Court Opinion

ID: 2996267
Source: CourtListenerOpinion
Date Created: 2015-09-24 19:26:56.640688+00
Date Added: 2024-06-11T11:45:29.189730
License: Public Domain

In the
    United States Court of Appeals
                   For the Seventh Circuit
                              ____________

No. 01-1952
IN   RE:   ABBOTT LABORATORIES DERIVATIVE
           SHAREHOLDERS LITIGATION
                       ____________
                Appeal from the United States District Court
           for the Northern District of Illinois, Eastern Division.
                 No. 99 C 7246—James B. Moran, Judge.
                              ____________
     ARGUED OCTOBER 23, 2001—DECIDED MARCH 28, 2003
                      ____________

  Before HARLINGTON WOOD, JR., CUDAHY, and KANNE,
Circuit Judges.
  HARLINGTON WOOD, JR., Circuit Judge. This share-
holder derivative suit arises from a consent decree be-
tween 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 Illi-
nois law for harm resulting from a consent decree which
required Abbott to pay a $100 million civil fine to the FDA,


  The panel issued an opinion on June 6, 2002. In re Abbott
Lab. Derivative S’holder Litig., 293 F.3d 378 (7th Cir. 2002). An
order vacating the panel opinion was issued on August 2, 2002. In
re Abbott Lab. Derivative S’holder Litig., 299 F.3d 898 (7th Cir.
2002).
2                                            No. 01-1952

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 manufactur-
ing procedures after six years of federal violations. The
district court dismissed the original complaint for fail-
ure to plead demand futility with particularity under Fed.
R. Civ. P. 23.1 and has now dismissed the amended com-
plaint for the same reason. We reverse and remand for
further proceedings.

                  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 prod-
ucts are heavily regulated by the FDA and must be manu-
factured in accordance with the “Quality System Regula-
tions” (“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 as-
sure compliance with the CGMP. 21 C.F.R. § 820.20. The
FDA periodically inspects manufacturing plants to en-
sure 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
No. 01-1952                                                       3

information concerning the in vitro1 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 483 to the
manufacturer which notes any deviations under the
CGMP, then discusses the findings with the manufactur-
er’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 adulterated2 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 reiter-
ated that certain in vitro diagnostic test kits had failed

1
  “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).
2
  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.”
4                                            No. 01-1952

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 “writ-
ten documentation of any other specific steps you have
taken or will be taking to correct these violations and
to prevent the recurrence of similar violations in cur-
rent and future studies.”
   On January 11, 1995, the WALL STREET JOURNAL pub-
lished 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 com-
prehensive 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 dis-
trict director sent the equivalent of a Warning Letter to
Abbott, stating that although the FDA “recognize[d] Ab-
bott 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
No. 01-1952                                                 5

White, a member of Abbott’s board of directors3 and cur-
rent CEO. This letter discussed the findings of adulterated
in vitro diagnostic kits and other problems after an in-
spection 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 ade-
quacy of Abbott’s compliance.
  On April 13, 1999, White sold 30 percent of his Ab-
bott 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 BLOOMBERG 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 “[a]lthough 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 com-
plaint for injunctive relief which would include the cessa-
tion 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 qual-
ity 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

3
  White replaced Burnham as chairman of the board of directors
in April 1999.
6                                            No. 01-1952

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 com-
panies 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 FDA
of noncompliance with the QSR at two of its facilities.
Abbott also reported they disagreed with the findings
of noncompliance and would fight any legal suit. On
November 2, 1999, the FDA filed a complaint for an in-
junction, detailing its problems with Abbott over the
prior six-year period. On the same date, both parties
signed a consent decree which prohibited Abbott from the
continued manufacture of certain in vitro diagnostic
devices until independent experts and FDA inspectors
deemed the two facilities in conformity with the CGMP
and FDA regulations. The decree also stated that Abbott
would pay a $100 million fine, the largest penalty ever
imposed for a civil violation of FDA regulations at that
time.
  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 com-
pliance 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 con-
sent decree, Abbott announced that it would take a $168
million charge against Abbott’s earnings in the third
No. 01-1952                                              7

