Choice of Law in Shareholder Derivative Litigation

U.S.-based investors hold trillions of dollars in equity of foreign companies. In the event of corporate wrongdoing, those investors may want to initiate shareholder derivative litigation in the United States against the managers of those corporations. This form of litigation is brought on behalf of the corporation itself rather than as a direct action. Derivative actions therefore raise a critical threshold question: whether the shareholder plaintiff has standing to bring such a suit.

In the United States, it is relatively easy for shareholders to establish standing to initiate derivative litigation. While there is some variability among states, the core requirements are to (1) establish share ownership at the time of the alleged misconduct and throughout the litigation; (2) make a pre-suit demand for action by the corporation’s board (or establish the futility of demand); and (3) adequately represent the interests of the other shareholders.

Many foreign systems are less hospitable to derivative litigation, limiting shareholder standing in a variety of ways. For instance, some impose minimum ownership requirements; some grant standing only to shareholders whose names are entered in the company’s share register and not to beneficial owners; and many require judicial approval before shareholders are permitted to initiate claims.

These differences create thorny choice-of-law issues when derivative litigation is initiated in the United States by plaintiffs holding shares in foreign companies. This post walks through those issues, highlighting some of the recurring issues in cross-border derivative claims.

The internal affairs rule

The starting point in determining the law applicable to shareholder derivative litigation is the internal affairs rule. According to that doctrine, matters related to the internal governance of a company are governed by the law of the company’s state of incorporation.

The rights that shareholders enjoy vis-à-vis managers plainly relate to internal corporate affairs. Both state and federal courts have uniformly held that, in general, a shareholder’s standing to bring a derivative claim on behalf of a non-U.S. corporation is decided according to that corporation’s home law. In a couple of settings, though, plaintiffs have argued for alternative choice-of-law rules.

New York statutory law

From time to time, shareholders in foreign corporations have argued that the internal affairs rule does not apply to derivative litigation initiated in New York. This argument rests on a pair of provisions in New York’s Business Corporation Law. Section 626 states that “an action may be brought in the right of a domestic or foreign corporation to procure a judgment in its favor, by a holder of shares or of voting trust certificates of the corporation or of a beneficial interest in such shares or certificates.” Section 1319(a)(2) states that Section 626 (among other provisions) “shall apply to a foreign corporation doing business in this state, its directors, officers and shareholders.” In the plaintiffs’ view, these provisions established a choice of law rule in favor of New York law on the issue of standing, overriding the common law internal affairs rule with respect to derivative litigation brought in New York.

Earlier this year, in Ezrasons, Inc. v. Rudd, New York’s highest court rejected this argument. After recounting the history of the internal affairs rule under New York law, it held that Section 626, itself adopted decades ago, lacked the clear and specific legislative intent that would have been necessary to override such a “long-observed choice-of-law rule.” Rather, the court concluded, the provision merely confirmed that New York courts had jurisdiction to hear derivative actions brought on behalf of foreign corporations.

Contractual choice of law with respect to American Depositary Shares

U.S. investors in foreign companies often hold American Depositary Shares (ADS) rather than ordinary shares. ADSs are issued not by the foreign corporation itself, but by a U.S. depository institution that holds that corporation’s ordinary shares. Each ADS represents a specific number of those ordinary shares. ADSs are denominated in U.S. dollars and can be traded in the United States, either on a U.S. exchange or, in the case of unlisted securities, over the counter. Under these arrangements, it is the depository bank, not the ADS holder, that is the registered shareholder of the foreign issuer.

As noted above, some foreign legal systems permit derivative litigation only by registered shareholders. Applying the internal affairs rule would therefore preclude actions initiated by ADS holders. In some cases, U.S. investors have attempted to get around this type of restriction by arguing that the standing of an ADS holder to bring a derivative action is governed by the law selected in the Deposit Agreement.

Courts have not been persuaded. In one representative case, a district court considered a claim brought by an ADS holder on behalf of Novartis, a Swiss corporation. The Deposit Agreement under which the ADSs were issued included a choice of law clause in favor of New York law. The court noted that the plaintiff’s claims were not predicated on any rights specified in the Deposit Agreement. It stated that as “extra-contractual claims,” they did not fall within the scope of the choice of law clause. Applying Swiss law pursuant to the internal affairs rule, it concluded that the plaintiffs lacked standing to initiate derivative litigation.

Substance/procedure distinction

Choice-of-law rules like the internal affairs doctrine select the law that governs substantive issues arising in cross-border litigation. Procedural matters, however, are always governed by the law of the forum. To the extent that particular foreign standing requirements are “merely procedural,” then, they will not be applied in U.S.-based litigation. This distinction between substance and procedure in derivative actions is frequently litigated.

Hausman v. Buckley, a 1962 case in the Second Circuit Court of Appeals, highlights the relevant issues. The case involved a derivative action brought in New York on behalf of a Venezuelan company. The court summarized the characterization issue presented:

“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 of a Venezuelan corporation.”

It concluded that a requirement under Venezuelan law that derivative actions must be approved by a vote of the majority of shareholders went to the substance of the claim and was therefore subject to the internal affairs rule.

In other cases, courts have characterized standing requirements under foreign corporation law as procedural. The leading decision here, another New York case, is Davis v. Scottish Re. The defendant in that case argued that the plaintiff had failed to comply with a rule of Cayman Island law requiring any action initiated in the Cayman Islands by writ to obtain leave of the court to proceed. On the defendant’s view, this was a substantive gatekeeping requirement intended to weed out unmeritorious claims. The court, however, concluded that it was procedural. It distinguished the provision from laws in other countries that required judicial approval of any derivative action—wherever filed—involving companies incorporated in those countries. As a procedural rule, the court held, it did not apply to a derivative action filed in New York.

The characterization of a particular standing requirement as substantive or procedural depends on the particular requirements of the relevant foreign law. Judicial approval requirements are more frequently held to be procedural than other restrictions on standing, such as those limiting standing to registered shareholders.

Public policy

If the application of foreign law would violate local public policy, a U.S. court will decline to apply that law. In a number of cases, shareholders have argued that the application of foreign rules barring them from initiating derivative litigation violates local public policy. These arguments have been unsuccessful. In one such case, the Southern District of New York considered whether Dutch law, which did not give shareholders a right to bring a derivative claim against members of its managing or supervisory boards, violated New York public policy. Noting that Dutch law provided other means of addressing corporate malfeasance, it concluded that it was “different from New York law, but … neither ‘immoral’ nor ‘fundamentally unjust.’”

Conclusion

More so than direct actions brought by investors against a corporation, shareholder derivative actions implicate core issues of corporate governance. That being so, it is not surprising that the internal affairs rule dominates the choice-of-law analysis in derivative actions brought on behalf of foreign corporations.