Primary Sources Used in This Chapter

ADW DRAFT 9/3/11

AP edits 9/5/11

Chapter 3. Corporate Federalism

Primary Sources Used in this Chapter

·  DGCL § 394

·  New York State Business Corporation Law, § 1304

·  California Corporations Code § 2115

·  DGCL § 160(c)

·  DGCL § 203

·  Trustees of Dartmouth College v. Woodward

·  Shaffer v Heitner

·  McDermott Inc. v. Lewis

·  Edgar v. MITE Corp

·  CTS Corp. v. Dynamics Corp. of America

·  Amanda Acquisition Corp. v. Universal Foods Corp.

Concepts for this Chapter

•  U.S. corporate law history

•  Internal affairs doctrine

–  Regulation of foreign corporations

–  Choice of law rules

–  Pseudo-foreign corporations

•  Federal abstention

•  “Race of laxity”

–  Delaware wins race

–  Race to bottom or top?

Introduction

Chapter 3 is the first of the three chapters in Module II: Corporations and Policy. Module II explores the relationship between federal and state corporate regulation, how corporate law views the corporation in society, and the corporation as a political actor.

Chapter 3 on corporate federalism (state vs. state, federal vs. state) reveals the essentially private nature of corporate law – and the importance of party choice. Later chapters assume students have understood the internal affairs doctrine, the history of the state-federal interplay in regulating corporations, and the relationship between the state bar/legislature/judiciary in formulating law. Later chapters also assume a knowledge of how corporate takeovers happen.

U.S. corporate law is mostly about state law, since there is no all-encompassing federal corporation law. Later chapters include material on federal law –such as federal securities law, federal environmental law, the Sarbanes-Oxley corporate governance provisions.

A. Brief History of U.S. Corporate Law

There is a long history of people attempting to organize in specialized hierarchies in pursuit of profit. The corporation has proven the superior organizational form for large enterprises. Later chapters describe the LLC (a corporate hybrid), which is proving superior for smaller enterprises.

Early antecedents of the corporation date back to ancient Rome. Forerunners of the U.S. business corporation included the incorporated and unincorporated English joint stock companies, for example the notorious South Sea Company, to which the English Parliament had granted a monopoly on trade with the Pacific Islands:

The South Sea Company was one of the arch speculators in, and manipulators of, its own shares. Its manipulations eventually caused a great increase in the market price of its shares. The huge increase in the price of South Sea Company shares led to a tremendous wave of company promotions and to speculation in the securities of newly formed companies. On a single day, for example, one thousand persons subscribed to shares in a company “for carrying on an undertaking of great importance, but nobody to know what it is.”[1]

In 1719, the South Sea Company launched an ambitious program to persuade investors holding government bonds and annuities to exchange them for shares of its stock. To make some funds available for speculation in its shares and to check the flotation of new companies competing for public funds, the South Sea Company inspired passage of the Bubble Act of 1720.[2] The purported objective of the Bubble Act was to prevent unwary persons from investing in fraudulent projects or undertakings. It prohibited unincorporated companies from acting as though they were corporate bodies or pretending that their shares were transferable. The South Sea Company and certain other existing companies were exempted from its prohibitions.

The Bubble Act was crudely drawn and failed to define clearly the practices and offenses condemned. The product of haste and self-interest, this ambiguous and incoherent legislation long caused great uncertainty and confusion and raised unnecessary doubts about the validity of the issuance of transferable shares by legitimate unincorporated companies.[3]

James D. Cox and Thomas Lee Hazen, 1 Treatise on the Law of Corporations (3rd), Chapter 2. The Evolution of Corporations in England and America, § 2:2. The Evolution of English Corporation Law. http://web2.westlaw.com/find/default.wl?rs=WLW11.07&rp=%2ffind%2fdefault.wl&vr=2.0&fn=_top&mt=208&cite=LAWOFCORP+%c2%a7+2%3a2&sv=Split

We trace the U.S. corporation from 1800, about the time states began recognizing the usefulness of incorporation of private business (as opposed to municipalities, colleges and churches). Early corporations were formed often as political favors, leading to general incorporation statutes.

Question: Is the corporation private property or a social institution?

