Derivative Standing And The Internal Affairs Doctrine

• Published date: 21 June 2023
• Subject Matter: Corporate/Commercial Law, Corporate and Company Law, Directors and Officers, Corporate Governance, Shareholders
• Law Firm: Farrell Fritz, P.C.
• Author: Mr Franklin C. McRoberts

Choice-of-law questions in shareholder derivative lawsuits venued in New York courts involving out-of-state or international entities can be confoundingly difficult, even for appeals court judges.

Last Friday, Manhattan's Appellate Division - First Department issued an important decision in which it was forced to reconcile two conflicting decisions of prior panels of the same Court with divergent rulings about whether New York's "internal affairs doctrine" mandates application of New York law, or the law of the state or nation of incorporation, to the threshold question of standing to sue in shareholder derivative actions.

Ezrasons, Inc. v Rudd (___ AD3d ___, 2023 NY Slip Op 02936 [1st Dept June 1, 2023]), involved a publicly-traded company, but the decision is of interest to any business divorce practitioner who represents entities incorporated outside of New York.

The genesis of the Ezrasons problem was a pair of decisions issued just 12 days apart.

The Lerner Decision

In May 2014, the First Department issued Lerner v Prince (119 AD3d 122 [1st Dept 2014]).

Lerner was a shareholder derivative suit involving a Delaware entity. The plaintiff requested, and the Court denied, discovery on the threshold question of pre-suit demand or demand futility, ruling that Delaware law, not New York law, governed whether plaintiff was entitled to discovery to attempt to plead standing.

Under the internal affairs doctrine, explained the Court, "New York choice-of-law rules provide that substantive issues such as issues of corporate governance, including the threshold demand issue, are governed by the law of the state in which the corporation is chartered'here, Delaware."

The Court ruled that although "New York courts have applied the law of the forum when deciding matters, such as discovery," the fact that "this case is a purported derivative action places it into a different context." Holding that Delaware law prohibits discovery to assist pleading pre-suit demand, the Lerner Court affirmed dismissal of the complaint.

Lerner is consistent with a long line of prior appellate case law holding that, under New York choice-of-law rules, the issue of shareholder derivative standing is "substantive," not "procedural," and therefore, determined by the laws of the state of incorporation, not the law of the forum:

• Hart v Gen. Motors Corp., 129 AD2d 179 [1st Dept 1987], lv denied 70 NY2d 608 [1987] ["One of the abiding principles of the law of corporations is that the issue of...