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September 21, 2005.

RHODA KANTER, Plaintiff,
HANS M. BARELLA, et al., Defendants.

The opinion of the court was delivered by: JEROME SIMANDLE, District Judge


The primary issue in this Rule 23.1 shareholder derivative action is whether Plaintiff's failure to make any demand on MedQuist's board of directors prior to instituting this suit may be excused. Because Plaintiff has failed to plead with the requisite particularity facts creating "a reasonable doubt that, as of the time the complaint was filed, the board that would be addressing the demand could have impartially considered its merits without being influenced by improper considerations," In re Sagent Tech., Inc., Derivative Litig., 278 F. Supp. 2d 1079, 1087 (N.D. Cal. 2003) (citing Rales v. Blasband, 634 A.2d 927, 934 (Del. 1993)), the Complaint will be dismissed with prejudice.*fn1 I. BACKGROUND

  According to the Complaint, Plaintiff Rhoda Kanter is, and has been at all relevant times, the owner of shares of common stock of MedQuist, Inc. ("MedQuist" or the "Company"). The Company, headquartered within the District of New Jersey, is a provider of medical transcription and healthcare information services.*fn2 The instant dispute centers on the billing practices utilized by MedQuist for its transcription services.

  According to the Complaint, the Company's billing system utilizes a computer program to "count" characters in each line of a formal report. (Id. ¶ 29.) The program then creates an invoice which is mailed to MedQuist's customers. The Company's charges are represented to its customers as being calculated on a basis of cost per line within each transcript.*fn3 (Id. ¶ 30.) MedQuist's pricing contracts with its customers define "line" for purposes of determining cost as an "AAMT line." An AAMT line is defined as any line having 65 "characters." A character is defined as any letter, number, symbol or function key necessary for the final appearance and content of a document including, without limitation, the space bar, carriage return, underscore, bold and any characters contained within the macro, header, or footer. A defined line is calculated by counting all characters contained within a document and simply dividing the total number of characters by 65 to arrive at the number of defined lines. Client acknowledges that the charges set forth in this Agreement are based upon the fact that character counts shall be determined using Vendor's software system and shall not be derived from any third party software or interfact system.

 (Id. ¶ 32.) According to the Complaint, MedQuist systematically inflated its line counts by, for instance, counting the same letter as multiple characters. (Id. ¶ 33.)

  On March 16, 2004, MedQuist filed a Form 12b-25 Notification of late filing with the Securities and Exchange Commission ("SEC") disclosing that the filing of its Form 10-K for the year ending December 31, 2003 would be delayed pending completion of an independent review of the Company's billing practices. (Id. ¶ 24.) The Complaint alleges that this review was initiated in response to assertions made by a Company employee regarding the alleged unlawful billing scheme. (Id.) On July 30, 2004, MedQuist announced key findings of the independent review conducted by Debevoise & Plimpton LLP and PricewaterhouseCoopers, LLP. (Id. ¶¶ 25-26.)

  In short, the independent review allegedly revealed an unlawful billing scheme. Those findings were announced to the Board of Directors, which ultimately took disciplinary action against five Company employees. (Id. ¶ 25.) On September 9, 2004, a class action was filed in the Central District of California arising from the alleged billing scheme. (Id. ¶ 27.) On October 29, 2004, MedQuist issued a press release announcing that its Board of Directors had concluded that the Company's previously issued financial statements included in its Form 10-K for the fiscal year ending December 31, 2002, its Form 10-Q filed during 2002 and 2003, and all earnings releases and similar communications relating to such periods, should no longer be relied upon. (Id. ¶ 39.)

