The Delaware Court of Chancery’s decision in Chelsea Therapeutics Stockholder Litigation (May 20, 2016) underscores the benefits of disclosure to stockholders with respect to a board’s decision—in valuing the company in connection with a sales process—to not take into account (or to modify or revise) projections prepared by management. It should be noted that the court’s discussion highlights that, as reflected in the trend of Delaware decisions over the past couple of years, there is only a narrow path to success for plaintiffs in establishing liability of independent and disinterested directors in a post-closing damages action.
- The court dismissed (at the motion to dismiss stage of litigation) the claim that directors had acted in “bad faith” by (i) not utilizing certain alternative sets of management projections in their valuation of the company in a sales process and (ii) directing the company’s bankers not to take them into account in connection with opining on the fairness of the proposed sale. The court dismissed the bad faith claim on the basis that the directors’ decision that the projections were too speculative to be meaningful was “not without the bounds of reason.”
- The court’s discussion reaffirms that, as a practical matter, the only viable path to liability of directors in a post-closing damages action—absent egregious facts—is a claim that the directors were conflicted (i.e., that the directors were not independent and disinterested).
Chelsea Therapeutics—which produced an FDA-approved “orphan” drug for use in connection with a rare medical condition—was sold to Lundbeck A/S, in a cash tender offer and short-form merger. Having failed to obtain a preliminary injunction to prevent the deal from closing, the plaintiffs pursued a post-closing action for damages, claiming that the directors had breached their duty of loyalty by knowingly selling the company at a price that they knew was substantially below its standalone value. The plaintiffs contended that, in furtherance of that disloyal act, the directors had ignored, and had directed Chelsea’s financial advisors to ignore (when opining on the fairness of the transaction), the value implied by two sets of alternative projections that had been prepared by management—one that indicated a higher value for Chelsea should the FDA determine to remove its main competitor from the market, and the other that predicted significantly increased revenues should the FDA approve Chelsea’s drug for expanded uses. The plaintiffs argued that there was no conceivable basis on which it was in the interests of the stockholders for the board and the bankers to have not taken into account these projections, and that, therefore, the directors—despite being independent and disinterested—“must have” acted in bad faith. The court dismissed the claims (at the motion to dismiss stage of litigation, but apparently taking into account facts developed in connection with the earlier motion for preliminary injunction).
The court’s determination that the board’s decision not to utilize certain projections was within “the bounds of reason.” While it may or may not have been “wise” for the directors to not take into account the projections, the court stated, their decision was “not without the bounds of reason—in fact, it [was] readily explicable.” The court acknowledged that the projections were “highly speculative”— “involv[ing] contingencies over which the company had no control, and which might never come to pass.” One set of the excluded projections assumed the elimination of the only competing drug by the FDA (as had been considered by the FDA and was not necessarily finally resolved). In the preliminary injunction action, the Court of Chancery found that, in the context of the sales process, the board had considered whether it was likely that the FDA would take the competing drug off the market and had determined that it was not. The other set of excluded projections assumed approval by the FDA of expanded uses for Chelsea’s drug and, as described by the court, “without adjusting for risk, projected revenues that could occur over fifteen years later,” and which assumed both that the drug would prove capable of other uses and that the FDA would approve it for those uses.
Further, the court noted that:
- The directors’ interests were aligned with the other stockholders’ interests in obtaining the maximum sale price, based on the directors’ significant equity holdings and their not having any other personal interest in the transaction;
- The projections at issue had been provided to the potential bidders—and, despite plaintiffs’ claim that the projections indicated a value for the company that was higher than the deal price by hundreds of millions of dollars, no competing bidder emerged during the 20-month long sales process; and
- The company had disclosed to the stockholders, in the company’s Schedule 14D-9, that the board considered utilizing the projections, determined that they were too speculative to be quantifiable, and directed the financial adviser not to consider them in rendering the fairness opinion. Further, for years, the company had disclosed in its public filings that the competing drug might be removed from the market by the FDA, and that there were other potential uses for Chelsea’s drugs.
The other facts and circumstances—all of which supported a view that the board had not acted in bad faith—included that: there was a strong sales process, with independent advisors and 65 potential bidders contacted; the sale price reflected a significant premium; as noted, no competing bidder emerged over the 20-month process; and there were no disclosure violations (based in part on the court having denied the earlier preliminary injunction motion that was based on disclosure claims).
Disinterested nature of the board. The court rejected the plaintiffs’ suggestion that the Chelsea directors may have been interested in the transaction due to their entitlement to a change-of-control bonus payment equal to 50% of their regular annual board compensation if the sale closed by the end of 2014. The court noted that, because the directors owned significant equity in the company, their interests in the bonus payments were not material as compared to their interests in maximizing the sale price.
