This shareholder derivative suit arises from a consent decree between Abbott Laboratories (“Abbott”) and the Food and Drug Administration (“FDA”). The action was brought in federal court on behalf of Abbott shareholders against Abbott’s board of directors alleging that the directors breached their fiduciary duties and are liable under Illinois law for harm resulting from a consent decree which required Abbott to pay a $100 million civil fine to the FDA, withdraw 125 types of medical diagnostic test kits from the United States market, destroy certain inventory, and make a number of corrective changes in its manufacturing procedures after six years of federal violations. The district court dismissed the original complaint for failure to plead demand futility with particularity under Fed.R.Civ.P. 23.1 and has now dismissed the amended com
I. BACKGROUND
Abbott, an Illinois corporation, is a diversified health care company that develops and markets pharmaceutical, diagnostic, nutritional, and hospital products. Abbott’s Diagnostics Division (“ADD”) manufactures hundreds of different kinds of diagnostic kits and devices, including tests which indicate the safety of donated blood, detect heart attacks, and identify cancerous tumors. These products are heavily regulated by the FDA and must be manufactured in accordance with the “Quality System Regulations” (“QSR”), 21 C.F.R. § 820, and the requirements of the “Current Good Manufacturing Practice” (“CGMP”), as defined in 21 C.F.R. § 820.1. These regulations expressly assign corporate management the responsibility to assure compliance with the CGMP. 21 C.F.R. § 820.20. The FDA periodically inspects manufacturing plants to ensure compliance.
During a six-year period from 1993 until 1999, the FDA conducted thirteen separate inspections of Abbott’s Abbott Park and North Chicago facilities. The inspections, some lasting for two months or longer, were conducted under a program designed not only to ensure that data and information concerning the in vitro 1 diagnostic products are scientifically valid and accurate, but to ensure that the human subjects are protected from undue hazard or risk during the course of the scientific investigations. After each inspection, the FDA first sends a Form 488 to the manufacturer which notes any deviations under the CGMP, then discusses the findings with the manufacturer’s representative, and requests a plan for correcting the violations.
In addition to the Form 483s and the ensuing follow-up after each inspection, the FDA sent four formal certified Warning Letters to Abbott. The first was sent by the FDA’s district director to David Thompson, president of ADD, on October 20, 1993, noting that an FDA on-site inspection at the North Chicago facility from April 7 through May 4, 1993 had found adulterated
2
in vitro diagnostic products not in conformance with the CGMP. The letter stated, “Failure to correct these deviations may result in regulatory action being initiated by the Food and Drug Administration without further notice. These actions include, but are not limited to seizure, injunction, and/or civil penalties.” All of the Warning Letters and follow-up letters contained that statement. A second Warning Letter from the district director was sent on March 28, 1994 to Thompson and copied to Duane Burnham, chairman of the board of directors and Chief Executive Officer (“CEO”) of Abbott. After an inspection at the Abbott Park facility, the FDA reiterated that certain in vitro diagnostic test kits had failed to comply with the CGMP. A follow-up letter from the FDA’s acting director to the manager of ADD, again copied to Burnham, was sent by overnight mail on October 11, 1994, detailing the continuing deficiencies of certain diagnostic test kits. This letter also noted that the FDA had reviewed Abbott’s responses to the 483s issued on June 10, 1994 and July 13, 1994, and requested “written documentation of any other specific steps you have taken or will be taking to correct these violations
On January 11, 1995, the Wall StReet Journal published an article discussing the fact that the FDA had “uncovered a wide range of flaws in Abbott Laboratories’ quality-assurance procedures used in assembling medical-diagnostic products, including kits to test for hepatitis and AIDS.” The article also noted that Abbott stock had fallen fifty cents to $31.25 a share.
In July 1995, the FDA and Abbott entered into a comprehensive Voluntary Compliance Plan to work “together to achieve compliance in areas recognized by FDA and Abbott to be problematic” at the Abbott Park and North Chicago facilities. On February 26, 1998, the FDA district director sent the equivalent of a Warning Letter to Abbott, stating that although the FDA “recognize[d] Abbott Laboratories’ efforts to meet all of the Compliance Plan commitments,” after finding continued deviations from the regulations, the FDA was closing out the Compliance Plan.
On March 17, 1999, the FDA district director sent the fourth and final certified Warning Letter to Miles White, a member of Abbott’s board of directors 3 and current CEO. This letter discussed the findings of adulterated in vitro diagnostic kits and other problems after an inspection at the Abbott Park facility from September 8 to November 4, 1998. The letter stated that the FDA would be conducting a re-inspection to determine the adequacy of Abbott’s compliance.
