Fagin v. Gilmartin

Opinions of the United
2005 Decisions 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Precedential or Non-Precedential: Precedential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
 (*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

2
 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

3
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

4
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

5
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

6
(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

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.

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.

10
 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

11
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

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 demand-
refused 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.

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.

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