Seventh Circuit Increasingly Problematic for Directors and Officers Defending Shareholder Derivative Suits

With its recent decision in Westmoreland County Employee Retirement System v. Parkinson, et al.,1 the United States Court of Appeals for the Seventh Circuit has confirmed that the courts of the Seventh Circuit can be a challenging place for a director or officer of a public company to be sued in a shareholder derivative lawsuit. In Westmoreland, Plaintiff Westmoreland County Employee Retirement System (“Westmoreland”), purportedly on behalf of Baxter International, Inc. (“Baxter” or the “Company”), sued the Company’s board of directors and certain officers for “consciously disregard[ing] their responsibility to bring Baxter into compliance with [a 2006] Consent Decree and related health safety laws,” which allegedly caused the Company to lose more than $550 million.2 The Seventh Circuit reversed the lower court’s decision dismissing the claim, holding that the totality of the complaint’s allegations supported a reasonable doubt that the defendants’ conduct was the product of a valid exercise of business judgment.3 This decision, in combination with the Seventh Circuit’s previous decision in In re Abbott Laboratories Derivative Shareholder Litigation,4 further reinforces the Seventh Circuit’s status as a particularly problematic jurisdiction for directors and officers defending shareholder derivative suits based on board action.

As a preliminary matter, plaintiffs bringing shareholder derivative suits on behalf of a corporation must overcome substantial pleading burdens.5 The Delaware Supreme Court has made clear that to plead demand futility under Delaware law, plaintiffs must show that the suit is “the rare case [where the board’s action was] so egregious on its face that board approval cannot meet the test of business judgment, and a substantial likelihood of director liability therefore exists.”6 Further, to prevail on a claim alleging the directors’ bad faith, the plaintiff must plead with particularity that defendants acted with “‘intentional dereliction of duty or the conscious disregard for [their] responsibilities.’”7

In 2003, however, the Seventh Circuit decision in Abbott Labs changed the legal landscape for shareholder derivative suits. Part of the criticism of Abbott Labs is that when applying the facts of the case, the Court side-stepped this substantial burden, requiring only a showing of “a reasonable doubt of business judgment protection.”8 The Court ultimately held that the plaintiffs had adequately alleged that the board’s “conscious inaction . . . fell outside the protection of the business judgment rule.”9

The Seventh Circuit’s recent ruling in Westmoreland expands upon the holding in Abbott Labs, further confirming that the Seventh Circuit can be a challenging jurisdiction to defend shareholder derivative suits. Although the Court did cite to Delaware’s rigorous pleading standards, it also relied upon Abbott Labs and emphasized that bad faith had been adequately pled because “[t]he totality of the complaint’s allegations need only support a reasonable doubt of business judgment protection.”10 The Westmoreland Court reversed the lower court’s decision, explaining that even though the Company had expended significant resources to address problems with certain medical devices for years,11 the plaintiff had adequately alleged that the directors breached their duty of loyalty by making the “conscious decision to halt these efforts.”12 By focusing solely on the “reasonable doubt” aspect of the standard, the Court appears again to have effectively side-stepped the standard for pleading bad faith.

All in all, as the threat of shareholder derivative suits continues to be a concern for directors and officers, they should be aware of the Seventh Circuit’s increasingly problematic landscape, particularly in light of this recent decision.

Footnotes

Westmoreland County Employee Retirement System v. Parkinson, et al., No. 12-3342, 2013 WL 4266586 (7th Cir. Aug. 16, 2013).

2 Id. at *1 (internal quotation omitted).

3 Id. at *9.

4 325 F.3d 795 (7th Cir. 2003).

5 Because Delaware is usually the state of incorporation for many companies, the requirements of pleading that demand on a corporation’s board is excused is often a question of Delaware law. See, e.g., Kamen v. Kemper Fin. Servs., Inc., 500 U.S. 90, 108–09 (1991).

6 Aronson v. Lewis, 473 A.2d 805, 815 (1984).

7 Westmoreland, 2013 WL 4266586, at *5 (quoting McPadden v. Sidhu, 964 A.2d 1262, 1274 (Del. Ch. 2008)).

8 325 F.3d at 809.

9 Id.

10 Westmoreland, 2013 WL 4266586, at *5.

11 Id. at *6.

12 Id. at *7.