On April 13, 1999, White sold 30 percent of his Abbott stock, totaling 89,895 shares sold at $52.72 per share, receiving $4,739,264. On June 15, 1999, the March 17 Warning Letter was reported in Bloom-beRG News, a news service providing national and international financial information. The article stated that Abbott was working with the FDA to resolve the problems and noted that Abbott shares had risen slightly to close at $43.25.
On September 28, 1999, Abbott issued a press release disclosing that it had been notified by the FDA of alleged noncompliance of the CGMP and QSR. The release stated that “[although Abbott believes that it is in substantial compliance with these regulations, the FDA disagrees,” and noted that if the discussions were not successful, the FDA had advised the company that it would “file a complaint for injunc-tive relief which would include the cessation of manufacturing and sale for a period of time of a number of diagnostic products.”
On September 29, 1999, Bloomberg News reported that shares of Abbott Laboratories “fell 6.3 percent [to $37.25] after U.S. regulators threatened to halt sales of some Abbott diagnostic products on concerns about quality controls,” stating this was the latest setback “in a string of manufacturing problems for Abbott” dating from 1998 and that “the FDA has given them a swift kick to prod them into fixing things.” The article noted that ADD represented approximately 22 percent, or $2.79 billion, of Abbott’s total sales in 1998, with an operating profit of $448 million, or 13 percent of the company’s total profit. Although the article quoted a stock analyst as having a “buy” rating on the stock, the analyst also stated that he did not understand “why [Abbott] seems to have dragged their feet fixing the problems. Wall Street punishes companies that have run-ins with the FDA.”
On September 30, 1999, Abbott filed a disclosure form with the Securities and Exchange Commission (“SEC”), acknowledging it had received notification by the
In addition, under a proposed master compliance plan, Abbott was ordered to destroy under FDA supervision certain inventories of specific in vitro diagnostic kits and withdraw those kits from the U.S. market until compliance had been achieved. The suspension of these kits would result in a loss of approximately $250 million in annual revenue. In a press release following the consent decree, Abbott announced that it would take a $168 million charge against Abbott’s earnings in the third quarter of 1999 to cover the FDA fine and the loss from the unmarketable test kits.
Plaintiffs also maintain that these problems with the FDA caused the collapse of Abbott’s acquisition of Alza Corporation (“Alza”), a drug delivery company, in a planned acquisition valued at approximately $7.3 billion, which plaintiffs assert was in the best interest of Abbott. Alza shareholders were to exchange one share of Alza stock for 1.2 shares of Abbott stock. Plaintiffs allege that the directors had a motive to conceal Abbott’s quality problems because disclosure of the continuing pattern of violations over a six-year period would have possibly doomed the buyout or, at the very least, jeopardized the agreed-upon price. On December 11, 1999, Abbott announced it was abandoning the acquisition. On December 17, 1999, the Wall Street JouRNAL reported, “Wall Street and industry officials widely viewed the transaction as being in jeopardy in recent weeks because the value to Alza shareholders had fallen” following a decline in the price of Abbott’s stock after the FDA filing and consent decree.
Shortly thereafter, several Abbott shareholders brought derivative actions which have been consolidated in this case. These plaintiffs seek to hold Abbott’s directors personally liable for the extensive corporate losses which arose from the continuing FDA violations.
At the time the litigation was initiated, Abbott had thirteen directors. Two of those thirteen, Miles White, Abbott’s chairman and CEO, and Robert Parkinson, president and Chief Operating Officer, were “inside directors” who are both corporate officers and full-time Abbott employees. The remaining eleven were “outside” or “independent” directors who received a monthly stipend for their services but were not Abbott employees. At the time the suit was filed, all of the directors except for four had served on the board throughout the six-year period. 4
Plaintiffs also maintain that the directors had a duty of due diligence by signing the SEC forms, which specifically address in part government regulations in the development, manufacture, sale, and distribution of products. These forms were signed by the directors every year during the six-year period in question. As the 1996 10-K illustrates, the directors signed off on statements alluding to the regulatory problems, such as, “[Abbott’s products] are subject to comprehensive government regulation [which] substantially increases the time, difficulty, and costs incurred in obtaining and maintaining the approval to market newly developed and existing products,” “[t]he FDA’s ... approach to regulations ... will increase the cost of compliance with those regulations,” “[t]he Company’s facilities [including Abbott Park and North Shore] are deemed suitable,” “[t]he Company is involved in various claims and legal proceedings ... [and] management is of the opinion that their disposition should not have a material adverse effect on the Company’s financial position, cash flows, or results of operations.”
