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Article Co-Authored with Christian Henel
The United States Supreme Court has settled a long-standing split among lower courts on the definition of a corporation’s “principal place of business” for purposes of diversity jurisdiction in federal court.

The Court held a corporation has a single principal place of business for purposes of diversity jurisdiction and that place is defined as the state where the corporation’s headquarters is located. Hertz Corp. v. Friend, No. 08-1107 (Feb. 23, 2010).

The ruling expanded upon and clarified the traditional notion of a business’s “nerve center” as applied in tests used by the 7th Circuit and sporadically in other circuits. It reverses tests in the 3rd, 4th, 5th, 6th, 7th, 8th, 10th and 11th Circuits that permitted courts to consider the extent of a corporation’s business activity in a given state as determinative of citizenship in that state. Perhaps most important, it reversed the standard in the 9th Circuit under which a corporation had a principal place of business in any state where the corporation conducted “significantly larger” operations or where its operations “substantially predominate.” Under that standard, a corporation could be considered a citizen of all 50 states – as long as it conducted significant operations in all 50 states.

By clarifying that a corporation can have only one principal place of business, the Hertz decision reduced the number of states in which a corporation is a citizen and therefore increased the likelihood that the corporation can obtain federal court jurisdiction for legal disputes.

Businesses often prefer federal courts over state courts. Among the reasons for this are predictable rules and the perceived higher quality of federal judges, on average, compared to state court judges. Anecdotally, some corporations claim to have experienced somewhat “fairer” treatment in federal court, especially in cases in which the corporation finds itself in the “home state” of its adversary.

But, federal courts have limited subject matter jurisdiction. Under 28 USC ยงยง1331 and 1332, federal subject matter jurisdiction exists only when: (1) the lawsuit asks the court to decide a federal question or (2) the lawsuit asks the court to resolve a dispute between citizens of different states and the amount in controversy exceeds $75,000. This second type of jurisdiction is known as diversity jurisdiction. Most business contract disputes do not involve federal questions, so the only basis for federal court jurisdiction is diversity.

Thus, for a federal court to exercise diversity jurisdiction, the underlying dispute must be between citizens of different states, i.e., no plaintiff in the lawsuit may be a citizen of the same state as any defendant in the lawsuit. For individuals, it is easy to determine citizenship; but courts have struggled in deciding in which state a corporation is a citizen, particularly when the corporation does business in multiple states.

Diversity jurisdiction is rooted in Article III, Section 2 of the Constitution, and ever since the Judiciary Act of 1789, Congress has authorized federal courts to use it. Beginning in 1844 and continuing for more than 100 years, a corporation was deemed to be a citizen solely of the state in which it was incorporated. In 1958, Congress modified the statute. It codified the courts’ traditional “place of incorporation” test but also provided that a corporation is a citizen of “the State where it has its principal place of business.” This change meant that corporations could be citizens of at least two states: The state of incorporation and, if different, the state where the corporation maintains its principal place of business.

But in the 60 years since the statute was changed, the circuits created a patchwork of different tests to determine where a corporation’s principal place of business was. Many of the tests were vague and were prone to outcome-determinative analyses in which a trial court could choose facts to fit the outcome it desired. The patchwork of vague tests had two negative impacts on corporations. First, it made it very difficult to predict where the corporation might be able to secure diversity jurisdiction. Consider some of the different tests:

The 3rd Circuit adopted a “center of corporate activities” test under which the corporation’s principal place of business was the state where its day-to-day headquarters was located, with day-to-day headquarters defined based on a totality of the circumstances.

The 6th, 8th and 10th Circuits adopted a version of the “total activity” test, a highly fact-specific test that does not limit principal place of business to the state containing the corporation’s headquarters.

The 2nd, 5th and 11th Circuits applied either the “nerve center” or “place of activity” test, depending on whether the court found the business to be “centralized” or “decentralized.”

The 4th Circuit applied either the “nerve center” or the “place of operations” test, depending on whether the court found the corporation to be managed actively or passively from headquarters.

