The Court of Appeals for the Third Circuit affirmed the dismissal of an action brought against the officers and directors of pharmaceutical company Cephalon Inc, where the district court held that in order for a shareholder to plead demand futility, the allegations must not be “framed in rote, conclusory language from the caselaw,” but rather must state “particularized facts” and “identify which individual director defendants breached his or her fiduciary duties, and when those duties were breached.” King v. Baldino, No. 09-3834 (3d Cir. Dec. 14, 2010). On a sad note, on December 16, 2010, two days after this decision was filed, Frank Baldino Jr. the 57-year old founder of Cephalon, died in Philadelphia of complications related to leukemia.
Cephalon shareholder Jared King brought a derivative suit (without making demand on the company) alleging that the company’s officers and directors “failed adequately to oversee Cephalon’s sales and promotions with respect to [prescription medication such as the drug Provigil, which is used to increase alertness,] . . . [and] that the officers’ and directors’ failure in that regard resulted in large losses and potential future losses to the company arising from federal and state investigations into Cephalon’s marketing practices. . . .” In particular, King referenced a recent $425 million settlement that the company entered to resolve the investigations. The district court granted defendants’ motion to dismiss for failure to plead pre-suit demand. King appealed.
Demand Futility Standard
Federal Rule of Civil Procedure 23.1 requires derivative plaintiffs to plead with particularity “(A) any effort by the plaintiff to obtain the desired action from the directors or comparable authority and, if necessary, from the shareholders or members; or (B) the reason for not obtaining the action or not making the effort.” Fed. R. Civ. P. 23.1(b)(3). Rule 23.1 provides the pleading standard for derivative actions in federal court, while the substantive rules for determining whether a plaintiff has satisfied that standard would be a matter of state (Delaware) law.
Under Delaware law and in particular Rales v. Blasband, 634 A.2d 927, 934 (Del. 1993), the question of demand futility depends on “whether or not the particularized factual allegations . . . create a reasonable doubt that, as of the time the complaint is filed, the board of directors could have properly exercised its independent and disinterested judgment in responding to a demand.” On appeal, King did not challenge the board’s independence, but instead alleged that the directors and officers were not sufficiently “disinterested” to respond to a demand.
To sufficiently plead disinterestedness, a shareholder must establish that the directors and officers “face a ‘substantial likelihood’ of personal liability.” Citing In re Caremark International Inc. Derivative Litigation, 698 A.2d 959, 967 (Del. Ch. 1996), the Court noted that where a shareholder alleges failure to oversee the corporation, the burden is particularly high – it is “possibly the most difficult theory in corporation law upon which a plaintiff might hope to win a judgment.” To be successful with a Caremark claim, the shareholder must plead facts showing:
(1) that the directors knew or (2) should have known that violations of law were occurring and, in either event, (3) that directors took no steps in a good faith effort to prevent or remedy that situation, and (4) that such failure proximately resulted in the losses complained of.
This standard is satisfied where there is “an utter failure to oversee the corporation,” – for example, where there is no audit committee or one that did not meet. The standard can also be satisfied through facts establishing that “‘the directors were conscious of the fact that they were not doing their jobs,’” and that they “ignored ‘red flags’ indicating misconduct in defiance of their duties.” Red flags exist where the board was “aware that [the corporation’s] internal controls were inadequate.”
The Court noted that the pleadings were in conclusory fashion and failed to identify the breaching parties and the specific breaches. In fact, King did not identify the specific facts supporting his claim that Cephalon lacks adequate oversight systems. King simply identified the existence of an audit committee and compliance auditors, but “Delaware law requires the plaintiff to allege particularized facts concerning the inadequacies in the corporation’s oversight mechanisms.”
As to red flags, King only pointed to the company’s marketing and sales practices – without ever connecting such practices with the board. However, a “bad outcome” does not necessarily amount to “bad faith” as “directors’ good faith exercise of oversight responsibility may not prevent employees from violating the laws, or from causing the corporation to incur significant financial liability, or both.”
This summary was prepared by Kevin F. Brady and Ryan P. Newell.