Vol. 78, No. 4, April 2005

Corporate Chaos: Replacing Home Rule with Foreign Law

by Shirley A. Wiegand

n a surprising decision, the Wisconsin Supreme Court recently held that the law of Wisconsin, not Delaware, determined the duty corporate officers and directors owe to creditors of a Delaware-registered corporation when the corporation had strong ties to Wisconsin. In its decision, the court relied on an unusual choice-of-law analysis and rejected the "venerable choice-of-law principle" known as the internal affairs doctrine.¹ The decision will force attorneys representing corporate clients to do battle with Wisconsin's imprecise choice-of-law methodology, will likely lead to forum-shopping and higher litigation costs, and may result in retaliation against Wisconsin corporations when they are sued in other states.

Wiegand

Shirley A. Wiegand, Kentucky 1983, is professor of law at Marquette University Law School, where she teaches civil procedure, conflicts of law, and remedies. Prof. Wiegand has published numerous articles on conflicts of law, civil litigation, and dispute resolution.

In Beloit Liquidating Trust v. Grade,² a group of unsecured creditors filed suit against seven officers and directors of Beloit Corporation (Beloit), claiming the officers and directors breached their fiduciary duty by negligently mismanaging and wasting corporate assets, which damaged the corporation and its creditors in excess of $300 million.³ Beloit (a Delaware corporation), Harnischfeger Industries Inc. (its 80 percent corporate parent), and other affiliated companies filed for chapter 11 bankruptcy protection in Delaware on June 7, 1999. In May 2001 the bankruptcy court approved Beloit's plan of reorganization. At the same time, the bankruptcy court authorized the official committee of unsecured creditors of Beloit to commence a lawsuit on Beloit's behalf against its officers and directors and subsequently transferred that authority to the plan administrator of the liquidating trust (trust) as specified in the reorganization plan.⁴ The trust filed a lawsuit in Milwaukee County circuit court in June 2001.

Eventually the circuit court dismissed all claims, and the trust appealed. The central question was whether the Beloit officers and directors owed a duty to the company's creditors before Beloit ceased doing business. The trust argued that, under Delaware law, a fiduciary duty arises whenever a corporation is insolvent regardless of whether it continues doing business. Thus, the officers and directors owed a duty to creditors well before the filing of bankruptcy, and that duty was breached by several of their decisions and actions as early as 1996, several years before filing bankruptcy. But the circuit court held, and the supreme court agreed, that Wisconsin law applies and, under such law, no duty is owed unless a company is both insolvent and no longer doing business. During the time in question, though it may have been insolvent, Beloit was doing business until it filed bankruptcy.

The Internal Affairs Doctrine

Key to the Wisconsin Supreme Court's analysis was the choice of law. Under Delaware law, it is at least arguable that the officers and directors owed a duty to the creditors. Under Wisconsin law, the court held, no duty was owed because the corporation continued doing business.

The Seventh Circuit Court of Appeals has noted that, "[w]hen the subject is liability of officers and directors for their stewardship of the corporation, the law presumptively applicable is the law of the place of incorporation." This principle, known as the internal affairs doctrine, "is recognized throughout the states, and by the Supreme Court as well."⁵ It has also been incorporated into Restatement (2d), Conflict of Laws, which holds that the law of the state of incorporation presumptively applies "to determine the existence and extent of a director's or officer's liability to the corporation, its creditors and shareholders," unless another state bears a more significant relationship to the parties and transaction.⁶ Most states adhere to the doctrine, though both California and New York have legislatively rejected it under specified circumstances. In Wisconsin, the legislature has adopted the internal affairs doctrine for limited partnerships and for aspects of shareholder derivative lawsuits.⁷

The doctrine can be justified on several grounds. First, it establishes certainty and predictability, which leads to lower litigation costs. Though a corporation may do business in many places, though its headquarters may be spread out over two or more states (or countries), though it may transfer its principle place of business from one state (or country) to another, it can and will have but one permanent "domicile," its place of incorporation. The law of that place dictates the conduct of corporate officers and directors. Thus, to promote predictability and certainty in corporate governance, the law of the domicile governs.

