Vaughn v. LJ International, Inc.

Opinion

A shareholder of a publicly traded corporation filed a derivative action in California alleging breaches of fiduciary duty by corporate officers and directors. The international business, a fine jewelry company incorporated in the British Virgin Islands, has no other connection to that jurisdiction. The company employs 3,000 people at its manufacturing facility in China. The majority of the company’s wholesale revenues are earned in North America, including substantial sales in California, where a few employees are based. The corporate headquarters is in Hong Kong, where all but one

The demurrer raised a choice-of-law issue, i.e., whether, assuming California’s jurisdiction to entertain a derivative lawsuit against a business incorporated outside the United States, a “leave to sue” provision of the incorporating jurisdiction is applicable. After setting out the provision at issue, we will address each of appellant’s reasons for contending the trial court erred in ruling the provision applicable to the present case.

2. British Virgin Islands Business Companies Act of 2004

As noted above, the trial court sustained respondents’ demurrer on the ground that appellant had not obtained leave to sue from the high court of the British Virgin Islands, where LJI is incorporated. The BVI Act, section 184C, provides;

“184C. (1) Subject to subsection (3), the Court may, on the application of a member of a company, grant leave to that member to [ft (a) bring proceedings in the name and on behalf of that company; or [ft! (b) intervene in proceedings to which the company is a party for the purpose of continuing, defending or discontinuing the proceedings on behalf of the company.

“(2) Without limiting subsection (1), in determining whether to grant leave under that subsection, the Court must take the following matters into account[:] [ft] (a) whether the member is acting in good faith; [ft] (b) whether the derivative action is in the interests of the company taking account of the views of the company’s directors on commercial matters; [ft (c) whether the proceedings are likely to succeed; [ft] (d) the costs of the proceedings in relation to the relief likely to be obtained; and [ft] (e) whether an alternative remedy to the derivative claim is available.

“(3) Leave to bring or intervene in proceedings may be granted under subsection (1) only if the Court is satisfied that [ft] (a) the company does not intend to bring, diligently continue or defend, or discontinue the proceedings, as the case may be; or [ft] (b) it is in the interests of the company that the conduct of the proceedings should not be left to the directors or to the determination of the shareholders or members as a whole.

“(4) Unless the Court otherwise orders, not less than twenty eight days notice of an application for leave under subsection (1) must be served on the

company and the company is entitled to appear and be heard at the hearing of the application.

“(5) The Court may grant such interim relief as it considers appropriate pending the determination of an application under subsection (1).

“(6) Except as provided in this section, a member is not entitled to bring or intervene in any proceedings in the name of or on behalf of a company.”

3. Procedure Versus Substance

Appellant Vaughn contends BVI Act section 184C has no application here because, as a foreign procedural provision, it should not be applied by the forum in which the litigation is prosecuted. (World Wide Imports, Inc. v. Bartel (1983) 145 Cal.App.3d 1006 , 1012 [ 193 Cal.Rptr. 830 ]; see also 3 Witkin, Cal. Procedure (5th ed. 2008) Actions, § 45, p. 115.) Appellant notes that section 184C imposes no liability and creates no cause of action; rather, he argues, because it deals only with the “mode of proceeding by which a legal right is enforced,” it is not a substantive provision as defined by Chavez v. Keat (1995) 34 Cal.App.4th 1406 [ 41 Cal.Rptr.2d 72 ] (Chavez). We disagree for the following reasons.

BVI Act section 184C by its own terms limits entitlement to sue to those shareholders who have complied with its provisions. Although those provisions do establish what may be called a procedure for compliance, the resulting decision as to presence or absence of standing to bring an action is most appropriately characterized as resolving a substantive right. We are not persuaded that standing to sue is a matter of mere court administration or “mode of proceeding” as argued by appellant. As stated in Hausman v. Buckley (2d Cir. 1962) 299 F.2d 696 , 701 (Hausman): “ ‘The words “substantive” and “procedural” ... are not talismanic. Merely calling a legal question by one or the other does not resolve it . [Citation.] [][] Our real inquiry must be directed to the question whether appellants’ right to bring this action involves no more than compliance with procedural requirements extraneous to the substance of their claim, or whether it concerns the very nature and quality of their substantive rights, powers and privileges as stockholders .... Thus defined, we think it is clear that appellants’ position cannot prevail. . . . The issue is not just ‘who’ may maintain an action or ‘how’ it will be brought, but ‘if’ it will be brought.”

Hausman held that a Venezuelan law requirement that a derivative action be approved by a majority of stockholders was substantive, and therefore applicable in a federal proceeding governed by New York procedural law. As

To the extent that California statutes which require a prefiling prima facie showing may be said to confer standing to bring a claim, we simply disagree with the federal courts’ characterization of them as procedural because, as stated above, we view standing to sue as a substantive right. Although prefiling requirements which grant or deny standing might be accurately described as “hybrids,” involving both procedure and substance, they must in our view be considered substantive for purposes of the present dispute.

