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In today’s highly regulated environment, companies and their directors and officers need to know what laws and standards will be applied to their actions. Even the best-intentioned executives will be challenged to fulfill their fiduciary duties to the corporation if they are uncertain what state’s laws apply to them. Because of these concerns, courts have long enforced the internal affairs doctrine, under which a corporation’s internal affairs, including the relationships and duties among its officers, directors and shareholders, are regulated by the laws of one state � the one in which the company is incorporated. California’s courts have historically followed this rule, and California Corporations Code §2116 contains a requirement that claims against an out-of-state corporation’s officers and directors for violating any aspect of their “official duty” must be determined under the law of the company’s state of incorporation. However, the internal affairs doctrine and §2116 no longer protect out-of-state corporations and their executives from liability under California’s securities laws. In Friese v. Superior Court, 134 Cal.App.4th 693 (Dec. 29, 2005), a California court of appeal allowed insider trading claims brought under the state’s securities laws to proceed against directors and officers of a Delaware corporation. In doing so, the court created an exception to the internal affairs doctrine and §2116 under which directors and officers of out-of-state corporations may now be sued not only for violating the federal securities laws and the laws of their corporation’s home state of incorporation, but also California’s securities laws. Friese follows California’s enactment 30 years ago of Corporations Code §2115, which has already extended the reach of the state’s securities laws to cover “quasi-California” corporations that conduct most of their business and have most of their shareholders within the state. FRIESE EXPANDS CALIFORNIA’S SECURITIES LAWS In rejecting the applicability of the internal affairs doctrine and §2116, the Friese decision relies largely on the policy argument that “California also has a legitimate and compelling interest in preserving a business climate free of fraud and deceptive practices.” This is a significant expansion of director and officer liability in California and as a practical matter will likely result in an increase of shareholder lawsuits in California. Shareholders typically prefer to pursue their claims in state court rather than federal court, where the heightened pleading standards of the Private Securities Litigation Reform Act of 1995 (PSLRA) apply. When Congress enacted the Securities Litigation Uniform Standards Act of 1998 (SLUSA) it pre-empted most state court securities class actions. As a result, shareholders seeking redress now often pursue derivative actions in state court, suing directors and officers for breaches of their fiduciary duties and violations of state securities laws on behalf of the corporation, rather than suing the corporation directly in a class action. California’s securities laws are similar in scope to the federal securities laws, and broader in certain respects. For example, California’s “blue sky” laws allow shareholders to pursue claims for unlawful insider trading that occurs within the state against a director or officer without proving that the executive actually intended to unlawfully trade. Under Section 10(b) of the federal Securities Exchange Act of 1934 and the Securities and Exchange Commission’s Rule 10b-5, plaintiffs must plead particularized facts demonstrating a “strong inference” of knowledge or “deliberate recklessness” by the director or officer. See In re Silicon Graphics Sec. Litig., 183 F.3d 970, 974 & 979 (9th Cir. 1999). Delaware law has no similar provision for insider trading claims and a similar claim brought under Delaware law would likely be dismissed. Accordingly, prior to Friese, California trial courts applying the internal affairs doctrine and §2116 often dismissed insider trading claims based upon the application of Delaware law. PRIOR LAW CONCERNING THE INTERNAL AFFAIRS DOCTRINE Friese, which was authored by Justice Patricia Benke of the Fourth District, is a departure from prior decisions applying the internal affairs doctrine and §2116 to claims against out-of-state corporations and their directors and officers under California law. Prior to Friese, courts addressing this issue largely applied the doctrine to prevent shareholders from pursuing such claims under California’s securities laws. For example, in August 2003 a federal district court concluded that under California law a shareholder could not bring an insider trading claim under California’s securities laws against a Delaware corporation’s directors and officers, because those claims were governed by Delaware law pursuant to the internal affairs doctrine. In In re Sagent Technology Deriv. Litig., 278 F.Supp.2d 1079 (N.D. Cal. 2003) the court recognized that §2116 requires that “The directors of a foreign corporation transacting intrastate business are liable to the corporation [and] its shareholders” for any “ violation of official duty, according to any applicable laws of the state or place of incorporation or organization, whether committed or done in this state or elsewhere.” The court held that “While insider trading is obviously not an ‘official duty,’ there is an ‘official duty’ at issue. That is the fiduciary duty owed by officers and directors of a corporation to that corporation and its shareholders.” Accordingly, “Under both §2116 and the ‘internal affairs’ doctrine” the court held that the directors and officers could not be liable under California’s insider trading laws. An earlier California appellate decision in October 2005 also had upheld the dismissal of a shareholder derivative action brought against a Delaware corporation’s directors and officers under California’s securities laws. In Grosset v. Wenaas, 133 Cal.App.4th 710 (Oct. 20, 2005), the court concluded that the threshold issue of whether plaintiff had proper standing to pursue a derivative action involved an internal affair of the corporation, making the issue subject to Delaware law rather than California law, and that “Only one state should have the authority to regulate a corporation’s internal affairs.” However, this decision is no longer good precedent because the California Supreme Court granted review of the decision on Jan. 4. In the original version of its opinion, the court in Friese stated that Grosset was distinguishable because that earlier decision was limited only to the specific issue of whether a plaintiff has standing to pursue a derivative lawsuit. Friese, 134 Cal.App.4th at 708 n.7 (original opinion filed on Dec. 2, 2005). (That part of the Friese opinion was later removed after the California Supreme Court granted review of the Grosset decision.) Friese also relies on a 15-year-old law review article for the proposition that in “recent years … the public objections to insider trading have assumed larger dimensions” and that “Congress has begun to see the problem in more fundamental cultural terms as a manifestation of undue greed among the already well-to-do, worthy of legislative intervention if for no other reason than to send a message of censure on behalf of the American people.” This analysis, however, did not address more recent actions by Congress such as the enactment of the PSLRA, which significantly heightened pleading requirements for securities fraud claims and was intended to curtail such lawsuits. Nor did it consider the enactment of SLUSA in 1998, which provides for the federal pre-emption of most state securities class actions. The Friese decision also relies upon three prior decisions that applied California’s securities laws to out-of-state corporations. But two of those decisions, Williams v. Gaylord, 186 U.S. 157 (1902) and Western Air Lines v. Sobieski, 191 Cal.App.2d 399 (1961), predate §2116, which became effective in 1977. The third decision, Diamond Multimedia Sys. v. Superior Court, 19 Cal.4th 1036 (1999), in which the state Supreme Court affirmed the ability of shareholders to pursue securities class actions under the state law, was largely abrogated by Congress’ pre-emption of most state securities class actions when it enacted SLUSA. STATUTE COVERS ‘QUASI-CALIFORNIA’ CORPORATIONS The Friese decision was not the first expansion by California of its securities laws over out-of-state corporations. Section 2115 also requires certain out-of-state corporations to conform to a wide range of internal affairs provisions, including requirements regarding shareholder rights, director duties of care and other corporate governance matters. A foreign corporation is considered subject to §2115 if at least half of its voting securities are held by California residents and half its business is conducted within the state as measured by a number of factors. The constitutionality of §2115 was upheld in a 1982 California appellate decision, Wilson v. Louisiana-Pacific Resources, 138 Cal.App.3d 216 (1982). However, Wilson was decided prior to several U.S. Supreme Court decisions clarifying the important constitutional concerns served by the internal affairs doctrine. See CTS v. Dynamics, 481 U.S. 69 (1987); Edgar v. MITE, 457 U.S. 624 (1982); Kamen v. Kemper Fin., 500 U.S. 90 (1991). A subsequent California appellate panel 20 years later in State Farm Mut. Auto. Ins. v. Superior Court, 114 Cal.App.4th 434, 447 n.3 (2003) criticized Wilson’s analysis of the internal affairs doctrine and affirmed that “the internal affairs doctrine has received broad acceptance by the courts.” Section 2115 has been criticized because it is inconsistent with the internal affairs doctrine, because of concerns that it is a constitutionally impermissible restriction on commerce and because the criteria for determining whether a corporation should be treated as a “quasi-California” entity can change from one year to the next. Whether half of a corporation’s shareholders or business is within California might well vary among years (or even during a particular year), resulting in uncertainty concerning whether the statute currently applies to a given corporation. For these reasons the Delaware Supreme Court recently rejected §2115 in VantagePoint Venture Partners v. Examen, 871 A.2d 1108 (Del. 2005). Within California, however, §2115 remains a valid statute that affects out-of-state corporations and their directors and officers. Michael C. Tu is a partner at Orrick, Herrington & Sutcliffe and a member of its securities litigation practice. � Practice Center articles inform readers on developments in substantive law, practice issues or law firm management. Contact Sheela Kamath with submissions or questions at [email protected].

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