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In re McKesson HBOC

September 9, 2005


The opinion of the court was delivered by: Ronald M. Whyte United States District Judge


Christine Chang and James Huffman ("plaintiffs"), former participants in McKesson Corporation's Profit-Sharing Investment Plan ("the Plan"), bring a class action lawsuit against multiple defendants for their alleged breaches of fiduciary duties under the Employee Retirement Income Security Act ("ERISA"), 29 U.S.C. § 1001, et seq. On January 12, 1999 McKesson Corporation merged with HBOC to form McKesson HBOC. Later that year, McKesson HBOC announced that HBOC had engaged in accounting irregularities. As a result, McKesson HBOC's stock price plummeted and the Plan lost substantial value. On April 30, 1999, McKesson HBOC made its annual contribution to McKesson HBOC 's Employee Stock Ownership Plan ("ESOP"). McKesson HBOC made this contribution in the form of stock. That contribution is the only contribution at issue in this litigation.

In March 2003 several defendants moved to dismiss plaintiffs' consolidated amended complaint ("CAC"), including: (1) McKesson HBOC, Inc. and HBO & Company; (2) Charles W. McCall, a former officer and director of HBOC and Chairman of the Board of Directors of the post-merger company for several months; (3) Mark A. Pulido, a former member of both McKesson Corporation's Board of Directors before the merger and the post-merger company for several months, (4) the McKesson Corporation Outside Directors;*fn1 and (5) the HBOC Outside Directors.*fn2 Plaintiffs opposed the motions. On May 10, 2005 the court granted preliminary approval of a settlement between plaintiffs and (1) HBOC and (2) its former officers and directors. The court thus stayed plaintiffs' claims against the HBOC subclass. On May 25, 2005 plaintiffs filed a motion for leave to file a second amended consolidated complaint ("SCAC"). The defendants other than the HBOC subclass oppose the motion. The court has reviewed the papers and considered the arguments of counsel.*fn3 For the reasons discussed below, the court grants defendants' motions to dismiss the CAC except for plaintiffs' allegations that McKesson HBOC breached its duty of prudence by contributing stock to the Plan on April 30, 1999. The court denies defendants' motions with respect to that claim. The court also denies plaintiffs' motion for leave to amend.


A. Factual Background

On December 31, 2002 plaintiffs filed the CAC.*fn4 Plaintiffs assert claims against McKesson HBOC, Inc, the members of McKesson Corporation's Board of Directors before the January 12, 1999 merger, and the members of McKesson HBOC's Board of Directors after the January 12, 1999 merger.

CAC ¶¶ 17, 22. The CAC also named the Plan as a nominal defendant. Id. at ¶ 24.

1. The Plan

The Plan is an "employee pension benefit plan" within the meaning of ERISA § 3(2)(A), 28 U.S.C. § 1002(2)(A). CAC ¶ 66. McKesson Corporation is the named fiduciary and administrator of the Plan. Id. at ¶ 19. The McKesson Corporation Compensation Committee is responsible for (1) selecting trustees and investment advisors and managers, and (2) the overall investment policy of the Plan. The McKesson Corporation Board of Directors have the authority to determine the investment policies and guidelines to be implemented by the Compensation Committee. Id. at ¶ 20.

Participants may make "basic contributions of between 2% and 6% . . . and supplemental contributions of between 6% and 10%" of their salary to the Plan. Id. at ¶ 69. The Plan also includes an ESOP component under which McKesson Corporation "'matche[s]' up to the first 6% of each participant's salary-deferral contributions" and makes supplemental contributions based on an employee's age and length of service. Id. at ¶¶ 71-72. Although the Plan allows McKesson Corporation to choose between initially contributing cash or company stock, it requires fiduciaries to convert cash contributions into company stock "as soon as practicable." McKesson Plan at §§ 4.3(a) & (c). Plaintiffs allege that "virtually 100%" of the Plan's assets "other than each participant's salary-deferral contributions was held and invested in . . . [c]ompany [s]tock" and that company stock "comprised approximately 75% of the overall value of the . . . Plan assets." CAC ¶¶ 75-76. The Plan does not allow participants to direct sales of company contributions until they reach the age of fifty-five, or when their age plus years of service exceed sixty-five years. Id. at ¶ 77. Thus, participants "could not safely diversify" their holdings. Id.

