In re Chelsea Therapeutics: Chancery Court Rejects Bad-Faith Claim for Board's Selective Use of Projections, Highlights Open Questions Post-"Corwin"

Practical Law Legal Update w-002-5014 (Approx. 6 pages)

In re Chelsea Therapeutics: Chancery Court Rejects Bad-Faith Claim for Board's Selective Use of Projections, Highlights Open Questions Post-"Corwin"

by Practical Law Corporate & Securities

Background

The case arises from the acquisition in 2014 of Chelsea Therapeutics International, Ltd., a developmental biopharmaceutical company, by Danish pharmaceutical company H. Lundbeck A/S. The acquisition was structured as a front-end tender offer pursuant to a merger agreement signed on May 7, 2014, and closed on June 23 of that year. For a summary of the merger agreement, see What's Market, H. Lundbeck A/S/Chelsea Therapeutics International, Ltd. Merger Agreement Summary.

The sale price ultimately agreed on was $6.44 in cash plus one contingent value right (CVR) per share, with each CVR paying up to an additional $1.50 per share if certain sales milestones related to Chelsea Therapeutics's drug NORTHERA were met. The class plaintiffs claimed that this price undervalued the company by between $266 million and $558 million. In support of their contention, the plaintiffs argued that the board deliberately ignored two projections for the company's value premised on possible future scenarios for NORTHERA. In particular, the plaintiffs claimed that the board:

Ignored the results of a study it had commissioned that anticipated new revenue streams if the FDA were to approve additional applications for NORTHERA.
Directed its financial advisor not to use a projection in which the FDA would take the main competitor drug to NORTHERA off the market.

The plaintiffs alleged that the board disregarded these projections even though they made no accusation that half or more of the directors were not independent or disinterested in the transaction. Therefore, with exculpation for breaches of the duty of care available under Section 102(b)(7) and with no allegation of a conflict of interest, the plaintiffs' only avenue to allege a breach of the duty of loyalty was to claim that the directors had failed to act in good faith. In the plaintiffs' view, this claim was viable because the directors' failure to consider the two optimistic projections was so unreasonable as to be explicable only on the basis of bad faith. To support the likelihood that the directors had acted in bad faith, the plaintiffs argued that the directors were willing to keep the company's valuation low because they were entitled to change-of-control payments under their stock options. Consequently, though the director defendants' interests were broadly aligned with those of the other stockholders (as they too owned equity in the company), only they were in a position to absorb a loss suffered by a low valuation.

The defendant directors moved to dismiss on several grounds. Primarily, the directors argued that they should be entitled to the presumptions of the business judgment rule under Corwin because the stockholders were adequately informed and had approved the transaction (though not in a formal vote, with the transaction structured as a tender offer). To support the contention that the stockholders had been adequately informed—even though the company in fact had not disclosed the substance of the two projections to the stockholders—the directors noted that the company had disclosed that the projections had been considered by the board and that the board had concluded that they were too speculative to be quantifiable.

Alternatively, even under traditional enhanced scrutiny typical of transactions where Revlon is triggered, the director defendants argued that the decision to discard the two projections was justifiable and not evidence of bad faith.

Outcome

The court granted the motion to dismiss without deciding whether Corwin was applicable. Instead, the court found that the plaintiff had not established a reasonably conceivable case that the directors had acted in bad faith.

Open Questions about Applicability of Corwin

In Corwin, the Delaware Supreme Court held that a vote by the fully informed and uncoerced stockholders restores the presumptions of the business judgment rule for the benefit of the board of directors, even when the merger is a change-of-control transaction to which Revlon ordinarily applies (Corwin v. KKR Fin. Hldgs. LLC, 125 A.3d 304, 308 (Del. 2015)). The preliminary issue in Chelsea Therapeutics, then, was whether the stockholders had been adequately informed about the acquisition by Lundbeck. The plaintiffs also pressed a disclosure claim as a standalone issue, asserting that the board had breached its fiduciary duty by failing to disclose the substance of the two projections.

The Chancery Court held that the stockholders were adequately informed about the transaction and the plaintiffs did not have an actionable claim based on inadequate disclosure. The court highlighted the minutes of two board meetings that stated that the board had assessed the scenarios in which the competitor drug was removed from the market and NORTHERA was approved for alternative uses and had found these scenarios to be highly speculative and unlikely to occur. The plaintiffs pointed out that the board had disclosed the projections to bidders, which implied that the projections were reliable and therefore should have been disclosed to the stockholders. The court disagreed, holding that the use of optimistic figures for the sake of soliciting bids does not prove the reliability of the projections or the likelihood that they would significantly alter the total mix of information available to the stockholders (the standard in Rosenblatt v. Getty Oil Co., 493 A.2d 929, 944 (Del. 1985)).

