Securities Snapshot
July 17, 2018

Delaware Supreme Court Holds That “Partial And Elliptical Disclosures” Cannot Support The Application Of Business Judgment Review

Delaware Supreme Court holds that “partial and elliptical disclosures” cannot support the application of the business judgment review; Delaware Chancery Court awards shareholders $20 million in fiduciary breach case against controlling shareholder, applying entire fairness standard; District of Massachusetts dismisses securities class action based on disagreement over interpretation of clinical trial data; District of Pennsylvania denies motion to dismiss securities class action based on Walgreens’ allegedly reckless statements concerning pending merger; SDNY continues trend of rejecting “loan sampling” discovery in RMBS trustee suits; District of Maryland dismisses Section 14(a) claim for failure to plead transaction causation, allows breach of fiduciary duty claims to proceed; and SEC imposes sanctions for inadequate disclosures of perquisites.

On July 9, 2018, the Delaware Supreme Court, in Morrison, et al. v. Ray Berry, et al., reversed a Delaware Chancery Court decision dismissing a stockholder suit brought by an investor of The Fresh Grocer over the company’s $1.4 billion take-private deal, holding that the lower court erred in finding that stockholders were fully informed when voting to tender their shares. The plaintiff initially brought breach of fiduciary duty claims against all ten of The Fresh Grocer’s directors, including the company’s founder, Ray Berry. Specifically, the plaintiff alleged that Berry and his son, Brett—who collectively owned 9.8% of the company’s shares—teamed up with private equity firm Apollo Global Management LLC to buy the company at a discount, by deceiving the board and inducing the directors to put the company up for sale through a process that “allowed the Berrys and Apollo to maintain an improper bidding advantage” and “predictably emerge[] as the sole bidder for Fresh Market” at a price below fair value. The Court of Chancery dismissed the complaint, holding that the transaction had been approved by a “fully informed, uncoerced majority of the disinterested stockholders,” and therefore, in accordance with the Corwin doctrine, the board was entitled to the protection of the business judgment rule. In a decision authored by Justice Valihura and joined by Justices Strine and Vaughn, the Delaware Supreme Court disagreed, ruling that the Corwin standards were not satisfied because the stockholders were not “fully informed” due to “partial and elliptical disclosures.” In reaching its decision, the Supreme Court compared side-by-side the company’s tender offer disclosures with certain internal emails that were unearthed following a litigated books and records request made pursuant to Section 220 of the Delaware General Corporation Law, which revealed apparent misstatements and omissions in the offering materials. For example, the court was troubled by the tender offer disclosures’ omission of the fact that Berry was committed to participating with Apollo at the time the firm first approached the company about a possible transaction. This omission was material, the court found, because it impacted the stockholders’ ability to determine whether the sales process that followed was “pre-ordained” in favor of Apollo, or whether it was intent on seeking the highest price. Given its finding of material misrepresentations and omissions, the court found that the “stockholders [could not] possibly protect themselves when left to vote on an existential question in the life of [the] corporation.” The court thus held that the lower court should have applied the entire fairness standard, rather than the more permissive business judgment rule, to review of the transaction and remanded the case to the Court of Chancery for further proceedings consistent with its opinion. This case is significant because whether or not the court can apply the business judgment rule to a particular transaction is often outcome-determinative at the motion to dismiss stage of post-closing litigation. The decision also serves as a reminder of the importance of ensuring that merger proxy and tender offer disclosures are accurate in all material respects.