2. The Merger

In mid-1998, McKesson Corporation and HBOC began to discuss the prospect of merging. HBOC had hired Arthur Andersen ("Andersen") to audit its 1996 and 1997 financial statements and to review its first and second quarter 1998 financial statements. Id. at ¶ 88. McKesson Corporation retained Deloitte & Touche LLP ("Deloitte") to perform accounting due diligence of HBOC. Id. at ¶ 87. Deloitte reviewed Andersen's audit work papers. Id. at ¶ 88. Deloitte also spoke with HBOC accounting personnel and reviewed additional financial schedules. Id. at ¶ 89. On July 12, 1998, Deloitte reported four accounting problems: (1) in 1996 and 1997, HBOC had recognized revenue from customer transactions before the customer had actually committed to purchase, violating generally accepted accounting principles ("GAAP"); (2) HBOC had overstated revenue by failing to defer revenue from maintenance service contracts in violation of GAAP; (3) HBOC had established excess reserves related to acquisitions, and had improperly used these reserves in 1997 and the first and second quarters of 1998; and (4) HBOC had understated the reserve for potentially uncollectible customer accounts receivable by approximately $10 million to $25 million. Id. at ¶¶ 90-100. Deloitte presented these findings to the McKesson Corporation Board-including Pulido, Richard Hawkins, McKesson Corporation's Chief Financial Officer, and Heidi Yodowitz, McKesson Corporation's Controller-in a meeting on July 13, 1998. Id. at ¶ 101. In addition, Deloitte stated that it was highly likely that the United States Securities and Exchange Commission ("SEC") would require HBOC to restate its financials. Id. On July 15, 1998 McKesson Corporation announced that it would not merge with HBOC. Id. at ¶ 102.

On August 19, 1998 the Center for Financial Research and Analysis-an independent financial research organization-reported that HBOC's revenue recognition had probably been too aggressive ("the CFRA Report"). Id. at ¶ 103. The CFRA Report noted several problems with HBOC's bookkeeping, including: (1) an increase in HBOC's accounts receivable, including unbilled balances; (2) a decrease in HBOC's cash flow from operations compared to reported net income; (3) questionable acquisition-related special charges; and (4) the reversal of charges into net income. Id. at ¶¶ 103-104. These problems were "in most respects identical" to the problems Deloitte identified. Id. at ¶ 105. The CFRA Report also noted that "several insiders had sold a significant number of HBOC shares during 1998." Id. at ¶ 106.

However, on October 13, 1998 McKesson Corporation and HBOC again discussed merging. Id. at ¶ 108. McKesson Corporation and HBOC agreed to a share exchange ratio of 0.37 McKesson Corporation shares for each share of HBOC. This was an 11% premium over the closing price of HBOC stock on October 16, 1998, but was more favorable to McKesson Corporation than previously-agreed-upon exchange ratios. Id. at ¶¶ 108-109. Deloitte updated its accounting due diligence, finding the same four accounting problems as in its earlier report. Id. at ¶ 113. Deloitte expressed these concerns to McKesson Corporation's Board. Id. at ¶ 114. McKesson Corporation's Board of Directors thus "knew . . . that HBOC's financial statements were suspect and there was a substantial risk that the SEC would require" HBOC to restate them. Id. at ¶ 116. Despite the fact that McKesson Corporation received a "Fairness Opinion" from Bear Stearns, McKesson Corporation's Board members knew that it was "incomplete" because they had "instructed Bear Stearns to ignore the information uncovered by Deloitte." Id. at ¶¶ 118-121. McKesson Corporation's Board and Directors also knew that "[t]he proposed merger . . . raised many substantial and very legitimate risk factors": that (1) 75% of all mergers fail to achieve expected results, (2) McKesson Corporation and HBOC were very different, and (3) both companies "had [recently] acquired numerous other businesses." Id. at ¶ 122. Finally, Pulido, McCall and Bergonzi "had a financial interest in seeing to it that the merger was completed, in the form of stock options and restricted stock that would vest." Id. Nevertheless, the shareholders of both companies approved the merger on January 12, 1999. Id. at ¶¶ 125-126. HBOC became a wholly-owned subsidiary of McKesson and the two companies became known as McKesson HBOC. Id. at ¶ 12.

