Tuesday, May 24, 2016

Omitting speculative projections was not bad faith

By Anne Sherry, J.D.

Directors of Chelsea Therapeutics did not breach their duty of loyalty in approving the biopharm company's sale to Lundbeck. The Chelsea shareholders seeking damages post-closing did not state a claim that the board acted in bad faith by instructing its advisors not to consider speculative projections that its assets would increase in value years in the future. That decision, the Delaware Court of Chancery held, did not amount to an intentional disregard for the directors' duties, nor was it inexplicable on any ground other than bad faith (In re Chelsea Therapeutics International Ltd. Stockholders Litigation, May 20, 2016, Glasscock, S.).

Chelsea had researched and developed a drug, Northera, to treat a blood-pressure condition associated with Parkinson's disease. During the negotiations with Lundbeck, the director defendants instructed Chelsea's financial advisors to ignore a set of projections that assumed a higher market share should the FDA remove the company's primary competitor from the market. The directors also disregarded a second set of projections predicting increased revenue streams should the FDA approve Northera for the treatment of other medical conditions. The plaintiffs contended that the defendants breached their fiduciary duties by intentionally concealing the true, higher value of the company from its stockholders.

Duties of care and loyalty. Because the directors were exculpated from liability for duty-of-care claims, the plaintiffs' damages action could only rest on a duty-of-loyalty theory. The only such claim articulated in the complaint was a narrow one based on bad faith. To state a breach-of-duty claim predicated on bad faith, a plaintiff must show either an extreme set of facts establishing that disinterested directors were intentionally disregarding their duties or that the decision was so far beyond the bounds of reasonable judgment that it is essentially inexplicable on any ground other than bad faith.

The plaintiffs conceded that the directors' and shareholders' interests were aligned because the directors held equity positions, but pointed out that they would receive change-in-control payments in the event of the company's sale. However, the plaintiffs failed to allege that those payments would overcome the alleged loss from undervaluing the company, much less exceed that loss in a way material to the defendants.

This left the plaintiffs to rely on the most difficult path to overcoming dismissal of a bad-faith claim: alleging that the action complained of is otherwise inexplicable so that bad faith must be at work. In fact, however, the court found that it was readily explicable that the board would decline to use the higher projections to value the company. The projections were both highly speculative, and the second set estimated potential revenue streams that could occur more than 15 years into the future, without adjustments for risk.

Can disclosure cleanse bad faith? The court did not reach the issue, raised by the defendants, of whether under Corwin v. KKR the company's disclosures were adequate to cleanse any bad faith on the part of the directors and thus the case should be dismissed under the business judgment rule. The complaint failed to state a claim regardless of the outcome of this issue. In dicta, the court did say it was "unclear" that Corwin would cleanse a bad-faith act, even if disclosed.

The case is No. 9640-VCG.

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