On July 6, 2018, a Delaware Court of Chancery levied $20.3 million in joint and several damage sanctions against Chester Davenport and his private equity fund Georgetown Basho Investors, LLC in Basho Technologies Holdco B et al. v. Georgetown Basho Investors LLC et al, ruling that defendants put Basho Technologies, Inc. on a “greased slide to failure” following a series of preferred stock financings that gave the defendants control over the company. Georgetown began investing in Basho—an early stage “big data” tech company—in 2010. After becoming a director of Basho, Davenport increased Georgetown’s control over the business through a series of preferred stock financings and eventually gained blocking rights over Basho’s access to outside capital. In 2014, Davenport and Georgetown forced the company through a Series G financing with highly favorable terms for Georgetown, and that provided Georgetown with hard control over the company. By 2015, Basho was in need of more capital, but Davenport caused Georgetown to block an outside investment he believed would dilute Georgetown’s equity position in Basho. Davenport then pursued, unsuccessfully, a sale of Basho, and Basho ran out of cash and was liquidated in 2016. The plaintiffs alleged that Davenport and Georgetown breached their fiduciary duties both in connection with the Series G financing and through their operation of the company following the Series G financing. Because the Series G financing involved self-dealing by a controlling shareholder, the court applied the entire fairness standard to the plaintiffs’ challenge. Applying this heightened standard, Vice Chancellor J. Travis Laster found that the transaction was unfair both in the way it was initiated and in the eventual terms offered to Basho. In particular, the court found that Davenport intentionally drove off competing investors by discouraging their submission of term sheets and insisting on vetting every investor before they could speak with management. Following the Series G, Davenport simultaneously attempted to sell Basho, to extract value for Georgetown, while also rebuffing competing investors that would have diluted Georgetown’s equity stake, which further harmed the company. Finding that Davenport and Georgetown breached their fiduciary duties, the court awarded plaintiffs $20.3 million—the difference between the value of their shares after the Series G financing and the value at the time of trial, which was zero. Recognizing that the Chancery Court’s damage award represents a rare, steep sanction of a controlling shareholder for fiduciary duty breaches, Vice Chancellor Laster explained that the decision does not signal a “heightened risk for venture capital firms who exercise their consent rights over equity financings.” Rather, the decision reflected a fact-specific analysis of Davenport’s “egregious” conduct. Had Davenport and Georgetown limited themselves “to use of their right to require consent to financing alternatives, the outcome might have been different,” the court explained. Instead, the record showed that “Davenport went far beyond, . . . driving away investors who were interested in the company and impeding better offers.” The decision is significant because it shows that large stockholders who take control of a corporation can, under certain circumstances, face steep liability for subsequent loss of shareholder value.


On June 27, 2018, the U.S. District Court for the District of Massachusetts in Whitehead v. Inotek Pharmaceuticals, Inc., et al., granted a motion to dismiss a securities fraud complaint against Inotek—a clinical-stage biopharmaceutical company that focuses on the development of novel therapies for diseases of the eye—and certain of its officers and directors, having determined that the plaintiffs had failed to allege scienter or a material misrepresentation or omission. Prior to August 2017, Inotek was developing one product, trabodenoson, or “trabo”, for the treatment of glaucoma. Inotek was attempting to develop trabo both as a monotherapy and as a fixed-dose combination with latanoprost, a leading glaucoma treatment, with the hope of producing a drug that was effective through once-daily administration. The company performed separate Phase 2 trials in support of the monotherapy and fixed-dose combination formulations. In the Phase 2 monotherapy trial, patients were dosed twice a day with trabo monotherapy. In the fixed-dose combination trial, trabo was co-administered with latanoprost twice daily in the first part of the study and then co-administered with latanoprost once daily in the second part of the study. Following these trials, Inotek performed a Phase 3 trial in support of its monotherapy formulation of trabo, which tested the effectiveness of the drug in a once-daily administration. In January 2017, Inotek announced that the Phase 3 trial did not achieve its primary endpoint. Later, in July 2017, Inotek announced that a second phase 2 trial in support of the fixed-dose combination therapy, which tested the drug’s effectiveness as a once-daily administration, also failed to meet its primary endpoint. The price of Inotek’s stock declined following both of these announcements. Investors filed suit, alleging that Inotek made false and misleading statements about the trials’ prospects for success, in violation of Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5, promulgated thereunder. Specifically, because neither the monotherapy Phase 2 study nor the first fixed-dose combination Phase 2 trial tested a once-daily dose of trabo alone, the plaintiffs contended that Inotek had no data from which to observe the effectiveness of trabo as a once-daily dose, and that defendants’ statements concerning the drug’s prospects for success were therefore fraudulent. Judge Leo T. Sorokin rejected the plaintiffs’ arguments, holding that an inference of scienter was not possible due to the fact that Inotek had disclosed in its SEC filings the very information that the plaintiffs alleged was concealed or misstated, namely all of the results of the first two Phase II trials. Further, the court rejected the plaintiffs’ “catch-all” allegations, which “merely assert[ed] motive and opportunity without something more,” including that Inotek—a “one-drug company”—was incentivized to misrepresent its clinical trial data because its success hinged on trabo. The court also held that the plaintiffs failed to allege actionable misstatements concerning the potential for trabo’s effectiveness as a once-daily dose, holding that Inotek’s statements “were not false or misleading as of the time [they] were made; they are not affirmative representations about what trabo had been shown to do but rather statements about what it might be shown to do going forward. [And] Inotek disclosed the basis for its view.” The decision demonstrates that plaintiffs face a high bar in pleading the required strong inference of scienter and actionable misstatements when challenging an issuer’s scientific interpretation of its fully disclosed clinical trial data. Goodwin represented the Inotek defendants in this case.


