California Court of Appeal Applies Delaware Law to Deny Discovery in Shareholder Derivative Action
In Jones v. Martinez, 230 Cal. App. 4th 1248 (2014), the California Court of Appeal, Second Division, held that a plaintiff asserting a shareholder derivative action against directors of a Delaware corporation in a California state court may not obtain discovery before the plaintiff establishes legal standing to sue derivatively as required under Delaware law. Under Delaware law, a stockholder-plaintiff may not prosecute a derivative suit unless he alleges that he demanded that the directors pursue the claim and the directors have wrongfully refused to do so, or that such demand is excused because it would have been futile. In order for pre-suit demand to be excused as futile, the stockholder-plaintiff must plead particularized facts creating reasonable doubt that the directors were unlikely to act in good faith in considering the demand. Delaware courts hold routinely that a derivative plaintiff is not entitled to discovery unless and until he has met the threshold standard for pleading demand futility. The decision in Jones marks the first time that a California appellate court has applied this rule to a derivative plaintiff suing in California state court under Delaware law.
Plaintiff held fewer than 2,000 shares of stock in Deckers Outdoor Corporation (“Deckers”) when he filed a shareholder derivative action on behalf of Deckers to recover damages he claimed Deckers suffered because of alleged misconduct by various Deckers officers and directors, including its CEO. The California Superior Court for Santa Barbara County sustained defendants’ demurrer with leave to amend, but plaintiff did not file an amended complaint. The trial court thereafter dismissed the action. Plaintiff appealed, asserting the trial court erred by applying Delaware law, instead of California law, to bar the discovery requests he served upon Deckers shortly after his complaint was filed.
The Court of Appeal agreed that a stockholder seeking to qualify as a plaintiff in a derivative action involving a Delaware corporation may not obtain discovery unless he first complies with the particularized pleading requirement of Delaware Court of Chancery Rule 23.1, outlining the demand requirements in shareholder derivative actions. Thus, plaintiff was not entitled to discovery before first establishing his right to sue derivatively.
In arriving to its ultimate decision, the Jones court addressed an issue that often arises in shareholder derivative actions: whether the demand requirement as a prerequisite to obtaining discovery is a substantive or procedural requirement. Under California law, matters of procedure are governed by the law of the forum whereas substantive issues are governed by the law of the state in which the corporation is incorporated. While issues related to discovery are generally viewed as procedural matters, under United States Supreme Court precedent, demand requirements for a derivative suit are determined by the law of the state of incorporation and are thus substantive in nature. See Kamen v. Kemper Financial Services, Inc., 500 U.S. 90, 96-97 (1991). Delaware’s discovery rules are part of its substantive law and are an integral part of its framework for shareholder derivative actions. The Jones Court observed that the demand requirement was a substantive right, and not simply a technical rule of pleading. In treating the demand requirement as a substantive matter, the court applied Delaware law and concluded that a derivative plaintiff would not be entitled to discovery in order to demonstrate demand futility.
Jones represents a departure from an oft-cited California Court of Appeal decision holding that, as a general rule, defendants may not refuse to respond to discovery on the ground that pleading issues had not yet been resolved. See Mattco Forge, Inc. v. Arthur Young & Co., 223 Cal. App. 3d 1429, 1436 n.3 (1990). The Mattco Forge court upheld an award of sanctions against the defendant for refusing to comply with discovery requests and held that the plaintiff could take discovery even after a demurrer was sustained in order to obtain facts to support its case. Jones essentially rejected Mattco Forge in the context of shareholder derivative cases brought in California, making clear that “[t]he proper purpose of discovery in a shareholder derivative action is to find out additional facts about a well-pleaded claim, not to find out whether such a claim exists.”
The Jones Court recognized that there is a presumption that directors generally act in a manner that is faithful to their fiduciary duties and noted that a plaintiff who seeks to overcome this presumption must do so at the pleading stage before the company or its officers and directors are asked to respond to discovery requests. The Court suggested that rather than relying upon discovery from the corporation’s directors and officers, derivative plaintiffs should instead consult and use the “tools at hand,” such as making an inspection demand under Section 220 of the Delaware General Corporation Law or taking the steps necessary to obtain the facts from publicly available SEC filings. Jones represents a welcome decision for defendants and corporations involved in shareholder derivative litigation because it protects corporations from having to expend resources in complying with discovery requests based solely on shareholder-plaintiffs’ unfounded opinions and conclusions and establishes that plaintiffs who seek to pursue such claims will have to clear a higher hurdle before obtaining discovery to bolster their claims.