A 'Holding Company Exception' to Hertz?

Author:Vincent, Lauren
  1. INTRODUCTION

    Diversity jurisdiction, as defined in 28 U.S.C. [section] 1332, requires that all persons on one side of a controversy be citizens of different states than all persons on the other side. (1) Specifically, [section] 1332(c) provides that a corporation is "a citizen of every State. .. by which it has been incorporated and of the State .. . where it has its principal place of business." (2) Defining the phrase "principal place of business," however, has proven challenging for the federal courts. (3) As a result, for several decades, courts developed and applied a plethora of tests that muddled the question of corporate citizenship, yielding widespread inconsistent results. (4)

    After the Supreme Court of the United States announced in Hertz Corp. v. Friend (5) that a corporation's principal place of business is its "nerve center"--i.e., its "center of direction, control, and coordination"--the complexity associated with determining a corporation's principal place of business seemed to be a thing of the past. (6) Although the Hertz decision brought substantial clarity to the issue of corporate diversity jurisdiction, its one-size-fits-all test for determining principal place of business has proven less than straightforward when applied to modern corporate structures--notably, holding companies. This Note addresses one perplexing problem that Hertz's "nerve center" test failed to anticipate: How should courts determine the "principal place of business" of a corporation that is designed to engage in few, if any, substantial business activities, such as a holding corporation?

    Although some attempts have been made to reconcile the unique nature of holding corporations with Hertz's "nerve center" test, the federal courts have begun crafting rules of corporate citizenship that deviate from Hertz precedent and pronounce new rules for determining the principal place of business of holding companies. (7) The dangers of such deviation are perfectly showcased in the 2018 decision of 3123 SMB LLC v. Horn (8) where the Ninth Circuit held that a recently-formed holding corporation's principal place of business can be located where it simply plans to hold board meetings--regardless of whether any such meetings have occurred prior to the filing of a lawsuit. (9)

    This Note argues the Ninth Circuit's approach to determining the corporate citizenship of a newly-formed holding corporation strays considerably from Hertz precedent, announces a "holding company exception" to Hertz, (10) and invites small business owners to invent diversity jurisdiction through the convenient creation of holding corporations just days before filing in federal court. This Note further argues that a newly-formed holding corporation's principal place of business must not be based on where its high level officers intend to direct, control, and coordinate its activities at a future date but must instead be based on where its high-level officers are actually directing, controlling, and coordinating its activities at the time a lawsuit is filed. Finally, this Note considers the ways in which the legislature and the courts can craft and interpret diversity jurisdiction rules to address the uniqueness of holding corporation structures while remaining true to the holding announced in Hertz.

  2. FACTS AND HOLDING

    A limited liability company known as 3123 SMB LLC (the "LLC") filed a legal malpractice action against attorney Steven J. Horn ("Horn") (the "Lawsuit") in the U.S. District Court for the Central District of California after retaining Horn to represent it in an underlying property damage lawsuit. (11) Due to the complex nature of the facts in 3123 SMB, LLC v. Horn, this Part proceeds chronologically in four Sections. First, Section A summarizes the underlying property damage lawsuit filed in California state court. Second, Section B describes the creation of the LLC and the subsequent termination of Horn's representation. Third, Section C articulates the formation of Lincoln One Corporation (the "Corporation")--a holding corporation. Lastly, Section D concludes this Part with a summary of the legal malpractice lawsuit that is the subject of the diversity jurisdiction issue presented in the 3123 SMB, LLC v. Horn.

    1. The Underlying Property Damage Lawsuit

      In July of 2008, Anthony Kling and his mother, Mary Kling, brought suit against multiple defendants, (12) claiming a nearby construction project was responsible for causing subsidence damage to an apartment building they owned in Santa Monica, California. (13) The Klings retained Horn, a California attorney, to represent them in the dispute and filed their complaint in Los Angeles Superior Court. (14)

    2. The Creation of 3123 SMB LLC and Horn's Termination

      In July of 2011, three years after the original filing of their property suit, the Klings organized the LLC (15) in Missouri and listed its place of business as Clayton, Missouri. (16) The Klings resided in California, but they claimed to have family and business connections in Missouri. (17) The Klings transferred their ownership of the Santa Monica property to the LLC. (18) The LLC's sole business activity was to manage the lawsuits that arose over the destruction of the Santa Monica property, and the Klings were the only persons authorized to act on the LLC's behalf. (19)

