In a recent decision out of the Delaware Court of Chancery—In re Chelsea Therapeutics International Ltd. Stockholders Litigation., Consol. C.A. No. 9640-VCG—Vice Chancellor Glasscock was faced with a claim that the board of Chelsea Therapeutics International Ltd. had breached its duty of loyalty by intentionally concealing from its shareholders the true value of Chelsea as part of the sale of Chelsea. At issue were two specific acts: (1) the board instructing Chelsea’s financial advisors to ignore one set of financial projections and (2) the board itself ignoring a second set of projections. In analyzing these, VC Glasscock provided a detailed recitation of the application of the “exacting, but narrow” duty of loyalty.
The duty of loyalty “allows directors wide latitude to take action and embrace risk for the benefit of the corporation,” but such action “must be in the interest of the corporation and its owners, the stockholders.” Slip Op. at 1. The duty of loyalty “prohibits actions for the benefit of the director herself, or others to whom she is beholden, absent entire fairness to the corporation.” As noted by the Court, “[t]hat is the most straightforward part of the loyalty obligation.” Id.
The more complicated analysis is within the duty of loyalty’s requirement that “disinterested, independent directors act in good faith.” Id. As VC Glasscock describes, good faith is “something of a catch-all,” namely “the absence of actions taken in bad faith.” Id. And this analysis is where, in the words of former Chancellor Chandler, the application of the duty of loyalty enters a “hazy jurisprudence.” Id. (quoting In re The Walt Disney Co. Derivative Litig., 907 A.2d 693, 754 (Del. Ch. 2005)). That is, the duty of loyalty “prohibits board action intended for purposes other than corporate weal, even though taken by independent, disinterested directors” and also prohibits a failure to act in the face of a duty to act. Id. (citing In re The Walt Disney Co., 907 A.2d at 754-55).
This bad faith rule “allows the equity judge something akin to a ‘fiduciary out’ from the business judgment rule, for situations where, even though there is no indication of conflicted interests or lack of independence on the part of the directors, the nature of their action can in no way be understood as in the corporate interest: res ipsa loquitur.” Id. at 1-2. However, such an occurrence is “rare” and was found lacking by VC Glasscock in Chelsea.
The plaintiffs in Chelsea had asserted that the board violated the duty of loyalty by selling the company for substantially less than its standalone value and concealing that alleged value from shareholders. In particular, the plaintiffs asserted that: (1) the board instructed Chelsea’s financial advisors to ignore a set of financial projections, which estimated a 16% increase in market share if the Federal Drug Administration would remove Chelsea’s primary competitor from the market; and (2) the board itself ignored a second set of financial projections, which projected an additional $860 million in revenue if the FDA would approve the company’s product “for the treatment of other medical conditions for which its use is currently neither proven effective nor approved.” Id. at 3. In the plaintiffs’ view, these acts undervalued the company by $266 million to $558 million (id. at 9) and could be viewed as nothing other than being contrary to the interests of the stockholders.
On the basis of findings of fact in a prior ruling by now-retired VC Parsons, the Court initially rejected the plaintiffs’ claim that there had been actionable disclosure violations associated with the sale of Chelsea. Indeed, VC Parsons had found the former projection “to be speculative and highly unlikely to occur” and the latter to be “highly speculative.” Id. at 13 (citations omitted). VC Parsons had concluded that “the board or management’s use of optimistic figures in an effort to solicit higher offers is not persuasive evidence that those figures are, in fact, reliable or likely to alter the total mix of information available to shareholders.” Id. at 13-14 (citation omitted).
The Court then turned to the plaintiffs’ bad-faith claim, noting that “to state a bad-faith claim, a plaintiff must show either an extreme set of facts to establish that disinterested directors were intentionally disregarding their duties, or that the decision under attack is so far beyond the bounds of reasonable judgment that it seems essentially inexplicable on any ground other than bad faith.” Id. at 16 (citations and quotations omitted). The plaintiffs had not alleged that the board should not be entitled to the business judgment rule, and thus the question was whether “the Chelsea Board’s decision to exclude the Projections [was] so egregious on its face that—notwithstanding that there are no allegations that the directors are interested or lack independence—the Plaintiffs have stated a case that it is reasonably conceivable that the Defendants acted in bad faith?” Id. at 18. Here, VC Glasscock concluded, “the answer is no.” Id. Regarding the former projection, although the plaintiffs alleged that the company’s financial statements had included this estimated increase in Chelsea’s market share if the competitor was removed from the market, “the Board had no assurances that [the competitor product] would ever be discontinued.” Id.
The latter projection “only estimate[d] potential revenue streams that could occur, over fifteen years later, without adjusting for risk.” Id. at 19 (emphasis in original). To be fulfilled, Chelsea’s product would both need to be proven capable of treating additional conditions and be approved by the FDA. Thus, the Court found it was “not without the bounds of reason—in fact it is readily explicable—that the Board would decline to use the Projections to value the Company, as both are highly speculative.” Id. at 18. As a result, “Plaintiffs have failed to plead facts that demonstrate that the Defendants’ decision to disregard the projections was so egregious that it is reasonably conceivable the Defendants acted in bad faith,” and finding no breach of the duty of loyalty, VC Glasscock dismissed the complaint. Id. at 20.
VC Glasscock’s ruling confirms that in conjunction with the sale of a company, there be circumstances where it is reasonable for a board to decide not to consider projections, where they “involve contingencies over which the Company ha[s] no control, and which might never come to pass…. Such actions do not, on their face, plead a conceivable breach of the Directors[’] loyalty-based duty to act in good faith.” Id.