432 F.3d 276 (3rd Cir. 2005), 04-3735, Fagin v. Gilmartin

Docket Nº:04-3735.
Citation:432 F.3d 276
Party Name:Ellen FAGIN; Judith Fagin, derivatively and on behalf of Merck & Co., Inc., * a New Jersey Corporation and edico 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
Case Date:December 15, 2005
Court:United States Courts of Appeals, Court of Appeals for the Third Circuit

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432 F.3d 276 (3rd Cir. 2005)

Ellen FAGIN; Judith Fagin, derivatively and on behalf of Merck & Co., Inc., * a New Jersey Corporation and edico Health Solutions, Inc., a Delaware Corporation, Appellants


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.

No. 04-3735.

United States Court of Appeals, Third Circuit.

December 15, 2005

Argued Sept. 29, 2005.

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

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Jason S. Feinstein, Sterns & Weinroth, Trenton, NJ, Jeffrey S. Abraham, (Argued), Abraham, Fruchter & Twersky, New York, NY, for Appellants.

Daniel J. Kramer, (Argued), Paul, Weiss, Rifkind, Wharton & Garrison, New York, NY, Gregory B. Reilly, Deborah A. Silodor, Lowenstein Sandler Roseland, NJ, for Appellees.

Before ALITO, and AMBRO, Circuit Judges and RESTANI, [**] Chief Judge.

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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 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 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

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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 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 cross-motion 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 (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

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the Merck board's conduct constituted 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., 202 N.J.Super. 148, 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., 173 N.J. 258, 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., 282 N.J.Super. 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....

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