The plaintiffs allege that the directors met officially seven times in 1996, six times in 1997, eight times in 1998, and ten times in 1999. Plaintiffs maintain that the directors received relevant information concerning regulatory actions and that the Warning Letters, several of which were sent to the chairman of the board, and Form 483s were “clearly information that was required to be brought to the attention of the Board members by the Chairman ... who had a duty to [do so].”
Plaintiffs state that the directors were aware of the problems as several directors were also members of the Audit Committee, which “is charged with communicating regularly with Abbott management” concerning management’s assessment of business risks facing Abbott, and that one of the functions of the Audit Committee was to familiarize themselves with any risks involving the legal and regulatory framework which would affect Abbott’s operations. Plaintiffs also stated that during the relevant time period, Abbott’s proxy statements noted that the Audit Committee “met with Abbott’s internal auditors to evaluate the effectiveness of their work in ensuring that Abbott’s various departments, including its Regulatory Affairs Department [which was responsible for Abbott’s compliance with FDA regulations], operated properly.”
Plaintiffs, however, did not make any demand on Abbott’s board of directors to institute an action against themselves for breach of their fiduciary duties, stating that such a demand would have been futile, due in part to the fact that a majority of the board who would have reviewed the demand were the same directors who had been board members during the six-year period in question. Plaintiffs maintain that the facts as alleged in the complaint demonstrate that the directors “knew of the continuing pattern of noncompliance with FDA regulations and knew that the continued failure to comply with FDA regulations would result in severe penalties and yet ignored repeated red flags raised by the FDA and in media reports and chose not to bring a prompt halt to the improper conduct causing the noncompliance, nor to reprimand those persons in
The district court dismissed the complaint for failure to plead demand futility with particularity under Fed.R.Civ.P. 23.1, stating that the complaint did not plead facts to show Abbott’s directors faced a substantial likelihood of liability for their actions. Plaintiffs filed an amended complaint, which the district court again dismissed. Plaintiffs now appeal.
II. ANALYSIS
A. Standard of Review
The Seventh Circuit has held that a uniform federal-law approach applies to procedural questions which concern the allocation of responsibility between the trial court and appellate court.
See Mayer v. Gary Partners & Co.,
Given the district court’s dismissal of the case on defendants’ motion, any inferences reasonably drawn from the factual allegations of the complaint must be viewed in the light most favorable to the plaintiffs.
In re Healthcare Compare Corp. Sec. Litig.,
B. Demand Futility
Because Abbott was incorporated under the laws of Illinois, Illinois law applies in determining whether a demand may be excused when shareholders file a derivative complaint on behalf of the company.
See Kamen v. Kemper Fin. Servs., Inc.,
In a derivative suit, an individual shareholder seeks to enforce a right that belongs to the corporation.
See Kamen,
Rule 23.1 requires the plaintiff “to allege with particularity the efforts, if any, made by the plaintiff to obtain the
The “futility” exception establishes the circumstances in which the shareholder is allowed to circumvent the directors’ authority to manage corporate affairs.
See Kamen,
The shareholder must state with particularity why a demand would have been futile.
Starrels,
After carefully reviewing the plaintiffs’ complaint, we conclude that the district court erred in determining the interpretation and application of state law.
1. Rales test
The district court, in interpreting Delaware state law, applied the test for demand futility under
Rales v. Blasband,
The
Rales
court found that the “essential predicate” for applying the
Aronson
test was that “a decision of the board of directors is being challenged in the derivative suit.”
Rales,
(1) where a business decision was made by the board of a company, but a majority of the directors making the decision have been replaced; (2) where the subject of the derivative suit is not a business decision of the board; and (3) where [ ] the decision being challenged was made by the board of a different corporation.
The plaintiffs in
In re Caremark Int’l Inc. Derivative Litigation,
Director liability for a breach of the duty to exercise appropriate attention may, in theory, arise in two distinct contexts. First, such liability may be said to follow from a board decision that results in a loss because that decision was ill advised or “negligent.” Second, liability to the corporation for a loss may be said to arise from an unconsidered failure of the board to act in circumstances in which due attention would, arguably, have prevented the loss.
Id.
at 967 (citation omitted) (emphasis in original). The first setting for liability is subject to review under the business judgment rule, assuming the decision “was the product of a process that was either deliberately considered in good faith or was otherwise rational.”
Id.
(citing
Aronson,
The
Caremark
court labels the second approach as “unconsidered” failure to act,
id.
at 968, the same characterization the district .court gave in describing the board’s inaction in
Abbott.