On July 11, 2018, the U.S. District Court for the District of Pennsylvania, in Hering v. Rite Aid Corp., et al., granted Rite Aid’s motion to dismiss a securities fraud lawsuit alleging it misled investors while trying to clear antitrust hurdles that ultimately stymied a $17.2 billion takeover bid by Walgreens, but held that the plaintiff’s similar claims against Walgreens could proceed. The plaintiff had asserted claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder, alleging that both Rite Aid and Walgreens misled investors about the probability that the merger would be approved by the Federal Trade Commission and also concerning the shareholder value that the merger would create. Specifically, the plaintiff alleged that while the FTC was reviewing the transaction, both companies repeatedly touted the purported benefits of the merger and downplayed any concern that it would not be consummated as structured, or fail to pass regulatory scrutiny. Both companies expressed optimism that the FTC’s review would not lead to any significant antitrust issues, and Walgreens would likely only have to divest 1,000 or fewer Rite Aid stores in geographic areas where Walgreens and Rite Aid operations overlapped. In spite of the two companies’ initial optimism, however, after facing prolonged regulatory review, Walgreens and Rite Aid terminated the merger agreement and entered into an asset purchase agreement whereby Walgreens simply purchased a specific number of Rite Aid stores. The plaintiffs alleged that the companies’ statements misled investors into believing that the transaction was progressing more successfully than it was. Judge John E. Jones rejected this argument with respect to all of Rite Aid’s statements and most of Walgreens’ statements, finding that that the challenged statements were non-actionable forward looking statements, opinions, or statements of corporate optimism, and dismissed the claims related to these statements. While the court’s determinations resulted in Rite Aid’s dismissal from the case, the court found that plaintiff’s claims against Walgreens could proceed based on certain statements that Walgreens made in response to journalists who were reporting that the deal was experiencing regulatory turbulence. Specifically, the plaintiff alleged that even after the FTC raised concerns and the original terms of the merger needed to be revised, Walgreens representatives doubled down on their publicly expressed confidence that the merger would go through as planned, and challenged news reports to the contrary. Based on these statements, the court held that Walgreens “ventured into actionable territory when they openly contradicted news reports of regulatory trouble by alluding to their non-public ‘inside’ knowledge of the FTC’s review.” The court found these statements, purportedly based on non-public information from the FTC, could have misled reasonable investors into thinking that the review process was progressing better than it was. And, while the court could not know exactly what Walgreens knew or did not know based on their internal discussions with the FTC, it found that the plaintiff had alleged enough facts to give rise to a strong inference that Walgreens had acted recklessly in challenging the news reports. The case serves as a reminder of the pitfalls of alluding to nonpublic information in expressions of corporate optimism.


