Quarterly State Compliance Review

This edition of the Quarterly State Compliance Review looks at some legislation of interest to corporate lawyers that went into effect from May 1 through July 1, 2010. It also looks at recent decisions of interest from the courts of Delaware, New York and California.

IN THE STATE LEGISLATURES

This has been a busy quarter for those who track changes to state business entity statutes, as a significant number of amendments went into effect. Below are some of the legislative highlights from around the country.

In Iowa, House File 2111, effective July 1, directed the Secretary of State to notify the Department of Workforce Development when a corporation or LLC applies for reinstatement after a dissolution, and directed the Department to report the entity's tax status to the Secretary of State. In Kansas, Senate Bill 132, effective July 1, enacted the Entity Transaction Act, which will govern mergers, conversions, interest exchanges and domestications involving all types of business entities.

In Maryland, Senate Bill 784, effective June 1, required foreign statutory trusts to register with the state before doing business there and imposed penalties for failure to do so. In Mississippi, Senate Bill 2003, effective July 1, allowed business entities to voluntarily register fictitious business names with the Secretary of State for renewable five-year terms.

In New Jersey, Senate Bill 895, effective May 6, eliminated the 10-day waiting period for effectiveness of actions other than mergers that are taken without a meeting upon consent of less than all shareholders. In South Dakota, House Bill 1109, effective July 1, authorized LLCs to enter into conversions and domestications.

In Tennessee, House Bill 3643, effective July 1, required that documents being filed to dissolve, terminate, or withdraw a corporation, LLC or LLP be accompanied by a tax clearance certificate. In Utah, Senate Bill 179, effective May 11, provided that a shareholder of a corporation, when acting solely in the capacity of a shareholder, has no fiduciary duty to any other shareholder.

In Virginia, Senate Bill 100, effective July 1, permitted bylaws requiring that if the corporation solicits proxies or consents with respect to an election of directors, the corporation include shareholder nominees, and requiring that the corporation reimburse the expenses incurred by a shareholder in soliciting proxies or consents in connection with an election of directors.

In Washington, House Bill 2657, effective June 10, provided that in winding up, an LLC may voluntarily file a certificate of dissolution to provide notice that it is dissolved and that an LLC that has filed a certificate of dissolution may dispose of known claims by following a specified procedure.

In West Virginia, Senate Bills 624 and 696, effective June 11, changed the due date for filing the Annual Report of an LLC and an LLP from April 1 to July 1. And in Wyoming, Senate Bill 18, effective July 1, enacted the Uniform Limited Liability Company Act, which provides default and mandatory provisions governing LLCs.

IN THE STATE COURTS

DE Chancery Court Holds That LP Act Permits Arbitration of Books and Records Action

In Aris Multi-Strategy Fund, LP v. Southridge Partners, LP, C.A. No. 5422, decided May 21, 2010, a limited partner filed an action in the Delaware Chancery Court under Sec. 17-305 of the Delaware LP Act, seeking access to a Delaware LP's books and records. The partnership agreement contained a clause stating that any claim or controversy arising among or between the parties pertaining to the LP shall be settled by arbitration. The LP moved to dismiss in favor of arbitration.

The Chancery Court, noting that this dispute pertained to the LP and that the arbitration provision clearly evinced an intent to submit such disputes to arbitration, granted the motion to dismiss. The plaintiff contended that inspection rights under Sec. 17-305 could not be determined by an arbitrator because the statute grants exclusive jurisdiction to the Chancery Court. However, the Chancery Court stated that this was incorrect. According to the court, Sec. 17-109 allows limited partners to waive their right to bring actions relating to the LP's internal affairs in the Delaware courts so long as they do so by agreeing to arbitrate such actions. And, according to the court, that was exactly what happened here. The court also noted that permitting limited partners to contractually agree to arbitrate their statutory rights is consistent with the manner in which Delaware courts have treated this issue in the context of corporations and LLCs.

DE Chancery Court: Seeking to Establish Demand Futility in a Previously Filed Derivative Suit Is Not a Proper Purpose

In King v. Verifone Holdings, Inc., C.A. 5047, decided May 12, 2010, the plaintiff sought to inspect books and records of a Delaware corporation. Several lawsuits were filed against the corporation after it announced that it was restating its financial statements. The plaintiff was the first to file a derivative suit and was named the lead plaintiff when the suits were consolidated in a California federal court. The plaintiff's counsel admitted to rapidly filing the derivative suit in order to become lead plaintiff.