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 prob-
lems 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 an-
nounced it was abandoning the acquisition. On Decem-
ber 17, 1999, the WALL STREET JOURNAL reported, “Wall
Street and industry officials widely viewed the trans-
action 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 di-
rectors” 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
8                                                   No. 01-1952

four had served on the board throughout the six-year
period.4
  In their claim for breach of fiduciary duty, plaintiffs
maintain that the directors were aware of the six-year
history of noncompliance problems with the FDA and
that they had a duty to take necessary action to correct
these problems in a division of Abbott which accounted
for 20 percent of the company’s annual revenues. They
allege that the directors demonstrated gross negligence
by ignoring the FDA problems for six years.
   Plaintiffs also maintain that the directors had a duty
of due diligence by signing the SEC forms, which specifi-
cally address in part government regulations in the de-
velopment, manufacture, sale, and distribution of prod-
ucts. 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 allud-
ing to the regulatory problems, such as, “[Abbott’s prod-
ucts] are subject to comprehensive government regula-
tion [which] substantially increases the time, difficulty,
and costs incurred in obtaining and maintaining the ap-
proval 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

4
  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. Smithburg, serv-
ing since 1990; John R. Walter, serving since 1990; and William
L. Weiss, serving since 1998.
No. 01-1952                                              9

in various claims and legal proceedings . . . [and] man-
agement is of the opinion that their disposition should
not have a material adverse effect on the Company’s fi-
nancial 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 manage-
ment’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 Ab-
bott’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 ques-
10                                              No. 01-1952

tion. Plaintiffs maintain that the facts as alleged in the
complaint demonstrate that the directors “knew of the
continuing pattern of noncompliance with FDA regula-
tions 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 involved, nor to seek
redress for Abbott for the serious damages it has sus-
tained . . . .”
  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 like-
lihood of liability for their actions. Plaintiffs filed an
amended complaint, which the district court again dis-
missed. 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 con-
cern the allocation of responsibility between the trial court
and appellate court. See Mayer v. Gary Partners & Co., 29
F.3d 330, 335 (7th Cir. 1994). State law does not govern
the relation between the trial court and the appellate
court in a diversity litigation. Id. Therefore, while the
district court was required to apply state substantive
law, appellate review is governed by federal law, which
is deferential except on questions of law. See Gasperini
v. Center for the Humanities, Inc., 518 U.S. 415, 437
(1996); Starrels v. First Nat’l Bank of Chicago, 870 F.2d
1168, 1170 (7th Cir. 1989); Powell v. Gant, 556 N.E.2d
1241, 1245 (Ill. App. Ct. 1990). Appellate review of the
No. 01-1952                                               11

legal precepts used by the district court and the court’s
interpretation of those precedents is plenary. Salve Regina
College v. Russell, 499 U.S. 225, 239 (1991) (“courts of
appeals review the state-law determinations of district
courts de novo”); Donovan v. Robbins, 752 F.2d 1170, 1178
(7th Cir. 1985).
  Given the district court’s dismissal of the case on defen-
dants’ 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 Health-
care Compare Corp. Sec. Litig., 75 F.3d 276, 279 (7th Cir.
1996).

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 deriva-
tive complaint on behalf of the company. See Kamen v.
Kemper Fin. Servs., Inc., 500 U.S. 90, 98-99 (1991). Illinois
case law follows Delaware law in establishing demand
futility requirements and uses the test to determine
demand futility set forth in Aronson v. Lewis, 473 A.2d 805
(Del. 1984), overruled on other grounds by Brehm v. Eisner,
746 A.2d 244, 253 (Del. 2000) (overruling abuse of discre-
tion standard of review on Rule 23.1 motion to dismiss
derivative suit). See Spillyards v. Abboud, 662 N.E.2d
1358, 1366 (Ill. App. Ct. 1996). Both parties correctly agree
that Delaware law controls.
  In a derivative suit, an individual shareholder seeks
to enforce a right that belongs to the corporation. See
Kamen, 500 U.S. at 95. However, given “the basic prin-
ciple of corporate governance that the decisions of a
corporation—including the decision to initiate litigation—
should be made by the board of directors or the majority
12                                                No. 01-1952

