On The Case

Are Delaware federal forum selection clauses unconstitutional?

(Reuters) - Shareholders last week failed in their first challenge to the Delaware Supreme Court’s 2020 ruling in Salzberg v. Sciabacucchi that corporations can adopt charter provisions requiring shareholders to bring Securities Act claims in federal court. San Mateo Superior Court Judge Marie Weiner dismissed shareholders’ class action claims against the Delaware-incorporated hair transplant company Restoration Robotics, concluding that plaintiffs' lawyers at Robbins Geller Rudman & Dowd and Cotchett Pitre & McCarthy had not shown that the company’s federal forum selection clause violated California law or policy.

Judge Weiner was the first state-court judge to apply the Delaware Supreme Court’s Sciabacucchi decision, which addressed the facial validity of these clauses under Delaware corporate law, so the decision is undoubtedly a setback for investors hoping to block corporations from steering them out of state court, where pleading standards are often lower than they are in federal court. Shareholders have been particularly successful in IPO class actions in California state courts, which adds sting to Judge Weiner’s decision.

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But the San Mateo judge – who was sharply critical of the Delaware Supreme Court’s ruling – also gave plaintiffs’ lawyers a reason to hope that her ruling is not the last word on the enforceability of federal forum selection clauses.

Judge Weiner discussed shareholders’ “very interesting argument” that these provisions are unconstitutional under the Commerce Clause or the Supremacy Clause of the U.S. Constitution. She ultimately concluded that constitutional questions were beyond the purview of a state-court judge ruling on a defendants’ forum non conveniens motion – but suggested that a constitutional challenge to Delaware’s interpretation of state corporate law could be brought as a declaratory judgment case in federal court.

Shareholders’ lawyers James Jaconette of Robbins Geller and Mark Molumphy of Cotchett did not immediately respond to an email requesting comment. Restoration Robotics counsel Matthew Rawlinson of Latham & Watkins said in an email that he and his colleagues “are pleased with the outcome, not only for our client but the many other companies that have been or could be subjected to costly duplicative federal and state court litigation.”

Restoration Robotics, which is now known as Venus Concept after a 2019 merger, still faces a shareholder class action in San Jose federal court over its IPO. Judge Weiner denied dismissal motions by the underwriters and venture capital firms involved in the corporation’s $23 million IPO in 2017, holding that they were not parties to the federal forum selection provision in the corporate charter.

As you know, and as Judge Weiner recounted in her decision, companies began adopting these provisions in droves after the U.S. Supreme Court held in 2018’s Cyan v. Beaver County Employees’ Retirement Fund that both state and federal courts have jurisdiction to hear shareholders’ Securities Act claims. Investors in IPOs by Blue Apron, Roku and Stitch Fix challenged the validity of the provisions in Delaware Chancery Court, contending that Securities Act claims are not internal affairs, so corporations cannot mandate where the claims are litigated. The Delaware Supreme Court, however, ruled in Sciabacucchi that Securities Act claims are intra-corporate, which means that Delaware corporate law allows companies to mandate their forum.

The Delaware justices acknowledged that it would be up to judges in other states to “respect and enforce” forum selection clauses that effectively stripped them of the jurisdiction that the U.S. Supreme Court upheld in Cyan. Citing the U.S. Supreme Court’s ruling in 1982’s Edgar v. Mite Corporation, which found an Illinois law to curb hostile takeovers to be unconstitutional under the Commerce Clause, the Sciabacucchi decision conceded that other states’ courts might be concerned about an “out-of-our-lane power grab,” and about Delaware “stepping on the toes of our sister states or the federal government.” The Delaware justices said they did not believe federal forum provisions violated the sovereignty of other states, in part because the clauses are merely procedural, regulating where shareholders can sue, rather than substantive restrictions on shareholder rights.

Restoration Robotics investors argued otherwise to Judge Weiner. After the Delaware Supreme Court’s Sciabacucchi decision, Latham renewed its dismissal motion, asserting that the company’s forum selection clause was a reasonable means of promoting efficient IPO litigation in a single forum and did not diminish shareholders’ substantive rights under California law. In their opposition brief, plaintiffs countered that the U.S. Supreme Court’s Edgar precedent holds that the Commerce Clause precludes states from enacting statutes to regulate commerce that takes place entirely outside of their borders. And the Supremacy Clause, they said, bars states from interfering with federal rights. Shareholders argued that the Delaware Supreme Court had added an unconstitutional gloss to Delaware’s corporate code by holding that the law extends beyond the traditional definition of internal affairs and by allowing corporations to override the concurrent state court jurisdiction specified in the Securities Act.

Judge Weiner appeared to express exasperation with the Delaware Supreme Court’s delineation of a category of claims that are not “internal” or “external” but, on the continuum between those poles are “intra-corporate” and therefore closer to internal affairs. (She referred to an “elliptical chart of gradations … invented” by the Delaware justices.) She also said that the Delaware opinion “provided no case law and legal analysis” to back its conclusion that federal forum provisions do not run afoul of federal law.

In particular, Judge Weiner said, the Delaware Supreme Court did not address whether, as it interpreted state law, Delaware’s corporate code “may infringe upon the extraterritorial restrictions under the Commerce Clause as enunciated in Edgar v. Mite.”

Moreover, she said, Delaware’s conclusion that corporations can condition the sale of shares on a provision restricting investors’ right to bring Securities Act claims in state court may be unconstitutional under the Commerce and Supremacy Clauses “given that the federal government has authority over securities nationally sold or traded.”

Ultimately, Judge Weiner said, it was not up to her, in the context of a motion to dismiss on jurisdictional grounds, to decide these difficult constitutional questions. But it’s notable that she found the issues important enough to address. I have a feeling that after Judge Weiner’s ruling, we’re going to see plenty more shareholders cite constitutional concerns about Securities Act forum selection clauses.