The Internal Affairs doctrine requires a court to apply the law of the state where a business was formed, or organized, to disputes between the owners regardless of the circumstances.
New Jersey courts have applied a more traditional analysis of conflict of laws issues and may refuse to apply the law of another state if the parties or the issues have no connection to the state of formation.
The Revised Uniform Limited Liability Company Act provides that the law of the state of organization governs the rights of members and their liability to third parties.
A New Jersey need not necessarily honor a Delaware choice of law provision in an operating agreement if the company has no substantial relationship to the state where it was organized, the Appellate Division holds in a case involving a Delaware limited liability company and an Israeli corporation.
This holding in which the appellate court reversed and remanded a trial court’s decision rejected the per se application of the “internal affairs” doctrine in which courts apply the law of the state where a business was organized to internal disputes without regard to the other principles that often govern choices about which state’s law applies to a lawsuit.
The Importance of Choice of Law Decisions
This is a technical issue, but an important one that has some very practical decisions. Business entities are formed under the laws of individual states, but have the right to do business in any state. That means as a practical matter that corporations and limited liability companies often do business in states, or even countries, other than whether they were formed. When a dispute arises in one state among the owners of a business formed in another state, the choice of law and authority of the court to act can be a thorny issue.
The holding in this case is contrary to a statutory choice of law provision applicable to limited liability companies. And while New Jersey courts have previously applied New Jersey law to foreign corporations in actions involving oppressed minority shareholders, there are significant differences between the corporations and limited liability company statutes, however.
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What Law Applies to Business Divorce Cases
This case, SKS Holdings v. Kaplan involved a Delaware limited liability company with its principle place of business in New Jersey. Two of the members of the LLC were New Jersey residents. The third member was the defendant Bennett Kaplan, an Israeli citizen. Although the outcome may not have been any different whether Delaware law was applied to the case or not, the fact that the court did not consider itself bound to the law of the state of organization was a departure from the position taken in most similar circumstances.
SKS was a holding company formed to invest in and operate an Israeli company, GlobusMax, that owned and operated IMAX theaters in Israel. Much of the dispute concerned a series of loans made among the various entities.
The relationship among the involved parties soured, as did the prospects for the business. Ultimately SKS sued Kaplan and other entities alleging fraudulent inducement, breach of fiduciary duty and seeking dissolution of SKS.
The trial court was dismissed two of the claims because in its view the claim related to Kaplan’s role as a director of an Israeli corporation, and Israeli law would require that action be brought as a derivative action on behalf of the corporation, not on behalf of individual owners.
Choice of Law Decisions Under Limited Liability Company Act
Although SKS operated in New Jersey, it was organized in Delaware and had chosen Delaware law. The rationale for organizing a new business in Delaware typically includes consideration its business-friendly approach to business law, a well-developed body of case law that provides greater certainty on legal issues and its favorable franchise taxes.
The internal affairs doctrine holds that the law of the state where a business is organized governs disputes among its owners It is often seen as a hard and fast rule that limits the authority of trial courts in lawsuits involving out-of-state companies.
The appellate division, however, applied a generalized choice of law analysis, however. It looked first at the statutory choice of law applicable to the dispute, an issue that had not been addressed by the trial court or the parties. New Jersey has adopted the the Revised Uniform Limited Liability Company Act (RULLCA), a model statue that has been adopted in approximately half the states. Delaware has its own statute.
Under the RULLCA, the law of the state of organization applies to the internal affairs of the LLC and to the liability of of the members and managers for the debts or obligations of the company. N.J.S.A. 42:2C-57. In most cases, courts consider this a hard and fast rule that trumps other choice of law considerations.
However, the choice of law rule in the RULLCA also runs counter to another principle governing choice of law applicable to a contractual dispute, and that is that the law chosen by the parties to a contract need not be applied when the state has no substantial relationship to the parties or the transaction and there is not other reasonable basis for the parties choice.
Court Rejects Delaware Per Se Choice of Law
The appellate court reasoned even despite the general rule applying the state of though because parties’ transactions have no connection to Delaware, that state’s law might not apply” under traditional conflict of law principles. The court then applied a traditional choice of law analysis, considering first whether there was a conflict of law between the two states and then, if there was no conflict, applying the law of the forum state.
The appellate court then reversed the trial court’s dismissal of claims as derivative (that is, claims belonging to the corporation) holding that these claims could be pursued directly as well. It held that there was no conflict between New Jersey and Delaware law on this issue.
The court then went on to consider that plaintiff’s claim for an order that SKS be judicially dissolved. It remanded the matter to the trial court because the judge below had not made any findings of fact or conclusions of law.
What is significant here is not that the court remanded on the basis that the record was incomplete, but that it failed to consider the more profound decision of whether a New Jersey court has authority to order a foreign corporation to dissolve. Courts in New York and Delaware, for example, have held that they do not have the authority to make such an order.
New Jersey Corporations Act Applies a Different Standard
The appellate division in an unreported decision from 2008 applied New Jersey law to an oppressed minority shareholder claim among the owners of a Massachusetts corporation, finding that there was no conflict between that state’s law and the law of New Jersey. However it is significant that in that case, the court applied the New Jersey Business Corporations Act, which contains no analogous choice of law provision.
To the contrary, the commentary to N.J.S.A. 14A:13-2 indicates that the Corporate Law Revisions Committee that drafted the overhaul of New Jersey’s corporations code, based on the ABA’s earlier version of the Model Business Corporations Act, intended to preserve the authority of New Jersey courts to apply its own equitable principles to corporations organized in another state.
Subject only to constitutional limitations, as expressed in subsection 14A:1-3(6), and to the restraints imposed by the principles of comity, as set forth in O’Brien v. Virginia-Carolina Chemical Corp., 44 N.J. 25, 39, 206 A.2d 878 (1965), our courts remain free under this Revision, including subsection 14A:13-2(2), to retain jurisdiction in cases involving the internal affairs of a foreign corporation and to grant relief on equitable principles wherever indicated, even to the extent of applying to a foreign corporation in a proper case certain substantive features of this Revision. Kahn v. American Cone & Pretzel Co., 365 Pa. 161 74 A.2d 160, 162 (Sup.Ct.1950) construing the Pennsylvania equivalent of Model Act section 100). There are modern choice of law doctrines developing in this field, which the Commission did not wish to restrict by adopting the approach in Model Act section 99.