of shareholders,” most jurisdictions require a pre-suit de-
mand be made of the corporation’s board of directors. Id.
at 96. This allows the directors to exercise their business
judgment and determine whether litigation is in the best
interest of the corporation. Id.
  Rule 23.1 requires the plaintiff “to allege with particu-
larity the efforts, if any, made by the plaintiff to obtain
the action the plaintiff desires from the directors . . . and
the reasons for the plaintiff’s failure to obtain the action
or for not making the effort.” However, the requirement
of a shareholder demand is more than a pleading require-
ment, it is a substantive right of the shareholder and the
directors. See Kamen, 500 U.S. at 97. It is the law of the
state of incorporation which controls these substantive
rights and governs what excuses are adequate for failure
to make demand. See id. at 98-99, 101; Boland v. Engle,
113 F.3d 706, 710 (7th Cir. 1997).
  The “futility” exception establishes the circumstances
in which the shareholder is allowed to circumvent the
directors’ authority to manage corporate affairs. See Kamen,
500 U.S. at 102. Whether a shareholder should be al-
lowed to proceed without making demand “is based on
the application of the State’s futility doctrine . . . .” Id. at
104. As a prerequisite to a derivative action, Illinois law
requires that a demand be made unless the demand is
excused because the request would be futile. 805 ILL. COMP.
STAT. 5/7.80(b) (1999) (also referred to as § 7.80(b) of the
Business Corporation Act of 1983); see also Schnitzer v.
O’Connor, 653 N.E.2d 825, 829 (Ill. App. Ct. 1995) (stating
that demand rule 7.80(b) is “almost identical” to Fed. R.
Civ. P. 23.1).
  The shareholder must state with particularity why a
demand would have been futile. Starrels, 870 F.2d at
1170 (citations omitted). However, it is not sufficient for
the shareholder to simply state “in conclusory terms that
No. 01-1952                                             13

he made no demand because it would have been futile.” Id.
(citation omitted). Although plaintiffs have a conclusory
paragraph in their claim of demand futility, they have
also incorporated all of the detailed factual allegations.
  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, 634 A.2d 927 (Del. 1993). In Rales, the Delaware
Supreme Court was asked to determine whether the
plaintiffs had alleged facts sufficient to show that de-
mand on a board of directors was excused, accepting the
well-pleaded factual allegations of the derivative com-
plaint as true when based on a motion of dismissal. Id.
at 931. Plaintiffs pleaded that review was based upon the
two-part Aronson test. Id. at 932. The court noted that
its analysis was not limited to the Aronson test but re-
quired a determination as to whether demand was ex-
cused “under the ‘substantive law of the State of Dela-
ware.’ ” Id.
  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, 634 A.2d at 933 (citing Pogostin v. Rice, 480
A.2d 619, 624 (Del. 1984)). The court in Rales stated
that “where the board that would be considering the
demand did not make a business decision which is be-
ing challenged in the derivative suit,” there are three
scenarios in which the Aronson test would not apply:
    (1) where a business decision was made by the board
    of a company, but a majority of the directors making
14                                               No. 01-1952

     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.
Id. at 934. Given the facts in the present case that a
majority of the directors during the six years in question
remained at the time the demand was made and that
the board of a different corporation was not involved, the
district court determined that plaintiffs were alleging
an omission rather that a conscious decision of the board.
In re Abbott, 141 F.Supp.2d 946, 948 (N.D. Ill. 2001) (citing
Rales, 634 A.2d at 934). However, in arriving at this
conclusion, we find the district court failed to fully scruti-
nize Delaware case law and the necessary circumstances
for application of the Rales test.
  The plaintiffs in In re Caremark Int’l Inc. Derivative
Litigation, 698 A.2d 959, 967 (Del. Ch. 1996), charged the
board of directors with a breach of their duty of attention
or care in connection with the on-going operation of corpo-
rate business. Where there is no conflict of interest or
no facts suggesting suspect motivation, it is difficult to
charge directors with responsibility for corporate losses
for an alleged breach of care. Id. In determining the direc-
tors’ alleged breach of the duty of care, the court noted
that liability may arise from two possible situations—
liability for decisions made by the directors or liability
for the directors’ failure to monitor the actions of the
corporation.
     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
No. 01-1952                                                15

