Case Information
*3 Before: ALITO, and AMBRO, Circuit Judges RESTANI,* Chief Judge
(Opinion filed : December 15, 2005)
Jason S. Feinstein, Esquire
Sterns & Weinroth
50 West State Street
P.O. Box 1298, Suite 1400
Trenton, NJ 08607-1298
* Honorable Jane A. Restani, Chief Judge, United States Court of International Trade, sitting by designation. Jeffrey S. Abraham, Esquire (Argued) Abraham, Fruchter & Twersky
One Penn Plaza, Suite 2805
New York, NY 10119
Counsel for Appellants Daniel J. Kramer, Esquire (Argued) Paul, Weiss, Rifkind, Wharton & Garrison 1285 Avenue of the America
New York, NY 10019-6064
Gregory B. Reilly, Esquire
Deborah A. Silodor, Esquire
Lowenstein Sandler
65 Livingston Avenue
Roseland, NJ 07068
Counsel for Appellees
OPINION OF THE COURT
AMBRO, Circuit Judge
Plaintiffs in this derivative action allege that the officers and directors of Merck & Co., Inc. and Medco Health Solutions, Inc. violated their fiduciary duties to shareholders and failed to prevent harm to the corporations. Shareholders bringing, on behalf of their corporations, actions derived from alleged wrongs to those entities must make demand on the boards of directors unless to do so would be futile. Claiming demand futility as to Medco’s board and in part as to Merck’s board, plaintiffs made demand on Merck’s board to take action as to certain of their claims. In response, that board retained counsel *5 to launch a three-month investigation. Upon receiving counsel’s report, the board refused plaintiffs’ demand to sue. After plaintiffs filed their derivative claim, defendants attached the Merck counsel’s investigatory report to their motion to dismiss. Federal Rule of Civil Procedure 12(b) requires conversion from a motion to dismiss to a motion for summary judgment when materials outside the pleadings are considered. The District Court said it excluded the report, but its analysis relied on facts that seem to come only from the report. Did the apparent inclusion of the report, which was not incorporated into plaintiffs’ complaint, require that the motion to dismiss be converted into a motion for summary judgment? We believe the answer here is yes and thus remand the demand-refusal issue to be decided on summary judgment.
I. Factual Background and Procedural History Merck, a New Jersey corporation, is a global pharmaceutical company, and Medco, a Delaware corporation, was its wholly owned subsidiary. Plaintiffs Ellen Fagin and Judith Fagin are Merck shareholders. Defendant Raymond Gilmartin is Chairman and CEO of Merck. The other defendants are directors and officers of Merck or Medco. Arthur Andersen, Merck’s former auditor, was named as a defendant initially, but plaintiffs voluntarily dismissed it from the suit.
Medco is a pharmacy benefits manager; it saves its clients money by negotiating discount rates with pharmacies. When a customer buys drugs at a pharmacy, the pharmacist checks with Medco to ensure that the customer is an approved *6 beneficiary. Then the customer pays a co-payment, which goes directly to the pharmacy, not to Medco.
In January 2002 Merck announced plans to spin Medco off in an initial public offering. Merck filed its first Form S-1 with the Securities and Exchange Commission for the Medco IPO on April 17 (Merck’s final S-1 was not approved until July 9). In June 2002 The Wall Street Journal reported that Medco had been recognizing co-payments as revenue and estimated that billions of dollars in pharmacy co-payments had been recognized this way. Less than a week after this article, Merck dropped Medco’s offering price. In July 2002 Merck disclosed in an amended S-1 that Medco had recognized over $14 billion in co-payment revenue from 1999 to 2002. A few days later Merck announced that it would postpone the Medco IPO indefinitely and later canceled it completely. Merck has now been sued in several securities fraud class actions.
Merck had other troubles. In 2003 the Government and several states joined in qui tam actions against Merck and Medco, charging various wrongful business conduct violations of the federal False Claims Act, 31 U.S.C. § 3729 et seq . Merck also settled an ERISA class action suit for over $40 million in December 2002.
Plaintiffs brought a derivative claim on behalf of Merck and Medco against Merck and Medco executives, charging them with unjust enrichment because their bonuses were based in part on reported revenues, the accuracy of which was their responsibility. Plaintiffs also charged the executives and directors with a breach of fiduciary duty for their roles in the *7 companies’ troubles.
In September 2002 plaintiffs made demand on Merck’s board for claims arising from the overstatement of Merck’s revenues, but the board refused this demand in December 2002. Plaintiffs claim that demand on the Merck board for claims arising from the qui tam actions would be futile. They claim futility as well for any demand on the Medco board.
