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 were “facially valid.” (See this PubCo post.) Given that Sciabacucchi involved a facial challenge, the Supreme 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, in light of the perceived benefits for defendants of litigating Securities Act claims in federal court, many Delaware companies that did not have FFPs adopted them, and companies with FFPs involved in ’33 Act litigation tried to enforce them by moving to dismiss state court actions. In 2020, in an apparent case of first impression, Wong v. Restoration Robotics, the San Mateo Superior Court in California upheld application of the FFP, declining “jurisdiction over the claims alleged against Restoration Robotics and its officers and directors only, pursuant to the FFP.” (See this PubCo post.) Plaintiff appealed. The California Court of Appeal, First Appellate District, has just affirmed the lower court’s decision, upholding enforcement of the FFP.
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. (See this PubCo post.) 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. (See this PubCo post.)
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.” In the view of the Delaware Supreme Court, however, the trial court had applied the doctrine too narrowly. In McDermott, the Delaware Supreme Court had 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 had, in effect, severed that tie.
Restoration Robotics—In the trial court. 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 related to its IPO that had been filed in that court on the basis of the FFP in its charter. The trial 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 trial court determined that the matter merited reconsideration. After discussing the decision in Sciabacucchi, the trial court set the stage by concluding that “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.”
The trial court examined relevant precedent. 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. In addition, 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.”
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 v. MITE Corp. However, the trial court declined the invitation to address these issues: the issue was “not the proper subject of a California court adjudication of a motion to dismiss for forum non conveniens.”
In the end, the trial court determined that the plaintiffs had not met their burden of proof to show that the FFP was unenforceable, unconscionable, unjust or unreasonable. 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 trial 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.” 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 trial court. 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 trial 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 trial court held that the FFP was not illegal under California law, nor did it violate any California statute or public policy. Although the trial court found that the FFP was “procedurally unconscionable”—similar to an adhesion contract and “buried in a prolix printed form,” 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.” Exercising its discretion, the trial court declined “jurisdiction over the claims alleged against Restoration Robotics and its officers and directors only, pursuant to the FFP.” (See this PubCo post.)
The decision on appeal. The plaintiff raised three arguments on appeal: first, that the FFP violates the 1933 Act, which states that both state and federal courts have jurisdiction over 1933 Act causes of action; second, that the Delaware statutory scheme permitting the FFP violates the Commerce Clause and the Supremacy Clause of the U.S. Constitution; and third, that the FFP is invalid and should not be enforced in any event because it is unfair and unreasonable.
’33 Act violation. The plaintiff contended that the FFP violated “Congress’s express policy choices” in the ’33 Act on two bases: the “removal bar,” which prohibits removal from state court to federal court, and the “anti-waiver provision,” which declares void any requirement binding the acquirer of a security to waive compliance with the securities laws. However, the Court observed that removal “is not at issue here,” and rejected plaintiff’s urging to look to the policy behind the words of the statute. To reinforce its point, the Court quoted Justice Kagan: “[t]he statute says what it says—or perhaps better put here, does not say what it does not say.” In addition, the Court pointed to a 1989 case in which SCOTUS held that arbitration provisions could override a decision by a plaintiff to litigate in state court. Citing the same case, the Court also concluded that the jurisdictional waiver of an FFP does not amount to a waiver of compliance.
Constitutionality. The plaintiff also contended that the Delaware statute violated the Commerce Clause and the Supremacy Clause of the U.S. Constitution, which would render the FFP unlawful. First, the plaintiff contended that the Delaware statutes indirectly burden interstate commerce and fail to pass the balancing test set forth in Edgar requiring examination of the burden imposed on interstate commerce in relation to the putative local benefits. The Court first questioned whether any state action was even involved—a necessary predicate to a Commerce Clause case. Here, plaintiff’s claim “arises from Restoration Robotics’ decision as a Delaware corporation to include an FFP in its certificate of incorporation, as permitted, but not required or even encouraged by Delaware law.” But the cases on which plaintiff relied for support, the Court noted, concerned state statutes that imposed requirements on corporations or associations based out of state. Accordingly, the Court held that the plaintiff’s claim did not involve state action. But even if it did, the Court did not buy plaintiff’s argument that the Delaware statutory scheme failed the balancing test: the Delaware Supreme Court determined that FFPs advance a number of Delaware policies with respect to corporations, and therefore, the burden on interstate commerce was not “clearly excessive in relation to the putative local benefits.” Rather, the Court viewed the burden on interstate commerce resulting from Delaware’s permissive statute as slight compared to the benefits: “[n]otably, the FFP does not prevent a shareholder from bringing a 1933 Act claim in court, and does not require venue in any particular federal district court. The FFP simply restricts the range of possible forums for a shareholder’s 1933 Act claim, absent consent from Restoration Robotics.”