    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 consid-
ered in good faith or was otherwise rational.” Id. (citing
Aronson, 473 A.2d at 812).
  The Caremark court labels the second approach as
“unconsidered” failure to act, id. at 968, the same char-
acterization the district court gave in describing the board’s
inaction in Abbott. 141 F.Supp.2d at 948, 951 (“plaintiffs
allege an omission, rather than a conscious board decision”)
(discussing defendants’ inaction). In analyzing a case of
unconsidered failure to take action by the directors, the
court in Caremark followed the reasoning in Graham v.
Allis-Chalmers Mfg. Co., 188 A.2d 125 (Del. 1963), which
addressed the issue of director liability for corporate
losses suffered as a result of anti-trust violations. In re
Caremark, 698 A.2d at 969. “There was no claim in [Gra-
ham] that the directors knew about the behavior of . . .
employees of the corporation that had resulted in the
liability.” Id.
  In re Caremark is a case where the corporation was
comprised of 7,000 employees with ninety branch opera-
tions, 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 de-
fendants 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
16                                             No. 01-1952

were blamelessly unaware of the conduct leading to the
corporate liability.” In re Caremark, 698 A.2d at 969
(quoting Graham, 188 A.2d at 130) (emphasis added). The
court noted that the true intent of a review where there
is no “considered” board action is based more upon corpo-
rate governance—whether there is a corporate informa-
tion gathering and reporting system in existence. See id.
at 969-70.
  As the court in Caremark explained, review of directors
liability was “predicated upon ignorance of liability creat-
ing activities,” 698 A.2d at 971, where there were no
facts to indicate the directors “conscientiously permitted
a known violation of law by the corporation to occur.” Id.
at 972. Plaintiffs in Abbott allege facts that the directors
were aware of known violations, providing evidence that
there was direct knowledge through the Warning Letters
and as members of the Audit Committee. Under proper
corporate governance procedures—the existence of which
is not contested by either party in Abbott—information
of the violations would have been shared at the board
meetings. In addition, plaintiffs have alleged that, as
fiduciaries, the directors all signed the annual SEC forms
which specifically addressed government regulations of
Abbott’s products. The Abbott case is clearly distinguished
from the “unconsidered” inaction in In re Caremark.
  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, 746 A.2d
244 (Del. 2000), dealt with a shareholder derivative
action which was limited to breach of the duty of care,
we agree with the court’s analysis as to the proper ap-
plication of the Rales test.
     This is a case about whether there should be personal
     liability of the directors of a [ ] corporation to the
No. 01-1952                                              17

    corporation for lack of due care in the decisionmak-
    ing 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.
746 A.2d at 255-56. The facts in Abbott do not support
the conclusion that the directors were “blamelessly un-
aware of the conduct leading to the corporate liability.” In
re Caremark, 698 A.2d at 969 (quoting Graham, 188 A.2d
at 130).
  The district court noted, correctly, that the plaintiffs
did not allege that Abbott’s reporting system was inade-
quate. 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 direc-
tors who were members of the Audit Committee were
aware of the violations. The SEC disclosure forms ac-
knowledging noncompliance with the QSR imputes knowl-
edge 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 viola-
tions 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.
18                                             No. 01-1952

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
at 808, holding that “demand can only be excused where
facts are alleged with particularity which create a rea-
sonable doubt that the directors’ action was entitled
to the protections of the business judgment rule.” See
Spillyards, 662 N.E.2d at 1366; Powell, 556 N.E.2d at
1245; see also Starrels, 870 F.2d at 1170-71; Silver v.
Allard, 16 F.Supp.2d 966, 969 (N.D. Ill. 1998).
  The court in Aronson stated that “the entire question
of demand futility is inextricably bound to issues of busi-
ness judgment and the standards of that doctrine’s ap-
plicability,” 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.” 473 A.2d at
812. Plaintiffs have the burden of establishing facts to
rebut this presumption. Id.
  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 reason-
able 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. 473 A.2d at 814; Starrels, 870 F.2d at 1171.