On April 1, 1999, several months after the merger of the companies, McKesson merged HBOC's employee benefits plan with the Plan. Id. at ¶ 25. Participants in the HBOC Plan received 0.37 shares of McKesson HBOC stock for each HBOC share held in their accounts. Id. at ¶ 127. However, "the McKesson [HBOC] Plan [f]iduciaries failed to consider whether the investment policies and guidelines for the McKesson [Corporation] Plan remained prudent, or whether [c]ompany [c]ontributions should be made in cash in lieu of McKesson [HBOC] [c]ompany [s]tock." Id. at ¶ 129.

3. The Post-Merger Accounting Restatements

On April 28, 1999 McKesson HBOC announced that HBOC had improperly recorded $16 million in software revenue during the first three quarters of the fiscal year ending March 31, 1999 and $26.2 million in the fourth quarter. Id. at ¶¶ 131-132. McKesson HBOC reversed these sales. The company also noted that the audit process was ongoing and that it might identify additional contingent sales. Id. at ¶ 131. The company also adjusted its fiscal year 2000 earnings per share projection downward and announced that it expected software revenues of the HBOC subsidiary to decrease from fiscal 1999. Id. After this announcement, McKesson HBOC's stock decreased from a closing price of $65.75 on April 27, 1999, to a closing price of $34.50 on April 28, 1999. Id. at ¶ 133.

On May 25, 1999 McKesson HBOC announced that it was making additional downward adjustments to software revenues and earnings for the March 31, 1999 fiscal year and quarters. Id. at ¶ 134. The company also stated that it might be required to make similar adjustments with respect to previous fiscal years. Id. These revisions all related to the HBOC subsidiary. Id. McKesson HBOC noted that the company's review of HBOC's financial statements was ongoing, and that it was delaying issuing its financial results for the March 31, 1999 fiscal year. Id. After this announcement, McKesson HBOC's stock decreased from a closing price of $38.18 on May 24, 1999, to a closing price of $33.50 on May 25, 1999. Id. at ¶ 135.

On July 14, 1999 McKesson HBOC announced that it had completed its investigation and was restating revenues by $245.8 million for the March 31, 1999 fiscal year, $48.8 million for the March 31, 1998 fiscal year, and $33.2 million for the March 31, 1997 fiscal year. Id. at ¶ 136. McKesson HBOC also noted that it would revise its net income downward by $152.2 million for the March 31, 1999 fiscal year, $25.8 million for the March 31, 1998 fiscal year, and $13.5 million for the March 31, 1997 fiscal year. Id. In addition, McKesson HBOC noted that it would recognize only some of these reversed revenues in the future. Id. at ¶ 137. The average closing price of McKesson HBOC stock for the months of May, June, July, and August 1999, was $33.14, $31.31, $30.22, and $30.46, respectively. Id. at ¶ 244. Between October 1999 and June 2000, McKesson HBOC stock traded for roughly $20 per share. Id.

B. Procedural Background

Discovery in this action was stayed pending the stay of discovery in In re McKesson HBOC Securities Litigation ("the Securities Litigation"). On September 30, 2002 the court granted the Defendants' Motions to Dismiss the Chang Plaintiffs' First Amended Complaint. See In re McKesson HBOC, Inc. ERISA Litigation, 2002 WL 31431588 (N.D. Cal. 2002) ("the September Order"). After the hearing on the motions to dismiss the FAC and prior to the issuance of the September Order, the court consolidated Adams v. McKesson Information Sys., C-02-00685 RMW, with Chang v. McKesson, C-00-20030 RMW. The court recaptioned the action In re McKesson ERISA Litigation.

1. The September Order

In the September Order, the court concluded that the McKesson Corporation Board and Compensation Committee and McKesson HBOC Board and Compensation Committee are ERISA fiduciaries "with regard to the investment policies of the . . . Plan and [thus] are proper defendants for the alleged breaches of fiduciary duty arising out of investment policy." September Order at *9-*10. However, the court held that plaintiffs could only seek redress from McKesson HBOC itself on their claims stemming from its decision to contribute stock, rather than cash, to the Plan. Id. at *10.