  On November 12, 2004, Plaintiff filed this derivative action on behalf of MedQuist pursuant to Rule 23.1, Fed.R.Civ.P., against Koninklijke Philips Electronic N.V. ("Philips"), which is alleged to be MedQuist's controllong shareholder, and ten individual current and former MedQuist directors.*fn4 As discussed more fully below, Plaintiff alleges that for the period 2001 through 2004 Defendants violated their fiduciary duties to the Company by (1) permitting artificial inflation of billing figures; (2) failing to adequately ensure accurate and lawful billing practices; and (3) failing to accurately report the Company's true financial condition in its published financial statements. (Id. ¶ 23.) According to Plaintiff, all of the named individual defendants were serving as board members at the time the Complaint was filed.*fn5 (Pl. Br. at 5.) According to MedQuist, at the time the Complaint was filed the MedQuist board was comprised of six directors, three of whom were independent (Messrs. Ruttenberg, Stowe and Underwood) and three of whom were employed by Defendant Philips or a Philips related entity (Messrs. Hommen, Rusckowski and Weisenhoff). (MedQuist Br. at 3-4.) Philips owns 71% of the common stock of MedQuist and is alleged in the Complaint to control MedQuist.*fn6 (Compl. ¶ 14.)

  Plaintiff concedes that she failed to make any demand on the Board pursuant to Rule 23.1, Fed.R.Civ.P., prior to instituting this action. Defendants have moved to dismiss the Complaint in its entirety, asserting, inter alia, insufficient pleading of demand futility and liability bar defenses.

  This Court has diversity jurisdiction over the subject matter pursuant to 28 U.S.C. § 1332. II. DISCUSSION

  A. Demand Futility

  Defendants argue that the Complaint should be dismissed pursuant to Rule 23.1, Fed.R.Civ.P., because Plaintiff failed to make any demand on the board of directors prior to commencing this action. Plaintiff argues that demand on the board would have been futile and, thus, that the Court should excuse any such failure.*fn7 For the reasons now explained, that failure was fatal to the Complaint.

  Rule 23.1, Fed.R.Civ.P., which governs shareholder derivative actions, provides in pertinent part:
In a derivative action brought by one or more shareholders . . . to enforce a right of a corporation . . ., the corporation . . . having failed to enforce a right which may be properly asserted by it, the complaint shall be verified and shall allege (1) that the plaintiff was a shareholder . . . at the time of the transaction of which the plaintiff complains . . ., and (2) that the action is not a collusive one to confer jurisdiction on a court of the United States which it would not otherwise have. The complaint shall also allege with particularity the efforts, if any, made by the plaintiff to obtain the action the plaintiff desires from the directors or comparable authority . . ., and the reasons for the plaintiff's failure to obtain the action or for not making the effort.
The demand requirement in Rule 23.1 "speaks only to adequacy of the shareholder representative's pleadings," and does not itself create a demand requirement. Kamen v. Kemper Financial Services, Inc. 500 U.S. 90, 97 (1990). "[T]he function of the demand doctrine in delimiting the respective powers of the individual shareholder and of the directors to control corporate litigation clearly is a matter of `substance,' not `procedure.'" Id. Thus, courts hearing a shareholder derivative action apply federal procedural rules in determining whether the allegations in the complaint satisfy the particularity requirement, and state substantive law to determine whether demand would have been futile so as to excuse demand.

  "The purpose of requiring that the complaining shareholder demand action from the board of directors before bringing suit under Rule 23.1 is related to the concept that a shareholder derivative suit is a device to be used only when it is clear that the corporation will not act to redress the alleged injury to itself." 7C Charles Alan Wright, Arthur R. Miller and Mary K. Kane, Federal Practice and Procedure § 1831 (2d ed. 1986). The demand requirement "recognizes the right of the corporate directory to corporate control; in other words, to make the corporation paramount, even when its rights are to be protected or sought through litigation." Delaware & Hudson Co. v. Albany & Susquehanna R.R. Co., 213 U.S. 435, 447 (1909). The power of a board of directors to continue or to discontinue a cause of action on behalf of the corporation is governed by the state law of the state of incorporation. Kamen, 500 U.S. at 96. Similarly, in diversity cases, such as this one, the relevant substantive law is the law of the state of incorporation. Abrams v. Koether, 766 F. Supp. 237, 249 (D.N.J. 1991) (citing RCM Securities Fund, Inc. v. Stanton, 928 F.2d 1318 (2d Cir. 1991)). The ...

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