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Under Certain Circumstances, a Derivative Plaintiff Can Be Barred From All Discovery

April 1, 2014

In a recent California decision, Jones v. Martinez,1 the Second Appellate District ruled that a plaintiff who derivatively sues a Delaware corporation, cannot conduct any discovery unless first establishing the right to bring a derivative action on behalf of the corporation. In other words, the plaintiff must first establish in the complaint that appropriate demand was made on the corporation or that doing so would have been futile, explaining with sufficient facts why that was so. The bare pleading of futility was not sufficient. The court also held that a derivative plaintiff was not entitled to discovery to demonstrate demand futility.

In the Jones case, the facts are that the officers and directors of a Delaware corporation with operations based in California were sued in California by a derivative plaintiff. The trial court granted defendants’ demurrer on the ground that plaintiff had failed to adequately plead futility.

On appeal, the plaintiff did not challenge the ruling on demurrer, conceding that he failed to plead futility. Instead, the plaintiff challenged the denial of his motion to compel discovery responses, contending that California law applied and the discovery was appropriate to learn facts necessary to plead futility.

The Court of Appeal applied Delaware law on the ground that the law of the state of incorporation establishes the applicable shareholder demand and futility pleading requirements. Delaware law requires a shareholder to either serve a written pre-filing demand on the board that details the shareholder's concerns or, alternatively, plead with particularity why it would have been futile to do so.

Delaware law also precludes derivative plaintiffs from propounding formal discovery to obtain facts needed to plead futility. The Court of Appeal confirmed that California’s policy of allowing broad discovery does not override Delaware’s discovery prohibition. Thus, derivative plaintiffs must satisfy Delaware’s requirement to plead futility, with particularity, without the aid of discovery.

Shareholder plaintiffs are not left entirely without recourse. The Court of Appeal added that shareholders have other means to conduct pre-filing discovery on futility issues, including a shareholder demand to inspect corporate books and records, obtaining any publicly available SEC filings and reviewing corporate reports or minutes otherwise provided to shareholders.

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1--- Cal. Rptr. 3d ---, 2014 WL 5425628 (2d Dist., 2014).