Answer: Both. Corporations are both “contracts” that cannot be unilaterally amended by the legislature and “artificial beings,” created by and modifiable by the legislature. The property vs. institution uncertainty is a recurring theme in corporate law. In Trustees of Dartmouth College v. Woodward. Chief Justice Marshall discusses the nature of the corporate charter of Dartmouth College.

Trustees of Dartmouth College v. Woodward, 17 U.S. 518 (1819),

Facts: Dartmouth College sued the state of New Hampshire claiming that amendments to its charter passed by the state legislature to give state officials a part in running the college were unconstitutional. Dartmouth’s trustees had originally been given the articles of incorporation by Great Britain.

Issue: Was the Dartmouth College corporate charter a private contract or a government-created institution?

Holding: Both

Reasoning: The corporation is both a contract between private parties and the state (by which the power to amend is enjoyed only by the parties) and a “creature of state law” that is created and can be modified as the state chooses.

Chief Justice Marshall wrote: “A corporation is an artificial being, invisible, intangible, and existing only in contemplation of law. Being the mere creature of law, it possesses only those properties which the charter of its creation confers upon it, either expressly, or as incidental to its very existence.”

Marshall’s opinion reinforces the basic attributes of a corporation learned in the last Chapter, but then the Court decides that the state can’t change the “corporate charter” because it is akin to contract. This leaves the nature of the corporation up in the air.

Justice Story’s concurring opinion suggested that states might grant future charters subject to a reserved right to amend them. Currently all states reserve the power to amend the statutes that govern corporations (and thus change corporate rights).

DGCL § 394. Reserved power of State to amend or repeal chapter; chapter part of corporation's charter or certificate of incorporation

This chapter may be amended or repealed, at the pleasure of the General Assembly, but any amendment or repeal shall not take away or impair any remedy under this chapter against any corporation or its officers for any liability which shall have been previously incurred. This chapter and all amendments thereof shall be a part of the charter or certificate of incorporation of every corporation except so far as the same are inapplicable and inappropriate to the objects of the corporation.

Delaware General Corporations Law, Title 8. Corporations. Chapter 1. General Corporation Law. Subchapter XVII, Miscellaneous Provisions. § 394. Reserved power of State to amend or repeal chapter; chapter part of corporation's charter or certificate of incorporation

http://web2.westlaw.com/find/default.wl?rs=WLW11.07&rp=%2ffind%2fdefault.wl&vr=2.0&fn=_top&mt=208&cite=8+Del.C.+%c2%a7+394&sv=Split

INSERT MBCA §102 and/or link? [Alan: good idea to include actual section]

Question: What hinges on the property vs. institution question?

Answer: If the corporation is property, it is only accountable to maximize wealth for its shareholders. If the corporation is a social institution, its obligations run beyond the shareholders to non-shareholder constituents and society.

Early corporate statutes distrusted corporate power -- placing limits on corporate purposes, activities, and capitalization. The evolution of corporate law has been one towards liberalization for corporations. At one time, the articles of incorporation had to describe the powers, purposes and activities in exhaustive detail. Today, the practice is to leave the description of powers and

purposes to broad statutes.

Question: Which state passed the first “liberal” corporate law?

Answer: New Jersey passed the first “liberal” corporate law, allowing corporations to own stock in other corporations (permitting holding companies). The holding companies allowed by New Jersey law were the “trusts” addressed by the Sherman Antitrust Act. Lawyers on New York City’s Wall Street used New Jersey law to create corporate power structures. New Jersey’s statute was an example of the trend toward liberalization in corporate law.

New Jersey later lost its “lead” to Delaware when NJ Governor Woodrow Wilson re-regulated NJ corporations. Delaware adopted the New Jersey statute verbatim and Wall Street looked across the Hudson to tiny Delaware. Delaware took the lead in advancing corporate law and has never looked back. This is the story of corporate law. If a jurisdiction gets too regulatory, private parties can migrate. Corporate migration depends on the internal affairs doctrine.

Question: What is the relationship between federal and state regulation of corporations?

Answer: Over time there has been an ebb and flow between federal and state law, with the federal government responding to reassert itself after state law failures to rein in unfettered capitalism or “choice”.

·  1800 State legislative special chartering

·  1819 Dartmouth College Case

·  1830- General incorporation statutes passed in many states (starting with New York)

·  The Sherman Antitrust Act in 1890 responded to corporate holding companies that engaged in monopolization of the oil industry and railroads.

