Opinion ID: 3014744
Heading Depth: 2
Heading Rank: 3

Heading: Did Merck’s board properly reject Plaintiffs’

Text: 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 12 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- 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 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 14 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 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 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 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 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 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.