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
No. 01-1952                                             19

devolves upon the corporation or all stockholders gen-
erally.” Aronson, 473 A.2d at 812. Plaintiffs have not of-
fered any specific facts to indicate that any of the direc-
tors had divided loyalties. There were no allegations of
improper motives or conflicts of interest. Nor, with the
exception of White’s sale of stock prior to the FDA’s
legal action, have plaintiffs presented allegations that
any of the other directors profited in any way by their
actions, or lack thereof. See In re Gen. Instr. Corp. Sec.
Litig., 23 F.Supp.2d 867, 874 (N.D. Ill. 1998) (using
Aronson test in finding eight directors [out of thirteen]
who sold their company stock at inflated price for over
$500 million while concealing adverse financial informa-
tion about company raised reasonable doubt as to direc-
tors’ disinterest).
  In addition, plaintiffs have not pleaded sufficient facts
to raise reasonable doubt as to the directors’ indepen-
dence. Independence exists when “a director’s decision
is based on the corporate merits of the subject before
the board rather than extraneous considerations or influ-
ences.” Aronson, 473 A.2d at 816. Although plaintiffs have
raised the allegation that perhaps one of the reasons
behind the board’s refusal to act was to conceal the extent
of Abbott’s problems while a buyout of Alza was pending,
there are no specific allegations indicating that individ-
ual directors were influenced by outside sources or consid-
erations in making decisions, or that Burnham or White
dominated or controlled the board. See id. at 815.
  We find the plaintiffs have not pleaded specific allega-
tions 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 corpora-
20                                               No. 01-1952

tion acted on an informed basis, in good faith and in the
honest belief that the action taken was in the best inter-
ests of the company.” Aronson, 473 A.2d at 812 (citations
omitted). To determine whether the complaint raises a
reasonable doubt that the directors exercised proper
business judgment, the second prong of the Aronson test
“requires us to look at both the substantive due care
(substance of the transaction) as well as the procedural
due care (an informed decision) used by the directors.”
Starrells, 870 F.2d at 1171 (citing Grobow v. Perot, 539 A.2d
180, 189 (Del. 1988), overruled on other grounds by Brehm,
746 A.2d at 253).
  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 . . . .” 473 A.2d at 815.
However, demand may be excused if “in rare cases a
transaction may be so egregious on its face that board
approval cannot meet the test of business judgment,
[resulting in] a substantial likelihood of director liability,”
id., or if the directors exhibited “gross negligence” in
breaching their duty of care. Brehm, 746 A.2d at 259 (cit-
ing Aronson, 473 A.2d at 812).
  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 Part-
ners v. Berlin, 787 A.2d 85, 90 (Del. 2001) (citing Malone
v. Brincat, 722 A.2d 5, 10 (Del. 1998)). The shareholders
of the corporation “are entitled to rely upon their board
of directors to discharge each of their three primary fidu-
ciary duties at all times.” Id.
  The chairman of the board received copies of the two
Warning Letters in 1994 and another in early 1999. Al-
though the district court described the language in the
Warning Letters as “boilerplate” and stated that the
No. 01-1952                                                21

