It’s not every day that New York’s highest court considers a question impacting the business divorce cases that we typically litigate.  And even when an interesting business divorce issue does make its way up to Albany, it’s even more rare to see the Court of Appeals, in a case of first impression, fashion a new framework for addressing a complex question.  We recently were treated to both.

When the directors of a foreign corporation headquartered in New York negotiate and consummate (in New York), a merger of the corporation (which derives millions in revenue from New York), which law governs suits arising from that merger?  On this question, we now have Court of Appeals guidance. 

According to Eccles v Shamrock Capital Advisors, LLC, the internal affairs doctrine, by which “matters peculiar to the relationships among or between the corporation and its current officers, directors, and shareholders” are governed by the law of the state of incorporation, the foreign law applies (2024 NY Slip Op 02841 [Ct App May 23, 2024]).  The Court’s analysis and decision require careful consideration by any owner of a foreign-incorporated entity considering New York litigation. 

FanDuel’s Merger Leaves Common Shareholders Out in the Cold

The Eccles case pits the common shareholders of FanDuel Ltd., a Scottish corporation, against the directors and preferred shareholders concerning the directors’ decision to merge FanDuel with a British sports betting company, Paddy Power.  The merger was negotiated while the entire sports betting industry held its breath; the Supreme Court was considering Murphy v National Collegiate Athletic Assn, 584 U.S. 453 (2018) the case that allowed states to legalize sports gambling.  Here’s how the merger unfolded:

• Early 2018: Moelis & Co., retained by FanDuel to explore financing options, projects that if sports betting were legalized in the U.S., FanDuel would earn more than $1.1 billion in annual revenue within five years.

• May 1, 2018: FanDuel agrees to a term sheet for a merger with Paddy Power, where the two would merge into a new company, PandaCo, Inc, each trading their equity for a share of PandaCo’s equity.  The term sheet specified that the merger values of the two companies would remain the same regardless of the Supreme Court’s decision in Murphy.

• May 14, 2018: The Supreme Court holds that Congress could not preclude states from legalizing sports gambling.

• May 22, 2018: FanDuel’s directors meet in New York and unanimously agree to proceed with the merger into PandaCo.  Notably, the directors were also “preferred” shareholders, a designation which, under FanDuel’s Articles of Association, entitled them to preferential payment for the value of their stock.

• July 11, 2018: FanDuel’s merger into PandaCo closes.  The merger proceeds were valued at approximately $460 million, while the value of the outstanding preferred stock was approximately $560 million.  So, because FanDuel’s preferred shareholders were compensated first, FanDuel’s common shareholders received nothing, and FanDuel was effectively dissolved.

Common Shareholders Sue Under New York Law

Following the merger, a group of FanDuel’s common shareholders sued in New York, pleading causes of action under New York law.  The common shareholders alleged that FanDuel’s directors engaged in a scheme to ensure that only the preferred shareholders would benefit from FanDuel’s merger.  This was the only logical explanation, argued the common shareholders, for why the directors agreed to proceed with a merger with the price established before the Supreme Court’s Murphy decision.  FanDuel, argued the common shareholders, was worth significantly more after Murphy.

Lower Court Proceedings

The directors moved to dismiss the common shareholders’ claims.  They contended that the internal affairs doctrine required the application of Scottish law—the place of FanDuel’s incorporation—and not New York law to the plaintiffs’ claims.  And under Scots law, directors of a corporation owe fiduciary duties to the corporation, but not to any individual shareholders. 

Plaintiffs argued that New York law applies.  FanDuel’s headquarters was in New York, the merger was negotiated and voted upon in New York, and New York, due to its status as a major revenue generator for FanDuel, has a greater interest in the litigation than Scotland.

The trial court sided with the common shareholders, finding that New York law applied to their breach of fiduciary duty claims.  The internal affairs doctrine was inapplicable, said the trial court, because the defendants were not the current officers, directors, and shareholders at the time of the lawsuit (the merger with PandaCo had changed that).