As framed by the Court, under the Supremacy Clause, “ ‘[a] state may not discriminate against rights arising under federal laws.’… The Supremacy Clause prohibits states from ‘dissociat[ing] themselves from federal law because of disagreement with its content,’ and from refusing to allow state court jurisdiction over federal claims while permitting state court jurisdiction over ‘similar state-law actions.’” The plaintiff’s argument, as the Court summarized it, was that the Delaware statutory scheme permitting FFPs discriminated against federal law in favor of state law, in violation of the Supremacy Clause, because it protects Delaware state court jurisdiction over state law securities claims that are “internal corporate claims” (Section 115) similar to ’33 Act claims, but fails to protect state court jurisdiction for similar federal claims. But the Court was unconvinced, observing that the contention “appears to rest on a false premise.” Claims under Section 115, the Court reasoned, even if they arise out of the purchase or sale of stocks, are not like the plaintiff’s ’33 Act claims because they “are essentially contractual disputes.” Cases cited by the plaintiff regarding the Supremacy Clause “stand for the principle that ‘a State cannot simply refuse to entertain a federal claim based on a policy disagreement.’….But the case before us does not involve Delaware refusing to entertain a federal claim…. By allowing corporations and shareholders to agree to forum selection provisions that limit 1933 Act claims to federal courts, Delaware does not purport to shut its doors, or the doors of any other state court to 1933 Act claims.” The Court concluded that “section 115 does not reflect any quarrel between Delaware and federal law over the content of the 1933 Act or the extent of the remedies available under the 1933 Act. Nor does it discriminate in favor of state law claims and against similar federal claims.” Rather, Delaware is simply maintaining internal Delaware corporate claims in Delaware. “This makes sense given Delaware’s interest and expertise in corporate law…. Other than that, Delaware leaves parties free to adopt forum selection provisions for state and federal claims.”
FFP validity and enforceability. The plaintiff further contended that the FFP is invalid and unenforceable under California law; Restoration Robotics argued that the validity of the FFP is governed by and valid under Delaware law, specifically Sciabacucchi, but agreed that California law governs the issue of enforceability. The Court agreed that, under the internal affairs doctrine, the validity of a provision of a certificate of incorporation is generally “a type of internal affair that is likewise governed by the law of the state of incorporation.” Here, the Delaware Supreme Court had held that FFPs are permitted in a company’s certificate of incorporation, and, therefore, “we need not consider their validity under California contract law.”
Turning to the question of enforceability, the Court cited Drulias for the proposition that a “forum selection clause that was not the subject of bargaining…may be enforced unless there is ‘a showing that it was outside the reasonable expectations of the weaker or adhering party or that enforcement would be unduly oppressive or unconscionable.’”
The Court concluded that the plaintiff failed to show that the trial court abused its discretion in enforcing the FFP. The plaintiff contended that an ordinary investor, typically the weaker party in an IPO, had no reason to expect to be bound by an FFP and could hardly be expected to ferret out the FFP among all the text and documents in the IPO registration statement. But the Court “hesitate[d] to agree that an investor is excused from attending to the required disclosures, particularly when they concern the governing documents of a corporation.’”
Similarly, the Court concluded that the FFP was not unconscionable. As defined by the Court, “unconscionability” has two components—procedural unconscionability (“oppression” or “surprise”) and substantive unconscionability (“overly harsh or one-sided results”). The plaintiff contended that the FFP was procedurally unconscionable because it was essentially an adhesion contract, a contention with which the trial court had agreed. The Court observed, however, that the plaintiff did not cite any cases in support involving certificates of incorporation and that amendments to certificates of incorporation are not typically negotiated. The plaintiff also argued that the FFP was “unduly harsh because it forces a plaintiff to waive ‘a congressionally granted right’ and unduly one-sided because it removes from plaintiff the ability to unilaterally select a state forum for litigation.” The Court, however, was unpersuaded and declined “to hold that there is anything substantively unconscionable in the waiver of the waivable procedural right to a state forum, particularly where, as here, the provision does not restrict a plaintiff’s procedural right under the statute to file suit in a local federal court.” Accordingly, the Court affirmed the decision of the trial court.
For more information about securities litigation, see the Cooley Securities Litigation + Enforcement blog.