California Court of Appeal Affirms: Early Discovery Will Not Be Permitted to Aid Derivative Plaintiff in Stating a Claim
Under Delaware law, before a private plaintiff can file a derivative lawsuit against a corporation’s officers or directors, he or she must either make a demand on the board or plead with particularity that it would be futile to do so.
The Shareholder Demand Requirement
The right to manage the affairs of a corporation is vested in the company’s board of directors. To prevent stockholders from usurping that right, a stockholder that believes the company should pursue legal action must ordinarily make a demand on the company’s board to take such action.
In Jones, the California court considered the scope of the internal affairs doctrine in connection with Delaware’s demand futility requirements. Delaware law precludes shareholder plaintiffs from obtaining discovery to aid the plaintiff in alleging demand futility to survive an early dispositive motion (e.g., motion to dismiss) under Court of Chancery Rule 23.1. The plaintiff attempted to argue that California’s procedural rules governing the right to discovery trumped Rule 23.1’s prohibitions. Jones directly addressed the issue of whether California’s policies on discovery could override Delaware’s rules precluding discovery in a matter of first impression in California.
Jones and Discovery in Shareholder Derivative Actions
Danny Jones owned 1,900 shares of Deckers common stock.
On appeal, Jones argued that the trial erred in applying Delaware law, rather than California law, to a “purely procedural matter concerning the timing of discovery.”
The Court of Appeal determined that no such right to discovery existed. Highlighting the “fundamental principle of Delaware law” that “directors, not shareholders, manage the affairs of the corporation,”
Jones May Result in More Books and Records Demands
The Court of Appeals decision in Jones demonstrates California’s deference to the substantive law of the company’s state of incorporation in connection with derivative lawsuits. It is now clear in California that a shareholder plaintiff may not leverage lenient procedural rules favoring discovery to aid in challenging the business and affairs of a Delaware corporation. The decision confirms the long-standing position that defendant corporations have taken in defending derivative actions in Delaware to foreclose premature discovery in demand futility derivative actions that would otherwise potentially distract the company’s board of directors from the daily operations of the company. Therefore, the decision is not a game-changer, but instead precludes another avenue for plaintiffs’ lawyers to escape Delaware law. While prospective shareholder plaintiffs may heed the advice of the Court of Appeal and seek discovery through alternative means, namely inspection demands to review a corporations books and records, these avenues will lead back to the Delaware Court of Chancery, which is well equipped to handle these demands and their narrow purpose. Corporations should be mindful of these shareholder rights to inspection and consult counsel on the appropriate response in the event a shareholder requests access to certain records.
_Partner Joshua G. Hamilton and associates D. Scott Carlton, Timothy D. Reynolds, and Scott M. Klausner contributed to this alert. _If you have any questions concerning these developing issues, please do not hesitate to contact any of the following Paul Hastings lawyers:__
Mark D. Pollack
Samuel W. Cooper
John S. Durrant
Joshua G. Hamilton
Howard M. Privette
William F. Sullivan
Douglas H. Flaum
Kevin C. Logue
Barry G. Sher
Peter M. Stone
Christopher H. McGrath
Grace A. Carter
Paul Hastings LLP
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