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29 • 2009

What Is a Pseudo Foreign Corporation?

Generally, a corporation is subject to the laws of the state in which the corporation was formed. Consequently, incorporating in Delaware, for example, is a common practice as businesses “shop” for the most favorable state corporate law advantages.

Straight forward, right?  Think again.

If branded a “pseudo foreign” corporation, California will apply California law to the company, regardless of where the corporation is formed.

Two Tests Must be Satisfied

California applies two tests for foreign, non-public, corporations that if met, would subject a foreign corporation to California law as a pseudo foreign corporation (see Corp Code §2115(b)):

1)       The “Tax-Factor” Test: Is the proportion of the corporation’s property, payroll, and sales in California compared to the company’s total property, payroll, and sales more than 50 percent during its latest full income year?  (see Corp Code §2115(a)(1)).

2)       The “Shareholder Residence” Test: Is the corporation’s outstanding voting securities held of record by persons having California addresses more than 50 percent?  (see Corp Code §2115(a)(2)).

If both tests are met (i.e., more than half of the shareholders live in California and most of the company’s business is conducted in California), California will consider the corporation a “pseudo foreign” corporation and will treat it, for certain purposes of fundamental importance to California, as if it had incorporated in California in the first place.

This means that the corporation would be subject to a “menu” of key California laws that are rooted in public policy concerns, including among others (See Corp C §2115(b)):

  • annual election of directors (Section 301)
  • removal of directors without cause (Section 303)
  • directors’ standard of care (Section 309)
  • indemnification of directors, officers, and others (Section 317)
  • shareholder’s right to cumulate votes at any election of directors (Section 708, subdivisions (a), (b), and (c))

Basically, California is trying to exert its public policies (most designed to protect minority shareholders) on corporations that are doing business in California even if the corporation has attempted to avoid California law by incorporating elsewhere.  If you want to shop around for the best corporate law and do business in California, beware that California law may trump the law of the home state of a corporation.  To learn more about the one reason that corporations are nonetheless well served to incorporate in Delaware – mobility, watch “What is the benefit of incorporating in Delaware”, http://www.eminutesonline.com/what-is-the-benefit-of-incorporating-in-delaware-watch-video/, or read “Delaware: Jurisdiction of Choice for a Mobile Generation”, http://www.eminutesonline.com/delaware-jurisdiction-of-choice-for-mobile-generation/.

Delaware Wrinkle & its Consequences

California courts have upheld Corp. Code Section 2115.  See., e.g., Wilson v Louisiana-Pacific Resources, Inc. (1982) 138 CA3d 216.  (Court upheld constitutionality of Corp C §2115 and imposed cumulative voting for directors on pseudo foreign Utah corporation).   However, the Delaware Supreme Court has repudiated the statute provision in VantagePoint Venture Partners 1996 v. Examen, Inc.,  871 A.2d 1108 (Del. 2005) (“VantagePoint”).  The court in VantagePoint affirmed the Delaware Court of Chancery ruling, relying on conflicts of law principles and the Commerce Clause of the U.S. Constitution to dismiss Section 2115 of the California corporate code.  The issue of which state law applies to a pseudo foreign corporation in California may ultimately turn on who wins the race to the courthouse in forum shopping.  In the meantime, the opposing opinions regarding Section 2115 from the California and Delaware courts will continue to leave uncertainty for foreign corporations with meaningful business in California.