California Jurisdiction on Out of State Businesses - Criteria for Being Sued in California

Introduction:

Most businesses engage in commerce in many states and, indeed, worldwide without even realizing it. If you have a website, which is common today, then your information and, often, ads appear on every computer in the world. And if someone in one of those jurisdictions uses your products or services, you risk them claiming that you breached contract, warranty, or related causes of action in their jurisdiction and thus must face claims in their courts or before their governmental agencies.

This is becoming increasingly complex as workers in other jurisdictions perform services for businesses remotely and may make claims as to employment regulations in those jurisdictions.

Recognizing that some limit must be placed on this type of worldwide forum exposure, most courts impose criteria before an entity located in another jurisdiction can be pulled into court in their own jurisdiction. California is no exception, as a recent case demonstrated to the relief of a foreign company. In examining the lack of jurisdiction, the Court listed the criteria in clear and considered manner which is useful to examine.

Basic Law:

Before a court can impose its power over a party, it must have “jurisdiction,” and jurisdiction is divided as to “subject matter” jurisdiction and “personal jurisdiction.” Subject matter jurisdiction means that the law allows the court to hear that type of matter. Thus, Federal Courts do not hear matters in which diversity or federal law is not involved and in which the amounts in controversy do not exceed a certain amount. Thus, courts will not hear disagreements as to who won a baseball game or marathon.

Personal jurisdiction is also required and that means that the party must have somehow consented, either by actions or expressly, to the jurisdiction of the court. Normally that means engaging in business in the locale of the court or locating offices in the locale, but it requires more than just a casual connection.

The  2020 case of Farina v. SAVWCL III, LLC, had the California Court of Appeal considering the question of whether California courts may exercise personal jurisdiction over a non-California real estate developer who raised money from investors in several states through a hard money broker, but who was not aware that a portion of the funds were raised from California investors. Was that enough connection with California to allow the California court to apply both jurisdiction and California law upon this Nevada LLC which did not knowingly use the jurisdiction for its business?

A Nevada real estate developer and related individuals and entities (“Developers”) used the services of a Nevada-based hard money broker. The broker raised investments from individual investors throughout the United States and pooled the money into loans for developers. The Developers in this case used two loans so raised to purchase property in Nevada for development.

The Developers’ loans were funded by over 500 investors, the majority of whom lived in Nevada, about one-fifth of whom lived in other states and about one-tenth of whom lived in California. Each investor was a holder on the promissory notes for the subject loans, and the notes provided that the Developers would make payment to the broker’s Las Vegas address.

Each individual entered into a separate loan servicing agreement with the broker, which made the Nevada broker the lender’s agent to service each promissory note, to protect each lender’s interest in and enforce the lender’s rights under each note and, if necessary, to manage, refinance and/or sell a property. The investors would provide the loan funds to the broker, who in turn gave the money to the Developers. Loan payments from the Developers to the investors also were paid via the broker. 

A real estate crash hit and the Developers were unable to make their loan payments. The Developers, through the broker, persuaded the investors to convert their interests in the promissory notes, deeds of trust and personal guaranties on the loans, to shareholder equity in a new joint venture that would take over the development of the property. Thus, loans became equity in a joint venture and cancelling the loans became payment for the securities.

The Developers ultimately liquidated the Nevada property that was purchased with the investors’ loans at a significant loss and distributed the proceeds to the investors for a return of only 17 cents on each dollar the investors lent.

The California investors sued the Developers in California, asserting causes of action for fraud, breach of contract and elder abuse, among other things. The Developers moved to quash service for lack of personal jurisdiction, claiming that jurisdiction was proper in Nevada which had far less stringent laws on elder abuse, fraud and securities offerings.

For the purpose of this analysis, the sole issue of interest is whether the above facts rendered jurisdiction in California and the rationale used by the Appellate Court.  

