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Fagin v. Gilmartin

December 15, 2005; as amended December 16, 2005

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.

The opinion of the court was delivered by: Ambro, Circuit Judge

PRECEDENTIAL

Argued September 29, 2005

Before: ALITO, and AMBRO, Circuit Judges RESTANI,*fn1 Chief Judge

OPINION OF THE COURT

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 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 ...


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