A laws of a company’s state of incorporation have important legal implications for public companies and their directors, officers and stockholders. Why? Because key legal issues affecting corporate governance are generally governed by the incorporating state’s laws. While most companies prefer Delaware, assessing the best fit for a company requires a case-by-case analysis given the many variations that exist between states.
To illustrate, this article provides representative examples of how states can differ, focusing on four areas that frequently impact stockholder litigation.
Books and Records Requests
Stockholders often use their right to make “books and records” requests to investigate potential wrongdoing. Companies may have several bases to reject or narrow requests based on the circumstances, with Delaware courts in particular having issued company-friendly decisions in this regard.
In addition, states can differ on which stockholders are even entitled to submit a request for books and records. While many states permit any stockholder of record to do so, others like Nevada, North Carolina and Texas have further ownership requirements (i.e., percentage of ownership or time holding the stock) to request inspection.
Certain states are also more limited on what records can potentially be obtained. Texas, for example, excludes informal electronic communications (emails, texts, etc.) from the scope of books and records requests unless they effectuate a corporate act. Delaware recently amended its laws to similarly narrow the definition of “books and records” to defined categories of records. Meanwhile, Nevada limits requests to books of account and financial records and exempts public companies from the requirement to permit inspection if certain federal reporting requirements were met in the preceding year.
Derivative Litigation Process
The procedures for derivative litigation also vary, such as “pre-suit demand” requirements. Georgia, North Carolina and Texas are among nearly two dozen “universal demand” jurisdictions which require stockholders to make a demand on the board and provide it an opportunity to investigate before filing litigation. By contrast, Delaware, Florida, New York and Nevada allow stockholders to either make a demand on the board or to file litigation without making a demand and allege that doing so would be futile due to the absence of an independent board. Regardless of which framework applies, failure to meet these governing procedural requirements can result in dismissal.
Substantive Legal Rules
States often apply similar substantive legal standards, but there are distinctions. For example, the business judgment rule (BJR)—available in every state in some form—can protect directors and officers from liability based on a presumption that their decisions were made in good faith, with due care and in the company’s interests. But how the BJR applies varies by state. Many states, like Georgia, North Carolina and Delaware, require stockholders to show gross negligence to overcome the BJR. Nevada and Texas generally require a higher level of misconduct, such as intentional misconduct, fraud or a knowing violation of law.
Fiduciary duties can also vary. Most states recognize the duties of care and loyalty for officers and directors (though often articulated differently). Texas also recognizes a duty of obedience, i.e., a duty to not commit “ultra vires” acts like acts beyond the scope of authority. Delaware has also recognized a duty of oversight—a subset of the duty of loyalty— that can result in liability (“Caremark claims”). California and North Carolina have recognized Caremark claims, while many states have not yet specifically addressed the issue.
Indemnification and Exculpation
The ability to indemnify and exculpate directors and officers from liability turns on state law as well. States often limit a company’s ability to exculpate its directors for duty of care claims and do not permit exculpation for breaches of the duty of loyalty. However, Nevada’s indemnification and exculpatory laws are not limited to duty of care claims and instead broadly provide these protections unless the breach involved fraud, intentional misconduct or a knowing violation of the law.
As these examples suggest, when it comes to corporate governance, it is critical to engage legal counsel knowledgeable about state-specific nuances and the legal rights and protections that are available in your state.
