in the complaints required that the "internal affairs doctrine must apply." The "complaints arise from 'internal' corporate conduct on the part of Dropbox's directors and officers and the plaintiffs' status as stockholders": allegations that the plaintiffs purchased shares in the IPO and, in at least one case, from insiders, and that the registration statement, which they alleged contained false or misleading statements, was reviewed and signed by the board and senior executives. According to the amici, "[t]hose are all internal matters 'peculiar to the relationship among or between the corporation and its current officers, directors, and shareholders.'" Because all of those aspects were internal, the question of governing law regarding the validity of the FFP, which would determine how those matters were to be resolved, must be internal.  Accordingly, they concluded, under the internal affairs doctrine, the validity of the FFP must be governed by Delaware law.

Moreover, they contended, "[n]othing in Sciabacucchi, or in similar Delaware precedent, represents an attempt by Delaware to reach out beyond the proper purview of that state's law. Rather, that decision gives Delaware corporations a tool, authorized under Delaware law, for ensuring that claims fundamentally based on a plaintiff's status as an owner of company stock are litigated in a single, efficient forum, thus avoiding the kind of duplicative litigation that imposes unnecessary costs on the company, its investors, and its other stakeholders."  All the FFP does is direct federal claims by shareholders to a federal court, they said.

Next, to the assertion by plaintiffs that the FFP contravenes Cyan and the '33 Act, amici contended that, although the SEC is authorized to prevent registration of securities that it believes are contrary to the public interest or the protection of investors, the SEC accelerated the Dropbox registration statement—and many others—with no objection to the FFP.  As to plaintiffs' argument that the bylaws were not binding because of the alleged absence of consent and consideration, amici argued (as did Dropbox), that plaintiffs' "position is irreconcilable with established California and Delaware precedent and, if followed, would prevent the ordinary operation of every publicly traded corporation in the United States."  In addition, the payment of money and receipt of shares constituted consideration. Finally, they asserted, there is no reason that "a federal forum is not fully adequate for litigation of [plaintiffs'] claims under the Securities Act," and, to minimize duplicative litigation, it is "perfectly rational for a corporation to specify a federal forum for the resolution of a federal claim."

While this case is not alone in seeking to enforce an FFP in states other than Delaware, companies and their counsel are waiting with bated breath for the outcome. How much of an impact the high-powered amicus brief will have on the result remains to be seen. While the views of a group of distinguished Delaware jurists may be highly persuasive in the courts of Delaware, will they hold the same sway for a Superior Court judge considering this case in California?

Originally published July 21, 2020.

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