Opinion ID: 3014744
Heading Depth: 2
Heading Rank: 1

Heading: Would demand on Merck’s board be futile?

Text: 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 7 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 8 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 9 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.