      In October of 2013, the LLC terminated Horn's representation after Horn failed to comply with certain California local court rules. (20) As a result of Horn's errors, the trial court dismissed the LLC's case with prejudice for failure to bring the action to trial within five years--which is a violation of California Code of Civil Procedure section 583.310. (21)

    3. The Incorporation of Lincoln One

      In September of 2014, roughly one year after the LLC terminated Horn's representation, Mary Kling organized the Corporation. (22) The Corporation's Missouri attorney filed the necessary articles of incorporation and listed his office in Clayton, Missouri, as Mary Kling's address. (23) Shortly after its incorporation, the Corporation became the sole member of the LLC. (24) Mary Kling served as the Corporation's president, secretary, and only high-level officer; Anthony Kling served as a board member. (25) The Corporation's sole business was "to provide direction to [the LLC]," which included prosecution of the lawsuits concerning the damage done to the Klings' Santa Monica property. (26) The Corporation's articles of incorporation specified that its board meetings would occur in Clayton, Missouri. (27)

    4. The Legal Malpractice Lawsuit: 3123 SMB LLC v. Horn

      Twenty-five days after the Corporation's incorporation, the LLC filed the Lawsuit. (28) The LLC's complaint alleged the Central District of California had subject matter jurisdiction to hear its case because the parties were of diverse citizenship. (29) According to the LLC, Horn was properly a citizen of California and the LLC was properly a citizen of Missouri because its sole member at the time the Lawsuit was filed--the Corporation--was properly a citizen of Missouri.

      The Corporation did not engage in any "fundamental daily real estate business operations" when the LLC filed the Lawsuit. (31) Indeed, the Corporation's only conceded business operation was to hold an annual meeting in Clayton, Missouri, at which it planned to approve directors and officers, modify bylaws, and issue stock. (32) Although the Corporation's annual board meetings were described as taking place annually, no such meetings had been held at the time the Lawsuit was filed. (33) Neither Anthony nor Mary Kling visited Missouri between the date of the Corporation's incorporation and the filing of the Lawsuit. (34) In October of 2015, subsequent to the filing of the Lawsuit, the Corporation held one board meeting in Clayton, Missouri. (35)

      Horn moved to dismiss the Lawsuit for lack of subject matter jurisdiction, arguing that, under the "nerve center" test set forth by the Supreme Court of the United States in Hertz Corp v. Friend, the Corporation was properly a citizen of California. (36) In so arguing, Horn relied on the following language of the Court from Hertz:

      [I]f the alleged 'nerve center' [of a corporation] is nothing more than a mail drop box, a bare office with a computer, or the location of an annual executive retreat, the court should instead take as the true 'nerve center' the place of actual direction, control, and coordination .. .. (37) On this foundation, Horn argued the Corporation's incorporation in Missouri and intent to hold board meetings in Clayton, Missouri, sometime in the future was not enough to establish its corporate nerve center in Missouri. (38) According to Horn, the LLC's principal place of business for purposes of diversity jurisdiction must have been California because the LLC provided no evidence that Mary Kling directed its activity from Missouri or anywhere besides California. (39) Therefore, because Horn was also a citizen of California, Horn argued the case was not between diverse parties and could not be heard in federal district court pursuant to the diversity jurisdiction requirements set forth in [section] 1332. (40)

      The LLC opposed Horn's motion to dismiss the Lawsuit. (41) Because the Corporation's sole business purpose was managing lawsuits, the LLC argued that the Corporation's activities "took place in conjunction with its outside counsel due to the narrow nature of its activities." (42) Put another way, the LLC argued that because its attorney is a citizen of Missouri, it, too, should be considered a citizen of Missouri.

      The Central District of California agreed with Horn and dismissed the Lawsuit for lack of subject matter jurisdiction, (43) concluding that California rather than Missouri was the Corporation's principal place of business under Hertz's "nerve test." (44) The court found that there was "no evidence that any of the operations of [the Corporation] are directed, controlled, or...

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