Quarterly State Compliance Review

In Alabama, Senate Bill 363, effective May 23, amended the Business Corporation Law to provide for share exchanges. In Iowa, Senate Bill 2260, effective July 1, amended the Nonprofit Corporation Act to permit member meetings to be held electronically and to permit directors to take corporate business opportunities under certain conditions. In Kansas, House Bill 2207, effective July 1, allowed for the formation of a series limited liability company.

In Ohio, House Bill 267, effective May 22, adopted the Revised Uniform Unincorporated Nonprofit Association Act and permitted nonprofit corporations to merge and consolidate with other types of entities. In Rhode Island, Senate Bill 353 and House Bill 5279, effective July 1, authorized the formation of low profit LLCs. In South Dakota, House Bill 1192, effective July 1, provided that the section of the LLC law governing charging orders applies to single member LLCs as well as to multi-member LLCs.

In Vermont, Senate Bill 217, effective July 1, amended provisions of the Benefit Corporation Act relating to closely held benefit corporations. In Virginia, House Bill 519, effective July 1, amended the provisions of the Stock Corporation Act, Nonstock Corporation Act, LLC Act and LP Act governing domestications, conversions, amendments, withdrawals and cancellations.

In Washington, House Bill 2239, effective June 6, authorized the formation of a social purpose corporation. And in West Virginia, Senate Bill 619, effective July 1, clarified that domestic and foreign LLCs are required to file an annual report by July 1, and revised the penalties and late fees imposed on corporations, LLCs, and LPs for filing delinquent annual reports.

IN THE STATE COURTS

DE Supreme Court: Error Deprives Stockholder of Standing to Seek Inspection

In Central Laborers Pension Fund v. News Corporation, No. 682, 2011 (Del. Supr.), decided May 29, 2012, the plaintiff, a beneficial stockholder, brought an action under Sec. 220 of the Delaware General Corporation Law to compel the defendant corporation to produce books and records. The corporation moved to dismiss. One of its grounds was that the plaintiff's inspection demand failed to comply with the procedural requirements of Sec. 220. Another was that the plaintiff did not have a proper purpose. The Chancery Court granted the motion to dismiss on the proper purpose grounds and the plaintiff appealed.

The Delaware Supreme Court affirmed the Chancery Court's dismissal but on the grounds that the inspection demand did not satisfy Sec. 220's procedural requirements. The court noted that Sec. 220 requires a beneficial stockholder to provide evidence of its beneficial ownership along with the demand for an inspection. Here, it was undisputed that the plaintiff did not provide such evidence along with the demand.

The court rejected the plaintiff's argument that this was merely a clerical error and that it was cured when the plaintiff submitted proof of beneficial ownership with its response to the motion to dismiss. According to the court Sec. 220's form and manner prerequisites are intended to protect corporations from improper demands and Delaware courts require strict compliance with these requirements. In addition the plaintiff did not cure the defect as the statute requires proof of ownership to be submitted with the demand. Thus, the plaintiff did not establish its standing to inspect the corporation's books and records and there was no need to reach the issue of whether the plaintiff had a proper purpose.

DE Chancery Court Applies Corporate Law to Shareholder Suit

In Protas v. Cavanagh, C.A. 6555 (Del. Ch.), decided May 4, 2012, the plaintiff, a common stockholder in a Delaware statutory trust, brought a suit alleging direct and derivative claims against the trustees. The issues for the Chancery Court were whether the direct claims were derivative and whether the plaintiff met the derivative suit pleading requirements set forth in the Statutory Trust Act.

The Delaware Chancery Court held that all of the claims were derivative. In doing so the court applied the corporate law test in which the court asks who suffered the alleged harm and who would receive the benefit of any recovery ' the stockholder class or the corporation. In this case the plaintiff claimed the defendants wasted assets by redeeming preferred shares at a substantial premium to their market value at a time when the trust had no obligation to do so. The plaintiff's direct claims were that the defendants depleted funds that could have been distributed to the common stockholders and that the redemption unfairly favored the interests of preferred stockholders over common stockholders.

The Chancery Court held that the claims were derivative because the harm to the common stockholders was entirely dependent on the harm to the statutory trust caused by the alleged overpayment and because any remedy would inure to the benefit of the statutory trust directly.

The court then found that the plaintiff failed to meet the pleading requirements for bringing a derivative suit under the Delaware Statutory Trust Act. The plaintiff failed to make a pre-suit demand on the trustees, who were independent and disinterested. The court noted that in the corporate context a plaintiff alleging waste must allege facts showing that the transaction was so one-sided that no business person of ordinary sound judgment could conclude that the corporation received adequate consideration. Here, the plaintiff presented only general allegations regarding the wisdom of the redemption and failed to allege that the statutory trust received no substantial consideration.

NY Court of Appeals: Chief Compliance Officer May Not Sue

In Sullivan v. Harnisch, 2012 N.Y. Slip Op 3574, decided May 8, 2012, the former Chief Compliance Officer of a hedge fund filed a suit for wrongful discharge, alleging he was fired because, in his capacity as CCO, he objected to improper stock sales made by the hedge fund's CEO.

