New Texas Shareholder Derivative Action Case: In re Crown Castle Intern. Corp., --- S.W.3d ----, 2008 WL 222770 (Tex. App.—Houston [14th Dist.] January 29, 2008).

The 14^th Court of Appeals dealt with the difficult intersection of procedural and substantive law in shareholder derivative actions. The case involves a shareholder derivative action filed in Texas state court but involving back-dated option claims on behalf of a Delaware corporation. There was no question that the Delaware substantive law applied under the Texas internal affairs doctrine. Tex. Bus. Corp. Act art. 5.14(K); Tex. Bus. Org. Code §21.562. The plaintiffs served written discovery on the corporation and its management. The defendants filed special exceptions to the plaintiffs' failure to plead futility of making a pre-suit demand. Defendants also objected to discovery on the grounds that it was premature because the plaintiffs' pleadings did not yet establish their standing to pursue derivative claims. Defendants file a motion for protection from the discovery, and the plaintiffs filed a motion to compel. The trial court held a hearing of all of these issues and granted both the special exceptions and the motion to compel. The trial court accepted the plaintiffs' contention that they needed discovery in order to satisfy the pleading requirements. Therefore, the trial court ordered the plaintiffs to replead 30 days after receipt of the discovery. Defendants brought a writ of mandamus in the court of appeals to challenge this order.

The court of appeals noted the well-settled distinction that substantive matters in shareholder derivative litigation are governed by the law of the state of incorporation; while procedural matters are governed by Texas law. The court held that Delaware law limits a shareholder's right to prosecute a derivative suit in cases where (1) the shareholder has demanded that the directors pursue the corporation's claim, but the directors have wrongfully refused to do so, or (2) demand is excused because the directors are incapable of making an impartial decision regarding such litigation, citing Rales v. Blasband, 634 A.2d 927, 932 (Del.1993); that presuit demand is excused if the derivative complaint pleads particularized facts creating a reasonable doubt that (1) the directors are disinterested and independent, or (2) the challenged transaction was the product of a valid exercise of business judgment, citing Aronson v. Lewis, 473 A.2d 805, 814 (Del.1984), overruled on other grounds by Brehm v. Eisner, 746 A.2d 244 (Del.2000); and that if either of the two prongs is satisfied, demand is excused, citing In re J.P. Morgan Chase & Co. S'holder Litig., 906 A.2d 808, 820 (Del. Ch.2005), aff'd, 906 A.2d 766 (Del.2006). In applying these principles, lawsuits filed in Delaware courts are subject to dismissal if the pleading requirements are not met, and plaintiffs are not permitted to conduct discovery until the requirements are met. Plaintiffs are not entitled to take discovery in order to prove allegations of futility, although they may employ a pre-suit demand for inspection of corporate records. Delaware courts have held that these pleading requirements are a matter of substance and not procedure. Therefore, the court of appeals conditionally granted the writ of mandamus, holding that the trial court clearly abused its discretion by ignoring Delaware substantive law.

While the opinion is clearly aimed at achieving the public policy objectives of Delaware substantive law, the court's analysis is extremely problematic and almost certainly wrong. Clearly, the requirement that a shareholder make demand on the corporation or be able to prove the futility of such a demand is a substantive limitation on the right of a shareholder to bring a derivative claim. However, the law governing how a plaintiff must plead its substantive rights in a lawsuit brought in Delaware has to be procedural; and so must the timing of discovery. Delaware civil procedure is very different from Texas procedure. Shareholder derivative claims in Delaware are brought solely in courts of Chancery, where there is no right to trial by jury. The statements of substantive law in Delaware cases are influenced greatly by a procedural system in which the judges decide shareholder cases in successive stages by motions to dismiss, and the law of fiduciary duties is a complex system of burdens of proof that flip-flop between the parties as certain evidentiary thresholds are met. However, the fact that the application of the substantive law by Delaware courts is influenced by Delaware procedure does not convert procedure into substance. It is almost impossible to convert the complex Delaware scheme of entire fairness review into instructions that can be intelligently communicated in a jury charge; but that difficulty does not enlarge the power of the court or diminish the right to a jury trial in a shareholder lawsuit in Texas governed by Delaware substantive law.

While Delaware courts may require that the elements of futility be pleaded with particularity and that discovery be stayed until the pleadings survive a motion to dismiss, those procedures are foreign to Texas law. Texas does not require fact pleading with particularity, but only fair notice to the defendant. TRCP 45(b), 47(a); State Fid. Mortg. Co. v. Varner, 740 S.W.2d 477, 480 (Tex. App.—Houston [1^st Dist.] 1987, writ denied). In Texas, there is no such thing as a motion to dismiss on the pleadings, and Texas procedural law does not provide for an automatic stay of discovery. Probably the clearest demonstration of this point is that prior to the 1997 amendments to the Texas Business Corporations Act, the Texas Rules of Civil Procedure did require a pleading of demand or futility (although not with any special requirements of particularity or a stay of discovery). Those provisions were amended out of the procedural rules when the new article 5.14 made prior demand an absolute requirement and eliminated the doctrine of futility. Notably, the current Texas statute does not require pleading of demand, but makes failure to make demand a basis for dismissal when raised by the defense. TBCA 5.14 C. The Texas statute does prescribe certain pleading requirements for actions that are subject to Texas substantive law. Art. 5.14(G). However, the statute does not alter the special exceptions practice and provide for dismissal on the pleadings. Moreover, the current Texas statute explicitly provides for a stay of discovery, but only when the corporation certifies that it is investigating the claim. Art. 5.14(D). This provision is also explicitly made a procedural provision by the statue, which applies even to foreign corporations sued in Texas. Art. 5.14(K).

Certainly a trial judge, who is sensitive to the substantive policy considerations reflected in Delaware procedural law, has the inherent authority to require a plaintiff to plead with greater particularity and to stay or adjust the schedule for discovery. However, those judgments are left to the sound discretion of the trial judge. The failure of a trial judge to stay discovery pending repleading simply cannot be the basis for mandamus relief based on clear abuse of discretion.