The court addressed plaintiffs' argument that defendants breached their duties under ERISA by following the Plan's terms and investing in McKesson Corporation or McKesson HBOC stock. The court explained that ERISA exempts ESOPs from its general duty of diversification. See 29 U.S.C. § 1104(a)(2). The court then noted that two out-of-circuit cases, Moench v. Robertson, 62 F.3d 553 (3d Cir. 1995) and Kuper v. Iovenko, 66 F.3d 1447 (6th Cir. 1995), hold that "ERISA imposes fiduciary duties upon ESOP fiduciaries which may require the[m] to deviate from a plan requirement to invest in company stock." September Order at *4. The court expressed doubts about these cases:

The logic of Moench and Kuper is not compelling. If there is no duty to diversify ESOP plan assets under the statute, it logically follows that there can be no claim for breach of fiduciary duty arising out of a failure to diversify, or in other words, arising out of allowing the plan to become heavily weighted in company stock. Both cases in effect hold that ERISA's fiduciary duty of prudent investment trumps the express statutory exemption from the duty to diversify.

Id. at *5. Moreover, the court noted that Moench and Kuper "may be distinguishable" on the grounds that both cases involved ESOP plans that required the companies to make contributions "primarily" in company stock, while the Plan requires McKesson HBOC to make all contributions either (1) in stock or (2) in cash that is converted to stock "as soon as practicable." Id. Thus, the court reasoned, the Plan fiduciaries have less discretion than the fiduciaries in Moench and Kuper. Id. Nevertheless, because the Plan gave fiduciaries some discretion-the choice between making contributions in stock or cash-the court determined that it could not foreclose the possibility that the fiduciaries could be liable for abusing this discretion. The court set forth a framework to evaluate this issue:

Assuming that Moench and Kuper apply, then an ESOP fiduciary may not blindly follow an ESOP plan's directive to invest in company stock and may be liable for breach of fiduciary duty if such investment was imprudent. However, these cases recognize that there is a presumption that the fiduciary's decision to follow the plan was reasonable and the presumption may be rebutted by showing that a prudent fiduciary acting under similar circumstances would have made a different investment decision and that the fiduciary abused his, her or its discretion by following the Plan and investing in employer securities. Plaintiffs must also demonstrate a causal link, specifically, that an adequate investigation would have revealed to a reasonable fiduciary that the investment at issue was improvident.

Id. at *5 (citations omitted).

The court then applied this standard and held that the FAC was deficient in several ways. First, the court concluded that plaintiffs failed to allege "facts, not mere conclusions," that defendants abused their discretion by allowing the Plan to become overly weighted in company stock before the merger. Id. at *6.

Second, the court considered plaintiffs' claim that defendants breached their duties by failing to divest the Plan of company stock after the merger but before the announcement of HBOC's accounting irregularities. The court determined that this theory was flawed because plaintiffs had failed to articulate what lawful conduct defendants could have taken to stop the Plan from declining in value. Indeed, the court reasoned, the McKesson HBOC fiduciaries could only have (1) sold the stock without disclosing HBOC's wrongdoing, thus engaging in illegal insider trading or (2) disclosed the improprieties, causing the stock price to fall immediately. Id. at *6-*7. Thus, the court held that plaintiffs failed to allege that this purported breach caused the Plan's losses. Id. at *7.

Third, the court evaluated plaintiffs' assertion that defendants breached their duties by continuing to invest in company stock after the merger. Id. at *8. Defendants claimed that (1) the company increased the number of shares it contributed after the merger to accommodate the lower stock price and (2) company stock has outperformed the market since the fallout over HBOC's wrongdoing. Id. The court rejected defendants' arguments, holding that they were "evidentiary in nature and go beyond what may properly be considered on a motion to dismiss." Id. However, the court dismissed this count with leave to plead the underlying facts with greater specificity. Id.

Fourth, the court acknowledged that, if pled in more detail, plaintiffs could state a claim for McKesson HBOC's failure to make contributions in the form of cash, as opposed to stock. Id. Finally, the court dismissed plaintiffs' co-fiduciary liability claims because they failed to explain (1) what duties defendants breached, (2) which defendants knew about these breaches, (3) how each defendant did not make reasonable efforts to remedy the breaches, (4) what acts defendants took to conceal information, and (5) what damages or harm resulted. Id. at *17.