The court’s explication of directors’ duty of loyalty under Delaware law. The court described the two prongs of the duty of loyalty, under long-established principles of Delaware law:
- The non-independence prong. The duty requires that directors act “in the interest of the corporation and its owners, the stockholders; the duty prohibits actions for the benefit of the director herself, or others to whom she is beholden, absent entire fairness to the corporation.”
- The bad faith prong. The duty “also requires that independent and disinterested directors act in good faith.” Good faith is “something of a catch-all” concept, the court wrote, prohibiting “actions taken in bad faith—[i.e.,]... board action intended for purposes other than the corporate [welfare], even though taken by independent, disinterested directors.”
“Bad faith” may be established, the court explained, when the plaintiffs show:
- an “extreme set of facts” establishing that the directors “were intentionally disregarding their duties” or
- that the directors’ decision was “so far beyond the bounds of reasonable judgment that it seems inexplicable on any grounds other than bad faith.”
This second basis for a bad faith claim (which is the one on which the Chelsea plaintiffs relied)—“that the action complained of is inexplicable, so that bad faith—a motive other than the interest of the Company— must be at work”—was characterized by the court as “similar to the much older fiduciary prohibition of waste,” a “rare bird,” and “the most difficult path to overcome dismissal of a claim based on bad faith.”
Narrow path to success in post-closing damages actions; strongest claims will be those based on directors not being independent and disinterested. Based on Chelsea and the courts’ past jurisprudence (including the recent Delaware Supreme Court decisions in Trulia, Corwin and Zale), in post-closing actions for damages, absent egregious facts, claims are likely to be dismissed at the motion to dismiss stage of litigation, unless they are based on the directors not being independent and disinterested. Specifically, claims based on:
- Director breaches of the duty of care—should be dismissed based on exculpation of directors (under company charters);
- Director breaches of the duty of loyalty by independent and disinterested directors acting in bad faith—as expressed in Chelsea, should be dismissed unless there is the equivalent of corporate “waste”;
- Directors’ inadequate disclosure to the stockholders—can be cured, prior to a shareholder vote, by supplemental disclosure by the company (i.e., “mooting” the claims, with a proceeding to follow to determine what fee, if any, plaintiffs’ attorneys are entitled to); and
- Financial advisors aiding and abetting directors’ breaches—should be dismissed unless the advisor acted in knowing bad faith and was a proximate cause of damages to the stockholders (i.e., in effect, knowingly induced the board to breach its fiduciary duties).
By contrast, claims based on breaches of the duty of loyalty by reason of the directors’ not being independent and disinterested, depending on the circumstances, may not be dismissed at the motion to dismiss stage if there are credible claims that the directors acted in their own interests or the interests of those to whom they were “beholden.” (We note that if, as discussed below, Corwin is held to apply to duty of loyalty claims, then these types of claims also likely would be dismissed at an early stage of litigation.)
Open issue whether disclosure can “cleanse” duty of loyalty breaches. The Court of Chancery’s seminal Corwin decision in 2015 (which was upheld by the Delaware Supreme Court) provided that the business judgment rule will apply to review of directors’ decisions in a post-closing damages action relating to a transaction that was approved by the disinterested stockholders in a fully informed and un-coerced vote. The Court of Chancery’s Oct. 29, 2015 Zale decision (later approved by the Delaware Supreme Court), applying Corwin, emphasized the “cleansing effect of a fully informed [stockholder] vote.” In Chelsea, the court acknowledged that—as we noted in the Fried Frank M&A Briefing, dated May 23, 2016, relating to the Delaware Supreme Court’s affirmance of Zale—there is an open issue whether, under Corwin, the business judgment rule would apply in a post-closing damages action in which a breach of the duty of loyalty claim is made. In Chelsea, the defendants urged the court to apply the business judgment rule, under Corwin, given the posture of the case as a post-closing damages action in which the court found that there were no disclosure violations. The Vice Chancellor stated that the defendants argued “that [the court should] make a finding that the disclosures were adequate to cleanse any bad faith on the part of the directors....” The court found that, because it held that plaintiffs’ allegations failed to state a claim upon which relief could be granted (and thus dismissal was warranted), the court did not need to reach the question, left open in Corwin, of “whether the rule in Corwin...would cleanse a bad-faith act.”
In connection with valuation of the company during a sales process, board (and banker) determinations to utilize or not utilize, or to revise or modify, projections prepared by management, should be carefully considered by the board. That consideration, and the reasons for the board’s actions, should be documented. Disclosure of the fact that the board considered the issues, and the reasons for the actions taken, should result in dismissal of claims of “bad faith” conduct by the directors, so long as the directors articulated a rational and legitimate business purpose for the actions taken.