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Posted: May 23, 2014

Organization State Law Determines Whether Derivative Action Plaintiff is Entitled to Discovery on Demand Refusal

On May 22, 2014, the First Department issued a decision in Lerner v. Prince, 2014 NY Slip Op. 03763, holding in a derivative action, the law of the state of organization, not the forum state, determines whether the plaintiff is entitled to discovery on the basis for the refusal of its demand.

In Lerner, the nominal-defendant corporation’s directors denied the plaintiff’s demand that it sue its “senior management, including present and former . . . officers and directors, for alleged mismanagement of the company’s subprime assets.” The plaintiff amended his complaint to add “causes of action including breach of fiduciary duty and aiding and abetting breaches of fiduciary duty” against the board and “also alleged that defendants had wasted corporate assets by causing” the corporation” to expend millions of dollars in an investigation that was allegedly a sham.”

The defendants moved to dismiss. The plaintiff then sought pre-answer discovery on the refusal of his demand. The trial court denied the plaintiff’s motion to compel and granted the defendants’ motion to dismiss. The First Department affirmed. It explained that the trial court properly denied the plaintiff pre-answer discovery, explaining:

Because New York is the forum state, New York’s choice-of-law principles determine whether a particular issue — in this case, the availability of discovery — is substantive or procedural. Under New York choice-of-law rules, matters of procedure are governed by the law of the forum. On the other hand, New York choice-of-law rules provide that substantive issues such as issues of corporate governance, including the threshold demand issue, are governed by the law of the state in which the corporation is chartered — here, Delaware.

We find that plaintiff’s right to discovery in this demand-refused case is a substantive question, rather than a procedural one, and therefore is governed by Delaware law. Although New York courts have applied the law of the forum when deciding matters, such as discovery, affecting the conduct of the litigation, that this case is a purported derivative action places it into a different context. The demand requirement is based on the bedrock principle of Delaware law that a corporation’s directors, and not its shareholders, manage the corporation’s business. Thus, the Delaware law on discovery is an integral part of the legal framework governing derivative proceedings; indeed, it is inextricably intertwined with the decision to act or decline to act on a shareholder demand. Were Delaware law to permit discovery in a demand-refused derivative action, it would essentially obviate the directors’ authority to decide, under the business judgment rule, whether litigation was in the corporation’s best interests — the very reason underlying the demand requirement. The decision whether to permit discovery once directors have refused a demand is therefore a substantive question, going directly to the basis of the purported derivative suit.

Under Delaware law, plaintiffs in a derivative suit are not entitled to discovery to assist their compliance with the particularized pleading requirement of Delaware Chancery Court Rule 23.1 in a case of demand refusal.

. . .

We also note that, even assuming for the sake of argument that New York law applies, plaintiff would not be entitled to discovery in this demand-refused case. Courts applying New York law in demand-refused cases presume that a board of directors’ decision was the exercise of valid business judgment. Therefore, where, as here, a complaint fails to set forth allegations overcoming the presumption that the board’s decision resulted from that valid judgment, courts will properly deny a plaintiff’s discovery request. Indeed, the purpose of discovery is to find out additional facts about a well-pleaded claim, not to find out whether such a claim exists.

(Internal citations and quotations omitted) (emphasis added).

This decision illustrates the additional level of complexity to which litigators must be sensitive in derivative actions.

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