The defendants moved to dismiss the derivative suit for failure to plead that demand was excused. The plaintiff did not seek discovery because federal precedent holds that a derivative plaintiff cannot obtain discovery until it meets its pleading burden to show grounds for excusal. Instead, the plaintiff filed this complaint in the Delaware Chancery Court seeking an inspection pursuant to Sec. 220 of the General Corporation Law.

The Chancery Court dismissed the complaint on the grounds that the plaintiff failed to state a proper purpose for the inspection. The plaintiff's stated purpose was to seek information to show that making a demand on the board of directors would have been futile. That purpose was improper for several public policy reasons.

First, according to the court, the plaintiff was doing a costly, inefficient end run around the federal discovery rule applicable to derivative suits. Second, filing a Sec. 220 action seeking discovery in a case pending in another court conflicts with the policies against subjecting defendants to simultaneous suits in separate forums. Third, the court stated that allowing a plaintiff to use Sec. 220 in an after-the-fact manner to bolster his derivative complaint would exacerbate the perverse incentives motivating some representative plaintiffs' unseemly and inefficient race to the courthouse.

NY Appellate Court Rules That 'Holder Claim' Violated Out-of-Pocket Rule

In The Starr Foundation v. American International Group, Inc., 2010 N.Y. Slip Op. 4526 (A.D. 1st Dept.), decided May 17, 2010, the plaintiff's main asset was nearly 50 million shares of AIG stock. It sought to divest itself of the stock and set a floor price of $65 per share for the sale of the stock. According to the plaintiff, it was induced to maintain that floor price by misstatements made by the defendants minimizing the degree of risk attached to AIG's credit default swap. The plaintiff claimed that if not for those misstatements it would have lowered the floor price and sold all of its remaining AIG stock. Instead, it held over 15 million shares when the value declined substantially. The plaintiff brought an action for fraud, which the trial court dismissed.

The New York Supreme Court, Appellate Division affirmed the dismissal, holding that the plaintiff's claim violated New York's out-of-pocket rule governing damages recoverable for fraud. The court noted that under that rule, the loss of an alternative contractual bargain cannot serve as a basis for fraud damages because the loss of the bargain was undeterminable and speculative. Here, the plaintiff sought to recover the value it might have realized from selling its shares during a period when it chose to hold, under hypothetical market conditions for AIG stock that never existed. According to the court, a bargain more undeterminable and speculative would be hard to imagine.

CA Appellate Court Holds That In-House Counsel Who Are Also Officers Are Not Exempt from Statute

In Gutierrez v. G & M Oil Company, Inc., G042041 (C.A. 4th Dist.), decided May 7, 2010, a class action suit was filed against a corporation. The corporation's general counsel was also a Vice President. The general counsel decided to handle the case himself. He did not tell anyone else at the company about the lawsuit. He also failed to respond to the amended complaint and took almost no steps to defend the case. A $4 million default judgment was taken against the corporation.

The trial court vacated the default judgment pursuant to Sec. 473 of the California Code of Civil Procedure. Sec. 473 provides mandatory relief where the application is accompanied by an attorney's sworn affidavit that it was his or her neglect or mistake that resulted in the default judgment. The plaintiff appealed, arguing that because the attorney was also a corporate officer his actions had to be imputed to the corporation, meaning that the corporation was at fault.

The California Court of Appeal held that Sec. 473 applied. The court noted that the text of Sec. 473 does not differentiate between outside and in-house attorneys, or between in-house attorneys who are corporate officers and those who are not, and that there was nothing in the language or structure of the section to require an implied differentiation.

In addition, the court noted that a corporation must be represented in court by an attorney and that the very corporate form then, in the context of litigation, treats in-house attorneys, whether they are officers or not, as agents separate from the corporation itself. Furthermore, case law distinguishes between corporate counsel who perform “strictly legal services” to a corporation and services of a “nonlegal business nature.” And, as the court noted, some defalcation on an attorney's part leading to a default judgment clearly falls on the legal services side of the legal services-business services dichotomy.

Sandra Feldman is a publications and research attorney for New York-based CT (www.ctlegalsolutions.com), a Wolters Kluwer business. She is a member of this newsletter's Board of Editors.