·  1888 New Jersey passed incorporation statute departing from strict limitation on corporations

·  1899 Delaware passed enabling statute modeled on New Jersey’s statute with a view to attracting incorporations and generating franchise tax revenues

·  1913 New Jersey amended its corporation law to reimpose a number of restrictive provisions

·  1933, 1934 the federal securities acts passed in response to corporate fraud and investor speculation that led to the Stock Market Crash of 1929

·  2002 the Sarbanes-Oxley Act passed in response to the accounting fraud at Enron and other corporate scandals of the 1990s.

Question: What was the impact of the wave of hostile tender offers in the 1980s?

Answer: Hostile tender offers are a takeover device in which buyers forego the consulting the board of directors and appeal directly to shareholders to give them control. Even in companies during this period that did not get a hostile bid, incumbent management changed the company to avoid being targeted. The resulting restructuring transformed the relationship between public shareholders and corporate management.

Question: What is a leveraged buyout (or LBO)?

Answer: The breakout box on p. 63 defines an LBO as the purchase of a controlling interest in a corporation in which the bulk of the purchase price comes from borrowed money (leverage). The assets of the target company are often used as the collateral for the borrowed money. Leveraged buyouts allow outside acquirers to purchase companies without committing a lot of capital.

Question: What is a hedge fund?

Answer: The breakout box on p. 64 explains that a hedge fund is an investment fund open to a limited group of investors, such as wealthy individuals and large institutional investors. Hedge funds (private investment pools) have been successful in pressuring managers to generate high returns for shareholders. Hedge funds were originally meant to diversify risk – to create a floor to downturns in market. However, they have become active investors, and engage in such practices as buying votes, creating downturns in company share prices and selling stock short to make money. But hedge funds also bring change …

Notice that there was not a federal response to the takeovers of the 1980s – in fact, we’ll soon see how the Supreme Court essentially abstained.

B. Horizontal Federalism: State View of Corporate Law

The Internal Affairs Doctrine

Question: What is a “foreign corporation”?

Answer: A “foreign corporation” is a corporation that does business in a state in which it is not incorporated.

Hypothetical Example (from p. 65)

A multi-state corporation operates in several states. The business is headquartered in North Carolina, incorporated in Delaware, does business in California and has investors in Florida.

Question: Which law applies to its various business affairs?

Answer: It depends on whether it is a question of corporate internal affairs or non-corporate law – such as the timing of a shareholders’ meeting or a question of consumer product safety.

Question: What is the internal affairs doctrine?

Answer: The internal affairs doctrine provides that the law of the state of incorporation should govern any disputes regarding that corporation’s “internal affairs.”

Question: What are “internal affairs”?

Answer: “Internal affairs” are matters peculiar to the relationships among the corporation and its officers, directors, and shareholders. Some examples include voting, selling shares, and fiduciary duties.

Question: What if the corporation sells bad doughnuts in California?

Answer: Selling bad doughnuts involves the relationship with customers and the corporation-- an external affair. The relationship between shareholders and management is not implicated.

Question: What if investors in Florida demand payment of dividends and sue in Florida court?

Answer: This is a conflict between shareholders and management-- an internal affair. The Florida court will probably determine that under Florida choice of law the substantive corporate law of Delaware applies.

Question: What if board members are sued in Delaware, but never have set foot in the state?

Answer: “Minimum contacts” analysis requires more than mere stock ownership in a corporation incorporated in that state.

The Supreme Court considered this question in Shaffer v Heitner in 1977. In Shaffer, a nonresident shareholder of Greyhound Corp. brought a shareholder’s derivative suit against Greyhound and its wholly owned subsidiary Greyhound Lines, Inc., as well as 28 present and former officers and directors [“managers”], who were also nonresidents of Delaware. The suit alleged that the individual managers had violated their duties to Greyhound by causing it and its subsidiary to engage in actions (which occurred in Oregon) that resulted in corporate liability for substantial damages in a private antitrust suit and a large fine in a criminal contempt action.

The Court ruled that Delaware's assertion of jurisdiction over the managers, based solely on the statutory presence of their' property (Greyhound stock) in Delaware, violated the Due Process Clause because the managers did not have contacts, ties or relations with Delaware. The managers’ holdings in Greyhound were unrelated to the cause of action of the derivative suit and this did not provide contacts with Delaware sufficient to support Delaware’s jurisdiction of the managers.