plaintiffs “ascribe much greater importance to the warn-
ing letters than they probably deserve,” In re Abbott, 141
F.Supp.2d at 949, continuing violations of federal regula-
tions over a period of six years cannot be minimized.
Several of the directors were members of the Audit Com-
mittee, which was charged with assessing any risks in-
volved in regulatory compliance. In addition, the directors
had a fiduciary duty under the SEC to comply with “com-
prehensive government regulations” and signed SEC forms
attesting to knowledge and responsibility for government
regulation compliance, noting that “[the] Company is in-
volved in various claims and legal proceedings” regarding
these regulations, as stated in the 1996 10-K.
  The FDA met at least ten times with Abbott representa-
tives, 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, correspond-
ingly, the board of directors, knew of the problems and
were aware that the FDA had threatened to file an in-
junction against Abbott.
  Delaware law states that director liability may arise
for the breach of the duty to exercise appropriate atten-
tion 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, 698 A.2d at 967 (citation omit-
ted) (emphasis in original). The court held that “a sustained
or systematic failure of the board to exercise oversight . . .
will establish the lack of good faith that is a necessary
condition to [director] liability.” Id. at 971. In Caremark,
there was a claim of fraud with no evidence to indicate
22                                             No. 01-1952

that the Caremark directors knew of the violations of
law and the directors’ liability was “predicated upon igno-
rance” of liability-creating activities which resulted in
unconsidered failure to act. See id. Given the extensive
paper trail in Abbott concerning the violations and the
inferred awareness of the problems, the facts support a
reasonable assumption that there was a “sustained and
systematic failure of the board to exercise oversight,” in
this case intentional in that the directors knew of the
violations of law, took no steps in an effort to prevent
or remedy the situation, and that failure to take any ac-
tion for such an inordinate amount of time resulted in
substantial corporate losses, establishing a lack of good
faith. We find that six years of noncompliance, inspections,
483s, Warning Letters, and notice in the press, all of
which then resulted in the largest civil fine ever imposed
by the FDA and the destruction and suspension of prod-
ucts which accounted for approximately $250 million in
corporate assets, indicate that the directors’ decision to
not act was not made in good faith and was contrary to
the best interests of the company. See Aronson, 473 A.2d
at 812.
  We also note that in McCall v. Scott, 239 F.3d 808 (6th
Cir. 2001), amended on denial of rehearing by McCall v.
Scott, 250 F.3d 997 (6th Cir. 2001), although the court’s
decision was based upon allegations of the directors’
“unconsidered inaction,” id. at 817, the Sixth Circuit held
that the directors’ sustained failure to act against a cor-
poration’s systematic health care fraud occurring from
at least 1994 to 1996 alleged sufficient facts “to present
a substantial likelihood of liability.” Id. at 814, 819. The
plaintiffs in McCall alleged that intentional or reck-
less disregard could be inferred from the directors’ fail-
ure to act in the face of audit information, ongoing ac-
quisition practices, allegations brought against the cor-
poration in a qui tam action, a federal investigation, and
No. 01-1952                                             23

an investigation by the NEW YORK TIMES into the com-
pany’s billing practices, based on the board’s inaction
prior to 1997. Id. at 819-20. While we recognize that
there were many more specific allegations to support
individual director liability in the McCall case, the court
also noted that “the magnitude and duration of the al-
leged wrongdoing is relevant in determining whether the
failure of the directors to act constitutes a lack of good
faith.” Id. at 823. The magnitude and duration of the FDA
violations in Abbott were so great that it occasioned the
highest fine ever imposed by the FDA. We also take
into consideration that evidently neither FDA censures
nor public notice motivated the directors to take any
action concerning the problems over a six-year period,
as opposed to an approximate two-year period in McCall.
Id. at 814.
  With respect to demand futility based on the directors’
conscious inaction, we find that the plaintiffs have suffi-
ciently pleaded allegations, if true, of a breach of the
duty of good faith to reasonably conclude that the direc-
tors’ actions fell outside the protection of the business
judgment rule. Aronson, 473 A.2d at 812. The totality of
the complaint’s allegations need only support a reason-
able doubt of business judgment protection, not “a judicial
finding that the directors’ actions are not protected by
the business judgment rule.” Grobow, 539 A.2d at 186.
Under the demand futility doctrine, demand should there-
fore have been excused. Aronson, 473 A.2d at 815; see In re
Baxter Int’l, Inc. S’holders Litig., 654 A.2d 1268, 1270-71
(Del. Ch. 1995).
  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.
24                                                     No. 01-1952

