United States: Justice Friedman Allows Breach Of Fiduciary Duty Claim To Proceed Against Corporate Directors Under Delaware Law

In AP Services, LLP v. Lobell et. al, No. 651613/2012, 2015 NY Slip Op 31115(U) (N.Y. Sup. Ct. June 19, 2015) (argued Feb. 21, 2014), Justice Friedman, applying Delaware Law, denied a motion to dismiss plaintiff AP Services, LLP's first cause of action alleging breach of fiduciary duty against the defendants, former directors of Paramount Acquisition Corp., while granting dismissal of the second cause of action against them for allegedly aiding and abetting the breach of fiduciary duty.This case arose out of a 2007 transaction between Chem Rx, the third largest long-term care institutional pharmacy in the U.S., and Paramount Acquisition Corp., a special purpose acquisition subsidiary whose parent company was Paramount BioSciences LLC ("Paramount"). Paramount entered into a leveraged buy-out transaction in which it acquired Chem Rx for $133 million. The combined company subsequently changed its name to Chem Rx Corporation (the "Company").

After the Company went bankrupt in 2010, the bankruptcy court established a litigation trust (the "Trust"), for the purpose of prosecuting actions on behalf of the Company's estate. On May 9, 2012, AP Services, LLP, the Trust commenced an action against the former directors of Paramount, claiming that they rushed to approve the transaction in order to avoid losing their own investments in Paramount and ignored red flags that should have alerted them to the fact that Chem Rx's audited financial statements were untrustworthy. The Trust further alleged that the transaction saddled the Company with massive debt that it was unable to service or repay.

The Trust asserted claims for breach of fiduciary duty against the directors of the Company under theories of both a breach of the duty of loyalty and a breach of the duty of due care. The defendant directors argued that the Trust failed to state a claim for breach of the duty of loyalty because the directors' interests in approving the transaction were wholly consistent with the interests of the stockholders. The Court held that plaintiff adequately pled that the former directors of Paramount breached the duty of loyalty because they had a financial interest which was not aligned with those of the Company's stockholders when entering into the transaction. Justice Friedman considered documents incorporated into the complaint such as the Company's proxy and registration statements, which explicitly stated that if the directors did not close on a corporate acquisition their stock would become "worthless," and identified the directors' risk of loss of their investment as a "conflict of interest." The Court therefore found that the complaint sufficiently alleged that the directors' interests deviated from that of the stockholders of the Company, even though a supermajority vote of the stockholders approved the transaction and the alleged conflict of interest was disclosed in the Company's proxy and registration statements.

The court further found that plaintiff had sufficiently alleged that the directors breached their duty of care by their intentional or conscious disregard of, or gross negligence in, failing to investigate alleged red flags that were "visible from the face of key transaction documents." Among the red flags cited by Justice Friedman was the fact that shortly before the transaction Chem Rx's independent auditor resigned to become its financial consultant. The former auditor was then paid a $4.63 million advisory fee rather than a $50,000 auditor's fee. The Court also cited the fact that one of the Company's largest creditors insisted upon the Company making a $11 million pre-transaction payment as security for the creditor to continue to do business with the Company. The court concluded that the defendants' alleged failure to investigate the excessive contingent fee, untrustworthy Chem Rx financial statements, and suspicious activity was sufficient to state a breach of the duty of care.

Based upon this evidence, the complaint overcame the presumption of the business judgment rule and shifted the burden to the defendants to prove the fairness of the transaction at trial. Justice Friedman found that an exculpatory clause in Paramount's articles of incorporation, which barred suit for the breach of the duty of care, did not bar the Trust from proceeding under this theory because the clause contained an exception for "acts or omissions not in good faith or which involve intentional misconduct or a knowing violation of the law." The Court did, however, dismiss the Trust's second cause of action that the directors aided and abetted each other's beaches of fiduciary duty on the grounds that the complaint did not plead any facts that would support the critical element of "knowing participation" in the breach, a required element under both Delaware and New York Law.

Each of the parties filed a notice of appeal of Justice Friedman's decision. The appeal will likely present some interesting issues for the Appellate Division, such as whether supermajority stockholder approval and disclosure of alleged conflicts in proxy and registration statements are sufficient to rebut an allegation of director self-interest as a matter of law.

*Nirav Bhatt was a summer associate in Sheppard Mullin's New York office.

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