A second justification is that by choosing where to incorporate, corporate organizers have chosen not only a physical location but also the law that will apply to its corporate governance. This, it can be argued, constitutes an implied choice of law that should be honored. Doing so protects the parties' justified expectations. When a business entity decides to incorporate in Delaware, for example, it does so for a reason and thereby commits itself to exist - to operate - under Delaware law. That does not mean, of course, that if a simple tort or breach of contract action arises in some other place that Delaware law will inevitably govern; generally it will not, because a tort or breach has little to do with corporate governance and operation. But the conduct of officers and directors has everything to do with how the corporation operates - and thus the law of its domicile governs. In addition, applying the law of the incorporating state protects corporate officers and directors from being held to differing standards of conduct from state to state. They need only conform their conduct to the law of the corporate domicile.

A third justification for the internal affairs doctrine is that the state of incorporation has a strong interest in the operation of its companies. "An incorporating state will likely want to ensure that its corporations are not used improperly or fraudulently."⁸

Despite these justifications, the internal affairs doctrine is not absolute. It permits the law of another state to apply in some instances. For example, section 302 of the Restatement (2d), Conflict of Laws, provides that the law of the incorporating state applies to issues involving the "internal affairs" of a corporation, that is, "the relations inter se of the corporation, its shareholders, directors, officers or agents," except in the "unusual case where ... some other state has a more significant relationship to the occurrence and the parties...."⁹ Section 309 specifically addresses the issue involved in Beloit; it provides that the incorporating state's law "will be applied to determine the existence and extent of a director's or officer's liability to ... its creditors ... except where, with respect to the particular issue, some other state has a more significant relationship." Thus, section 302 raises a strong presumption and section 309 raises an ordinary presumption that the incorporating state's law will apply, but either presumption can be replaced by the law of a state that has a more significant relationship to the parties and transaction. Cases abound in which courts have found the presumption overcome because of a stronger interest held by a nonincorporating state.

The Court's Choice-of-law Analysis

Although a strong case could be made for the application of Delaware law, the court's choice of Wisconsin law in Beloit is not shocking. What is surprising is the court's unusual choice-of-law analysis and its implications.

The argument against applying Wisconsin law under the Beloit facts is strong. Beloit Corporation is domiciled - incorporated - in Delaware. When company officials decided to file bankruptcy, they returned to the corporate home state to do so. The company thus began and ended its business existence in its home state. For a part of the relevant period, corporate headquarters were in Illinois, where four of the seven defendants resided, even though for most of its existence, the primary place of business was in Beloit. The company operated 65 wholly-owned or partially-owned subsidiaries, including locations in the United Kingdom, Asia, Italy, Poland, and Austria. Two of the most significant negligent acts complained of occurred in Massachusetts and Asia, though decisions preceding those acts may have occurred in Wisconsin. Only one of the seven defendants was a Wisconsin resident.¹⁰ Under these circumstances involving a multi-national corporation, the internal affairs doctrine provides a clear, rational, predictable choice-of-law rule that makes sense: Apply the law of the only permanent place of corporate domicile - the place of corporate birth.

On the other hand, a strong argument can be made that Wisconsin has an even more significant relationship to the parties and transactions. Beloit's principal place of business was located in Wisconsin for 140 years, the stock's majority owner (Harnischfeger) was headquartered in Wisconsin, and the officers and directors undoubtedly conducted business in Wisconsin at Beloit's headquarters. Furthermore, the unique circumstances of the case do not fit one important rationale of the internal affairs doctrine, that is, the risk of being subjected to states' differing standards. Because the case began in bankruptcy court and consolidated the creditors' claims, the law chosen in Beloit is determinative of all creditor claims against the officers and directors.