Because the disclosures to the stockholders were adequate, the defendant directors urged the court to extend Corwin to the case and apply the business judgment rule. The Chancery Court, however, pointed out that the Supreme Court had left open two issues that made it unclear whether Corwin applied:

Bad-faith conduct. If the board has acted in bad faith, it is unclear whether the stockholder vote cleanses that act, even if the act was disclosed to the stockholders.
Application to tender offers. The rule in Corwin applies to mergers, where the stockholders affirmatively vote whether to approve the transaction. With tender offers, the stockholders do not vote on the transaction (though they obviously do submit their shares into the offer). It is therefore uncertain whether Corwin applies. (This is similar to the open question of whether the business judgment rule can be restored in tender offers conducted by controlling stockholders, as discussed in Practice Note, Fiduciary Duties in M&A Transactions: Controlling-Stockholder Transaction Structured as a Front-End Tender Offer.)

The Chancery Court chose to leave these questions unanswered and instead addressed the plaintiffs' arguments on their own (preferred) terms. Nevertheless, the court held that the board's conduct did not rise to the level of bad faith.

The Directors Did Not Act in Bad Faith

The court began its decision with a rumination on the definition of bad faith, lamenting the "hazy jurisprudence" that amounts to a "fiduciary out" from the business judgment rule exercisable by the Chancery Court when, even though there is no conflict of interest or lack of independence on the part of the board, the board's conduct cannot be understood as having been in the interest of the corporation. The court settled on the formulation from Dent v. Ramtron International Corp., which held that bad faith is demonstrated when either:

"An extreme set of facts" establishes that the directors, though disinterested, were "intentionally disregarding their duties."
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."

(, at *6-7 (Del. Ch. June 30, 2014).)

By that standard, the court held that the plaintiffs had not established that the board had acted in bad faith. The court credited the board with having considered the reliability of the projections and coming to a justifiable decision to disregard them. As the court explained, the board had no assurance that the competitor drug would ever be discontinued, while any projected future revenue streams for NORTHERA were 15 years out and unadjusted for risk. The fact that no bidder (throughout a 20-month long sale process) made an offer that reflected the two projections further supported the board's conclusion that the projections were speculative and not reliable indicators of the company's value.

The change-of-control payments to which the directors were entitled did not change this calculation. The payments were not large enough to overcome the losses that the directors, as stockholders themselves, would have suffered by deliberately keeping the offer price low for the sake of a deal. On the contrary, had the payments been large enough to be material to the directors net of a loss on their stock positions, they would have supported an allegation of an outright conflict of interest. Short of that, the directors' interests were aligned with the other stockholders' and the payments could not support an allegation of bad faith.

Practical Implications

The decision highlights two open questions that remain unresolved after Corwin. One question is whether the rule in Corwin applies in tender offers (where there is no formal vote on the transaction) the same way that it does in mergers (where there is). The second is whether the stockholder vote not only restores the presumptions of the business judgment rule when enhanced scrutiny would ordinarily apply, but cleanses board actions taken in bad faith as well (as long as those actions have been disclosed to the stockholders).

The bad-faith question has the potential to be significant, because in Revlon situations, the inquiry into the board's conduct is almost always tied up with the question of whether the board acted in bad faith. As long as the corporation has an exculpation provision in its charter, the court necessarily examines the board's conduct for bad faith (which forms the basis for a finding that the board breached its duty of loyalty). If an act taken in bad faith cannot be cleansed by an informed stockholder vote, then by definition the rule in Corwin can never apply if the corporation has an exculpation provision and the plaintiffs have made an accusation that the board acted in bad faith.

Irrespective of the answers to those questions, Chelsea Therapeutics represents another example of the broad latitude afforded to disinterested and independent directors to conduct a sale process and make decisions that will not be subject to judicial second-guessing. Delaware courts are inclined to credit boards with acting in good faith as long as the board can demonstrate that it gave reasonable attention to matters affecting the company's value, as did the board of Chelsea Therapeutics. To that end, boards of directors should:

Openly consider all issues that have a significant impact on value. In ordinary third-party transactions (where the court does not apply entire fairness), the board does not need to obtain the objectively best price possible or run a perfect process. It needs only to act reasonably in pursuit of obtaining the best price.
Keep detailed records and minutes of these deliberations to evidence the board's deliberations. The minutes should be written as soon after the meeting as possible and not in anticipation of litigation, when they will be given far less weight.
Not hide bad facts from the record or the court. The board is entitled to decide on a course of action that others might disagree with, but it will be much easier for the board to defend its rationale if it is open about the issues it considered. A finding during litigation that the board was aware of a factor that could negatively impact the company's value but did not consider it in detail or document its deliberations over it can be expected to produce a skeptical judicial view of the board's conduct.

In re Chelsea Therapeutics: Chancery Court Rejects Bad-Faith Claim for Board's Selective Use of Projections, Highlights Open Questions Post-"Corwin" | Practical Law