California-based companies beware: An appeals court in that state has held that California’s plaintiff-friendly insider trading law can be applied to a company that is incorporated in Delaware.
Typically, a principle called the “internal affairs doctrine” protects companies in California that are incorporated elsewhere from being subjected to the Golden State’s securities laws. The theory of the doctrine is that a company’s internal affairs are regulated by the state where it is incorporated, and allowing another state to simultaneously regulate such matters would create confusion (see box below, left).
A trial judge had tossed out the insider-trading suit in Friese v. Superior Court of San Diego County, finding that the claims were governed by Delaware law, which—unlike California—requires a heightened showing of intentional wrongdoing and does not provide for triple damages.
But the 4th District of the California Court of Appeal said the suit against officers and directors of a Delaware-incorporated company could proceed.
“[T]he [California] Legislature’s historic and well-established intent to regulate both intrastate conduct and intrastate securities transactions subject securities transactions which take place in this state to California’s securities laws even if those securities are issued by foreign corporations,” the court wrote.
Friese
Robert Friese, the litigation trustee who filed the lawsuit, tells Compliance Week that the court was right to allow the insider trading claims to proceed under California law. “Our position was that, when you get into an area of alleged misconduct on part of officers and directors, it’s not an internal affairs issue,” he says. “It’s an issue of personal misconduct. In that instance, there’s not a reason to give deference to the state of incorporation.”
Although this case only involves insider trading, “the gist of the opinion seems to be that the interests of the state [of California] can reach potentially other areas that aren’t really corporate matters but are more personal matters involving the conduct of the officers and directors as it impacts third parties,” says Friese, who is a founding partner of the San Francisco law firm Shartsis Friese and co-chair of the American Bar Association’s SEC Enforcement Subcommittee of its Litigation Section.
‘Broad Public Interests’
The Friese case involves a suit against directors of Peregrine Systems, a San Diego-based software company that is incorporated in Delaware. The suit was filed by the successor litigation trustee by a Bankruptcy Court in Delaware, where Peregrine has filed for Chapter 11 reorganization.
INTERNAL AFFAIRS
Internal Affairs Doctrine
Tung
According to a March 2005 study conducted by Emory University School of Law professor Frederick Tung, for disputes over a corporation's internal affairs—the relations among a firm's investors and managers—states generally apply the law of the state of incorporation.
"To the modern corporate scholar or lawyer, this internal affairs doctrine seems in the natural order of things," writes Tung. "Corporate law is state law. Each corporation is formed under the law of its chosen state of incorporation, and consistency and predictability argue for application of that law to govern the corporation's internal affairs."
According to Tung, widespread acceptance of this doctrine assures that a firm's choice of corporate law will be respected outside the incorporating state.
Greenfield
Another study by Boston College Law School professor Kent Greenfield found that the internal affairs doctrine, "is a foundational principle "wholeheartedly embraced" by the corporate law academy and bar because of its seeming "irresistible intuitive appeal."
Despite its foundational status, or perhaps because of it, notes Kent, the doctrine attracts scholarly attention only sporadically. "Fierce defenses are infrequent, but forceful attacks rarer still." Nevertheless, says Kent, doctrine is getting more attention, "especially in a time of growing public distrust in the methods of corporate governance and increasing attention on the issue of corporate accountability.
The suit claims that officers and directors of Peregrine engaged in extensive insider trading. Under California’s insider trading law, Friese seeks to recover up to three times the amount that each officer or director earned by virtue of insider trading. Unlike laws elsewhere, California does not require a showing that the insider trading actually harmed shareholders.
A trial judge in San Diego found that the insider trading claims could not go forward under California law because the internal affairs doctrine applied and thus Delaware law governed the actions of the company.
But, in reinstating the claims, the appellate court said that California’s insider trading law was meant to protect “broad public interests rather than the more narrow interests of a corporation’s shareholders” and said that forcing Peregrine’s officers and directors to face suit in California for alleged insider trading was consistent with the state Legislature’s “concern about discouraging conduct it found destructive to the pubic interest.”
Tung
The case “raises interesting questions about how insider trading laws are to be enforced, whether at the state or the federal level,” says Joseph Allerhand, a partner with the law firm Weil, Gotshal & Manges in New York. “Unfortunately, these issues do not appear to have been addressed by the court and may well have to await review by the California Supreme Court, if it decides to hear the case [on appeal].”
Boost For Derivative Suits
Muck
Kevin Muck, a partner in the San Francisco office of the law firm Fenwick & West, tells Compliance Week that the ruling is “of substantial interest to companies headquartered in California but incorporated in Delaware.”
Muck notes that the court’s decision in the Friese case seems to be at odds with another recent ruling by the same appellate court in Grosset v. Wenass, as well as with a 2003 decision by a federal judge in California in a case known as Sagent Technology, Inc. Derivative Litigation (see box above, right). “I’m not sure the way [the judges in the Friese case] try to reconcile the decisions is terribly persuasive,” Muck says.
Although the Friese case involves a suit by the litigation trustee of a company in Chapter 11 bankruptcy, Much says the ruling has implications for shareholders who bring derivative cases on behalf of companies.
“[Plaintiffs in derivative suits] want to argue that certain directors engaged in insider trading under California law, and that’s a basis for saying the board of directors isn’t sufficiently disinterested to make the decision on its own,” he says. “Courts have said—some courts have said—that the plaintiffs really don’t have a claim if it’s a Delaware corporation, that Delaware law is going to govern the directors. This [Friese case] gives [plaintiffs] an argument that, even if you’re talking about a non-California corporation, there is the potential for this sort of claim under the California code. It gives derivative plaintiffs an argument that they might not otherwise have.”
The court in Friese attempts to limit the application of the California statute to insider trading activity, Muck notes. “The decision seems to try to restrict the holding by [saying] that when you’re dealing with the sale of stock, that really is a different kettle of fish—that’s the kind of decision [where] we don’t think the internal affairs doctrine would require the application of Delaware law,” he says. However, he adds that “once you start down that path, it’s not hard to imagine creative lawyers coming up with other circumstances that might be analogous.”
Muck says the biggest problem with the decision is that it creates uncertainty for officers and directors about what law governs their conduct. “It’s an awkward situation,” he says. “There really needs to be certainty when addressing rights of shareholders and the obligations of officers and directors.”
The complaint and opinion can be found in the box above, right.
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