The internal affairs doctrine is a choice of law rule under which a court will apply the law of the state of the subject entity’s formation (lex incorporationis) rather than the law of the jurisdiction where suit is brought (lex fori) to governance disputes and other internal conflicts concerning rights and duties among the entity, its owners and managers. So, for instance, when a shareholder or member of a New York based Delaware corporation or LLC brings suit in a New York court against an officer or manager for breach of fiduciary duty, the New York judge ordinarily will adjudicate the claim under Delaware law, which may differ materially from the analogous New York common or statutory law.

The internal affairs doctrine in theory acknowledges the superior interest of the state of formation in the application of its laws to the entity’s internal governance, even when the entity is based outside the state and has no connection with the state other than its formation. The doctrine also serves to avoid the uncertainty and high transactional costs that would occur if a business entity operating in multiple states was subject to different rules of governance in each state. Finally, it reflects a strong presumption that those who chose to form their entity in a particular state desire to have their legal relations governed by the laws of that state.

I don’t think I’m going out on a limb stating that the overwhelming majority of partnership agreements, shareholder agreements and LLC agreements that contain an express choice of law provision select the law of the state of formation, i.e., there is no inconsistency between the parties’ contractually stated preference and the internal affairs doctrine. But once in a while I come across an exceptional case. Those of you who followed the Pappas v. Tzolis saga may recall that the New York-based Delaware LLC involved in that case had an operating agreement with a New York choice of law clause. As I noted in one of my several posts about the case (read here), the trial judge side-stepped the conflicts of law issue by finding the result the same under either state’s law, and the issue unfortunately was not addressed in the subsequent appellate rulings deciding the case under New York law.

Another exceptional case recently came to my attention. Gelman v. Gelman, Index No. 12664/10 (read here), is an unreported decision dated April 3, 2013, by Nassau County Supreme Court Justice Daniel Palmieri involving a dispute between two siblings who co-own a Delaware LLC. The court enforced a New York choice of law provision in the operating agreement in deciding the right to appointment of a receiver. As in Pappas, however, the court opined that the result would be the same under either state’s law.

In Gelman, sister Corey Gelman holding a 50.5% membership interest sued brother Gary Gelman holding the remaining 49.5% interest in a dispute over a single-asset realty company named Charles Court Bellmore, LLC. The LLC was originally formed in 1996 as a New York LLC and later merged into a Delaware LLC. After the 1999 merger, the siblings never amended or restated their 1997 operating agreement containing a New York choice of law clause.

At some point the realty was sold for $4.4 million. Except for a partial distribution of $625,000, Corey retained control of the sales proceeds which she refused to distribute pending resolution of the lawsuit. Gary applied to the court for an order distributing the remaining cash and appointing a receiver for that purpose.

Corey opposed the application. She argued that the New York choice of law clause in the 1997 operating agreement controlled, and that New York statutory and case law does not authorize a court to appoint a receiver or liquidating trustee for an LLC except when winding up a dissolved LLC, which was not the case in Gelman. (Read here my prior post highlighting the limited authority under New York law for appointment of a receiver for an LLC prior to an order of dissolution.)

Gary argued for application of what he characterized as the more liberal standard for appointment of a receiver for an LLC under Delaware law. Indeed, the Delaware Chancery Court has invoked its “inherent power as a court of equity” to appoint a receiver for an LLC notwithstanding the lack of statutory authority, e.g., Ross Holding and Management Co. v. Advance Realty Group, LLC (read here).

The court’s decision does not lay out Gary’s rationale for applying Delaware law. Presumably he contended that the 1999 merger of the original New York LLC into a Delaware LLC vitiated the 1997 operating agreement such that its New York choice of law clause was trumped by the internal affairs doctrine requiring the court to apply Delaware law. He also may have pointed out that, unlike New York’s LLC Law, Delaware’s LLC Act does not mandate a written operating agreement.

Whatever his argument, Justice Palmieri didn’t buy it, instead finding that the 1997 operating agreement controlled. Here’s what he wrote:

The only Operating Agreement submitted by the parties is from the New York company, dated April, 1997. It contains a choice of law provision which obligates the members to apply New York law, “all rights and remedies being governed by said laws.” The New York company was never dissolved but as noted merged into the new company, and in the absence of a contrary operating agreement stating that Delaware law shall control, the Court finds that pursuant to the one Operating Agreement submitted New York law should be applied. This is especially true given the claims of tortious conduct made by both sides. [Citation omitted.]

Gary may have lost the choice-of-law battle but he still came out on top. Justice Palmieri alternatively considered Gary’s application to appoint a receiver under the general, more rigorous provision for receivership in Article 64 of the Civil Procedure Law and Rules and concluded that the appointment was warranted for purposes of making an interim distribution pending resolution of the lawsuit. In so ruling, Justice Palmieri commented that the high standard for ordering a receivership under CPLR Article 64 is “consistent” with the Delaware standard under which receivership is deemed an “extraordinary remedy” to be granted “cautiously and only as necessitated by the exigencies of the case before it.”

On the merits, Justice Palmieri cited Corey’s refusal to make any distribution as the controlling 50.5% member notwithstanding the facts that:

  • she never argued that Gary ultimately will be owed nothing
  • she offered no evidence that Gary is indebted to the LLC
  • she admittedly issued to Gary an erroneous, grossly inflated 2011 K-1 form
  • she confirmed that all of the LLC’s debts and final taxes are paid
  • the operating agreement contemplates interim distributions
  • there are available distributable funds.

The above factors, together with Corey’s “obvious animus toward her brother,” Justice Palmieri found, “renders her continued control of the assets a danger to the minority holder’s interest in the funds, and places her in an untenable position to oversee such a distribution.” Justice Palmieri accordingly ordered the appointment of a receiver, among other things, to recommend to the court a proposed interim distribution.

Two final notes. First, there is nothing obvious or settled when it comes to conflict between the internal affairs doctrine and the stated contractual preference of the company owners.  In Rosenmiller v. Bordes, 607 A2d 465 (Del Ch 1991), which as far as I can tell is still good law, the Delaware Chancery Court disregarded a New Jersey choice of law clause in a shareholders agreement and applied Delaware law under the internal affairs doctrine to resolve a dispute over a shareholder voting trust because, the court found, “Delaware . . . has a greater interest than does New Jersey in regulating stockholder voting rights in Delaware corporations.”

Second, the internal affairs doctrine does not displace the general conflict of laws principle that requires the court to make a threshold determination whether the law or rule at issue is procedural or substantive. Matters of procedure generally are governed by the law of the forum. It is not always an easy distinction to make, as illustrated by Curbow Family LLC v. Morgan Stanley Investment Advisors, 36 Misc 3d 889 (Sup Ct NY County 2012), involving a shareholder derivative suit against a Massachusetts corporation, where the court held that pre-trial discovery provisions in Massachusetts’ corporations law were an “integral” part of the statutory scheme and therefore superseded New York discovery rules. The Gelman decision does not address the issue, so presumably both sides explicitly or implicitly agreed that the interim remedy of receivership is a substantive matter.