The 1st Circuit applied as many as three tests, primarily employing a “nerve center test,” sometimes in combination with a “center of corporate activity” test and a “locus of operations” test.

The 9th Circuit held that a corporation’s principal place of business was located in the state where it conducted a “significantly larger” amount of its business activity or where its business activity “substantially predominates,” resorting to a “nerve center” analysis only when it cannot be said that activity predominates in a particular state.

The second negative impact for corporations was that under many of the tests, a corporation could have its principal place of business in more than one state. This meant that the corporation was a “citizen” of multiple states for diversity jurisdiction purposes: The more states in which the corporation was a citizen, the fewer states in which it could seek federal diversity jurisdiction.

The Supreme Court resolved this uncertainty by holding that a corporation’s principal place of business is located in a single state: the state where its day-to-day headquarters exists.

In Hertz, California citizens sued Hertz in a California state court. Hertz removed the case to federal court, asserting that it was not a citizen of California and that federal jurisdiction was proper. In support of this contention, Hertz submitted that its principal place of business was in New Jersey, where Hertz’s headquarters was located and where Hertz carried out all of its core executive and administrative functions.

The U.S. District Court disagreed. It applied the 9th Circuit’s test for principal place of business and concluded that Hertz’s business activity was “significantly larger” and “substantially predominated” in California. Based on this conclusion, the District Court held that Hertz was a California citizen. Because the plaintiffs also were California citizens, the District Court concluded that there was no diversity and remanded the case to state court. The 9th Circuit affirmed.

The Supreme Court reversed the 9th Circuit. After briefly describing the numerous and varied tests developed by circuit courts to identify a corporation’s principal place of business, the Supreme Court observed: “Not surprisingly, different circuits (and sometimes different courts within a single circuit) have applied these highly general multifactorial tests in different ways.”

To clarify the principal place of business issue once and for all, the Court concluded that a corporation’s principal place of business is best interpreted as “the place where a corporation’s officers direct, control, and coordinate the corporation’s activities.” The Court went on to hold that in practice, the principal place of business should be the corporate headquarters, “provided that the headquarters is the actual center of direction, control, and coordination, i.e., the “nerve center.” On the facts in the Hertz case, the Court concluded that because Hertz’s nerve center and corporate headquarters were in New Jersey, Hertz was a New Jersey citizen, and removal to federal court was proper.

In denominating the “nerve center” as a corporation’s discrete principal place of business and in providing a relatively administrable test for determining what constitutes the nerve center, i.e., corporate headquarters, the Hertz decision makes it much less likely that a corporation will be deemed a citizen of more than two places for diversity jurisdiction purposes. In turn, corporations that previously could not litigate in federal court because of diversity restrictions may find those restrictions lifted. Potential examples from the construction industry could include:

A California general contractor builds a project in California for a national developer that is incorporated in Delaware and that is headquartered in Illinois but which conducts a large part of its business in California. Assume a dispute arises and the California contractor would prefer a lawsuit in federal court. Under the previous 9th Circuit rule assigning citizenship based upon the significance of a corporation’s business activities in a state, the developer might be deemed a citizen of California on account of its substantial activity there, and the federal court would not have jurisdiction to hear the contractor’s claim. Under the new Hertz rule, the developer may only be considered a citizen of Delaware (its state of incorporation) or Illinois (its headquarters “nerve center”) but not California. Accordingly, California’s federal courts would have jurisdiction over the case.

An owner headquartered in Arizona seeks to avoid litigating a breach of warranty claim in federal court in New Mexico. It does so by arguing it is a citizen of New Mexico because it does business in New Mexico, has an office there and holds annual board meetings there. Under the 10 Circuit’s earlier “total activity” test, such activities may have been enough to confer citizenship on the owner. Under the new Hertz rule, the owner’s presence in New Mexico would not confer citizenship unless the owner was directing, controlling and coordinating its day-to-day work from the New Mexico office. Assuming these activities were instead performed in the owner’s Arizona headquarters, the owner will be deemed a citizen of Arizona, diverse in New Mexico and subject to federal court jurisdiction there.