On July 9, 2018, a Southern District of New York magistrate judge granted U.S. Bank NA’s request for a protective order in Royal Park Investments SA/NV v. U.S. Bank NA, precluding Royal Park Investments from using loan sampling (i.e., a statistical sampling of a set of loans used to extrapolate estimated data about the entire set) to prove liability or damages in its proposed class action, which accused the bank of breaching its contractual and fiduciary duties as trustee for an array of residential mortgage-backed securitization trusts. By way of background, U.S. Bank is one of many RMBS trustees that has faced lawsuits alleging dereliction of its duties as RMBS trustees because they allegedly knew that the RMBS trusts they oversaw had a large number of defective loans and other problems, yet failed to take adequate steps—including requiring the RMBS issuer to repurchase defective loans underlying the securities—to protect the trusts’ investors leading up to and following the financial crisis of 2008. Some courts have previously allowed plaintiffs in similar cases to use sampling to establish liability and damages against other parties in the securitization process, such as sponsors or issuers of the securities. U.S. Magistrate Judge Robert W. Lehrburger, however, held that loan sampling discovery is inappropriate in RMBS trustee suits, and granted U.S. Bank’s request for a protective order. Consistent with multiple prior Southern District of New York, Magistrate Judge Lehrburger held that sampling is inappropriate because, under the language of the relevant trust agreements, the sole remedy provided to the trustee with regard to breaching loans is to seek repurchase on a loan-by-loan, trust-by-trust basis. Consequently, whether U.S. Bank could have obtained repurchase of breaching loans must be determined separately for each specific loan. The court held that, “U.S. Bank, as trustee, stands in different shoes subject to trustee-specific contractual terms. As has been consistently held to date, that contractual language dictates a ‘loan-by-loan’ analysis, a standard that cannot be met with sampling.” The plaintiff attempted to distinguish this case from the other recent decisions, many of which involved a challenge to the court’s use of statistical sampling evidence at trial, rather than a protective order against sampling-related discovery. The plaintiff argued that this difference was significant because it had not issued any sampling-related discovery to U.S. Bank and did not plan to do so. The court rejected this argument, noting that allowing for sampling would still place a burden on the defendant because, “[i]n a litigation with as much at stake as this one, no responsible defense attorney would move forward without at least analyzing plaintiff’s sampling expert report, deposing the expert, preparing to cross-examine the expert at trial, and retaining an expert to potentially rebut the plaintiff’s expert.” This case represents the latest in a string of Southern District of New York decisions rejecting the use of statistical sampling to prove liability or damages in RMBS cases arising out of the housing crisis. 