Plaintiffs filed their shareholder derivative complaint in New Jersey state court in May 2003, and in June 2003 the defendants removed it to the District Court for the District of New Jersey. Plaintiffs amended their complaint in July 2003. In September 2003 the defendants filed a motion to dismiss under Federal Rules 12(b)(6) and 23.1. Plaintiffs filed a cross- motion to convert the motion to dismiss into a motion for summary judgment, as the defendants had sent the Court a report created by Merck’s outside counsel. The District Court granted the motion to dismiss and denied the cross-motion in August 2004. Plaintiffs now appeal to our Court.
II. Jurisdiction and Standard of Review
The District Court had subject matter jurisdiction under
28 U.S.C. § 1331, as part of the claim involves the federal
securities laws. It took jurisdiction of this case under 28 U.S.C.
§ 1441 after the case was removed from the state court. Because
the Court granted a motion to dismiss under Rule 12(b)(6), we
have jurisdiction under 28 U.S.C. § 1291. We exercise plenary
review of its grant of a 12(b)(6) motion, and “we apply the same
test as the district court.”
Maio v. Aetna, Inc.
,
Although we normally would review the District Court’s
determination of demand futility for abuse of discretion, the
legal precepts used by it in making that determination have been
challenged, so we exercise plenary review here.
Blasband v.
Rales
, 971 F.2d 1034, 1040 (3d Cir. 1992);
see also Salve
Regina Coll. v. Russell
,
III. Discussion
A. Would demand on Merck’s board be futile? The District Court held that plaintiffs did not establish demand futility for the claims arising from the qui tam actions for three reasons: (1) plaintiffs did not sufficiently plead that the directors were not independent or disinterested because of their participation in the wrongful conduct or their exposure to personal liability; (2) they did not show by particularized facts that members of Merck’s board were unable to act independently because of their business and personal relationships; and (3) the complaint did not demonstrate that the Merck directors were self-interested because of their personal gain from the alleged wrongful conduct.
Plaintiffs argue that the test applied by the District Court was inapplicable because the Merck board’s conduct constituted *9 an active decision not to act rather than inaction. They also argue that, because Medco’s business conduct was unlawful, Merck’s directors were not exercising business judgment by allowing Medco to persist in this conduct.
In a case where state substantive law applies, we must
apply the forum state’s choice-of-law rules.
See Klaxon Co. v.
Stentor Elec. Mfg. Co., Inc.
,
For the second prong of the demand futility test,
PSE & G
adopted the gloss applied by another New Jersey
court,
In re Prudential Ins. Co. Deriv. Litig.
,
In its 1993
Rales v. Blasband
decision, 634 A.2d at
933–34, the Delaware Supreme Court created the second
prong’s inaction exception (later followed by
PSE & G
and
Prudential
): the demand futility test does not apply where,
inter
alia
, there was no “business decision of the board,”
id.
at 934.
The
Rales
Court suggested that a “failure to oversee
subordinates” would fall under this exception.
Id.
at 934 n.9.
Prudential
followed this suggestion, holding that a company’s
directors’ “failure to oversee both subordinates and a subsidiary
corporation” fell within the exception and thus that the second
prong—whether the contested transaction was the product of a
valid exercise of business judgment—did not apply.
Prudential
,
Plaintiffs dispute this reading of the cases and cite a
Seventh Circuit case for the propositions (1) that application of
the
Rales
test is only proper when directors were “blamelessly
unaware” of the conduct in question and (2) that when a
corporate governance structure exists, inaction is an affirmative
decision not to act.
See In re Abbott Labs. Deriv. S’holders
Litig.
,
The Abbott Laboratories opinion makes much sense, but the Seventh Circuit’s interpretation of Illinois law (which purportedly follows Delaware law) is simply not controlling in New Jersey. The New Jersey Supreme Court’s most recent opinion on the subject—although before Abbott *11 Laboratories —followed Delaware’s interpretation of Rales . We therefore follow New Jersey’s last statement on the matter and apply the Rales standard to plaintiffs’ complaint.
As noted, under Rales the second prong of the demand futility test does not apply to excuse demand on the Merck board for claims stemming from the qui tam actions, so plaintiffs’ arguments about the board’s failure to exercise business judgment are unavailing. Plaintiffs may only establish demand futility by creating a reasonable doubt that the Merck directors are “disinterested and independent.” They do not challenge the disinterestedness and independence of Merck’s directors, so we affirm the District Court’s finding that demand would not be futile.