In re Caremark
is a case where the corporation was comprised of 7,000 employees with ninety branch operations, having had a decentralized management structure, and, as a result of government investigations, had begun making attempts to centralize management oversight of the company’s business practices.
Id.
at 962. The court compared the defendants in
In re Caremark
to the defendants in
Graham,
stating that the claim asserted in both cases was only that the directors “ought to have known” of the violations, and that the directors had no duty “to ferret out wrongdoing which [the directors] have no reason to suspect exists,” particularly where “there were
no grounds for suspicion ...
and the directors were
blamelessly unaware
of the conduct leading to the corporate liability.”
In re Caremark,
As the court in
Caremark
explained, review of directors liability was “predicated upon ignorance of liability creating activities,”
Plaintiffs allege that the directors “knowingly” in an “intentional breach and/or reckless disregard” of their fiduciary duties “chose” not to address the FDA problems in a timely manner. Although
Brehm v. Eisner,
This is a case about whether there should be personal liability of the directors of a[ ] corporation to the corporation for lack of due care in the deci-sionmaking process and for waste of corporate assets. This case is not about the failure of the directors to establish and carry out ideal corporate governance practices.
The district court noted, correctly, that the plaintiffs did not allege that Abbott’s reporting system was inadequate. In Abbott, the first two Warning Letters were copied to Burnham, chairman of the board. After the Voluntary Compliance Plan was initiated in 1995, the FDA sent a letter in 1998 closing down the plan due to continued violations. The final Warning Letter was sent to White, at the time a member of the board. The directors who were members of the Audit Committee were aware of the violations. The SEC disclosure forms acknowledging noncompliance with the QSR imputes knowledge to the directors. And as early as 1995, the FDA’s problems with Abbott were public knowledge. All of these alleged facts imply knowledge of long-term violations which had not been corrected. In Abbott, reasonable inferences determined from all of the facts taken together are exactly the opposite of Caremark; members of the board in Abbott were aware of the problems. Where there is a corporate governance structure in place, we must then assume the corporate governance procedures were followed and that the board knew of the problems and decided no action was required. Therefore, we cannot agree that the Rales test is applicable in this particular factual situation.
2. Aronson test
To determine whether demand is futile under Illinois law, the Illinois courts have applied the standard set forth by the Delaware Supreme Court in
Aronson,
473 A.2d
The court in
Aronson
stated that “the entire question of demand futility is inextricably bound to issues of business judgment and the standards of that doctrine’s applicability,” explaining that the business judgment rule is “a presumption that in making a business decision the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.”
The two-pronged test in
Aronson
provides that demand futility is established if, accepting the well-pleaded facts as true, the alleged particularized facts raise a reasonable doubt that either (1) the directors are disinterested or independent or (2) the challenged transaction was the product of a valid exercise of the directors’ business judgment.
a. First prong — disinterest or independence
A disinterested director “can neither appear on both sides of a transaction nor expect to derive any personal financial benefit from [the challenged transaction] in the sense of self-dealing, as opposed to a benefit which devolves upon the corporation or all stockholders generally.”
Aronson,
In addition, plaintiffs have not pleaded sufficient facts to raise reasonable doubt as to the directors’ independence. Independence exists when “a director’s decision is based on the corporate merits of the subject before the board rather than extraneous considerations or influences.”
Aronson,
We find the plaintiffs have not pleaded specific allegations to create a reasonable doubt as to the majority of the directors’ disinterestedness or independence.
b. Second prong — business judgment
The business judgment rule is a presumption that in making a business decision, “the directors of a corporation acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company.”
Aronson,
Under
Aronson,
“the mere threat of personal liability for approving a questioned transaction, standing alone, is insufficient to challenge either the independence or disinterestedness of directors .... ”
Delaware law imposes three primary fiduciary duties on the directors of corporations; the duty of care, the duty of loyalty, and the duty of good faith.
Emerald Partners v. Berlin,
The chairman of the board received copies of the two Warning Letters in 1994 and another in early 1999. Although the district court described the language in the Warning Letters as “boilerplate” and stated that the plaintiffs “ascribe much greater importance to the warning letters than they probably deserve,”
In re Abbott,
The FDA met at least ten times with Abbott representatives, including White and other senior officers, concerning the continuing violations. The Wall Street JouRNAL published information about Abbott’s FDA problems in 1995. By 1999, even a third-party analyst questioned why Abbott continued to “drag[ ] their feet fixing the [FDA] problems.” Although Abbott sought to negate the effects of this news in its press release of 1999, the release itself substantiates the fact that the company, and, correspondingly, the board of directors, knew of the problems and were aware that the FDA had threatened to file an injunction against Abbott.