This edition of the Quarterly State Compliance Review looks at some legislation of interest to corporate lawyers that went into effect from May 1 through July 1, 2010. It also looks at recent decisions of interest from the courts of Delaware, New York and California.

IN THE STATE LEGISLATURES

This has been a busy quarter for those who track changes to state business entity statutes, as a significant number of amendments went into effect. Below are some of the legislative highlights from around the country.

In Iowa, House File 2111, effective July 1, directed the Secretary of State to notify the Department of Workforce Development when a corporation or LLC applies for reinstatement after a dissolution, and directed the Department to report the entity's tax status to the Secretary of State. In Kansas, Senate Bill 132, effective July 1, enacted the Entity Transaction Act, which will govern mergers, conversions, interest exchanges and domestications involving all types of business entities.

In Maryland, Senate Bill 784, effective June 1, required foreign statutory trusts to register with the state before doing business there and imposed penalties for failure to do so. In Mississippi, Senate Bill 2003, effective July 1, allowed business entities to voluntarily register fictitious business names with the Secretary of State for renewable five-year terms.

In New Jersey, Senate Bill 895, effective May 6, eliminated the 10-day waiting period for effectiveness of actions other than mergers that are taken without a meeting upon consent of less than all shareholders. In South Dakota, House Bill 1109, effective July 1, authorized LLCs to enter into conversions and domestications.

In Tennessee, House Bill 3643, effective July 1, required that documents being filed to dissolve, terminate, or withdraw a corporation, LLC or LLP be accompanied by a tax clearance certificate. In Utah, Senate Bill 179, effective May 11, provided that a shareholder of a corporation, when acting solely in the capacity of a shareholder, has no fiduciary duty to any other shareholder.

In Virginia, Senate Bill 100, effective July 1, permitted bylaws requiring that if the corporation solicits proxies or consents with respect to an election of directors, the corporation include shareholder nominees, and requiring that the corporation reimburse the expenses incurred by a shareholder in soliciting proxies or consents in connection with an election of directors.

In Washington, House Bill 2657, effective June 10, provided that in winding up, an LLC may voluntarily file a certificate of dissolution to provide notice that it is dissolved and that an LLC that has filed a certificate of dissolution may dispose of known claims by following a specified procedure.

In West Virginia, Senate Bills 624 and 696, effective June 11, changed the due date for filing the Annual Report of an LLC and an LLP from April 1 to July 1. And in Wyoming, Senate Bill 18, effective July 1, enacted the Uniform Limited Liability Company Act, which provides default and mandatory provisions governing LLCs.

IN THE STATE COURTS

DE Chancery Court Holds That LP Act Permits Arbitration of Books and Records Action

In Aris Multi-Strategy Fund, LP v. Southridge Partners, LP, C.A. No. 5422, decided May 21, 2010, a limited partner filed an action in the Delaware Chancery Court under Sec. 17-305 of the Delaware LP Act, seeking access to a Delaware LP's books and records. The partnership agreement contained a clause stating that any claim or controversy arising among or between the parties pertaining to the LP shall be settled by arbitration. The LP moved to dismiss in favor of arbitration.

The Chancery Court, noting that this dispute pertained to the LP and that the arbitration provision clearly evinced an intent to submit such disputes to arbitration, granted the motion to dismiss. The plaintiff contended that inspection rights under Sec. 17-305 could not be determined by an arbitrator because the statute grants exclusive jurisdiction to the Chancery Court. However, the Chancery Court stated that this was incorrect. According to the court, Sec. 17-109 allows limited partners to waive their right to bring actions relating to the LP's internal affairs in the Delaware courts so long as they do so by agreeing to arbitrate such actions. And, according to the court, that was exactly what happened here. The court also noted that permitting limited partners to contractually agree to arbitrate their statutory rights is consistent with the manner in which Delaware courts have treated this issue in the context of corporations and LLCs.

DE Chancery Court: Seeking to Establish Demand Futility in a Previously Filed Derivative Suit Is Not a Proper Purpose

In King v. Verifone Holdings, Inc., C.A. 5047, decided May 12, 2010, the plaintiff sought to inspect books and records of a Delaware corporation. Several lawsuits were filed against the corporation after it announced that it was restating its financial statements. The plaintiff was the first to file a derivative suit and was named the lead plaintiff when the suits were consolidated in a California federal court. The plaintiff's counsel admitted to rapidly filing the derivative suit in order to become lead plaintiff.