Had the court adopted the internal affairs doctrine, it would have begun with the presumptive rule favoring Delaware law and then determined whether the presumption was overcome. Instead, in a unanimous opinion authored by Justice Crooks,¹¹ the court rejected the internal affairs doctrine altogether and, in the process, may have created ambiguity and confusion in two respects.

The first involves its reliance on Wis. Stat. section 180.1704, which states that chapter 180 "applies to all foreign corporations transacting business in this state on or after January 1, 1991." However, none of chapter 180's provisions pertain to the duty that corporate officers and directors owe to creditors. The chapter simply provides no substantive law for the issue in Beloit. Indeed, the court cautiously noted that the language of section 180.1704 is "helpful in discerning our legislature's intent with respect to corporations and choice of law principles." The language "supports the holding" but does not mandate it.¹²

By basing its decision on chapter 180, the court suggested that Wisconsin law governs all issues involving corporations transacting business in Wisconsin simply because chapter 180 governs some aspects of corporate conduct. The court suggested that, because the legislature intended to place some statutory restraints on companies doing business in Wisconsin, the legislature intended for Wisconsin law to always control.

Next, the court bolstered its choice-of-law decision by applying Wisconsin's choice-of-law rules, but in doing so the court employed a test that will likely create confusion. Historically, Wisconsin has applied Leflar's "better law" analysis to tort claims. That analysis directs a court to consider five choice-influencing considerations when choosing the applicable law: predictability of results, maintenance of interstate and international order, simplification of the judicial task, advancement of the forum's governmental interests, and application of the better rule of law.¹³ But the court in Beloit begins its analysis by holding that "application of Delaware law ... would constitute officious intermeddling with the laws of Wisconsin." The "officious intermeddling" test first surfaced in 1973 in Hunker v. Royal Indemnity Co., in which the court indicated that this test referenced constitutional concerns; choice-of-law analysis should proceed only if "the facts on their face reveal that to apply any of multiple choices of law would not constitute mere officious intermeddling, in the constitutional sense."¹⁴ A true constitutional analysis in Beloit clearly would have permitted the court to apply Delaware law.

A court cannot apply the law of a state if doing so would violate the U.S. Constitution. Well-established U.S. Supreme Court decisions dealing with choice of law focus primarily on the Constitution's due process and full faith and credit clauses. Beginning with Home Insurance Co. v. Dick and culminating in Allstate Insurance Co. v. Hague and Phillips Petroleum Co. v. Shutts, the U.S. Supreme Court has established constitutional limits on choice of law. In short, the Court will invalidate "the choice of law of a State which has had no significant contact or significant aggregation of contacts, creating state interests, with the parties and the occurrence or transaction."¹⁵ The test, easily overcome in most cases, is clearly satisfied when a state serves as the place of incorporation - the domicile - and also as the place in which the corporate bankruptcy was filed and in which a court authorized the lawsuit itself. In Beloit, Delaware clearly had a "significant contact" with the parties and the transaction.

But the Wisconsin Supreme Court, though referring to "officious intermeddling," really performed no constitutional analysis at all; it merely counted the number of contacts that Beloit Corporation had with Wisconsin. So what did the court mean? Apparently it meant that Wisconsin's interest is greater than Delaware's interest. That is a rational conclusion, but the court need not have muddied the choice-of-law waters by introducing an undefined and confusing "officious intermeddling" test. All it needed to do was move immediately to Wisconsin's own "better law" analysis and conclude that the internal affairs doctrine's presumption of Delaware law had been overcome.

Implications for Future Cases

The Wisconsin Supreme Court's opinion suggests that the court has solidly rejected the internal affairs doctrine including even its presumption that the incorporating state's law should apply. Indeed, a case decided the following month parroted the court's analysis, including the reference to both Wis. Stat. section 180.1704 and the officious intermeddling test.¹⁶ The court's decision in Beloit creates concerns in two areas, one substantive and the other procedural.

