What is the “Internal Affairs Doctrine”?
The internal affairs doctrine indicates what state’s law is applicable to a corporation or limited liability company’s (LLC) internal affairs. This is important in adjudicating any corporate disputes like breach of contract, breach of fiduciary duty or other lawsuits that might arise involving business and corporations.
What is a corporation?
A corporation is a legal entity that creates an identity separate from its shareholders. (Merco Const. Engineers v. Municipal Court (1978) 21 Cal.3d 724, 729.) These shareholders do not own the corporation’s property and are considered to be a separate party from the corporation itself. (Union Bank v. Anderson (1991) 232 Cal.App.3d 941, 949.) This separation allows shareholders to avoid some liability that comes with running a corporation. For example, shareholders will not be personally liable for the corporation’s debts. In order to establish a corporation, the person or partnership interested in forming it must file articles of incorporation. (Cal. Corp. Code § 200(a).) Where those articles are filed means the corporation is incorporated in that given state. If a corporation is incorporated in California, that corporation must abide by the California Corporations Code.
What is an LLC?
A limited liability company allows for a partnership to get the same limited liability as corporate shareholders. (Ontiveros v. Constable (2018) 27 Cal.App.5th 259, 273.) Under an LLC there only needs to be one person or member for it to exist. (Cal. Corps. Code § 17701.02(s).) Like a corporation, an LLC allows that person or persons to avoid personal liability for the entity’s debts. (Cal. Corps. Code § 17703.04.) To exist, the person wishing to establish the LLC must file articles of organization with the secretary of state. (Cal. Corps. Code § 17702.01(a), (d).) Like a corporation, an LLC is required to abide by the California Corporations Code. Since 2014, LLC must also abide by the California Revised Uniform Limited Liability Company Act. (Kennedy v. Kennedy (2015) 235 Cal.App.4th 1474, 1486-149.)
LLCs have an operating agreement, which as the name indicates sets out how it will operate and whether the partners have any limited or special duties. This means the agreement cannot allow a member or manager of the LLC to entirely escape any liability on behalf of the LLC or violate their fiduciary duty towards the LLC. (Cal. Corps. Code § 17701.10(c)(4), (5), (14), (15).)
What is the internal affairs doctrine?
The internal affairs doctrine means the laws of a business entity’s state of formation governs matters concerning its internal affairs. Internal affairs mean the issue relates to the relationship between the entity and its shareholders, officers, or directors. (Edgar v. MITE Corp. (1982) 457 U.S. 624, 645.) Internal affairs also may include election or appointment of directors or officers, adoption of bylaws, meetings, and shareholder rights. Internal affairs involve matters of internal corporate governance. (Lidow v. Superior Court (2012) 206 Cal.App.4th 351, 363.) This doctrine is implicated when disputes arise between shareholders, managers, directors or other individuals. If the internal affairs doctrine applies, the law of the state where the corporation or LLC was incorporated will be the law that applies.
This is important because corporations and LLCs may interact with other states in doing business. The choice of law matters so as to not require corporations to abide by two conflicting state laws. (Grosset v. Wenaas (2008) 42 Cal. 4th 1100, 1106-1107.) In the interest of justice though a local court can take jurisdiction over a corporation’s internal affairs and apply local law. (Friese v. Superior Court (2005) 134 Cal.App.4th 693, 707-708.)
How would the internal affairs doctrine apply to a corporation?
Because a corporation or LLC is its own legal entity it has the capacity to be sued. As such, determining how the internal affairs doctrine applies is important. The court taking jurisdiction will apply the laws of the state of incorporation. If the corporation has sufficient contacts with the non-incorporation state, like conducting business or having an office in the state, local law may be applied over the incorporation state’s law. (McLean v. Tucker (1938) 26 Cal.App.2d 126, 130-131.) The internal affairs doctrine can be overridden in this way. A court will exercise its jurisdiction unless it is an inappropriate or inconvenient forum for the trial of the action. (Restatement (Second) of Conflict of Laws § 313 (1971).)
