U.S. Supreme Court Narrows Definition of Corporate Citizenship – Opening Door to Federal Courts

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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 §§1331 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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