A subcontractor in Michigan seeks to hale a Florida-based general contractor into state court in Michigan for breach of contract, and the Florida-based general contractor seeks removal to federal court. Under the 6th Circuit’s earlier “total activity” test, the subcontractor might attempt to characterize the general contractor as a Michigan citizen to defeat diversity and prevent removal. Under the new Hertz rule, the general contractor need only show that it is headquartered in Florida and its business is directed, controlled and coordinated out of Florida to establish Florida citizenship and permit removal.

The Hertz decision received little notice in the media. But for many businesses, it will prove to have been the most important decision of the year from the Supreme Court.

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Don’t email our testifying expert! Keep it all verbal – phone calls or in person. And for crying out loud, never let your expert keep drafts of his report!

 

For the last 17 years, this sort of talk has been commonplace for lawyers and clients working with testifying experts in federal court cases. But that changed at the end of 2010. A new Federal Rule of Civil Procedure 26 went into effect December 1, 2010, and it brought significant changes to the treatment of communications with experts and to draft expert reports.

Draft reports from testifying experts are now subject to work product protection. The new Rule 26 also confers work product protection on communications between lawyers and experts. But, it carves out three exceptions to that work product protection, and those exceptions may create as many problems as are solved by the work product protection conferred on the other communications.

Finally, the new Rule 26 tightened a loophole that previously only required parties to designate experts who are not specially retained – i.e., hybrid fact/expert witnesses, occasionally called “treating physician-type experts” – but not to produce a written report that sets forth their opinions. The new Rule 26 did not completely close the loophole because it did not require hybrid fact/expert witnesses to produce a full-blown report meeting the stringent requirements of Rule 26(a)(2). But it does require the party offering such testimony to produce a statement of the witness’ opinions. This statement is a watered-down version of the Rule 26(a)(2) report.

A Brief History Lesson

Historical context is critical to understanding any changes to the Federal Rules, and the changes coming this December are no exception. This history is more than passing interest. The rules spur motion practice; anecdotal evidence suggests that motion practice is very common in disputes about expert discovery. That motion practice obviously involves resort to case law, and many cases that address these issues are outdated not just by the new changes to the rules but by previous changes. Many judges know the older rules but may not be as up-to-date on the changes. Accordingly, it is necessary to be aware of the major changes to the rule throughout the last 40 years.

Expert discovery generally was off limits before 1970, with experts and their materials being deemed protected work product. The rules changed in 1970, with the addition of subsection (b)(4) to Rule 26, which allowed some discovery from testifying experts when it eliminated some privilege objections. The discovery that those changes allowed generally was limited to interrogatories. The 1970 changes did not force experts to produce reports, and their files were still considered work product. There was no clarity on whether expert depositions would be allowed. Depositions gradually became more common starting in 1970, however, and by 1993, they were the norm. The deposition of an opponent’s expert was not a procedural right, however. Either a stipulation or a court order was required.

The next sea-change came in 1993. That year saw the addition of Rule 26(a)(2)(B), which required parties to produce a written report for all specially retained testifying experts, outlining their opinions and the “data or other information considered by the witness in forming them.” Lest there be any doubt, the Advisory Committee stressed that the materials that experts relied on in forming their opinions no longer could be protected by work product privilege:

The [expert] report is to disclose the data and other information considered by the expert and any exhibits or charts that summarize or support the expert’s opinions. Given this obligation of disclosure, litigants should no longer be able to argue that material furnished to their experts to be used in forming their opinions – whether or not ultimately relied upon by the expert – are privileged or otherwise protected from disclosure when such persons are testifying or being deposed.

The revised 26(b)(4)(a) officially allowed depositions of expert witnesses without the need for consent or a court order. The Advisory Committee explained that the rules finally had caught up to standard practice: “[E]xperts who are expected to be witnesses will be subject to deposition prior to trial, conforming the norm stated in the rule to the actual practice followed in most courts, in which depositions of experts have become standard.” The 1993 revisions only allowed expert depositions after the expert’s report was served. The Committee thought that this timing requirement would shorten expert depositions and, in many cases, obviate them. But the opposite happened. Expert depositions became more common and longer.