B. Would demand on Medco’s board be futile?
Medco is a Delaware corporation, so we apply Delaware
law to determine whether demand on its board was properly
excused.
See Blasband
, 971 F.2d at 1047. This is a double
derivative suit because Medco was Merck’s subsidiary at the
time the actions leading to the
qui tam
claims arose. Under
Delaware law, a plaintiff must satisfy the test for demand futility
for the subsidiary’s board as well as for the parent’s board.
Rales
,
The District Court held that plaintiffs did not meet their burden of demonstrating demand futility, as their complaint failed to allege anything more than that Medco’s directors were executives at the time of the alleged wrongdoing. The Court thus dismissed plaintiffs’ claims against Medco.
Delaware law provides that demand on a board may be
excused if,
inter alia
, a plaintiff creates a reasonable doubt that
a majority of the directors are disinterested and independent.
Aronson
,
Plaintiffs also argue that a majority of Medco’s directors
were neither independent nor disinterested because three of
Medco’s inside directors are exposed to liability through various
claims against the company. A plaintiff can demonstrate interest
by showing that “a corporate decision [could] have a materially
detrimental impact on a director, but not on the corporation and
the stockholders.”
Rales
,
Plaintiffs argue that Medco may be subject to future
*13
litigation arising from its past wrongful business conduct and
that this future litigation could result in personal liability, and
thus interest in the outcome, for the directors. But this future
litigation is different from the current suit. In
Aronson
, as in
Rales
, the directors’ personal liability stemmed from the
transaction challenged in the derivative suit.
Cf. id.
;
Aronson
,
473 A.2d at 815. Potential liability from other, unrelated
litigation would not make Medco’s directors interested in the
decision to consider a demand for this specific derivative suit.
For example, if Medco’s directors were faced with damages
from an ERISA suit, and if plaintiffs made demand on the
Medco board for an unrelated claim, it is unlikely that the
specter of the ERISA damages would so worry the directors as
to cause them to reject plaintiffs’ demand. Were that to be the
standard for directors’ interest, any possible future litigation
could serve to create demand futility. Judgment counsels
against such an open-ended course and its unintended
consequences; thus we affirm the District Court’s opinion as to
demand futility on Medco’s board.
Cf. Decker v. Clausen
, Civ.
A. Nos. 10,684 & 10,685,
C. Did Merck’s board properly reject Plaintiffs’ demand regarding Medco’s revenue-recognition policy?
To recap, plaintiffs made demand on the Merck board in September 2002, and the board rejected that demand three months later. The District Court held that the board properly rejected the demand, but plaintiffs challenge this holding.
New Jersey’s test for whether demand was properly *14 rejected is “a modified business judgment rule.” [1] PSE & G , 801 A.2d at 312. The corporation rejecting demand has the burden of demonstrating that, in the decision to reject, the directors “(1) were independent and disinterested, (2) acted in good faith and with due care in their investigation of the shareholder’s allegations, and that (3) the board’s decision was reasonable.” Id. Although we agree generally with the District Court’s analysis of the first and third elements of this test, some concerns about its reasoning on the second element prevent us from affirming its decision on this point at this time.
After plaintiffs made demand, Merck’s board retained the law firm of Schulte Roth & Zabel, LLP to conduct an independent investigation of the issues raised in the demand letter and to advise the board what to do. Schulte Roth reviewed documents and interviewed witnesses over a three-month period, and produced a 44-page report concluding that the Merck board should reject plaintiffs’ demand. In December 2002 Schulte Roth informed plaintiffs of Merck’s decision to reject their demand. Plaintiffs sought a copy of this report, but Schulte Roth declined to provide it to them.
After plaintiffs filed their complaint, defendants filed a motion to dismiss for failure to state a claim and attached the Schulte Roth report to that motion. Plaintiffs filed a cross- *15 motion to convert the motion to dismiss into a motion for summary judgment, claiming that the submission of the report—a document outside the pleadings—made the defendants’ motion one for summary judgment. The District Court denied this cross-motion.
In the context of a Rule 12(b)(6) motion, if materials “outside the pleading are presented to and not excluded by the court, the motion shall be treated as one for summary judgment.” Fed. R. Civ. P. 12(b). Here, the District Court expressly stated that it “exclude[d] the substance of [Schulte Roth’s] report from its conclusion and thus decide[d] the motion without aid from outside materials.” Fagin v. Gilmartin , Civ. A. No. 03-2631(SRC), slip op. at 37 (D.N.J. Aug. 20, 2004). Yet its opinion includes several pieces of information that appear to have come only from the report. The Court detailed Schulte Roth’s investigation, listing the documents reviewed and the witnesses interviewed. Id. at 5, 28. The Court also described the length of the report and summarized the report’s conclusion. Id . at 5–6.