The defendants moved to dismiss the derivative suit for failure to plead that demand was excused. The plaintiff did not seek discovery because federal precedent holds that a derivative plaintiff cannot obtain discovery until it meets its pleading burden to show grounds for excusal. Instead, the plaintiff filed this complaint in the Delaware Chancery Court seeking an inspection pursuant to Sec. 220 of the General Corporation Law.

The Chancery Court dismissed the complaint on the grounds that the plaintiff failed to state a proper purpose for the inspection. The plaintiff's stated purpose was to seek information to show that making a demand on the board of directors would have been futile. That purpose was improper for several public policy reasons.

First, according to the court, the plaintiff was doing a costly, inefficient end run around the federal discovery rule applicable to derivative suits. Second, filing a Sec. 220 action seeking discovery in a case pending in another court conflicts with the policies against subjecting defendants to simultaneous suits in separate forums. Third, the court stated that allowing a plaintiff to use Sec. 220 in an after-the-fact manner to bolster his derivative complaint would exacerbate the perverse incentives motivating some representative plaintiffs' unseemly and inefficient race to the courthouse.

NY Appellate Court Rules That 'Holder Claim' Violated Out-of-Pocket Rule

In The Starr Foundation v. American International Group, Inc. , 2010 N.Y. Slip Op. 4526 (A.D. 1st Dept.), decided May 17, 2010, the plaintiff's main asset was nearly 50 million shares of AIG stock. It sought to divest itself of the stock and set a floor price of $65 per share for the sale of the stock. According to the plaintiff, it was induced to maintain that floor price by misstatements made by the defendants minimizing the degree of risk attached to AIG's credit default swap. The plaintiff claimed that if not for those misstatements it would have lowered the floor price and sold all of its remaining AIG stock. Instead, it held over 15 million shares when the value declined substantially. The plaintiff brought an action for fraud, which the trial court dismissed.

The New York Supreme Court, Appellate Division affirmed the dismissal, holding that the plaintiff's claim violated New York's out-of-pocket rule governing damages recoverable for fraud. The court noted that under that rule, the loss of an alternative contractual bargain cannot serve as a basis for fraud damages because the loss of the bargain was undeterminable and speculative. Here, the plaintiff sought to recover the value it might have realized from selling its shares during a period when it chose to hold, under hypothetical market conditions for AIG stock that never existed. According to the court, a bargain more undeterminable and speculative would be hard to imagine.

CA Appellate Court Holds That In-House Counsel Who Are Also Officers Are Not Exempt from Statute

In Gutierrez v. G & M Oil Company, Inc., G042041 (C.A. 4th Dist.), decided May 7, 2010, a class action suit was filed against a corporation. The corporation's general counsel was also a Vice President. The general counsel decided to handle the case himself. He did not tell anyone else at the company about the lawsuit. He also failed to respond to the amended complaint and took almost no steps to defend the case. A $4 million default judgment was taken against the corporation.

The trial court vacated the default judgment pursuant to Sec. 473 of the California Code of Civil Procedure. Sec. 473 provides mandatory relief where the application is accompanied by an attorney's sworn affidavit that it was his or her neglect or mistake that resulted in the default judgment. The plaintiff appealed, arguing that because the attorney was also a corporate officer his actions had to be imputed to the corporation, meaning that the corporation was at fault.

The California Court of Appeal held that Sec. 473 applied. The court noted that the text of Sec. 473 does not differentiate between outside and in-house attorneys, or between in-house attorneys who are corporate officers and those who are not, and that there was nothing in the language or structure of the section to require an implied differentiation.

In addition, the court noted that a corporation must be represented in court by an attorney and that the very corporate form then, in the context of litigation, treats in-house attorneys, whether they are officers or not, as agents separate from the corporation itself. Furthermore, case law distinguishes between corporate counsel who perform “strictly legal services” to a corporation and services of a “nonlegal business nature.” And, as the court noted, some defalcation on an attorney's part leading to a default judgment clearly falls on the legal services side of the legal services-business services dichotomy.

Sandra Feldman is a publications and research attorney for New York-based CT (www.ctlegalsolutions.com), a Wolters Kluwer business. She is a member of this newsletter's Board of Editors.