1. The court emphasized that the primary concern when assessing case-linked jurisdiction is the burden that such jurisdiction imposes upon an out-of-state defendant. This encompasses not only the practical problems of litigating in a foreign court, but also “the more abstract matter of submitting to the coercive power of a State that may have little legitimate interest in the claims in question”.
2.  The court analyzed whether it was proper for California to exercise “case-linked” jurisdiction over the Developers, in which the exercise of personal jurisdiction is predicated on a defendant’s contact with the forum state. Case-linked jurisdiction exists where: (1) the defendant has purposefully availed itself of a forum state’s benefits, (2) the controversy relates to or arises out of the defendant’s contact with the forum and (3) the exercise of jurisdiction comports with “fair play and substantial justice.”
3. The issue was whether the Developers had purposely availed themselves of California’s benefits.  The court stated that a defendant purposely avails itself of a forum state’s benefits if it intentionally directs its activities at a forum such that, by virtue of the benefits the defendant receives, the defendant should reasonably expect to be hauled into the forum state’s courts. The “purposefully availed” requirement ensures that a defendant is not hauled into another state’s courts solely as a result of incidental or attenuated contacts or because of the unilateral activity of another party. The intentions and actions of one party cannot be imputed to other parties.
4. The court held that, in order to be sued in California as a result of your business activities, you must intend that your business will benefit from California. In this case, the court found that there was no reason that the Developers should have known or cared where the investors were located. The Developers received the loan funds from the Nevada broker, not from the individual investors, and made payments to the broker’s Las Vegas office, not to the individual investors. Because the Developers did not know that a portion of the loan funds came from California and did not intentionally avail themselves of the benefits of doing business with California, the Developers could not be sued in California.

Note that the court imposes rather amorphous criteria in making its decision…namely “fair play and substantial justice.” That is going to differ from court to court and means that the final decision is going to rely to some extent on the “gut reaction” of the court.

Practical Lessons:

The underlying problem/defense that the Developers had was ignorance and lack of direct connection with the investors. The usual intelligent protections that any business wishes in its documentation…arbitration and mediation of all disputes, attorney’s fees being awarded to the prevailing party, clear indication of what law and jurisdiction applies, could not be obtained because the loan agent did not advise the Developers as to its soliciting California investors nor show the Developers the documentation the loan agent was using. Thus, the Developers found themselves arguing in California with people they had no idea were involved in the transaction.

This time the Developers were fortunate in that the Court did not impose jurisdiction. Indeed, if the Developers had “approved” the contract documents the loan agent used, it could very well have resulted in enough knowing contact with California that jurisdiction could have been vested.

But the cost of the hearings on jurisdiction, including the appeal to the Court of Appeals, was probably in the hundreds of thousands of dollars in attorney’s fees and costs. This “win” already cost the Developer a tremendous amount of money and note that all that would happen next would be an action filed in Nevada alleging the very same causes of action. While Las Vegas courts and juries may be less generous than California juries, that is by no means assured and it will cost hundreds of thousands to even find out.

Ignorance is seldom bliss in business transactions. Here, it did allow the Developers to sidestep jurisdiction (at significant cost) but it could easily have gone against them.  A better approach would have been to confront the issue directly, find out what other jurisdictions were being brought into the transaction, insist upon arbitration and attorney’s fees and verbiage vesting jurisdiction in Nevada, giving rationale why that makes sense (property and witnesses there, all entities there, etc.) The use of arbitration would have saved more than half of the cost of the later litigation in terms of fees and discovery.

In short, this “win” was not as clear cut as one would think. The Courts did not find sufficient knowing contact or use of California in this particular effort at vesting jurisdiction. In weighing the equities, the Court determined there was simply not enough contact and involvement of the named defendant to California. But note that this required the Developers to rely on the documentation of the loan broker without prior approval. And the actions of the loan broker opened the door for a very expensive fight. This could have been avoided by intelligent and sophisticated drafting of the documents rather than blind reliance on the actions of a loan agent.

And the lesson for any entity is to not rely on the fact that ignorance as to the extent of one’s business activities will protect one from local jurisdiction. Contractual protection is always better. In terms of the website, requiring the user to agree by clicks to appropriate jurisdiction. For non-web transactions, either have sufficient contact with another jurisdiction to avoid California jurisdiction or create the proper contract documents that the dispute resolution is not in the expensive medium of the foreign courts.

And in determining how risky is the chance to be dragged into a foreign jurisdiction, note that most courts require more than a website or a response to an outside inquiry to bring an entity into their jurisdiction. Engaging in actual business, sending product or services into the state, having an office or locale in the state, active and continuing advertising and promotion, and having much of your business in the state can act to vest jurisdiction. The protection: be aware of your activities; have the right contract documents vesting jurisdiction where you are; and realize that the courts essentially have the underlying rule that the more you use the state for your benefit, the more likely you will be subject to their jurisdiction.