Disregard of Speculative Financial Projections Was Not Bad Faith
In a stockholder challenge to a sale of the company, a plaintiff may rebut the business judgment rule by pleading facts that support a reasonable inference that at least half of the directors, who approved the sale, were not disinterested or independent in breach of their fiduciary duty of loyalty. While the prohibition against self-interested transactions by the board is the most fundamental obligation under the duty of loyalty, the good-faith corollary to the duty of loyalty under In re The Walt Disney Derivative Litigation, 907 A.2d 693, 754-55 (Del. Ch. 2005), is "something of a catch-all," providing a "fiduciary out from the business judgment rule." Good faith under the duty of loyalty prohibits "intentional dereliction of duty, [or] inaction in the face of a duty to act," which allegations support a claim for bad faith. In a bad-faith claim, the board's intentional action, or inaction in the face of a known duty to act, cannot be explained "as in the corporate interest: res ipsa loquitor." The Delaware Court of Chancery has emphasized that pleading facts to support a bad-faith claim is the "most difficult path to overcome dismissal" and that such facts are a "rara avis."
In a recent decision, In re Chelsea Therapeutics International Stockholders Litigation, C.A. No. 9640-VCG (Del. Ch. May 20, 2016) (Glasscock, V.C.), the Court of Chancery held that the plaintiff stockholders of Chelsea Therapeutics International Ltd. had failed to plead facts that the Chelsea board's decision to disregard higher financial projections in recommending the sale of the company to stockholders was so egregious to support a claim for bad faith. The court reasoned that while these higher projections were used to entice bidders in the sale process, they were based on speculation that the U.S. Food and Drug Administration would approve one of Chelsea's products for currently prohibited uses, or would remove a competing product from the market. Thus, because Chelsea had no control over the contingencies upon which these higher projections were based, the board determined that these projections were too speculative to consider or rely upon before recommending the sale to Chelsea's stockholders. Accordingly, the court concluded that the complaint failed to state a claim for bad faith under the duty of loyalty, and dismissed the action.
The plaintiff stockholders brought fiduciary duty claims against the Chelsea board in connection with the sale of Chelsea through a tender offer and short-form merger with Lundbeck A/S. Chelsea is a developmental biopharmaceutical company that developed a drug called Northera to treat neurogenic orthostatic hypotension, which is a rare low blood pressure disorder. The plaintiffs claimed that the board intentionally concealed the true, higher value of the company from its stockholders, and thus, knowingly sold the company for an amount substantially below its standalone value.
The plaintiffs alleged that the board improperly instructed Chelsea's financial advisers to ignore one set of the company's financial projections in their fairness opinion. This first set of projections assumed a higher market share for Northera (and a corresponding increase in sales revenues) if the FDA were to remove Midodrine, which is the primary competitor of Northera, from the market based on its side effects and apparent ineffectiveness. But, after the public outcry in response to the FDA's proposed removal of Midodrine, the FDA changed course and allowed continued marketing of Midodrine. The plaintiffs also challenged the board's decision to disregard a second set of financial projections before recommending approval of the sale to Chelsea's stockholders. The second set of projections assumed an increase in the company's sales revenues if the FDA approved Northera for treatment of other medical conditions, but which treatment or uses had not yet been proven to be effective.
The plaintiffs asserted that these board actions resulted in the undervaluation of the company, and were inexplicable as actions in the interests of stockholders, for whom maximizing value was, at that point, the only proper purpose of the board. Therefore, despite the disinterest and independence of the board in the sale, the plaintiffs asserted that these board actions supported a claim of bad faith in breach of the duty of loyalty.
Board's Disregard of Higher Financial Projections not Bad Faith
First, the Court of Chancery ruled that the plaintiffs had failed to assert viable disclosure claims against the board based on its failure to disclose two sets of higher financial projections to stockholders in connection with the sale of Chelsea. Relying on its prior findings in connection with the denial of a preliminary injunction, the court reasoned that while these optimistic higher projections were used to solicit higher offers in the sale process, they were based on speculative FDA approval of Northera for currently prohibited uses that were yet to be proven effective, and the FDA's unlikely removal of a competing product from the market. Therefore, these higher projections were not sufficiently "reliable or likely to alter the total mix of information available to shareholders" in connection with their decision to accept or reject the tender offer.
To state a bad-faith claim, the court ruled that 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." The plaintiffs conceded that the directors held equity positions in Chelsea that aligned their interest to maximize the value of the company in the sale with the interest of other stockholders. Thus, the plaintiffs did not contend that the board had conflicting interests in the sale. Despite the board's disinterest and independence, the plaintiffs nevertheless pressed their claim that the board's decision to exclude the two sets of higher financial projections before recommending approval of the sale to stockholders was in bad faith.
The court found that the board's decision to disregard the two sets of higher financial projections in recommending the sale to stockholders was not beyond the bounds of reasonable judgment, and was rather readily understandable as a board action in the interests of stockholders to maximize the value of the company in the sale. While the first set of projections assumed an increase in sales revenues for Chelsea's product Northera, the increase in sales was premised on the FDA's removal of the competing product with Northera from the market, which was very unlikely after the public outcry against the FDA's proposed removal of the competing product. The second set of projections also assumed an increase in the company's sales revenues, but only if the FDA approved Northera for treatment of other medical conditions, which uses were currently prohibited and had not even been proven to be effective.
In sum, the court held that the plaintiff stockholders had failed to plead facts that the board's decision to disregard the higher financial projections in recommending the sale to stockholders was "so egregious that it was reasonably conceivable [that the board] acted in bad faith." Accordingly, the court concluded that the plaintiffs had failed to state a bad-faith claim for breach of the duty of loyalty, and granted the defendants' motion to dismiss the action.
The Chelsea Therapeutics decision reaffirms that a bad-faith claim under the fiduciary duty of loyalty is probably the most difficult to plead and overcome dismissal. It is only the rare set of facts or actions challenged that are so inexplicable that a bad-faith motive unrelated to the interests of the company must be at work.
Albert H. Manwaring IV (firstname.lastname@example.org) is a corporate governance and fiduciary litigation partner at Morris James in Wilmington.