Delaware law states that director liability may arise for the breach of the duty to exercise appropriate attention to potentially illegal corporate activities from “an
unconsidered failure of the board to act
in circumstances in which due attention would, arguably, have prevented the loss.”
In re Caremark,
We also note that in
McCall v. Scott,
With respect to demand futility based on the directors’ conscious inaction, we find that the plaintiffs have sufficiently pleaded allegations, if true, of a breach of the duty of good faith to reasonably conclude that the directors’ actions fell outside the protection of the business judgment rule.
Aronson,
We note that this holding applies only with respect to demand futility and reflects no opinion as to the truth of the allegations or the outcome of the claims on the merits.
C. Directors’ Exemption Clause
The directors contend that they are not liable under Abbott’s certificate of incorpo
A director of the corporation shall not be personally liable to the corporation or its shareholders for monetary damages for breach of fiduciary duty as a director, except for liability (i) for any breach of the director’s duty of loyalty to the corporation or its shareholders, (ii) for acts or omissions not in good faith or that involve intentional miscon'duct or a knowing violation of law, (iii) under Section 8.65 of the Illinois Business Corporation Act, 5 or (iv) for any transaction from which the director derived an improper personal benefit ....
This language is identical to that of the Illinois Business Corporation Act. See 805 III. Comp. Stat. § 5/2.10(b)(3). The provision was adopted pursuant to del. Code Ann. tit. 8, § 102(b)(7), 6 which eliminates personal liability of the directors for damages for breaches of the duty of care.
Generally, when the validity of a waiver clause is not contested and where the plaintiffs allege only a breach of the duty of care, with no claims of “bad faith, intentional misconduct, knowing violation of law, or any other conduct for which the directors may be liable,” the waiver provision may be considered and applied in deciding a motion to dismiss.
See In re Baxter,
As noted, breaches other than duty of care may not exempt the directors from liability and would disable the directors from considering a demand fairly.
In re Baxter,
The Sixth Circuit followed Delaware law in
McCall
in finding that the directors’ fiduciary duties include not only the duty of care but also the duties of loyalty and good faith, stating that although “duty of care claims alleging only grossly negligent conduct are precluded by § 102(b)(7) waiver provision, it appears that duty of care claims based on reckless or intentional misconduct are not.”
In
McCall,
where the duty of care claims arose from the board’s unconscious failure to act, the Sixth Circuit held that with a Certificate of Incorporation which exempts the directors from personal liability (with language identical to the Abbott provision), “a conscious disregard of known risks, which conduct, if proven, cannot have been undertaken in good faith. Thus, ... plaintiffs’ claims are not precluded by [the companyj’s § 102(b)(7) waiver provision.”
III. CONCLUSION
For the above-stated reasons, the order of the district court is ReveRsed and the case is Remanded for further proceedings consistent with this opinion. Circuit Rule 36 shall not apply on remand.
Notes
. "In vitro” is defined as "within glass; observable in a test tube; in an artificial environment.” Dorland's Illustrated Medical Dictionary 915 (29th ed.2000).
. Under 12 U.S.C. § 351(h), a device is deemed "adulterated” if the product is not manufactured, processed, packed, or held in accordance with "current good manufacturing practices.”
. White replaced Burnham as chairman of the board of directors in April 1999.
. White and Parkinson were long-time Abbott employees. The remaining eleven directors were: J. Laurance Fuller, serving since 1988; David A. Jones, serving since 1982; Jeffrey M. Leiden, serving since April 1999; the Right Hon. Lord Owen CH, serving since 1996; Boone Powell, Jr., serving since 1985; Addison Barry Rand, serving since 1992; W. Ann Reynolds, serving since 1980; Roy S. Roberts, serving since 1998; William D. Smilhburg, serving since 1990; John R. Walter, serving since 1990; and William L. Weiss, serving since 1998.
. 805 III. Comp Stat. 5/8.65 details particular circumstances other than those specified in § 5/2.10(b)(3), and not pertinent to this case, when a corporate director may be held liable.
. The Delaware Code provides under Title 8, § 102(b)(7) that:
(b) In addition to the matters required to be set forth in the certificate of incorporation by subsection (a) of this section, the certificate of incorporation may also contain any or all of the following matters:
(7) A provision eliminating or limiting the personal liability of a director to the corporation or its stockholders for monetary damages for breach of fiduciary duty as a director, provided that such provision shall not eliminate or limit the liability of a director: (i) For any breach of the director's duty of loyalty to the corporation or its stockholders; (ii) for acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of law; (iii) under § 174 of this title; or (iv) for any transaction from which the director derived an improper personal benefit.