More persuasive, in our view, are cases involving analogous statutory conditions precedent to a shareholder suit, such as Hausman, supra, 299 F.2d 696 , and cases classifying as substantive a requirement that shareholders make a demand on the board of directors before bringing a derivative action. (See Kamen v. Kemper Financial Services, Inc. (1991) 500 U.S. 90 , 96-97 [ 114 L.Ed.2d 152 , 111 S.Ct. 1711 ] [“the function of the demand doctrine in delimiting the respective powers of the individual shareholder and of the directors to control corporate litigation clearly is a matter of ‘substance,’ not ‘procedure’ ”]; Rales v. Blasband (Del. 1993) 634 A.2d 927 , 932, fn. 7 [quoting Kamen and holding that “the demand requirements for a derivative suit are determined by the law of the state of incorporation”].)

Accordingly, the common law “substance versus procedure” analysis does not assist appellant. That being so, we turn to appellant’s contentions that choice-of-law principles require California courts to ignore BVI Act section 184C.

4. Choice-of-law Principles

Although the trial court did not articulate a specific basis for its ruling, respondents’ opposition papers relied on the “internal affairs doctrine” as codified in Corporations Code section 2116. That section provides that “The directors of a foreign corporation transacting intrastate business are liable to the corporation, its shareholders, creditors, receiver, liquidator or trustee in bankruptcy for the making of unauthorized dividends, purchase of shares or distribution of assets or false certificates, reports or public notices or other violation of official duty according to any applicable laws of the state or place

A. The internal affairs doctrine and Corporations Code section 2116

“The internal affairs doctrine is a conflict of laws principle which recognizes that only one State should have the authority to regulate a corporation’s internal affairs—matters peculiar to the relationships among or between the corporation and its current officers, directors, and shareholders— because otherwise a corporation could be faced with conflicting demands.” (Edgar v. MITE Corp. (1982) 457 U.S. 624 , 645 [ 73 L.Ed.2d 269 , 102 S.Ct. 2629 ], quoted with approval in Havlicek v. Coast-to-Coast Analytical Services, Inc. (1995) 39 Cal.App.4th 1844 , 1854 [ 46 Cal.Rptr.2d 696 ] (Havlicek).) “States normally look to the State of a business’ incorporation for the law that provides the relevant corporate governance general standard of care.” (Atherton v. FDIC (1997) 519 U.S. 213 , 224 [ 136 L.Ed.2d 656 , 117 S.Ct. 666 ].)

Corporations Code section 2116 codifies the modem view of the common law doctrine, whereby a court will entertain an action involving the internal affairs of a foreign corporation. With certain exceptions, the law of the state of incorporation applies. (See 9 Witkin, Summary of Cal. Law (10th ed. 2005) Corporations, § 239, p. 1005; Friese v. Superior Court (2005) 134 Cal.App.4th 693 , 706 [ 36 Cal.Rptr.3d 558 ] [“As applied to directors’ liability, section 2116 is a codification of the ‘internal affairs doctrine’ ”].)

Thus, in State Farm Mutual Automobile Ins. Co. v. Superior Court (2003) 114 Cal.App.4th 434 , 449 [ 8 Cal.Rptr.3d 56 ], where policyholders sought to hold defendant State Farm liable for not declaring a dividend, the internal affairs doctrine required California courts to apply the law of Illinois, where State Farm is incorporated. By contrast, in Friese v. Superior Court, supra, 134 Cal.App.4th at page 706, the court held that Corporations Code section 2116 could not be used as a shield against a suit by a bankrupt corporation’s trastee alleging liability of former officers and directors for insider trading in violation of California’s Corporate Securities Law of 1968. The corporation involved in Friese, although incorporated in Delaware, had its headquarters and principal place of business in San Diego, and the securities transactions at issue took place in California. (Friese, at p. 699.) The Court of Appeal rejected the defense claim that Delaware securities regulations were applicable, reasoning that securities regulations designed to protect participants in California’s securities marketplace are not limited by the internal affairs doctrine. (Id. at p. 698.)

Whether a permission to sue provision is governed by the internal affairs doctrine as codified in Corporations Code section 2116 appears to be a question of first impression in California. The plain meaning of the broad statutory language strongly supports the position of respondents and the trial court’s ruling. Appellant’s contention that BVI Act section 184C, by divesting a corporation of authority to control litigation, operates outside a company’s internal affairs, misses the point. BVI Act section 184C regulates the liability of directors to shareholders for violations of official duty, exactly as described by section 2116.

Appellant’s reply brief argument, that BVI Act section 184C was intended to govern only lawsuits filed in the British Virgin Islands, is unsupported and ignores the reality that most businesses incorporated in the BVI are unlikely to be sued there. Like Delaware and other similar locations, the BVI is used as a place of incorporation by businesses not located there for a variety of reasons, including enhancing confidence that a predictable legal framework will govern the relationship between investors and the corporation. This is a salutary purpose. As the United States Supreme Court has stated, “Th[e] beneficial free market system depends at its core upon the fact that a corporation—except in the rarest situations—is organized under, and governed by, the law of a single jurisdiction, traditionally the corporate law of the State of its incorporation.” (CTS Corp. v. Dynamics Corp. of America (1987) 481 U.S. 69 , 90 [ 95 L.Ed.2d 67 , 107 S.Ct. 1637 ].)

