New York courts should follow Delaware’s no-discovery rule once a shareholder plaintiff has made a pre-suit demand upon a corporate board that is refused, a unanimous panel on the Appellate Division, First Department held Thursday.

The so-called “demand refusal” context arises when a shareholder plaintiff in a derivative proceeding urges a board to bring suit against a corporation but the board refuses after review.

In the case at hand, Citigroup shareholder Stanley Lerner made such a demand upon the Citigroup board in 2007 to compel litigation against upper management for its alleged mishandling of assets that led to write-downs of $8 to $11 billion as the result of its investments in collateralized debt obligations and subprime mortgages.

The Citigroup board refused to bring claims based upon the recommendation of a one-person demand committee that investigated Lerner’s allegations. Lerner filed a request to compel the production of documents in connection with this review, which was overseen by independent counsel Potter Anderson & Corroon.

In an amended complaint, Lerner also alleged that the investigation was a “sham” due to its one-person make-up whose interests were allegedly aligned with Citigroup’s corporate board.

In 2010, then-Commercial Justice Bernard Fried of the Manhattan Commercial Division denied Lerner’s motion to compel discovery. A year later, he dismissed the amended complaint, saying that under the heightened pleading standard used to evaluate demand-refusal cases, Lerner failed to allege specific facts indicating the board had not acted in good faith or was unreasonable in refusing Lerner’s demand.

A four-judge panel on the First Department affirmed these trial-level decisions, engaging in an analysis that acknowledged Delaware’s strong deference to corporate directors’ management of its affairs.

Justice Karla Moskowitz, writing for the four-judge panel in Stanley Lerner v. Charles O. Prince, 650419/2009, said that the issue of discovery in derivative suits was “inextricably intertwined with the decision to act or decline to act on a shareholder demand.”

This makes the right to discovery a question of substantive, not procedural, law, said the judge, requiring the application of Delaware law where the demand requirement is “based on the ‘bedrock principle’…that a corporation’s directors, and not its shareholders, manage the corporation’s business.”

“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,” Moskowitz wrote.

The concurring judges included Rosalyn Richter, Sallie Manzanet-Daniels and Judith Gische.

The panel heard oral arguments on the motions in September 2013. Appearing for Lerner was Richard Greenfield of Greenfield & Goodman. Arguing for Citigroup’s outside directors was Richard Clary, partner at Cravath, Swaine & Moore.

Others involved in the litigation include Brad Karp, Richard Rosen and Susanna Buergel, partners at Paul, Weiss, Rifkind, Wharton & Garrison on behalf of inside directors at Citigroup; Lawrence Pedowitz and Bradley Wilson, partners at Wachtell, Lipton, Rosen & Katz, on behalf of nominal defendant Citigroup; and Jonathan Cuneo of Cuneo Gilbert & LaDuca, on behalf of Lerner.

On appeal, Lerner argued that his right to discovery was procedural and that New York law, which can permit discovery in situations where a board decides not to pursue litigation on behalf of a corporation, should govern.

The panel disagreed, stating that it was a substantive question, and that regardless of the fact that New York applied its own choice-of-forum law when deciding discovery matters, the fact that this case involved a derivative action “places it into a different context.”

Moskowitz, who sat in Manhattan’s Commercial Division from 2001 until her appointment to the appellate bench in 2008, said that to allow Lerner to proceed with discovery after his pre-suit demand was refused would “thwart the purposes underlying Delaware’s law on demand refusal—specifically, its recognition that deciding whether to pursue litigation is a decision entitled to deference under the business judgment rule.”

In addition, the panel gave no weight to Lerner’s argument that the pre-suit demand investigation was conducted in bad faith, pointing out among other things, that under Delaware law, “a board may delegate matters to a committee, and the committee may consist of ‘one of more’ directors.’ ”

The panel also held that Fried correctly exercised his discretion in refusing to convert the dismissal motions into summary judgment motions by relying on facts included only in the demand refusal letter.

Clary declined comment. Greenfield and Cuneo could not be reached for comment.