2005 Decisions

Opinions of the United

States Court of Appeals

for the Third Circuit

12-15-2005

Fagin v. Gilmartin

Precedential or Non-Precedential: Precedential

Docket No. 04-3735

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PRECEDENTIAL

UNITED STATES COURT OF APPEALS

FOR THE THIRD CIRCUIT

 

No. 04-3735

 

ELLEN FAGIN; JUDITH FAGIN,

derivatively and on behalf of

Merck & Co., Inc.,* a New Jersey

Corporation and Medco Health

Solutions, Inc., a Delaware Corporation,

Appellants

v.

RAYMOND V. GILMARTIN; JUDITH C. LEWENT;

WILLIAM B. HARRISON, JR.; HEIDI G. MILLER;

THOMAS E. SHENK; SAMUEL O. THIER;

MERCK & CO., INC.; RICHARD T. CLARK;

JOAN A. REED; RICHARD J. RUBINO;

LAWRENCE A. BOSSIDY; JEANETTA B. COLE;

WILLIAM N. KELLY; WILLIAM G. BOWEN;

NIALL FITZGERALD; ANNE M. TATLOCK;

EDWARD M. SKOLNICK; ARTHUR ANDERSEN, LLP

*MERCK & CO., INC., A New Jersey

Corporation and MEDCO HEALTH

SOLUTIONS, INC., a Delaware

Corporation,

Nominal Appellees
2

(*Amended per Clerk's Order of 2/10/05)

 

Appeal from the United States District Court

for the District of New Jersey

(D.C. Civil Action No. 03-cv-02631)

District Judge: Honorable Stanley R. Chesler

 

Argued September 29, 2005

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
3

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
4

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
5

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
6

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 crossmotion 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., 221 F.3d 472, 481
7

(3d Cir. 2000). In reviewing the motion to dismiss, we must

accept as true the facts alleged in the complaint and view them

in the light most favorable to plaintiffs. Id. at 482.

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, 499 U.S. 225, 239 (1991) (“[C]ourts of

appeals [must] review the state-law determinations of district

courts de novo.”).

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
8

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., 313 U.S. 487, 496 (1941). Under

New Jersey’s choice-of-law rules, the law of the state of

incorporation governs internal corporate affairs. See Brotherton

v. Celotex Corp., 493 A.2d 1337, 1339 n.1 (N.J. Super. Ct. Law

Div. 1985). Merck is a New Jersey corporation, so we apply

New Jersey law. The New Jersey Supreme Court recently

adopted Delaware’s demand futility standard. In re PSE & G

S’holder Litig., 801 A.2d 295, 310 (N.J. 2002). That standard

requires a plaintiff to create a reasonable doubt that either “(1)

the directors are disinterested and independent, or (2) the

challenged transaction was otherwise the product of a valid

exercise of business judgment.” Id. (adopting the test as set out

in Aronson v. Lewis, 473 A.2d 805 (Del. 1984), overruled on

other grounds by Brehm v. Eisner, 746 A.2d 244 (Del. 2000)).

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., 659 A.2d 961 (N.J.

Super. Ct. Ch. Div. 1995), cited by PSE & G, 801 A.2d at 310,

which noted that the test’s second prong does not apply to

situations in which the board has not taken an action,

Prudential, 659 A.2d at 975 (citing Rales v. Blasband, 634 A.2d

927 (Del. 1993)); see also PSE & G, 801 A.2d at 309–10.

Plaintiffs alleged that Merck’s board “failed to act” by allowing
9

Medco to continue wrongful business practices and inflate

revenue. The issue is therefore whether the second prong of the

demand futility test applies. 

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,

659 A.2d at 975.

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., 325 F.3d 795, 806 (7th Cir. 2003). 

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
10

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, 634 A.2d at 934.

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. 
11

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, 473 A.2d at 814–15. But the “mere threat of personal

liability” for a director’s actions is by itself insufficient to show

that the director is not independent or disinterested. Id. at 815.

This is similarly true for mere allegations that the directors

“approved, participated, or acquiesced in a challenged

transaction.” Grobow v. Perot, 526 A.2d 914, 924 (Del. Ch.

1987), aff’d, 539 A.2d 180 (Del. 1988). Plaintiffs allege that

demand on Medco’s board would be futile because three of the

four Medco directors also were its executives at the time of the

alleged wrongdoings. The fact that a director is also an officer,

without more, is insufficient to establish the director’s interest

or lack of independence. Cf. 2 David A. Drexler et al.,

Delaware Corporation Law and Practice § 42.03[2][a], at 42-20

(2004).

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, 634 A.2d at 936. For example, in

Rales the Court concluded that, because another court had

determined that demand futility had been established for the

board, there was a “‘substantial likelihood’” of the directors’

liability, and that established their interest. Id.

Plaintiffs argue that Medco may be subject to future
12

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, 1989 WL 133617, at *2 (Del. Ch.

Nov. 6, 1999).

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
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., 307 F.3d 556, 560 (7th Cir. 2002).

13

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-
14

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
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, 801 A.2d at 312 (stating

that demand-refused shareholders “must be permitted access to

corporate documents and other discovery” regarding the board’s

decision to reject demand), this procedural state rule does not

control in federal court. Federal Rule 23.1 governs shareholder

derivative actions. Among other things, it requires plaintiffs to

allege that they were shareholders at the time of the transaction

complained of and to state “with particularity” the efforts they

have made to secure action from the directors or, alternatively,

why they have not made such efforts. Fed. R. Civ. P. 23.1. 

The Federal Rules generally control on the matters of

procedure and are not displaced by their state counterparts

unless those state rules are substantive. See Chamberlain v.

Giampapa, 210 F.3d 154, 159 (3d Cir. 2000); cf. Hanna v.

Plumer, 380 U.S. 460, 472–74 (1965). We can find no decision

squarely on point to say whether discovery in the demandrefused situation is substantive or procedural under Federal Rule

23.1. But several questions related to other portions of Rule

23.1 have been decided. A federal court must apply a state’s

demand-futility exception under Rule 23.1. See Kamen, 500

U.S. at 108–09. Because Rule 23.1 “‘speaks only to the

adequacy of the shareholder representative’s pleadings,’” state

15

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
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, 96 F.3d 1337,

1340 n.3 (10th Cir. 1996) (internal quotation marks omitted); cf.

16
Sibbach v. Wilson & Co., Inc., 312 U.S. 1, 14 (1941). 

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).

17

Our Court faced a related situation in Kulwicki v.

Dawson, 969 F.2d 1454, 1462 (3d Cir. 1992). There, additional

materials were admitted to the record on a motion to dismiss, but

the district court judge “expressly limited his ruling to the face

of the complaint.” Id. The appellants claimed that the

additional material converted the motion to dismiss into one for

summary judgment and that, as a result, we were to review all

the materials in the record. Id. But we held that where the

district court “explicitly confines its ruling to the

complaint, . . . [appellate] review is as under a motion to

dismiss, even where additional materials were admitted into the

record.” Id. Here, on the other hand, the District Court included

facts in its opinion that seem to come only from the report; thus

to follow Kulwicki would be procrustean in this instance.

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., 998 F.2d 1192, 1196 (3d

Cir. 1993). Here, plaintiffs’ complaint references the Merck
18

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.