What concerns us most is the District Court’s analysis of the Merck board’s good faith in rejecting plaintiffs’ demand. The Court rested its analysis of this issue on two grounds: (1) the board’s first investigation of the revenue-recognition issue and (2) the investigation undertaken by Schulte Roth. See id. at 27–28. The facts describing both these investigations (and even a case citation, see id. at 27 n.12) seem to have come from the report. (For certain, none of these facts was derived from plaintiffs’ pleadings.) Thus, even if the Court excluded the “substance of the report” (allowing in only non-substantive *16 items like the report’s length), its analysis would have been lacking without the information derived from the report.
We therefore believe that it would be better for the District Court to consider this issue on summary judgment. In so doing, we do not intrude on the Court’s discretion as to the extent of discovery it needs to decide the issue. [2] *17 law governs the substantive demand requirements. Blasband , 971 F.2d at 1047 (quoting Kemper , 500 U.S. at 96). The question of whether the plaintiff is a “shareholder” is determined by state law, which we have held to be substantive. See Gallup v. Caldwell , 120 F.2d 90, 93 (3d Cir. 1941). A state statute requiring plaintiffs to post a bond when filing a derivative action was held to apply in federal diversity actions. Cohen v. Beneficial Indus. Loan Corp. , 337 U.S. 541, 556–57 (1949). The “standard as to the specificity of facts alleged,” however, is a federal standard. RCM Sec. Fund, Inc. v. Stanton , 928 F.2d 1318, 1330 (2d Cir. 1991).
Rule 23.1 does not address discovery, neither allowing
nor prohibiting it, so New Jersey’s mandatory-discovery rule
does not directly conflict with Rule 23.1. Without a direct
conflict, we must apply the
Erie
test to determine whether the
New Jersey law is substantive or procedural.
Chamberlain
, 210
F.3d at 161. (Of course, judge-made state common law is just
as binding as state statutes or state constitutions. 28 U.S.C.
§ 1652.) We therefore need to decide whether application of the
state rule would be outcome determinative, while keeping in
mind
Erie
’s disdain for forum shopping and inequitable
administration of the laws.
Id.
at 158–59. New Jersey’s
mandatory-discovery rule is not
per se
outcome determinative,
and the use of federal discovery law would probably not lead to
forum shopping. Moreover, the use of a single federal standard
on discovery would probably lead to more consistent
administration of the laws—though this has not yet happened,
see
Note,
Discovery in Federal Demand-Refused Derivative
Litigation
, 105 Harv. L. Rev. 1025, 1028 (1992). Also,
discovery is typically a “procedural matter . . . governed by the
Federal Rules.”
Univ. of Tex. at Austin v. Vratil
,
Our Court faced a related situation in
Kulwicki v.
Dawson
,
Merck suggests that, even if the District Court did not
exclude the report, the Court was allowed to take judicial notice
of that document. This is true, however, only if “the plaintiff’s
claims are based on the document.”
Pension Benefit Guar.
Corp. v. White Consol. Indus., Inc.
,
With this backdrop, we hold that discovery in the demand-refused context is procedural, so federal law applies here. Because federal law applies, the District Court is not bound by New Jersey’s mandatory-discovery rule, though (as noted above) limited discovery seems in order in the factual context of this case (including the District Court’s decision). *19 board’s demand-rejection process but does not explicitly discuss the report. It is mentioned in exhibits to plaintiffs’ complaint, but only insofar as their counsel and Schulte Roth were arguing over access to the report. Plaintiffs did not even receive the report until after the suit was filed, so they were not able to rely on the document to frame their complaint. As such, their claims were not “based on” the report.
IV. Conclusion
Because plaintiffs fail to show sufficiently that the Merck directors or the Medco directors were not disinterested or independent, we affirm the District Court on the issues of demand futility for Merck’s and Medco’s boards. We remand, however, the issue of demand refusal concerning Medco’s revenue-recognition policy to the District Court for consideration on summary judgment.
Notes
[1] We note that New Jersey’s modified business judgment
rule is a defense,
see PSE & G
, 801 A.2d at 312, and “the
existence of a defense does not undercut the adequacy of the
claim” on a Rule 12(b)(6) motion to dismiss,
Deckard v. Gen.
Motors Corp.
,
[2] Although the New Jersey Supreme Court’s opinion in
PSE & G
makes limited discovery a mandatory part of its
demand-refused procedure,
PSE & G
,