Significant Texas Decision of First Impression Holds Shareholder Inspection Rights are "Internal Affairs."
On Thursday, January 27, 2022, the Houston Court of Appeals (1st District) issued a significant decision resolving an issue of first impression in Texas. The question was whether shareholder inspection rights are included within the Internal Affairs Doctrine that is codified in the Texas Business Corporations Act. The Internal Affairs Doctrine, codified in Texas law, provides that the law of the state of incorporation governs the “internal affairs” of a corporation. Therefore, a foreign corporation doing business in Texas is not subject to Texas law, but is instead governed by the law of its home state, with respect to its “internal affairs.” What are “internal affairs?” Section 1.105 of the Texas Business Organizations Code defines a company’s internal affairs to “include: (1) the rights, posers, and duties of its governing authority, governing persons, officer, owners, and members; and (2) matters relating to its membership or ownership interests.” On its face, a common sense approach to the language would seem to indicate that a shareholder’s right to inspect corporate documents would fit within this definition, but it is not that simple. Section 9.203 of the Code provides that, as to foreign corporations doing business in Texas, “each member, owner, or managerial official of the entity is subject to the same duties, restrictions, penalties, and liabilities imposed on a domestic entity to which it most closely corresponds or on a member, owner, or managerial official of that domestic entity.” Many other jurisdictions have held that inspection rights are not within the ambit of the Internal Affairs Doctrine. This is an issue that significantly affects foreign corporations doing business in Texas and, heretofore, was a thorny, unsettled matter of Texas law. We have previously addressed the complexities of this issue in this blog: https://shareholderoppression.com/blog/do-texas-inspection-laws-apply-to-foreign-corporations-part-one and https://shareholderoppression.com/blog/do-texas-inspection-laws-apply-to-foreign-corporations-part-two.
In the First Court of Appeals’ case, Hartman Income REIT, Inc. v. MacKenzie Blue Ridge Fund III, L.P., No. 01/20-00218-CV, the Texas appellate court resolved this issue in favor of a common sense reading of the Code and held that inspection rights are subject to the Internal Affairs Doctrine. Hartman is a real estate investment trust (REIT) – a special kind of corporation whose purpose is to invest in real estate and which receives favorable tax treatment. REIT’s are governed by their own chapter in the Texas Business Organizations Code, but its provisions basically track the provisions of the for-profit corporations chapter. Hartman was incorporated in Maryland, but essentially all of its business, investments, and its headquarters are in Texas. Most REIT’s nationwide incorporate under Maryland law, similar to the practice of virtually all public corporations incorporating under Delaware law. McKenzie is an investment fund that purchased shares in Hartman. At the time of the controversy, McKenzie held approximately 4500 shares, or 0.03% of the total shares, of Hartman Income REIT. McKenzie issued a demand to inspect Hartman’s corporate records, particularly the current list of names and addresses of current members, the number of shares held by each, and the transfer records. The stated purpose was to “exercise [] shareholder rights under federal proxy and tender offer laws,” and “to contact other shareholders about buying or selling shares.” Hartman is a public corporation for purposes of SEC reporting and regulation, but there is no established public market for its shares. This gives the company considerable power to regulate the buying and selling of shares and the price of those transactions. Therefore, the information requested by MacKenzie was kept confidential and closely guarded by Hartman. Hartman denied the request. MacKenzie filed suit for a writ of mandamus to compel the inspection of the requested records. Both sides moved for summary judgment. The trial court denied Hartman’s motion, granted MacKenzie’s motion, and ordered the inspection. Hartman appealed. And the appellate court reversed the judgment of the trial court and rendered judgment in favor of Hartman.
The sole dispute was of the choice of law. Under Maryland law, a shareholder could only demand inspection of records if that shareholder owned 5% of the total shares outstanding. Since MacKenzie owned far less than 5% and Hartman was a Maryland corporation, Hartman asserted that MacKenzie had no right to see the shareholders list. Under Maryland law, Hartman was right. If Maryland law governed MacKenzie’s inspection rights, then MacKenzie would have no right to see the shareholder list. However, MacKenzie contended that since Hartman was operating completely within Texas, Texas law should govern its inspection rights. Under the Texas Code, a shareholder has the right to inspect, including gaining access to the shareholders list, if that shareholder owns 5% OR has owned the shares for at least six months. Furthermore, Texas common law recognizes an even broader right to inspect for any shareholder. The difference between the statutory and common law rights are that under the statute the shareholder only has the obligation to “state” a proper purpose, while under the common law the shareholder must prove that he has a proper purpose for the inspection. The statute also provides penalties for noncompliance that the common law does not. If Texas law governed, then MacKenzie would be entitled to the shareholders list. The entire issue came down to the application of the Internal Affairs Doctrine. If inspection rights are “internal affairs” within the meaning of the Code, then Maryland law would apply, and MacKenzie would not get the list. If inspection rights were not “internal affairs,” then Texas law would apply, and MacKenzie would be entitled to obtain the shareholders list. No Texas court had ever before grappled with this issue.
The Texas First Court of Appeals chewed on the issue for almost two years before rendering its decision. The opinion, issued Thursday, January 27, 2022, held that inspection rights are within the Internal Affairs Doctrine. Therefore, Maryland law governs the request for the list, and Hartman had the right to deny the request. The court held that statutory interpretation was chiefly a matter of common sense reading of the plain language. Under that reading, a shareholder’s right to inspect documents clearly was a right stemming from ownership of his shares and was thus within the definition of internal affairs. The apparent conflict with Section 9.203 was no conflict at all because that section plainly stated that the Internal Affairs Doctrine took precedence.
Next the court had to deal with the numerous cases from foreign jurisdictions seeming to reach a contrary result under similar state laws. The court of appeals started by noting that judicial opinions from foreign jurisdictions are not binding authority on a Texas court dealing with issues of Texas. No matter how persuasive might be the reasoning, the plain language of a Texas statute governs. However, in this case, the court also found all the cited foreign authority to be distinguishable. Almost all of the cases were quite old and did not deal with the Internal Affairs Doctrine as a choice of law issue. These cases dealt with whether the state had the power to regulate shareholder inspections at all, not which state was entitled to regulate inspections. Really, only one case was directly comparable. Sadler v. NCR Corp., 928 F.2d 48 (2d Cir. 1991) dealt with a shareholder in a Maryland REIT that was based in New York seeking the shareholder’s list. The REIT had refused to provide that list based on Maryland law, but the Second Circuit had ruled for the shareholder. However, the reason why was that New York had a statute making the submitting to New York shareholder inspection laws a condition of doing business in the state. Texas has nothing similar.
Finally, the court dealt with the application of Texas common law. The court noted the authority that inspection rights under Texas common law are even broader than under the Code. However, none of these cases apply that common law to a foreign corporation. In effect, the court held that the Internal Affairs Doctrine determines choice of law for both Texas statutory and common law, which it clearly does. It would have been helpful if the court had actually said that.
Hartman Income REIT, Inc. was represented by the Fryar Law Firm — in its last case before our colleague Eric Fryar retired from the practice of law. Click below to read a complete copy of the opinion authored by Justice Kelly and joined by Chief Justice Radack and Justice Landau.
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