In Salzberg v. Sciabacucchi (pronounced Shabacookie), the Delaware Supreme Court unanimously held that charter provisions designating the federal courts as the exclusive forum for ’33 Act claims are “facially valid.” (See this PubCo post.) Given that Sciabacucchi involved a facial challenge, the Court had viewed the question of enforceability as a “separate, subsequent analysis” that depended “on the manner in which it was adopted and the circumstances under which it [is] invoked.” With regard to the question of enforceability of exclusive federal forum provisions if challenged in the courts of other states, the Delaware Supreme Court said that there were “persuasive arguments,” such as due process and the need for uniformity and predictability, that “could be made to our sister states that a provision in a Delaware corporation’s certificate of incorporation requiring Section 11 claims to be brought in a federal court does not offend principles of horizontal sovereignty,” and should be enforced. But would they be? Following Sciabacucchi, many Delaware companies that did not have FFPs adopted them, and companies with FFPs involved in current ’33 Act litigation tried to enforce them by moving to dismiss state court actions. In an apparent case of first impression, one such case was just decided in the San Mateo Superior Court in California, Wong v. Restoration Robotics (18CIV02609, Sept. 1, 2020).

It’s worth noting up front that the California Superior Court’s view of FFPs is far from sympathetic. To the Court, Delaware corporations, disappointed with Cyan, “decided to craft a unilateral, specially-targeted provision, to be added to and buried in their corporate governing documents, to force all persons purchasing their corporate stock to give up their opportunity to pursue 1933 Act claims in any state court. In this fashion, they seek to circumvent the express language of the 1933 Act, circumvent the Supreme Court and its Cyan decision, and circumvent Congress.”  Hardly augurs well for FFP enforceability, you might conclude. But, surprisingly, that’s not how the case turned out.

Background. You might recall that Sciabacucchi took on heightened significance when, in March 2018, SCOTUS held, in Cyan Inc. v. Beaver County Employees Retirement Fund, that state courts continue to have concurrent jurisdiction over class actions alleging only ’33 Act violations and that defendants cannot remove these actions from state court to federal court. (See this PubCo post.) Both before and especially after Cyan, many companies adopted FFPs in their charters or bylaws to avoid state court litigation of ’33 Act claims (and forum shopping by plaintiffs for the most favorable state court forum). Section 115 of the Delaware General Corporation Law (DGCL) expressly permits the adoption of a charter or bylaw provision designating Delaware as the exclusive forum for adjudicating “internal corporate claims.” The statute defines “internal corporate claims” as those claims “(i) that are based upon a violation of a duty by a current or former director or officer or stockholder in such capacity, or (ii) as to which this title confers jurisdiction upon the Court of Chancery.” Claims under the ’33 Act, however, are not expressly included. (See this PubCo post.)

In Sciabacucchi, the Chancery Court had previously invalidated the FFPs in the charters of three Delaware companies because, among other reasons, Delaware’s enabling statute (Section 102(b)(1))—which provides general authority for non-mandatory charter provisions—was, in the lower court’s view, inherently limited to “internal affairs,” while FFPs were “external” matters. On de novo review, the Delaware Supreme Court rejected this binary analysis, holding that Delaware FFPs were facially valid.  The Delaware Supreme Court reasoned that ’33 Act claims, although governed by federal law, can involve aspects of internal matters and are often brought together with state fiduciary duty and disclosure claims based on the same facts. Accordingly, “Section 11 claims are ‘internal’ in the sense that they arise from internal corporate conduct on the part of the Board and, therefore, fall within Section 102(b)(1).” For purposes of the enabling statute, the Delaware Supreme Court characterized FFPs as intra-corporate matters, located in a new territory—the “outer band” between internal and external matters—which fell within the statutory scope of Section 102(b)(1) and were, therefore, valid on their face.

