In the July/August 2002 issue of A Potpourri, we reported on the 7th U.S. Circuit Court of Appeals’ decision concerning Abbott Laboratories (“Abbott”). Several shareholders brought derivative suits against Abbott’s 13-member board of directors, accusing them of consciously ignoring quality-control problems which ultimately left the company liable for a $100 million civil fine arising from a consent decree between Abbott and the Food and Drug Administration (“FDA”). A derivative suit is one brought by shareholders to enforce rights belonging to the corporation.
The trial court dismissed the original suit, finding that the complaint did not plead facts to show the directors faced a substantial likelihood of liability for their actions. The Court of Appeals, applying the rationale of Delaware law to this Illinois corporation, reinstated the suit and found that director liability may arise from the breach of the duty to exercise appropriate attention to potentially illegal corporate activities.
After being remanded (sent back) to the trial court, the shareholders filed an amended derivative complaint. Once again, the board members moved to dismiss and argued the shareholders should have demanded that the board vote to have the company take action against them prior to filing suit. The trial court agreed and dismissed the amended complaint. Principles of corporate governance require that decisions of a corporation should be made by the board of directors or the majority of the corporation’s shareholders. In that regard, Illinois requires a pre-suit demand be made which would allow the directors to exercise their business judgment and, essentially, determine whether litigation is in the best interest of the corporation. A pre-suit demand is necessary unless demand would otherwise be futile – hence, the “futility exception” to the pre-suit demand rule.
In Illinois, the “futility exception” applies when facts are alleged with particularity create a reasonable doubt that the directors are entitled to the protection of the business judgment rule. The business judgment rule is a presumption that in making a business decision the directors have acted on an informed basis, in good faith and in the honest belief that the action taken was in the best interests of the company. To determine whether there is reasonable doubt that the directors exercised proper business judgment, courts are required to determine whether the directors used both substantive and procedural due care. In doing so, courts should examine the three primary fiduciary duties of the directors: the duties of care, loyalty, and good faith. Where a board fails to act under circumstances where due care would, arguably, have prevented a loss, director liability may arise and pre-suit demand would be futile.
In Abbott, the Court of Appeals found that the amended complaint alleged sufficient facts to apply the “futility exception.” The Abbott shareholders did not make any demand on Abbott’s board of directors to institute an action against themselves. They asserted that such a demand would be futile, since a majority of the board who would have received the demand were the same directors who had been board members during the period in question. Allegedly, the directors knew of the violations of law and took no timely steps over a six-year period to prevent or remedy the violations. The delay resulted in substantial corporate losses, in the largest civil fine ever imposed by the FDA, and in the destruction and suspension of products, which accounted for approximately $250 million in corporate assets. The allegations of the amended complaint supported a reasonable doubt of business judgment protection. Accordingly, the trial court’s dismissal of the complaint was reversed and remanded. The directors also argued they were not liable under a provision of Abbott’s certificate of incorporation, which purports to exempt the directors from certain liabilities. We will address the Court’s responses to the directors’ assertion in our next issue. If you have any questions about the Abbott case or any director liability issues, please do not hesitate to contact us.