Rethinking the Internal Affairs Rule

Image by Mohamed Hassan at Pixabay.

The internal affairs rule posits that a court should generally apply the law of the state in which an entity is incorporated to resolve questions relating to that entity’s internal affairs. These affairs encompass such matters as the election of directors, the rights of shareholders, and the fiduciary duties owed to shareholders. In a trio of recent transnational cases, the courts in New York have considered the continued viability and scope of the internal affairs rule. In this post, I provide a brief overview of these decisions.

Should the Internal Affairs Rule Be Replaced?

In Eccles v. Shamrock Capital Advisors, LLC, the New York Appellate Division applied the law of Scotland to resolve a lawsuit brought by shareholders in FanDuel—a company incorporated in Scotland—against that company’s board of directors. The application of Scottish law in this decision was not particularly surprising. There are many cases where the New York courts have invoked the internal affairs rule to apply the law of a company’s state of incorporation to a fiduciary duty claim. What is surprising is that the New York Court of Appeals agreed to hear an appeal from this decision. This is significant because the appellants are asking the court to replace the internal affairs rule with an interest-balancing test.

The decision to hear the appeal has precipitated a flurry of amicus activity that pitted conflict-of-laws scholars against corporate law scholars. As John Coffee recently wrote in the New York Law Journal:

[W]hen the Court of Appeals agreed to hear the case . . . both sides began to seek allies. First, plaintiffs assembled a team of law professors specializing in conflicts law, who explained that an “interest-balancing” test would be superior to the internal affairs rule, and plaintiff’s counsel further argued that New York had long read the internal affairs rule to include such a balancing test. In response, defendants assembled an amicus team of “corporate governance” law professors to explain the need for a strong internal affairs rule.

As someone who teaches both corporate law and conflict of laws, I am disappointed—and a little insulted—that neither side reached out to ask me to join their amicus brief. The brief filed by the conflicts scholars urging the Court of Appeals to take the case can be found here. The merits brief filed by the corporate scholars can be found here. The merits brief filed by the Securities Industry and Financial Markets Association—which generally supports the arguments made by the corporate law scholars—can be found here. The New York Court of Appeals will hear oral argument in this case on April 16, 2024.

Can Parties Contract Around the Internal Affairs Rule?

In another recent case, Pentacon BV v. Vanderhaegen, the U.S. District Court for the Southern District of New York (Judge Katherine Polk Failla) had to decide whether a choice-of-law clause took precedence over the internal affairs rule.

The plaintiffs were investors in Origis Energy. The defendants were various individuals who allegedly conspired to defraud the plaintiffs. The defendants argued that the plaintiffs’ fiduciary duty claims against them were governed by the laws of Belgium—per the internal affairs rule—because Origis Energy was incorporated in Belgium. The plaintiffs argued that these claims were governed by the laws of New York because the Share Redemption Agreement (SRA) contained a New York choice-of-law clause.

The court held that the choice-of-law clause was controlling. It noted that, in addition to choosing New York law, the choice-of-law clause directed the court to refuse to “give effect to any conflict-of-law rules or principles that would result in the application of the Laws of any other jurisdiction.” Because of this language, and because the internal affairs rule is a choice-of-law rule, the court reasoned that the parties had agreed that the internal affairs rule should not be applied.

This outcome is broadly in line with prior decisions to have considered the issue. It raises the interesting question, however, whether the same result would obtain if the language in the choice-of-law clause did not specifically direct the court to ignore other choice-of-law rules. In past work, I have argued that courts will generally read language excluding choice-of-law rules into the clause even when it is absent. This line of decisions suggests that the internal affairs rule would probably be displaced even if the clause at issue merely stated: “This agreement and all claims relating thereto shall be governed by the laws of the State of New York.”

Are There Limits on Party Autonomy?

It is important to note that there are limits on the ability of the parties to rely on choice-of-law clauses to displace the internal affairs rule.

In some cases, a statute requires the court to apply the law of the state of incorporation regardless of any choice-of-law clause. In Petróleos de Venezuela S.A. v. MUFG Union Bank, N.A., decided in February 2024, the New York Court of Appeals held that UCC 8-110(a)(1), which states that “[t]he local law of the issuer’s jurisdiction . . . governs . . . the validity of a security,” is a mandatory rule, meaning that the parties cannot contract around it. The court held that when Section 8-110 is applicable, “any issue of the validity of a security . . . is determined by the law of the issuer’s jurisdiction.” It concluded that the validity of a security issued by a Venezuelan oil company must necessarily be determined by reference to the law of Venezuela notwithstanding a New York choice-of-law clause.

In other cases, a statute mandates that the law of the forum be applied regardless of party intent or the internal affairs rule. These limiting statutes are described in detail in Deborah DeMott’s classic article, Perspectives on Choice of Law for Corporate Internal Affairs. As she explains:

[T]he view that the state of incorporation is relatively insignificant to internal affairs questions as well has found many expressions, most notably in those state statutes that, as an exercise in statutory outreach, mandate the application of local law to specified internal affairs questions for certain foreign corporations. The outreach statutes, along with the case law that achieves a similar result, represent a counterculture to the mainstream choice of law approach that has wholeheartedly embraced the internal affairs doctrine.

In the face of such statutes, the internal affairs rule and choice-of-law clauses are irrelevant. The court must apply the law of the forum—without conducting any choice-of-law analysis—as a matter of state public policy.

Conclusion

The internal affairs rule is sometimes presented as absolute: the courts will apply the law of the state of incorporation to resolve any and all questions relating to the internal affairs of a corporate entity. The cases discussed above suggest that this is not always true. In one case, the court is considering whether to jettison the doctrine. In another case, the court ruled that a choice-of-law clause may take precedence over the internal affairs rule. And there are a number of state statutes that specifically direct the courts to ignore all choice-of-law rules—including the internal affairs rule—and apply local law.