The Delaware Supreme Court then considered the question of the application of the “internal affairs doctrine,” established by SCOTUS under Edgar v. MITE Corp. and the Delaware Supreme Court’s parallel definition in McDermott v. Lewis. Those cases defined the “internal affairs doctrine” as a conflict of laws principle recognizing that, to avoid conflicting demands on a corporation, only one state should have the authority to regulate the “corporation’s internal affairs—matters peculiar to the relationships among or between the corporation and its current officers, directors, and shareholders.”  The trial court, however, had departed from “the established definition” of “internal affairs” set forth in those cases by unduly narrowing the doctrine to apply only to claims involving “the rights, powers, or preferences of the shares, language in the corporation’s charter or bylaws, a provision in the DGCL, or the equitable relationships that flow from the internal structure of the corporation.” In McDermott, the Delaware Supreme Court reiterated that the “umbilical tie of the foreign corporation to the state of its charter is usually still religiously regarded as conclusive in determining the law to be applied in intracorporate disputes,” and that the doctrine has serious constitutional implications. By unduly narrowing the definition, the trial court was in effect severing that tie.

Wong v. Restoration Robotics. Prior to the Delaware Supreme Court’s decision in Sciabacucchi, Restoration Robotics, a Delaware corporation, filed a motion in the California Superior Court to dismiss the ’33 Act litigation that had been filed in that Court on the basis of the FFP in its charter.  The Court initially denied the motion, consistent with the decision of the Delaware Chancery Court in Sciabacucchi that the FFP was invalid. Given the reversal of Sciabacucchi by the Delaware Supreme Court, however, the Court held that the matter now merited reconsideration.

According to the Court, although the Delaware Supreme Court had asserted in Sciabacucchi that FFPs  “do not offend federal law and policy” and “suggests that other state court[s] should consider finding them enforceable under the laws of their own state,” that assertion was simply dictum. What’s more, Sciabacucchi cited no caselaw or legal analysis in support.  Indeed, the Court reasoned, by characterizing the claim as involving an intracorporate affair—“[c]omplete with [an] elliptical chart of gradations it invented”—but not a matter of internal affairs, “the Delaware Supreme Court acknowledged that its holding that [an] FFP is enforceable under Delaware corporate law was not binding on courts in other states faced with the issue of whether an FFP is enforceable under their states’ laws.” As the Court then set the stage, “the holding by the Delaware Supreme Court that the provision is allowable under Delaware law…is basically irrelevant to our case. Our issue is whether the Federal Forum Provision is legal and enforceable under California law and/or under Federal law.”

Because there were no cases directly on point, the Court looked at the potential applicability of various established standards to consider the enforceability of the FFP under California law, such as the standards applied with respect to mandatory arbitration provisions or settlement releases.  However, the Court considered these examples as not particularly analogous. Ultimately, the Court concluded that, analytically, the subject FFP was “most akin to a contractual forum selection clause,” and examined those cases. In Smith, Valentino & Smith Inc. v. Superior Court (1976), the “California Supreme Court held that, in a breach of contract lawsuit, a contractual forum selection clause was enforceable, and that the trial court could exercise its discretion to stay the California action.” Later, Berg v. MTC Electronics Technologies Co. (1998) held that even enforcement of “mandatory” forum selection provisions is subject to the court’s discretion, although “the modern trend is to enforce mandatory forum selection clauses unless they are unfair or unreasonable.”  In California, if a forum selection clause is mandatory, “the test is simply whether application of the clause is unfair or unreasonable; and the clause is usually given effect. Claims that the previously chosen forum is unfair or inconvenient are generally rejected.”

In 2018, in Drulias v. First Century Bancshares Inc., a case involving the enforceability in California of an internal affairs forum selection bylaw change adopted by a Delaware corporation without shareholder approval, a California appellate court “held that mandatory forum selection clauses are generally enforceable, that the trial court has discretion whether to decline to exercise jurisdiction, and that the burden rests with the opposing party to show that application of the forum selection clause would be ‘unfair or unreasonable.’” The Drulias court found that it was not “unreasonable” or “unfair” to require litigation over the internal affairs of a Delaware corporation to be adjudicated in the Delaware courts, even if the bylaw had been adopted unilaterally and simultaneously with the subject merger. The forum selection clause did not need to be negotiated to be enforceable. To prevent enforcement, the plaintiff had to show “unconscionability: “Under that test, the Court of Appeal held that a shareholder of a Delaware corporation should reasonably expect that the Delaware corporation will adopt a bylaw allowing the corporation to unilaterally [make] changes to its bylaws to its own benefit, and that the corporation will use that power to adopt restrictive Delaware forum selection clauses.”