The New York Court of Appeals affirmed the appellate court's dismissal of the claim. The court noted that New York does not recognize a cause of action for the wrongful discharge of an at-will employee. The court further noted that it has recognized an exception to this rule only once ' when the plaintiff was a lawyer who claimed to be fired by his law firm because of his insistence the firm comply with disciplinary rules. In granting that exception the court stressed both the ethical obligation of members of the bar and the importance of these obligations to the employment relationship between a lawyer and law firm. According to the court, neither of these factors were present here.

While acknowledging the importance of regulatory compliance by hedge funds, the court stated that it could not be said that the plaintiff's regulatory and ethical obligations and his duties as an employee were so closely linked as to be incapable of separation. In fact, the plaintiff had a number of roles in the hedge fund other than being its CCO. Furthermore, the existence of federal regulations furnishes no reason to make state common law governing the employee-employer relationship more intrusive.

California Law Applies to Wrongful Termination Claim Against Delaware
Corporation

In Lidow v. Superior Court of Los Angeles County, B239042 (Cal. App.), decided May 23, 2012, the former CEO of a Delaware corporation based in California filed a suit in California for wrongful termination. He alleged he was fired in retaliation for complaining about possible illegal or harmful activity, including witness intimidation and threats to employees, and breaches of ethical conduct, including hiring the same law firm that conducted an independent investigation into the alleged misconduct to defend the corporation against that misconduct. The trial court granted the corporation's motion for summary adjudication on the grounds that under the internal affairs doctrine Delaware law applied and under Delaware law a CEO may not bring a wrongful termination claim. The plaintiff challenged the trial court's order.

The California Court of Appeal reversed. The court noted that under the internal affairs doctrine the law of the state of incorporation will be applied except where some other state has a more significant relationship to the parties and the transaction. The court then stated that removing an officer in retaliation for complaining about illegal or harmful activity and breaches of ethical conduct goes beyond internal governance and touches upon broader public interest concerns that California has a vital interest in protecting. Thus, under the circumstances presented in this case the internal affairs doctrine was inapplicable and California law governed the claim.

Sandra Feldman, a member of this newsletter's Board of Editors, is a publications and research attorney for CT Corporation, part of Wolters Kluwer Corporate Legal Services (www.ctlegalsolutions.com).

This edition of the Quarterly State Compliance Review looks at some legislation of interest to corporate lawyers that went into effect between May 1 and July 1, 2012, as well as some recent cases of interest. It includes two rulings from Delaware's courts, and decisions from California and New York on whether corporate officers may sue for wrongful termination.

IN THE STATE LEGISLATURES

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

In Alabama, Senate Bill 363, effective May 23, amended the Business Corporation Law to provide for share exchanges. In Iowa, Senate Bill 2260, effective July 1, amended the Nonprofit Corporation Act to permit member meetings to be held electronically and to permit directors to take corporate business opportunities under certain conditions. In Kansas, House Bill 2207, effective July 1, allowed for the formation of a series limited liability company.

In Ohio, House Bill 267, effective May 22, adopted the Revised Uniform Unincorporated Nonprofit Association Act and permitted nonprofit corporations to merge and consolidate with other types of entities. In Rhode Island, Senate Bill 353 and House Bill 5279, effective July 1, authorized the formation of low profit LLCs. In South Dakota, House Bill 1192, effective July 1, provided that the section of the LLC law governing charging orders applies to single member LLCs as well as to multi-member LLCs.

In Vermont, Senate Bill 217, effective July 1, amended provisions of the Benefit Corporation Act relating to closely held benefit corporations. In Virginia, House Bill 519, effective July 1, amended the provisions of the Stock Corporation Act, Nonstock Corporation Act, LLC Act and LP Act governing domestications, conversions, amendments, withdrawals and cancellations.

In Washington, House Bill 2239, effective June 6, authorized the formation of a social purpose corporation. And in West Virginia, Senate Bill 619, effective July 1, clarified that domestic and foreign LLCs are required to file an annual report by July 1, and revised the penalties and late fees imposed on corporations, LLCs, and LPs for filing delinquent annual reports.

IN THE STATE COURTS

DE Supreme Court: Error Deprives Stockholder of Standing to Seek Inspection

In Central Laborers Pension Fund v. News Corporation, No. 682, 2011 (Del. Supr.), decided May 29, 2012, the plaintiff, a beneficial stockholder, brought an action under Sec. 220 of the Delaware General Corporation Law to compel the defendant corporation to produce books and records. The corporation moved to dismiss. One of its grounds was that the plaintiff's inspection demand failed to comply with the procedural requirements of Sec. 220. Another was that the plaintiff did not have a proper purpose. The Chancery Court granted the motion to dismiss on the proper purpose grounds and the plaintiff appealed.