Further, federal circuit courts have resolved very similar issues in respondents’ favor. In Batchelder v. Kawamoto (9th Cir. 1998) 147 F.3d 915 , a shareholder in Honda of Japan attempted to bring a derivative action in California. The court found his standing to sue was governed by the law of Japan under the terms of an applicable deposit agreement. (Id. at p. 920.) The court then analyzed the case under the internal affairs doctrine, assuming the deposit agreement was inapplicable. The court stated: “Under the ‘internal affairs’ doctrine, the rights of shareholders in a foreign company, including the right to sue derivatively, are determined by the law of the place where the company is incorporated. See Hausman v. Buckley[, supra], 299 F.2d 696 , 702 (2d Cir. 1962) . . . .” (Ibid., citations omitted.) In Hausman, the Second Circuit

We thus conclude that the modem view of the internal affairs doctrine, whether viewed through the prism of the Restatement or that of Corporations Code section 2116, favors application of the law of the incorporating jurisdiction in the present case.

C. Governmental interest analysis

Appellant asserts error in the trial court’s failure to apply a “governmental interest analysis,” which he argues would preclude application of BVI Act section 184C. That analysis resolves substantive choice-of-law issues by balancing the interests of the involved states and parties. (See Tucci v. Club Mediterranee (2001) 89 Cal.App.4th 180 , 188-194 [ 107 Cal.Rptr.2d 401 ] [applying governmental interest analysis in a tort case, and holding that the law of the Dominican Republic governed].)

However, the governmental interest approach has been applied almost exclusively in tort and contract cases, and occasionally to statute of limitations issues. (3 Witkin, Cal. Procedure, supra, Actions § 44, p. 113.) Only dictum supports appellant’s claim that California courts might utilize this approach in a derivative action against the directors of a foreign corporation. In Shields v. Singleton (1993) 15 Cal.App.4th 1611 , 1621 [ 19 Cal.Rptr.2d 459 ], a derivative action was brought against a Delaware corporation which was headquartered in and did “substantially all of its business in” California. The defense argued that Delaware law regarding a prefiling demand requirement should apply pursuant to the internal affairs doctrine, but made no showing of a difference between California and Delaware law. (Ibid.) The court’s decision to apply California law was therefore based on the lack of a showing of a trae conflict of law rather than rejection of the internal affairs doctrine. (Ibid.) Similarly, Grosset v. Wenaas (2008) 42 Cal.4th 1100 , 1104 [ 72 Cal.Rptr.3d 129 , 175 P.3d 1184 ], involved a Delaware corporation based in California. The case presented the question whether a derivative action could

Thus, appellant has cited no authority actually applying the governmental interest analysis to resolve choice of law in a derivative action against the directors of a foreign corporation. He relies heavily on Havlicek, supra, 39 Cal.App.4th 1844 . But that case did not involve the liability of directors to the corporation for alleged breaches of fiduciary duties; rather, it involved a director’s right of access to books and records of a company incorporated in Delaware. Thus, Corporations Code section 2116 was not implicated, and the Court of Appeal found the internal affairs doctrine inapplicable because no violation of Delaware law would result. (39 Cal.App.4th at p. 1854.)

We again find Hausman, supra, 299 F.2d 701 , to be instructive. In the course of applying New York law in a diversity case, the Second Circuit noted that, although New York had formulated a choice-of-law test similar to the governmental interest analysis (called “center of gravity”), it had not been applied to corporate stockholder litigation. Consequently, the court invoked the traditional internal affairs test and found that the law of the state of incorporation applied to a question of a stockholder’s standing to bring a derivative action. (Id. at p. 704.)

Finally, a close look at the analysis involved in the governmental interest approach reveals that it is inapposite to a shareholder derivative action involving the posture of the present case. The required analysis consists of three steps, as summarized in Havlicek: “First, we determine whether the two concerned states have different laws. Second, we consider whether each state has an interest in having its law applied to this case. Finally ... we apply the law of the state whose ‘interests would be more impaired if its policy were subordinated to the policy of the other state.’ [Citations.]” (Havlicek, supra, 39 Cal.App.4th at p. 1851.) In a shareholder case where the jurisdiction of incorporation has little if any other contact with the company, this test will invariably result in the application of California law. That predictable result ignores the factors identified by the Restatement

The trial court’s ruling sustaining the demurrer without leave to amend and the ensuing dismissal are affirmed. Costs on appeal are awarded to respondents.

Rubin, Acting P. J., and Bigelow, J., concurred.

Appellant’s petition for review by the Supreme Court was denied August 19, 2009, S174392. Kennard, J., was of the opinion that the petition should be granted.