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A Refreshing Judicial Reminder That Failure To Act Consistent With “Best Practices” Is NOT A Legal Violation

Judicial Decision

Several prior posts (see here, here, here, here, here, here and here) have highlighted the general issue that a troubling amount of Foreign Corrupt Practices Act enforcement (particularly by the SEC and its internal controls theories) amounts to little more than ipse dixit ((Latin for he himself said it – an unsupported statement that rests solely on the authority of the individual who makes it – in other words because the SEC says so).

The FCPA’s internal controls provisions require issuers to have “internal accounting controls sufficient to provide reasonable assurances” that certain limited financial objectives are met. The FCPA then provides the following definition of “reasonably assurances” and “reasonable detail” – “such level of detail and degree of assurance as would satisfy prudent officials in the conduct of their own affairs.”

Beyond these general definitions, there is no binding authority on what constitutes, in any particular context, “sufficient” internal controls to provide “reasonable” assurances. Indeed, in SEC v. World-Wide Coin (believed to be the only judicial decision to substantively address the FCPA’s books and records and internal controls provisions – see here for the prior post) the court stated: “the main problem with the internal accounting controls provision of the FCPA is that there are no specific standards by which to evaluate the sufficiency of controls.”

Against this vacuum, the SEC often advances enforcement theories, with the perfect benefit of hindsight, that seem to equate failure to act consistent with “best practices” (as fuzzy and undefined as that term is) with legal violations.

This recent decision by the influential Delaware Chancery Court has really nothing to do with the FCPA specifically. Rather, it was a decision granting a motion to dismiss in a derivative action filed against Orexigen Therapeutics, Inc. and certain executives and officer and directors in connection with the development of a drug to battle obesity.

But then again it has direct relevance to FCPA enforcement actions, specifically the SEC’s seemingly ipse dixit enforcement theories, because the court rejected the assertion that failure to act consistent with best practices (including best practices articulated in non-binding government guidance) equates to a legal violation.

As stated by the court:

“Early results of a clinical trial indicated that this drug may have unanticipated, but significant, positive effects on cardiovascular health. Excited by the prospect of following in the footsteps of the likes of Alexander Fleming, the board of directors sought regulatory approval of, and patent protection for, their drug. If further clinical trials confirmed the effects, the drug would be revolutionary and, presumably, worth a great deal of money.

As the company moved through the processes required for both regulatory approval and patent protection, two less-than-ideal events occurred. First, a greater number of people than originally contemplated became aware of the preliminary data. While this did not affect the market approval process, the dissemination of the data threatened the integrity of the ongoing trial and, in part, necessitated the commission of a new clinical trial to further test the safety of the drug. This new clinical trial came with a hefty price tag. Second, through the patent process, the preliminary data from the clinical trial eventually became public. The market originally reacted positively to the news, but later data revealed that the early results were an aberration. The drug was not a revolutionary treatment for heart disease, though it continued to prove safe for its intended weight-loss use. The company’s stock price declined in response to the news. Thereafter, stockholders filed this action, arguing that the board of directors made the wrong decisions along the way.

Plaintiff’s case rests on the premise that “Delaware law does not charter law breakers.” Plaintiff alleges that the board was not free to make the decisions it did because doing so violated positive law. This case, however, is a prime example of the difference between a best practice and a legal obligation. Plaintiff sets forth an in-depth explanation of best practices in clinical drug trials. All the pages of filings Plaintiff submitted to the Court show that the directors’ decisions ultimately led to a violation of these best practices, but Plaintiff fails to point to a single legal obligation the directors violated. The first clinical trial was compromised and a new trial required. This new trial cost the company money. The preliminary results were not confirmed, and the stock price dropped. But Plaintiff has not pled facts that give the Court reason to doubt that these outcomes stemmed from rational, good faith decisions of faithful, loyal directors.

These same directors, therefore, retain their ability to make managerial decisions for the company, including whether or not to bring suit on behalf of the company. Plaintiff has failed to plead that he made demand on the board and has failed to plead sufficient facts to show a majority of the board faces a substantial likelihood of liability such that they cannot exercise their independent and disinterested business judgment when considering such a demand. Thus, the Motion to Dismiss … is grated.” (emphasis added).

Relevant to the unique pleading requirements of derivative actions, the court thereafter stated:

“A review of Plaintiff’s allegations shows the main deficiency in the entirety of Plaintiff’s demand futility analysis. Plaintiff attempts to plead knowing and intentional violations of the law without any violation of the law. Instead, Plaintiff paints a picture of directors who, at worst, failed to follow best practices. But, a failure to follow best practices does not create a substantial likelihood of liability.

[…]

Plaintiff’s brief and the Complaint also discuss, and quote from, various FDA guidance. All of the guidance is just that—guidance. This is obvious from the notation on the top of every page of each document that says “Contains Nonbinding Recommendations.” Pleading violations of nonbinding recommendations does not constitute pleading a violation of positive law such that the board faces a substantial likelihood of liability and cannot consider demand.”

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