The Delaware Supreme Court affirmed the Chancery Court's dismissal but on the grounds that the inspection demand did not satisfy Sec. 220's procedural requirements. The court noted that Sec. 220 requires a beneficial stockholder to provide evidence of its beneficial ownership along with the demand for an inspection. Here, it was undisputed that the plaintiff did not provide such evidence along with the demand.

The court rejected the plaintiff's argument that this was merely a clerical error and that it was cured when the plaintiff submitted proof of beneficial ownership with its response to the motion to dismiss. According to the court Sec. 220's form and manner prerequisites are intended to protect corporations from improper demands and Delaware courts require strict compliance with these requirements. In addition the plaintiff did not cure the defect as the statute requires proof of ownership to be submitted with the demand. Thus, the plaintiff did not establish its standing to inspect the corporation's books and records and there was no need to reach the issue of whether the plaintiff had a proper purpose.

DE Chancery Court Applies Corporate Law to Shareholder Suit

In Protas v. Cavanagh, C.A. 6555 (Del. Ch.), decided May 4, 2012, the plaintiff, a common stockholder in a Delaware statutory trust, brought a suit alleging direct and derivative claims against the trustees. The issues for the Chancery Court were whether the direct claims were derivative and whether the plaintiff met the derivative suit pleading requirements set forth in the Statutory Trust Act.

The Delaware Chancery Court held that all of the claims were derivative. In doing so the court applied the corporate law test in which the court asks who suffered the alleged harm and who would receive the benefit of any recovery ' the stockholder class or the corporation. In this case the plaintiff claimed the defendants wasted assets by redeeming preferred shares at a substantial premium to their market value at a time when the trust had no obligation to do so. The plaintiff's direct claims were that the defendants depleted funds that could have been distributed to the common stockholders and that the redemption unfairly favored the interests of preferred stockholders over common stockholders.

The Chancery Court held that the claims were derivative because the harm to the common stockholders was entirely dependent on the harm to the statutory trust caused by the alleged overpayment and because any remedy would inure to the benefit of the statutory trust directly.

The court then found that the plaintiff failed to meet the pleading requirements for bringing a derivative suit under the Delaware Statutory Trust Act. The plaintiff failed to make a pre-suit demand on the trustees, who were independent and disinterested. The court noted that in the corporate context a plaintiff alleging waste must allege facts showing that the transaction was so one-sided that no business person of ordinary sound judgment could conclude that the corporation received adequate consideration. Here, the plaintiff presented only general allegations regarding the wisdom of the redemption and failed to allege that the statutory trust received no substantial consideration.

NY Court of Appeals: Chief Compliance Officer May Not Sue

In Sullivan v. Harnisch , 2012 N.Y. Slip Op 3574, decided May 8, 2012, the former Chief Compliance Officer of a hedge fund filed a suit for wrongful discharge, alleging he was fired because, in his capacity as CCO, he objected to improper stock sales made by the hedge fund's CEO.

The New York Court of Appeals affirmed the appellate court's dismissal of the claim. The court noted that New York does not recognize a cause of action for the wrongful discharge of an at-will employee. The court further noted that it has recognized an exception to this rule only once ' when the plaintiff was a lawyer who claimed to be fired by his law firm because of his insistence the firm comply with disciplinary rules. In granting that exception the court stressed both the ethical obligation of members of the bar and the importance of these obligations to the employment relationship between a lawyer and law firm. According to the court, neither of these factors were present here.

While acknowledging the importance of regulatory compliance by hedge funds, the court stated that it could not be said that the plaintiff's regulatory and ethical obligations and his duties as an employee were so closely linked as to be incapable of separation. In fact, the plaintiff had a number of roles in the hedge fund other than being its CCO. Furthermore, the existence of federal regulations furnishes no reason to make state common law governing the employee-employer relationship more intrusive.

California Law Applies to Wrongful Termination Claim Against Delaware
Corporation

In Lidow v. Superior Court of Los Angeles County, B239042 (Cal. App.), decided May 23, 2012, the former CEO of a Delaware corporation based in California filed a suit in California for wrongful termination. He alleged he was fired in retaliation for complaining about possible illegal or harmful activity, including witness intimidation and threats to employees, and breaches of ethical conduct, including hiring the same law firm that conducted an independent investigation into the alleged misconduct to defend the corporation against that misconduct. The trial court granted the corporation's motion for summary adjudication on the grounds that under the internal affairs doctrine Delaware law applied and under Delaware law a CEO may not bring a wrongful termination claim. The plaintiff challenged the trial court's order.

The California Court of Appeal reversed. The court noted that under the internal affairs doctrine the law of the state of incorporation will be applied except where some other state has a more significant relationship to the parties and the transaction. The court then stated that removing an officer in retaliation for complaining about illegal or harmful activity and breaches of ethical conduct goes beyond internal governance and touches upon broader public interest concerns that California has a vital interest in protecting. Thus, under the circumstances presented in this case the internal affairs doctrine was inapplicable and California law governed the claim.

Sandra Feldman, a member of this newsletter's Board of Editors, is a publications and research attorney for CT Corporation, part of Wolters Kluwer Corporate Legal Services (www.ctlegalsolutions.com).