The internal affairs doctrine is a choice of law rule in corporations law. Simply stated, it provides that the “internal affairs” of a corporation will be governed by the corporate statutes and case law of the state in which the corporation is incorporated. The doctrine ensures that such issues as voting rights of shareholders, distributions of dividends and corporate property, and the fiduciary obligations of management are all determined in accordance with the law of the state in which the company is incorporated.
However, there are a few interesting issues that have arisen under the doctrine. In the Delaware Chancery Court case of Sunder Energy v. Jackson et al., the Court had to determine whether certain LLC members and employees violated noncompetes included in the LLC agreement. The recent trend has been for companies to attempt to avoid the employment law of states where they do business by writing employment-related terms into entity organizational documents, and then issuing equity compensation to employees. By doing so the companies hope the employment-related terms will then be treated as entity internal affairs matters governed by the state of organization rather than employment terms governed by the employee’s home state.
In Sunder Energy, several people formed an LLC, but did not initially draft an LLC Operating Agreement. Later, the two managing members sought legal counsel for themselves and drafted a formal LLC agreement that dramatically changed the arrangement in a manner that favored themselves and limited the rights of the other members. The other members signed the new agreement as presented to them, but the changed terms were never explained, and the managing members implied this was just a formality recommended by entity lawyers.
The Court held that when the original LLC was formed – before the agreement was drafted – the default rules for LLC organization kicked in, which meant the managing members had fiduciary duties to the minority. By rewriting the agreement in such a self-interested fashion – and presenting it to the minority members without disclosing what it meant – they violated those duties, rendering the new agreement unenforceable. As Laster put it:
A second instructive internal affairs doctrine case is from Nevada, Adrian Dominican Sisters et al. v. Mark P. Smith. There, several communities of Catholic nuns filed a derivative lawsuit against Smith & Wesson, arguing that the company acted in bad faith by failing to oversee Smith & Wesson’s compliance with laws regarding the marketing of its AR.
Smith & Wesson is organized in Nevada, but, until recently, its headquarters were in Massachusetts (they just moved to Tennessee). Plaintiffs sought to inspect Smith & Wesson’s documents, but, under Nevada law, inspection rights were only available for investors with at least a 15% stake. Therefore, the plaintiffs sought books and records under Massachusetts law that did not have this requirement. The Court held that inspection rights are an internal affairs matter and, therefore, Nevada law would apply.
If your company is confronted with a shareholder or member lawsuit, or receives a request for documents, contact your business attorney. Depending upon where your company was incorporated or organized, you may or may not have to provide the requested information.
The information presented is not intended to be, and does not constitute, “legal advice.” Because each situation varies, and only brief summary information is provided here, you should not use this information as a basis for action unless you have independently verified with your own counsel that it applies to your particular situation.