The substantive concern is that the court has rejected the internal affairs doctrine, a doctrine that advances certainty and predictability and thereby minimizes transactional costs. Rather than presume that matters related to corporate governance will be governed by the law of the incorporating state, parties will now have to perform what is generally an imprecise choice-of-law analysis in each case, no doubt leading to increased litigation costs. The court's decision will encourage forum shopping and may also influence an organization's decision as to where to incorporate or where to locate a principal place of business. Wisconsin corporations may find, too, that they will not benefit from Wisconsin law when sued in other states.

The procedural concern is the way in which the court reached its decision once it rejected the internal affairs doctrine - relying on an unusual, and unsatisfactory, choice-of-law analysis. Though the court arguably reached the correct result, future decisions should articulate a sounder methodology.

First, the court should make it clear that chapter 180 does not provide a Wisconsin choice-of-law rule for all issues that involve corporations transacting business in Wisconsin. Such a broad rule would surely go further than the legislature intended and might prompt retaliatory action by other states. Such a parochial approach cannot be what the court intended.

Second, the court will need to abandon its inexact "officious intermeddling" test. If by using such a test it means to conduct a constitutional analysis, then it should do so by reliance on U.S. Supreme Court jurisprudence that has evolved over time. If the facts of a case suggest no constitutional violation (and they rarely will), the court should move directly to choice-of-law analysis and apply the choice-influencing considerations.

Conclusion

The Wisconsin Supreme Court's decision in Beloit represents a break with historical practice in this country. The court rejected the internal affairs doctrine that presumptively favors the incorporating state's law. Instead, by applying an unusual and imprecise choice-of-law analysis, the court determined that Wisconsin law should determine the fiduciary duty of corporate officers and directors to corporate creditors. The result can be justified under the circumstances of the case, but the decision will most likely lead to forum shopping, less certainty and predictability, greater litigation costs for parties and courts, and perhaps retaliatory action when Wisconsin corporations are sued in other states.

In the future, the court could address these concerns by clarifying its analysis, particularly its reliance on Wis. Stat. section 180.1704 and on its use of "officious intermeddling" language, and it could set forth more clearly the narrow circumstances under which Wisconsin law, rather than the law of the place of incorporation, will govern.

Endnotes

¹Resolution Trust Corp. v. Chapman, 29 F.3d 1120, 1122 (7th Cir. 1994).

²2004 WI 39, 270 Wis. 2d 356, 677 N.W.2d 298.

³See Brief for Plaintiff/Appellant.

⁴Beloit Liquidating Trust v. Grade, 2003 WI App 176, 266 Wis. 2d 388, 669 N.W.2d 232.

⁵Resolution Trust Corp., 29 F.3d at 1122.

⁶Restatement of the Law (2d), Conflict of Laws § 309 (emphasis added).

⁷See Wis. Stat. §§ 179.81, 180.0747.

⁸Note, The Internal Affairs Doctrine: Theoretical Justifications and Tentative Explanations for Its Continued Primacy, 115 Harv. L. Rev. 1480, 1489 (2002).

⁹Restatement of the Law (2d), Conflict of Laws § 302.

¹⁰2003 WI App 176, ¶ 1 n.1, 266 Wis. 2d 388.

¹¹ Beloit, 2004 WI 39, 270 Wis. 2d 356. Justice Prosser did not participate.

¹²Id. ¶ 23.

¹³See Shirley A. Wiegand, Officious Intermeddling, Interloping Chauvinism, Restatement (Second), and Leflar: Wisconsin's Choice of Law Melting Pot, 81 Marq. L. Rev. 761 (1998), analyzing Home Ins. v. Dick, 281 U.S. 397 (1930), Allstate Ins. Co. v. Hague, 449 U.S. 302 (1981), and Phillips v. Shutts, 472 U.S. 797 (1985).

¹⁴Hunker v. Royal Indemnity Co., 57 Wis. 2d 588, 204 N.W.2d 897 (1973).

¹⁵See Wiegand, supra note 13, at 792-93.

¹⁶Finch v. Southside Lincoln-Mercury Inc., 2004 WI App 110, 274 Wis. 2d 719, 685 N.W.2d 154.

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