The Appellate Division held that Scots law applied to the plaintiffs’ claims; the internal affairs doctrine was applicable because the defendants were directors, officers, and shareholders at the time of the events giving rise to the lawsuit.

A New Test for the Applicability of the Internal Affairs Doctrine

The Court of Appeals found that both State and Federal courts have been inconsistent in their application of New York’s internal affairs doctrine.  Specifically, while the courts have almost unanimously held that New York rejects a per se application of the internal affairs doctrine, those courts have been varied in the showing required to overcome application of the rule.

So the Court of Appeals fashioned a new test for applicability of the internal affairs doctrine:

[W]e clarify that the substantive law of a company’s place of incorporation presumptively applies to causes of action arising from its internal affairs. Moreover, because of the important interests that the internal affairs doctrine represents, we decline to create any broad exceptions to that presumption. Rather, in order to overcome this presumption and establish the applicability of New York law, a party must demonstrate both that (1) the interest of the place of incorporation is minimal—i.e., that the company has virtually no contact with the place of incorporation other than the fact of its incorporation, and (2) New York has a dominant interest in applying its own substantive law.”

Applying its new test, the Court of Appeals held that Scots law presumptively applied to Plaintiffs claims, which “centers around the valuation of merger consideration by the director defendants in the course of approving a merger agreement and their legal duties to certain shareholders as it pertains to those actions.”  And Plaintiffs could not demonstrate either that FanDuel had virtually no contact with Scotland, or that New York had a dominant interest in applying its own law.  On the latter element, the Court noted that “only” 10–15% of FanDuel’s total revenue was derived from New York customers.

Thus, Scots law applied to the common shareholders’ claims for breach of fiduciary duty.

A Walk Through the “Special Circumstances” of Scots Law

Having received extensive expert submissions concerning Scots law, the Court of Appeals saw fit to take judicial notice of Scots law governing the relationship between directors and minority shareholders.  The Court observed that, under “the relevant English common law principles, a director does not owe any fiduciary duties directly to the shareholders solely based on his or her relationship to the company.”  There may, however, be “special circumstances” in which a fiduciary duty is owed by a director to a shareholder personally. 

At the pleading stage, the Court found that the common shareholders sufficiently allege special circumstances warranting the imposition of a fiduciary duty in favor of the individual common shareholders.  The Articles of Association’s waterfall provision (by which the preferred shareholders got paid first) combined with the drag-along rights (which allowed the preferred shareholders to force the merger without a vote), the Court observed, left the common shareholders “in an especially vulnerable position:”

Taken together, this arrangement could give rise to an inference that the directors, in being vested with the power to negotiate a merger agreement and subsequently value intangible merger consideration, undertook a duty not to undermine the common shareholders’ interests in those transactions, much less to do so for their own self-interest.”

Conclusions

Call it hometown bias, but in my view, New York sits among the preferred jurisdictions for litigation of shareholder and other intra-owner business disputes.  Sophisticated judges and counsel, the existence of the Commercial Division, and the benefit of a rich body of caselaw concerning mergers, corporate formalities and shareholders rights, all fuel that preference.   

I wonder if the Court of Appeals’ belt-tightening with respect to the internal affairs doctrine may temper that preference, if only slightly.  Shareholders of foreign-incorporated corporations with a substantial, but not exclusive, presence in New York may find themselves less able to avail themselves of New York’s shareholder laws.

And while not directly applicable to domestic intra-company disputes, the Court’s discussion of Scots’ law is sure to make for some interesting fireside discussion about the English common law on which New York law is based.  For instance, one need not peruse the pages of this blog for long to find cases discussing the burden-shifting that occurs when those in control of a corporation orchestrate a self-interested transaction (see here).  Is that framework a long lost relative of the “special circumstances” standard of Scots law?     

[View source.]