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Kitley v. Isoray, Inc.

United States District Court, D. Minnesota

October 19, 2017

DAVID M. KITLEY, derivatively on behalf of IsoRay, Inc., Plaintiff,
v.
ISORAY, INC., DWIGHT BABCOCK, PHILIP J. VITALE, MICHAEL W. MCCORMICK, THOMAS LAVOY, and ALAN HOFFMANN, Defendants.

          SHAWN M. PERRY, PERRY & PERRY, PLLP, AND THOMAS J. MCKENNA, GAINEY MCKENNA & EGLESTON, FOR PLAINTIFF.

          GREGORY L. WATTS, WILSON SONSINI GOODRICH & ROSATI, P.C., AND JULIE H. FIRESTONE, BRIGGS & MORGAN, PA, FOR DEFENDANTS.

          MEMORANDUM OPINION AND ORDER GRANTING DEFENDANTS' MOTION TO DISMISS

          JOHN R. TUNHEIM CHIEF JUDGE UNITED STATES DISTRICT COURT

         Plaintiff David Kitley filed this shareholder-derivative action against the former CEO of IsoRay, Inc. (“IsoRay”), Dwight Babcock, and IsoRay's four current directors: Thomas LaVoy, Philip Vitale, Michael McCormick, and Alan Hoffmann (the “Director Defendants”). Kitley's action arises under state law and includes claims for breach of fiduciary duties, gross mismanagement, and unjust enrichment. Defendants move to dismiss the Complaint. Because Kitley both lacks derivative standing and fails to demonstrate that a demand on IsoRay's board would be futile under Minnesota law, the Court will grant Defendants' motion and dismiss.

         BACKGROUND

         I. FACTUAL BACKGROUND

         IsoRay is a Minnesota corporation whose “primary business involves developing, manufacturing, and marketing radiation ‘seed' therapy used to treat cancer.” (Verified S'holder Am. Derivative Compl. (“Am. Compl.”) ¶¶ 2, 12, Jan. 23, 2017, Docket No. 34.) Seed therapy allows physicians to “deliver higher doses of radiation to more specific areas of the body, compared with the conventional form of radiation therapy (external beam radiation) that projects radiation from a machine outside of the body.” (Id. ¶¶ 24.) IsoRay supplies purified Cesium-131 “for use in low-dose radiation seed therapy.” (Id. ¶ 2.) Cesium-131 is a radioactive isotope of the element cesium used to treat certain cancers. (Id. ¶¶ 22-23, 25.) Cesium-131 is most commonly used to treat prostate cancer. (Id. ¶ 2.) According to the Complaint, IsoRay's future growth will depend on Cesium-131 being used to treat non-prostate cancers, such as lung cancer. (Id. ¶¶ 41-43.)

         On May 19, 2015, the medical journal Brachytherapy published an online article about a study that evaluated using Cesium-131 seed therapy to treat lung cancer. (Id. ¶ 3, 68.) The next day, before the stock market opened, IsoRay issued a press release titled “IsoRay's Cesium-131 Lung Cancer Treatment Reports 96% Success in Local Control and 100% Survival in Five Years in High Risk Patients in Newly Published Report” (the “Press Release”).[1] (See Id. ¶¶ 4, 90-91.) The Press Release stated that the study showed “improved results using IsoRay's Cesium-131 seeds, ” that patients had “outstanding” outcomes, and that the five-year survival rate was “exceptional” for the patients that received Cesium-131 seed therapy. (Id. ¶ 4.) Then-CEO of IsoRay, Dwight Babcock, was quoted several times in the Press Release. (Id. ¶ 88.) That day, May 20, IsoRay's stock price peaked at $3.35 per share, up from $1.62 at the market's close on May 19. (Id. ¶ 86, 93.) It was also on May 20 that Kitley purchased his IsoRay shares - after IsoRay had issued the Press Release and after the market had opened.[2]

         Around noon the next day, May 21, Adam Feuerstein, a writer for a financial-news website, published an online article titled “IsoRay Takes Liberties with Lung Cancer Study Results to Prop Up Drug Price.” (Id. ¶ 96.) The Feuerstein article “disclosed, for the first time, that IsoRay had selectively reported the conclusions” of the Brachytherapy article, “omitting critical and material comparisons and conclusions.” (Id. ¶ 97.) For example, treatment with Cesium-131 “demonstrated statistically equivalent rates of [tumor] control” as two other, non-Cesium-131 treatment regimes. (Id. ¶ 98.) That day, May 21, IsoRay's stock price peaked at $3.79 per share before Feuerstein published his article, and closed at $2.01. (Id. ¶ 95, 100.) At the time that Kitley filed this action, IsoRay's stock price was approximately $0.62 per share. (Id. ¶ 102.)

         On May 28, 2015 - one week after Feuerstein published his article - IsoRay's investors filed a class-action complaint in the United States District Court for the Eastern District of Washington against Babcock and IsoRay, alleging violations of federal securities laws. Complaint, In re IsoRay, Inc. Sec. Litig., 189 F.Supp.3d 1057 (E.D. Wash. 2016) (No. 15-5046), ECF No. 1. In June 2016, the district court denied Babcock's motion to dismiss. IsoRay, 189 F.Supp.3d at 1080. The court found that the class-action complaint sufficiently alleged that the Press Release contained false and misleading statements. Id. at 1069-72. It also found that the class-action plaintiffs sufficiently alleged that Babcock knew that the Press Release contained false and misleading statements. Id. at 1078-79. While the class action was pending, Babcock resigned from all his positions with IsoRay. (Am. Compl. ¶ 13.)

