Superior Court Dismisses Shareholder Derivative Suit For Failure To Plead With Particularity That Pre-suit Demand Was Futile

| Oct 4, 2013 | Firm News

The Superior Court has dismissed without prejudice a shareholder derivative suit on the grounds that it failed to allege with sufficient particularity that making a pre-suit demand of the board of directors would be futile. The Court also said plaintiff failed to allege that she was a shareholder at the time of the transactions at issue.

Defendants consist of current or former members of the board of directors of the nominal defendant CVS Caremark Corporation (“CVS”) which the Court described as “the largest healthcare provider in the United States.” It is incorporated in Delaware and has its headquarters in Woonsocket, Rhode Island.

Plaintiff alleged that there were three different events that gave rise to her claims. First, CVS allegedly failed to monitor adequately the sales of pseudophedrine resulting in it entering into a non-prosecution agreement with federal authorities, paying a $75 million fine and forfeiting $2.6 million in profits. Second, in 2011, two CVS stores in Sanford, Florida purchased oxycodone in amounts sufficient to supply eight times the local population and filled prescriptions written by doctors who were under investigation and located more than 200 miles away. This resulted in those two stores losing their licenses to sell controlled substances. Third, CVS paid an $11 million penalty to avoid civil charges by the DEA respecting a failure to follow proper recordkeeping procedures for sales of narcotics in Oklahoma.

The Court reviewed the law with respect to shareholder derivative suits. They are a legal mechanism to allow shareholders to sue directors on behalf of the corporation. However, because the cause of action belongs to the corporation, the shareholder must either request permission from the corporation to bring the suit and be denied or allege that it would be futile to do so. The shareholder must plead with particularity why it would be futile to ask permission. Since CVS was a Delaware corporation, Delaware law would control whether the request would be deemed futile.

Under Delaware law, if the plaintiff is challenging an affirmative action by the director(s), the request will be deemed futile if the complaint raises a reasonable doubt that (1) the directors are disinterested or futile; or (2) the transaction was the product of a valid exercise of business judgment, i.e. the Aronson test. If the plaintiff is alleging a failure to act, then the test is whether at the time the complaint was filed the board of directors could have exercised its “independent and disinterested business judgment in responding to a demand,” i.e., the Rales test. The Court said the Rales test applies even when the allegation is the directors engaged in “conscious inaction.”

The Court said there was no allegation with respect to the alleged incidents that the directors took any affirmative action. At best, the plaintiff was alleging that the directors engaged in conscious inaction by failing to monitor situations or employees, so the Rales test applied. To show the directors should be liable for a failure to monitor, plaintiff must demonstrate that “the directors knew they were not discharging their fiduciary obligations or that they demonstrated a conscious disregard to their duties.” Plaintiff must show that there were “red flags” that were either waved in the directors’ faces or displayed so that they are visible to the careful observer. In this case, while there is information that may have put the directors on notice of problems, there is no allegation that the information was presented to the board, either directly or through their participation in the audit committee.

Alternatively, plaintiff argues that a demand should be excused because the board faces “substantial liability” for the failing to prevent the illegal conduct. For the board to face “substantial liability,” plaintiff must allege:

“(a) the directors utterly failed to implement any reporting or information system or controls; or (b) having implemented such a system or controls, consciously failed to monitor or oversee its operations thus disabling themselves from being informed or risks or problems requiring their attention. In either case, imposition of liability requires a showing that the directors knew that they were not discharging their fiduciary obligations.”

The Court said CVS satisfied both prongs: it implemented various controls and it took corrective actions.

Finally, with respect to this issue, the court said CVS’ shareholders had voted to limit the monetary personal liability of its directors pursuant to Delaware law. Under the limitation, the directors were only liable for a breach of their fiduciary duty when:

•(1) They breached their duty of loyalty;

•(2) They committed acts or omissions that were not in good faith or involved intentional misconduct or a knowing violation of the law;

•(3) They made unlawful payments of dividends or unlawful stock purchase redemptions; or

•(4) They engaged in a transaction in which a director derived an improper benefit.

The Court said plaintiff had failed to plead any of these exceptions which alone was sufficient grounds to dismiss the complaint.

Finally, the Court said plaintiff had failed to plead that she was a shareholder at the time of the events in question or that she had continuously held CVS stock since those events.

Gordon v. Ryan, P.B. 12-3098, slip opinion (R.I. Super. Oct. 1, 2013)

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