C. Directors’ Exemption Clause
  The directors contend that they are not liable under
Abbott’s certificate of incorporation provision which ex-
empts the directors from liability. The Articles of Amend-
ment to Abbott’s Articles of Incorporation dated April 29,
1994, include the following provision:
      A director of the corporation shall not be personally
      liable to the corporation or its shareholders for mone-
      tary damages for breach of fiduciary duty as a direc-
      tor, except for liability (i) for any breach of the direc-
      tor’s duty of loyalty to the corporation or its sharehold-
      ers, (ii) for acts or omissions not in good faith or that
      involve intentional misconduct or a knowing viola-
      tion 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 ILL. 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

5
  805 ILL. 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.
6
    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 mone-
                                                       (continued...)
No. 01-1952                                                          25

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 con-
duct 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, 654 A.2d at 1270; see
also Zirn v. VLI Corp., 681 A.2d 1050, 1062 (Del. 1996)
(holding that breach of care claim is barred with § 102(b)(7)
waiver provision); Malpiede v. Townson, 780 A.2d 1075,
1094 (Del. 2001) (affirming dismissal of shareholder ac-
tion under 12(b)(6) where the complaint alleged only duty
of care violations and corporation’s charter had waiver
provision).
  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,
654 A.2d at 1270; Emerald Partners v. Berlin, 726 A.2d
1215, 1223-24 (Del. 1999) (holding that § 102(b)(7) is an
affirmative defense, that breach of loyalty claim falls
outside of exculpatory waiver provision, and burden of
demonstrating good faith rests with party seeking protec-
tion of the statute). Directors are not protected under a

6
    (...continued)
       tary 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 direc-
       tor derived an improper personal benefit.
26                                              No. 01-1952

§ 102(b)(7) provision when a complaint alleges facts that
infer a breach of loyalty or good faith. See Emerald Part-
ners, 787 A.2d at 94. The complaint must plead these
other claims of non-exempt conduct with sufficient par-
ticularity to permit the court to reasonably conclude the
directors’ conduct falls outside the exemption. See In re
Baxter, 654 A.2d at 1270. Where the complaint suffi-
ciently alleges a breach of fiduciary duties based on a
failure of the directors to act in good faith, bad faith ac-
tions present a question of fact that cannot be determined
at the pleading stage. Desert Equities, Inc. v. Morgan
Stanley Leverage Equity Fund, 624 A.2d 1199, 1209-10 (Del.
1993). While plaintiffs’ complaint did allege a breach of
the duty of care with grossly negligent conduct on the
part of the directors, it also, as previously discussed, al-
leged “omissions not in good faith” and “intentional mis-
conduct” concerning “violations of law,” which conduct
falls outside of the exemption and cannot be determined
at the pleading stage.
   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.” 250 F.3d at 1000; see also Emerald Partners, 787 F.3d
at 90. The McCall court noted, “To the extent that reck-
lessness involves a conscious disregard of a known risk,
it could be argued that such an approach is not one tak-
en in good faith and thus could not be liability exempted
under the [ ] statute.” Id. at 1000-01 (internal quotations
and citation omitted). The court further stated, “Under
Delaware law, the duty of good faith may be breached
where a director consciously disregards his duties to the
corporation, thereby causing its stockholders to suffer.” Id.
No. 01-1952                                              27

at 1001 (citation omitted). Plaintiffs in Abbott accused the
directors not only of gross negligence, but of intentional
conduct in failing to address the federal violation prob-
lems, alleging “a conscious disregard of known risks, which
conduct, if proven, cannot have been undertaken in good
faith.” McCall, 250 F.3d at 1001.
  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 iden-
tical 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 company]’s § 102(b)(7) waiver provi-
sion.” 250 F.3d at 1001.

                   III. CONCLUSION
  For the above-stated reasons, the order of the district
court is REVERSED and the case is REMANDED for fur-
ther proceedings consistent with this opinion. Circuit
Rule 36 shall not apply on remand.

A true Copy:
      Teste:

                        ________________________________
                        Clerk of the United States Court of
                          Appeals for the Seventh Circuit

                   USCA-02-C-0072—3-28-03