This shareholder derivative lawsuit arose out of a long and unsuccessful effort by Baxter International Inc. to fix various problems with a medical device called Colleague Infusion Pump. The plaintiff in the case, Westmoreland County Employee Retirement System (Westmoreland) alleged that Baxter’s directors and officers breached their fiduciary duties by “consciously disregard(ing) their responsibility to bring Baxter into compliance with the 2006 Consent Decree and related health and safety laws.”
The breach was alleged to have caused Baxter to lose more than $550 million after the Food and Drug Administration (FDA) mandated a recall of the Colleague Infusion Pumps in 2010. Westmoreland was a shareholder that sustained a significant stock value loss; it claimed the loss was caused by Baxter’s board’s and officers’ breach of fiduciary duty.
In the mid-1990s, Baxter was manufacturing and selling a product called the Colleague Infusion Pump (Pump), an electronic medical device used to deliver intravenous fluids to patients. The FDA closely regulates the medical device industry and required that companies comply with “current good manufacturing practices” and “quality system regulations” (see 21 C.F.R. Part 820), when manufacturing such medical devices. Between 1999 and 2005, the pumps were suffering from a range of defects, some relating to the manufacturing process and others to flaws in the machinery. The FDA discovered some of these problems during its inspections on Baxter’s facilities. The FDA sent a series of warning letters to Baxter in which it detailed Baxter’s failure to bring its manufacturing process into compliance with quality-controlled standards. In October 2005, the FDA took the drastic step of filing a complaint in federal court seeking forfeiture of all of Baxter-owned Colleague Infusion Pumps.
In June 2006, the FDA and Baxter entered into a Consent Decree. Baxter agreed to stop manufacturing and distributing all models of the pump within the United States and it committed to bringing approximately 200,000 pumps already in the hands of healthcare professionals “into compliance with the (Federal Food, Drug and Cosmetics) Act . . .” There was no deadline set for Baxter to complete these remedial efforts.
Baxter spent a lot of time and money trying to fix the pumps, but the problems with them persisted into the first part of 2010. Because Baxter was unsuccessful in trying to solve the problems with the pumps, the FDA invoked its power under the 2006 Consent Decree by ordering Baxter to recall and destroy all Colleague Infusion Pumps then in use in the United States and to reimburse customers for the value of their recalled device and to assist in finding replacement devices for those customers. As a result, the company’s stock price fell by more than 4% after the announcement and the company later recorded a pre-tax charge of $588 million to account for the estimated costs of the recall.
At this point, Westmoreland brought this shareholder derivative action on behalf of Baxter against 13 “Director Defendants,” including its CEO and Chairman of the Board, Robert L. Parkinson Jr. and five non-director “Officer Defendants,” alleging breach of fiduciary duty in connection with the Colleague Infusion Pump remedial efforts.
In the lawsuit, the entire troubled history of the pump was recounted as well as the relevant period for Westmoreland’s claims from late 2008 through May 3, 2010, which is when the defendants allegedly “consciously disregarded the responsibility to bring Baxter into compliance with the Consent Decree and related health and safety laws.”
Importantly, Westmoreland did not file a pre-suit demand with Baxter requesting that the directors initiate this action (against themselves) on the corporation’s behalf. It skipped this step because it contended that such a demand would have been futile. Westmoreland cited Federal Rule of Civil Procedure 23.1(b). The defendants then filed a motion to dismiss arguing that Westmoreland had not “alleged with particularity facts sufficient to excuse demand under Delaware law.”
The United States district court granted the motion and this appeal to the court of appeals was taken. In the district court it was concluded that Westmoreland chose not to meet its burden of showing that the demand would have been futile, because Westmoreland failed to allege facts that would create a reasonable doubt (1) that “the board is disinterested in the lawsuit” or (2) that the “challenged transaction was otherwise the product of a valid exercise of business judgment.”
The court of appeals stated that the business judgment rule establishes a presumption that directors of a corporation act on an informed basis and in good faith. But, if a director breaches the fiduciary duty of loyalty, the business judgment rule provides no protection. Because Baxter is incorporated in Delaware, Delaware law determines whether Westmoreland may litigate derivatively on Baxter’s behalf. Under the law, Federal Rule of Civil Procedure 23.1, plaintiffs like Westmoreland must make a pre-suit demand of the board of directors, unless “under the particularized facts alleged, a reasonable doubt is created that: (1) the directors are disinterested and independent; or (2) the challenged transaction was otherwise the product of a valid exercise of business judgment. Abbott Labs, 325 F.3d at 807-09.
In this case, since Westmoreland has put forward enough facts to show with the necessary particularity how the defendants acted in “bad faith,” such that they breached their duty of loyalty to Baxter, the alleged conduct would fall into the narrow range of activity that falls outside the scope of the business judgment rule. Westmoreland would then be permitted to proceed with its suit, because Delaware law excuses failure to make a pre-suit demand when a reasonable doubt exists that the challenged conduct was “the product of a valid exercise of business judgment.”
“The totality of the complaint’s allegations need only support a reasonable doubt of business judgment protection, not ‘a judicial finding that the director’s actions are not protected by the business judgment rule.’” Abbott Labs, 325 F.3rd at 809.
The court of appeals analyzed the complaint and concluded that Westmoreland’s allegations asserted that Baxter’s directors consciously flouted FDA’s regulations in a way that steered Baxter on a course that was all but certain to prompt the FDA to take enforcement action under the 2006 Consent Decree.
Accordingly, the court of appeals reversed the district court’s order dismissing the case and sent the case back to the district court for further disposition.
Westmoreland County Employee Retirement System v. Robert L. Parkinson, Jr., et al., No. 12-3342. (7th Cir. Court of Appeals, August 16, 2013).
Kreisman Law Offices has been handling shareholder disputes, business litigation and jury trials for individuals and businesses for more than 37 years, in and around Chicago, Cook County and its surrounding areas, including Rosemont, Buffalo Grove, Wheeling, Itasca, Hickory Hills, Worth, Evergreen Park, Chicago (Stockyards, Polish Village, Belmont Heights, Albany Park, Pulaski Park, Rose Hill), Northlake and Villa Park, Ill.
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