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Delaware Law Applies to Internal Affairs of a Delaware Corporation Operating in Massachusetts.

With some exceptions, we have long recommended that corporate management choose Delaware over Massachusetts as the state of incorporation, in order to take advantage of Delaware’s procedural efficiencies and legal structure.

However, it has been somewhat unsettled whether Massachusetts courts would apply Delaware law to the internal affairs of a Delaware corporation operating in Massachusetts, leaving open the potential that some of the benefits sought under Delaware law might be denied by a Massachusetts court applying Massachusetts law.

In March 2001, the Massachusetts Supreme Judicial Court decided a case that resolved this issue, holding that the law of the state of incorporation governs matters of a corporation’s internal affairs.

In this case, Harrison v. NetCentric Corporation, Kevin Harrison, a founding stockholder of the Internet software company NetCentric, sued NetCentric, its CEO, four of its directors and two VC firms that had invested in NetCentric, claiming (among other things) that the other stockholders had breached their fiduciary duty to Harrison by terminating Harrison’s employment.

Under Massachusetts law, stockholders in a “close corporation” (generally, a closely held corporation with significant participation by its stockholders in corporate management and operations) owe each other a duty of “utmost good faith and loyalty.” This means that a stockholder can be liable for a wide variety of actions that may be construed as discriminatory toward other stockholders, including termination of employment under some circumstances. Except in limited circumstances, this duty does not exist under Delaware law.

Because NetCentric’s main office and operations were based in Massachusetts, Harrison argued that Massachusetts law should apply to his fiduciary duty claim, and after losing in the trial court he appealed this issue to the SJC. Indeed, Harrison could not succeed unless the SJC held that Massachusetts law took precedence over Delaware Massachusetts law. Harrison’s hopes were not baseless – in 1997 the SJC, in the widely publicized Demoulas case (which involved dueling owners of a grocery store chain), applied Massachusetts law to corporate claims of breach of fiduciary duty in the case of a corporation that initially had been incorporated in Delaware and later reincorporated in Massachusetts.

In a straightforward opinion, however, the SJC made it clear that its decision in Demoulas was limited to the particular facts present in that case, and that it had never intended to overrule a long case history of applying the law of the state of incorporation to matters of a corporation’s internal affairs. Since Delaware law does not contemplate a stockholder’s fiduciary duty under the NetCentric facts, the SJC would not impose one.

With NetCentric, the SJC eliminated any remaining uncertainty as to the applicability of Delaware law to the internal affairs of a corporation incorporated in Delaware but operating in Massachusetts. It did not, however, direct how Massachusetts courts would treat similar claims made with regard to a corporation that originally incorporated in Massachusetts and then reincorporated in Delaware. It is unclear, under those facts, whether Delaware or Massachusetts law would apply. Based on Demoulas, which had a reincorporation in the opposite direction (from Delaware to Massachusetts), it appears likely that a court’s decision in such a case will depend on timing (when the disputed acts occurred relative to the timing of the reincorporation) and on further evolution of the Demoulas decision by Massachusetts courts. Since reincorporation in Delaware is a common occurrence among Massachusetts corporations, we can expect the Massachusetts courts to examine this question in the future.