On July 3, 2018, the U.S. District Court for the District of Maryland, in In re AGNC Investment Corp. Stockholder Derivative Litigation, partially dismissed investors’ shareholder derivative suit for failure to plead transaction causation when alleging that certain current and former officers and directors of AGNC Investment Corporation, a real estate investment trust, violated federal securities law and breached their fiduciary duty in negotiating the renewal of the REIT’s management agreement. The plaintiffs, shareholders of AGNC, asserted claims based largely upon a contract that governed the relationship between AGNC and American Capital AGNC Management, LLC, both subsidiaries of American Capital. Under the agreement, AGNC Management was responsible for administering AGNC’s day-to-day business activities, subject to the supervision and oversight of AGNC’s Board. The thrust of the plaintiffs’ complaint was that the terms of the Management Agreement required AGNC to pay AGNC Management “exorbitant fees in excess of $100 million” each year, regardless of the performance of AGNC’s investment portfolio. These fees, the plaintiffs alleged, were unreasonable; exceeded the costs of the services actually provided by AGNC Management; and ultimately enriched the defendants by subsidizing the operations of other American Capital subsidiaries. The plaintiffs asserted that the defendants, as members of AGNC’s board of directors, owed a fiduciary duty to AGNC that required them to renegotiate or cancel the Management Agreement, but because they personally benefited from the payment of the fees, they failed to do so. The plaintiffs also alleged that the individual defendants made false and misleading statements relating to the Management Agreement in proxy solicitations sent to shareholders, in which AGNC’s directors also requested that shareholders vote to reelect them to the board, thereby violating Section 14(a) of the Securities Exchange Act of 1934. According to the plaintiffs, the proxy statements acknowledged that AGNC would be subject to a significant penalty for terminating the Management Agreement, but failed to disclose that provision of the Management Agreement that would have allowed for a renegotiation to more favorable terms for AGNC. The plaintiffs contended that shareholders were misled into believing that AGNC was essentially locked into the Management Agreement, and would not have voted to re-elect the board if they had known the proxy statements were misleading. The defendants moved to dismiss the breach of fiduciary duty claim because plaintiffs failed to make pre-suit demand upon AGNC’s board of directors to remedy the alleged harm to AGNC. Judge Theodore D. Chuang rejected this argument, holding that the plaintiffs had properly alleged demand futility, finding that the renewals of the Management Agreement were financially detrimental to AGNC but advantageous to the other American Capital subsidiaries, and therefore were sufficient to establish a conflict of interest that raised a reasonable doubt “whether the directors honestly and in good faith believed that the action was in the best interests of the corporation.” The defendants also moved to dismiss the 14(a) claim on the basis that the board’s decision to renew the Management Agreement was not directly approved by the shareholders in response to the proxy statements, and therefore any alleged defect in the proxy solicitation did not cause the plaintiffs harm. The court agreed, noting that the U.S. Courts of Appeals “have consistently held that successfully pleading ‘transaction causation’ in a Section 14(a) suit requires a showing that the challenged proxy statement induced shareholders to directly authorize the specific transaction that resulted in the economic loss.” In other words, the plaintiffs failed to plead transaction causation because the alleged economic loss was not caused by the allegedly misleading proxies, but by the later misconduct by the board. This decision highlights that challenges to allegedly disloyal board conduct is the realm of fiduciary breach claims and not Section 14(a) claims, unless the challenged proxy induced direct authorization of a harmful transaction.


On July 2, 2018, the U.S. Securities and Exchange Commission issued an order faulting the Dow Chemical Company for failing to disclose $3 million worth of perquisites, also known as “perks”, as “other compensation” to its named executive officers over the course of 2013 to 2016. According to the order, the SEC found that Dow did not follow SEC guidance for disclosing perks, which provides that: “An item is not a perquisite or personal benefit if it is integrally and directly related to the performance of the executive’s duties.” Instead, Dow applied its own test, whereby any benefit conferred on an executive did not require disclosure if it was “related to a business purpose.” Notably, this business-purpose standard used by Dow was specifically rejected by the SEC during a 2006 overhaul of the Commission’s executive compensation disclosure requirements. The SEC reiterated this point in its order, noting that the applicable integral-and-direct exception “is a narrow one,” which “draws a critical distinction between an item that a company provides because the executive needs it to do the job, making it integrally and directly related to the performance of duties, and an item provided for some other reason, even where that other reason can involve both company benefit and personal benefit.” Following this framework, the SEC determined that Dow had failed to properly disclose the following perks: (i) the use of the company aircraft for personal purposes, such as travel to outside board meetings and sporting events; (ii) club memberships; (iii) the use of personal assistant time for non-work related purposes; and membership fees to sit on the board of a charitable organization. For these violations, the SEC charged Dow with violating Rule 14a-9, which prohibits materially false or misleading information in proxy statements, and fined the company $1.75 million. Furthermore, the SEC ordered Dow to retain an independent consultant for a period of one year to review the company’s policies, procedures, controls and training relating to the characterization and disclosure of expense reimbursements and other payments as perks, and to adopt the consultant’s recommendations. As is common in many settlements of SEC enforcement actions, the company neither admitted nor denied fault. Although SEC enforcement actions related to the disclosure of perks are rare (because violations are difficult to detect), the order and the terms of the settlement serve as a reminder that the SEC takes executive compensation disclosure seriously, and will impose sanctions when it determines that a company’s disclosure practices do not comply with SEC standards.