2. The CAC

Plaintiffs' seventh cause of action claims that individual McKesson Corporation Board members breached their fiduciary duties of prudence, loyalty, and diversification under ERISA § 404, 29 U.S.C. § 1104 ("section 404") during the period before the January 12, 1999 merger. CAC ¶¶ 196-220. Plaintiffs' eighth cause of action alleges that individual McKesson HBOC Board members breached their section 404 duties between January 12, 1999 through April 20, 1999, after the merger but before McKesson HBOC publicized HBOC's accounting irregularities. Id. at ¶¶ 221-235. Plaintiffs' ninth cause of action asserts that the individual McKesson HBOC Board members breached their section 404 duties after the announcement on April 28, 1999. Id. at ¶¶ 236-251. Plaintiffs' tenth cause of action claims that McKesson HBOC (1) breached its duties under section 404 by making contributions in stock rather than cash and (2) is liable for the individual Board members' wrongdoing "under the law of agency, including the principles of vicarious liability and respondeat superior." Id. at ¶¶ 252-258.*fn5 Plaintiffs' twelfth cause of action alleges that defendants are subject to co-fiduciary liability under ERISA § 405(a), 29 U.S.C. §§ 1105(a)(2)-(3) ("section 405"). Id. at ¶¶ 272-277. Plaintiffs' thirteen cause of action claims that McCall is liable under section 404 and under equitable principles. Id. at ¶¶ 278-281.

3. The Proposed SCAC

On May 25, 2005 plaintiffs requested leave to file the SCAC.*fn6 The SCAC adds citations and quotes from articles to support the proposition that "75% of mergers fail to achieve expected results." SCAC ¶ 122(a). The SCAC also alleges that McKesson HBOC, McCall, Pulido, Bergonzi, and Hawkins engaged in a variety of post-merger wrongdoing, including improperly recognizing revenue from thirty-seven contracts in the first quarter after the merger. Id. at ¶ 140A. One contract in particular, with Data General Corporation, led to McKesson HBOC's improper recognition of $20 million in revenues. Id. McCall and Hawkins were "directly involved" in the Data General transaction. Id. at ¶ 140B, 140D(d). Bergonzi "knew of and participated in" this fraud. Id. at ¶ 140D(a). Pulido also knew about the fraud and yet failed to make the 1999 plan contribution in cash. Id. at ¶ 140C. Moreover, "[d]efendants neither considered nor evaluated the prudence of the investment policy of the . . . Plan regarding its holdings in McKesson [HBOC] stock, or whether to continue contributing cash or . . . [s]tock to the Plan . . . at any time during this timeframe . . . ." Id. at ¶ 140E (emphasis omitted). Finally, McKesson HBOC's decision to contribute stock in 1999 occurred on April 26, 1999-after the company knew that it was going to have to restate its earnings-and was therefore imprudent.*fn7


A. Legal Standards

1. Motions to Dismiss

Dismissal under Federal Rule of Civil Procedure Rule 12(b)(6) is proper only when a complaint exhibits either a "lack of a cognizable legal theory or the absence of sufficient facts alleged under a cognizable legal theory." Balistreri v. Pacifica Police Dept., 901 F.2d 696, 699 (9th Cir. 1988). The court must accept the facts alleged in the complaint as true. Id. "A complaint should not be dismissed 'unless it appears beyond doubt that the plaintiff can prove no set of facts in support of his claim which would entitle him to relief.'" Gilligan v. Jamco Dev.Corp., 108 F.3d 246, 248 (9th Cir. 1997) (quoting Conley v. Gibson, 355 U.S. 41, 45-46 (1957)).*fn8

2. Motion for Leave to Amend

Federal Rule of Civil Procedure 15(a) instructs courts to give leave to amend "when justice so requires." Courts weigh four factors when deciding whether the grant leave to amend: "undue delay, bad faith or dilatory motive, futility of amendment, and prejudice to the opposing party." Serpa v. SBC Telecomms., Inc., 318 F. Supp. 2d 865, 870 (N.D. Cal. 2004). "The party opposing amendment bears the burden" of proving that leave is inappropriate. DCD Programs, Ltd. v. Leighton, 833 F.2d 183, 187 (9th Cir. 1987). Futility ...

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