For example, where a corporate officer as an employee was sued for a breach of duty the internal affairs doctrine did not override the California choice of law clause in the employment contract. (Colaco v. Cavotec SA (2018) 25 Cal.App.5th 1172, 1191, 1195.) The corporation was incorporated in Delaware, but the parties had a substantial relationship with California. (25 Cal.App.5th at 1192.) The only reason Delaware law would have been applied would be if Delaware had a materially greater interest in the determination of the particular issues involved. The sections of the Corporations Code which apply to violations of duty do not require all misconduct claims to have incorporated state law apply against corporation executives. It only applies to a corporation’s directors. (25 Cal.App.5th at 1195.)
What if the corporation was incorporated outside of California?
If the corporation has made California its principal place of business and had records and offices there, California law may apply. (Sharp v. Big Jim Mines (1940) 39 Cal.App.2d 435, 438.) For example, directors of a foreign corporation doing business in California are liable for a violation of duty under the laws of the state where the corporation was incorporated. However, that liability could be enforced in California court whether or not the act was done in California. (Saracco Tank & Welding Co. v. Platz (1944) 65 Cal.App.2d 306, 314.) Another instance of its application could be where the state of incorporation was Illinois and so Illinois law governed California policyholders when they challenged a director’s decision in distributing dividends in California court. (State Farm Mut. Auto. Ins. Co. v. Superior Court (2003) 114 Cal.App.4th 434, 446.)
How would the internal affairs doctrine apply to an LLC?
An operating agreement cannot vary the applicability of California law to the LLC’s internal affairs if the LLC was organized in California. (Cal. Corps. Code § 17701.10(c)(2), 17701.06.) Like corporations, the internal affairs doctrine applies to foreign LLCs registered to do business in California. (Cal. Corps. Code § 17713.04(a), (d).) Similarly, internal affairs mean its organization, the authority of members and managers, or their liability for the LLCs debts. (Cal. Corps. Code § 17708.01(a)(1) & (2).) For example, the internal affairs can prevent a California court from ordering dissolution of a foreign LLC just because the LLC was going business in California. (Boschetti v. Pacific Bay Investments Inc. (2019) 32 Cal.App.5th 1059, 1066-1069.) Dissolution is governed specifically by the state in which the LLC was organized. If the LLC was organized in California, then a California court could order dissolution.
What is an example?
For example, Julie is a director of a corporation and Shawn is an officer of that corporation. The corporation is incorporated in Delaware. If Shawn wishes to dispute Julie’s election of certain officers to the board of directors for another’s company’s gain, he could sue the corporation for breach of duty of loyalty. This would be a matter of internal affairs as it concerns the corporate governance of the corporation. Because the corporation was incorporated in Delaware, and this is a matter of internal affairs, Delaware law would apply. There is not really a reason to apply any other state’s law. This would be the same case if Julie and Shawn were partners in an LLC. If Shawn disagreed with Julie’s management of the LLC, he could sue for that. Because the LLC was organized in Delaware, Delaware law would apply. A California court would apply Delaware law in the case of the corporation and the LLC.
However, if the corporation was incorporated in Delaware but its primary place of conducting business was in California, California law might apply. If the issue being litigated revolves around California and especially if the individual parties live in California, local law may overcome the internal affairs doctrine.
Similarly, if the matter concerning the LLC revolved around California, a California court would have the ability to apply California law.
Most importantly, the issue must be a matter of internal affairs to be exempted. Things like dissolution may be limited to the jurisdiction of the state of incorporation or organization. This acts as a limit to protect corporations as well as state sovereignty.
Conclusion
The internal affairs doctrine is important because it dictates what state’s law is applicable to a corporation or limited liability company’s internal affairs. If you are involved in a corporation or LLC, it is important to know what laws the entity must abide by and when that internal affairs doctrine may be overridden by local law. If the entity owns property, this may affect any issues or lawsuits arising from that property. If sale or disposal of property is a point of contention, partition may be a solution. At Underwood Law, our partition attorneys can help you navigate your partition action efficiently and with care. We are here to help.