Lawyers always try to exploit rules changes, and the 1993 revisions were no exception. It became commonplace to seek drafts of the other side’s experts’ reports. Lawyers tried to identify changes between the drafts and the final reports and then argue that the lawyers – not the experts – directed the changes. Lawyers also sought discovery of all communications between the lawyer and the expert to try to develop an argument that the lawyer improperly molded the expert’s opinions.

Of course, for every action there is an equal and opposite reaction. No sooner had it become standard to seek communications between lawyers and experts and to seek drafts of expert reports than lawyers limited their communications with experts to verbal ones only (either in person or by telephone). Lawyers also instructed their experts not to save drafts of their reports – thereby preventing discovery. In its comments on the December 2010 revisions, the Advisory Committee described some of the abuses that resulted from the 1993 revisions:

The Committee has been told repeatedly that routine discovery into attorney-expert communications and draft reports have had undesirable effects. Costs have risen. Attorneys may employ two sets of experts – one for purposes of consultation and another to testify at trial – because disclosure of their collaborative interactions with expert consultants would reveal their most sensitive and confidential case analyses. At the same time, attorneys often felt compelled to adopt a guarded attitude toward their interaction with testifying experts that impedes effective communication, and experts adopt strategies that protect against discovery but also interfere with their work.

2010 Amendments

The 2010 amendments to Rule 26 make three significant changes.

First, draft expert reports and communications between experts and lawyers (with certain defined exceptions) will be deemed work product. Revised Rule 26(b)(4)(B) creates the work product protection for draft expert reports. The format or medium of the draft expert report is irrelevant. The work-product protection extends to the draft reports “regardless of the form in which the draft is recorded”.

Revised Rule 26(b)(4)(C) creates the work-product protection for communications between lawyers and experts. Again, there are certain defined exceptions. It only excepts communications that 1) “relate to compensation for the expert’s study or testimony”; 2) “identify facts or data that the party’s attorney provided and that the expert considered in forming the opinions to be expressed”; or 3) “identify assumptions that the party’s attorney provided that the expert relied on in forming the opinions to be expressed.”

Second, the revised Rule 26(a)(2) closes a loophole that previously allowed some experts – those who were not specially retained and whose ordinary job duties did not involve giving expert testimony – to avoid the expert report requirement. Revised Rule 26(a)(2)(C) still exempts a party intending to offer testimony from a non-specially-retained expert from producing a report that conforms to the stringent requirements of a Rule 26(a)(2)(B) report. But, that party (N.B., the “party” – not the expert) must submit a disclosure with “the subject matter on which the witness is expected to present evidence” and “a summary of the facts and opinions to which the witness is expected to testify.

Third, the new Rule 26 will only require the expert report to identify “facts” that the expert considered in forming the opinions. The 1993 revisions required the expert’s report to identify a much broader scope of “other information” considered by the witness in forming the opinions.

Outlook

There are rules, and there are laws. One law that never seems to change is the law of unintended consequences. Most prior revisions to the Federal Rules of Civil Procedure have resulted in unintended consequences, and this set of revisions almost certainly will bring some unintended consequences. The imposition of work product protection on communications between lawyers and experts obviously is intended to reduce discovery disputes in which one party seeks the communications between the other party’s lawyer and its expert. But the exceptions to the work product protection may thwart the intent to reduce those disputes. Instead, the result may be that the source of the dispute merely shifts. Now, lawyers will fight over whether a particular lawyer-expert communication relates to facts or not.

One early effect of the new rules will be an expansion of privilege logs due to the fact that a greater volume of material will be subject to a claim of work product privilege. Of course, more privilege logs mean more claims of privilege to dispute.

It may very well be that the 2010 revisions create as many disputes as they resolve, but only time will tell.