In Restoration Robotics, the Plaintiffs also raised constitutional arguments under the Commerce Clause and under the Supremacy Clause, particularly the application of the “internal affairs doctrine,” established by SCOTUS under Edgar. While Sciabacucchi  “uniquely determined that the scope of Section 102 of its Delaware General Corporation Law goes beyond the internal affairs of a Delaware corporation,” the Court viewed the Delaware Supreme Court’s analysis of the application of the internal affairs doctrine to be far from definitive.  Accordingly, the Court  found “that the issue and proper analysis is whether or not Section 102, as broadly interpreted and applied by the Delaware Supreme Court, is unconstitutional under Edgar and the Commerce Clause.”  However, the Court declined the invitation to address the issue: the issue was “not the proper subject of a California court adjudication of a motion to dismiss for forum non conveniens.” Rather, a “more appropriate procedural avenue might be a declaratory relief action in federal court specifically addressing the constitutionality of that Delaware statute.”

In the end, the Court determined that the Plaintiffs had not met their burden of proof and, exercising its discretion, declined “jurisdiction over the claims alleged against Restoration Robotics and its officers and directors only, pursuant to the FFP.” In the Court’s analysis, the defendants had shown that the FFP was mandatory, that it restricted “all Securities Act claims to federal court, without limitation on venue.” While the FFP was not “mutual in its effect or application,” it was “subject to [a] shareholder vote and approval, and was not applied retroactively herein, i.e., it was effective before these lawsuits were filed.  Accordingly, the burden of proof shifted to the Plaintiffs to demonstrate that the FFP is unenforceable, unconscionable, unjust or unreasonable.”

But that burden was not met. First, the substantive rights of the shareholders to the protections of the 1933 Act were not “disrupted.” By mandating a federal forum, the FFP affected only the procedural aspect of forum selection. Importantly, the Court considered the FFP to be “cautiously and narrowly drafted to only address the choice of forum, but leave intact all of the substantive rights and remedies (and the right to a jury trial) provided to investors under the Securities Act of 1933.” The FFP did not result in any “procedural loss of Due Process, as [shareholders] can present their federal law claims to a federal court, in a state or province of a state close to their residence, have the opportunity for discovery, and trial by jury. There is even greater authority in federal court to obtain personal jurisdiction over defendants, and to subpoena witnesses to trial.” Nor could the Court conclude the FFP was “unfair or unreasonable” in light of the decision in Drulias, which had held all of the same elements as present in this instance to not be unfair or unreasonable. In fact, the absence of a shareholder vote in Drulias made that situation even more “unfair.”

Similarly, the Court held that the FFP was not illegal under California law, nor did it violate any California statute or public policy. And even applying an “unconscionability” standard, the Court found that the FFP was only “procedurally unconscionable”—similar to an adhesion contract and “buried in a prolix printed form.” But the provision was not substantively unconscionable: according to the Defendants and the Delaware Supreme Court, “the purpose of the FFP is to protect the corporation and its officers and directors from spending time, money, and effort in dealing with competing shareholders lawsuits pending in state and federal court. Is this a ‘justification’ for a ‘legitimate commercial need’? Perhaps. Does it ‘shock the conscience’? Not really.”

However, the FFP could be illegal, contrary to public policy or unconscionable if it were “shown to be unconstitutional or illegal under federal law. Plaintiffs had a heavy burden; and Plaintiffs have no federal law actually holding that the forum selection clauses are unconstitutional or illegal under federal law.”  The Court viewed the “real culprit of Plaintiffs’ dismay” to be “the broad scope of Section 102 of the Delaware General Corporation Law, which the Delaware Supreme Court has held goes beyond the regulation of internal affairs of a corporation or of intrastate commerce.”  But that was not a question this Court could decide.

As a result of this case, there is now precedent from at least one court in California enforcing a Delaware FFP.  Notably, the FFP in question was “cautiously and narrowly drafted to only address the choice of forum.” And it did not mandate any particular federal court as the venue, but instead left the decision as to venue to the parties, apparently a key factor to the Court. Another case involving the enforceability of an FFP is also currently pending in California against Dropbox. (See this PubCo post.)  Whether that court follows the lead set in Restoration Robotics remains to be seen.

Note: Cooley LLP represented the venture capital defendants in this case.

Posted by Cydney Posner