         The class action settled later in 2016. See In re IsoRay, Inc. Sec. Litig., No. 15-5046, 2016 WL 7234807 (E.D. Wash. Oct. 20, 2016). Shortly before the parties in the class action settled, Kitley filed this shareholder derivative action. (See Verified S'holder Derivative Compl. (“Compl.”), Sept. 29, 2016, Docket No. 1.)

         II. THE DEFENDANTS AND KITLEY'S ALLEGATIONS

         When Kitley filed this action, IsoRay's board comprised one officer-director - LaVoy, [3] who was then CEO and board chair - and three outside directors: Vitale, McCormick, and Hoffmann. (Am. Compl. ¶¶ 14-17.) Also at this time, IsoRay's audit committee had three members: LaVoy, Vitale, and Hoffmann (chair). (Id. ¶¶ 17-18.) Vitale is a board-certified urologist who has studied prostate cancer. (Id. ¶ 15.) In May 2015, Babcock was IsoRay's CEO; LaVoy and Vitale were both outside directors; LaVoy was the audit-committee chair; McCormick was an audit-committee member; and neither McCormick nor Hoffmann were on IsoRay's board. (Id. ¶¶ 13-17.)

         Kitley asserts state-law claims for breach of fiduciary duties, gross mismanagement, and unjust enrichment stemming from the Press Release and the Defendants' alleged failure to correct it. (Id. ¶¶ 150-164.) Kitley's allegations are effectively two-fold. First, Kitley alleges that the Defendants breached their fiduciary duties by allowing IsoRay to issue a false and misleading Press Release.[4] Second, Kitley alleges that Defendants breached their fiduciary duties by failing to maintain internal controls over IsoRay's issuance of false and misleading statements. For both of these reasons, Kitley alleges that demand on IsoRay's board would be futile. (See Id. ¶¶ 107-149.)

         With respect to the Press Release, Kitley alleges that LaVoy and Vitale “had to know” that the Press Release was false and misleading. (Id. ¶¶ 122, 130, 141.) Kitley relies on their statuses in May 2015 as both outside directors and audit-committee members (and LaVoy as the audit-committee chair) to support his allegation.[5] (Id. ¶¶ 123-141.) With respect to internal controls, Kitley alleges that none of the Director Defendants did anything to correct the Press Release and have still done nothing to correct it. (Id. ¶¶ 129, 137, 140, 144, 146.) Kitley relies on their statuses as directors and audit-committee members (except for LaVoy) to support his allegation. (Id.) Kitley argues that the Director Defendants face liability for breaching their duty of loyalty and failing to act in good faith because they have “consciously disregarded an obligation to be reasonably informed about the business and its risks or consciously disregarded the duty to monitor and oversee the business.” (Pl.'s Mem. Opp. Defs.' Mot. to Dismiss at 22, Apr. 20, 2017, Docket No. 51 (quoting In re Citigroup Inc. S'holder Derivative Litig., 964 A.2d 106, 125 (Del. Ch. 2009)).)

         DISCUSSION

         I. STANDARD OF REVIEW

         A federal court hearing an action on the basis of diversity jurisdiction applies state substantive law but federal procedural rules. E.g., Torti v. Hoag, __ F.3d __, 2017 WL 3528447, at *3 (8th Cir. Aug. 17, 2017). Kitley's Complaint invokes diversity jurisdiction (Am. Compl. ¶¶ 8-9), so Federal Rule of Civil Procedure 23.1 applies to his shareholder-derivative action. Kanter v. Barella, 489 F.3d 170, 176 (3d Cir. 2007); Hockstein v. Collins, No. 14-4020, 2015 WL 5737073, at *3 (D. Minn. Sept. 30, 2015).

         Rule 23.1 “imposes a heightened pleading standard on complaints in derivative actions.” Gomes v. Am. Century Cos., 710 F.3d 811, 815 (8th Cir. 2013). It “require[s] derivative plaintiffs to satisfy more stringent pleading requirements than the notice pleading regime of Rules 8 and 12(b)(6).” Stepak v. Addison, 20 F.3d 398, 402 (11th Cir. 1994); see also In re Sonus Networks, Inc. S'holder Derivative Litig., 499 F.3d 47, 66 (1stCir. 2007).

         II. DERIVATIVE STANDING

         Rule 23.1(b)(1) requires that a shareholder-derivative complaint “allege that the plaintiff was a shareholder or member at the time of the transaction complained of.” This is commonly called the “contemporaneous-ownership” rule (or “derivative standing” or “shareholder standing”).[6] See, e.g., Bangor Punta Operations, Inc. v. Bangor & A.R. Co., 417 U.S. 703, 708-09, 708 n.4 (1974); Iron Workers Mid-South Pension Fund v. Davis, 93 F.Supp.3d 1092, 1098 n.3 (D. Minn. 2015). The meaning of and compliance with Rule 23.1's contemporaneous-ownership rule is a question of federal law. Silverstein ex rel. Tetragon Fin. Grp. Ltd. v. Knief, 843 F.Supp.2d 441, 444-45 (S.D.N.Y. 2012).

         The contemporaneous-ownership rule “stems from the equitable nature of derivative litigation which allows a shareholder ‘to step into the corporation's shoes and to seek in its right the restitution'” that the shareholder could not otherwise obtain. Lewis v. Chiles, 719 F.2d 1044, 1047 (9th Cir. 1983) (quoting Cohen v. Beneficial Loan Corp., 337 U.S. 541, 548 (1949)). It is “a procedural requirement which, in effect, denies a putative derivative plaintiff standing to challenge wrongdoing that predated the time the plaintiff became a shareholder.” In re Facebook, Inc., Initial Pub. Offering Derivative Litig., 797 F.3d 148, 157 (2d Cir. 2015). Accordingly, the rule prevents “the federal courts from being used to litigate purchased grievances” - claims brought by ...


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