The Law and Other Anomalies

Chris Coburn, who runs the Partners Healthcare Innovation Center, delivered what amounted to a sales pitch to emerging life science companies, urging them to work with the vast Partners system. Addressing a meeting of MassMEDIC, the association of the medical device industry, last week, Coburn outlined Partners’ value proposition: come to us with your idea, if we decide to work together we can provide reliable funding, brand recognition, networking, and robust practical information to develop your company with guidance from the Partners staff, and using documented experience of the Partners Hospitals.

Partners has established nine vertical areas, and has assigned a leadership team in each area to foster innovation and identify promising emerging medical technology. He suggests that approaching Partners makes particular sense these days, where funding in the device space has become very difficult and regulatory timelines have continued to lengthen.

(With respect to the latter point, many of the business plans we see here in my firm call for rollouts in Europe and, indeed, I now have one on my desk looking for an initial rollout in India, given the regulatory log jam here in the United States.)

Coburn emphasized fundamental changes taking place in the life science arena: new trends in managing and insuring risk, substantial shifts in the nature of delivery systems. It is not clear what companies are doing which functions, noting that Medtronics is now managing clinical services in European hospitals rather than just being an outside supplier. He also painted two startlingly different futures for the approximately 6,000 hospitals now in the United States; some experts suggest efficiency through substantial consolidation so that in a decade there will be only 600 hospitals; the contrary view is that technology will unbundle delivery of health services and there will be 60,000 hospitals.

Finally, Coburn noted that Partners has both a venture capacity and a substantial portfolio of licenses and additional licensing opportunities, with 190 licenses in place and $1,400,000,000 approximately of sponsored research now in the process. Seems that Partners is big and intends to get bigger, whether or not expansion of its physical hospital network (which has become quite contentious) moves forward.

Corporate directors generally are aware of the fact that they are protected by the so-called “business judgment rule”: if a director of reasonable intelligence applies reasonable diligence and doesn’t make a personal profit out of any decisions, then courts will not hold the director liable because he made a mistake.

Corporate statutes, including Delaware and Massachusetts, have long codified this rule, although they do it in a particular way: they set forth an affirmative standard of conduct for directors and then say there will be no liability if this standard is met.

What about corporate officers? They have fiduciary duties to their corporations also. Do they have the benefit of the business judgment rule? Spoiler alert: sometimes.

There is Delaware judicial authority for the proposition of the business judgment rule also applies to officers. In Massachusetts there is a specific statute in the (fairly) new General Business Corporation Act which sets forth a standard of conduct for officers which is similar to (not quite as broad as) the protection from liability afforded by that statute to directors. The supposition that officers are covered in a manner similar to directors is contrary to traditional analysis, but seems to be the judicial trend in Delaware, and in Federal courts in Florida, New York, Illinois and Georgia.

However, recent litigation in various courts has perhaps set in motion a retreat back to the limitation of the business judgment rule as protecting only directors and not officers. Cases in California decided by state (as opposed to Federal) courts seemingly now have restricted the business judgment rule only to directors. And, now director protection is under assault.

Additionally, there is more than one way to skin the cat; persons who might otherwise be protected by the business judgment rule may lose that protection by reason of the nature of the company (bank directors should be held to a different standard given the impact of a bank failure on the economy), directors must be wholly disinterested (often not true in private corporations), directors may have close family ties or business relationships which taint their judgment and deny them use of the Rule, directors may become “interested” if they are intimidated by an interested director (this from Delaware). Further, directors have been held liable if they fail to inform themselves sufficiently of the facts of the case, and directors also are now being attacked by claims made under Federal Securities Laws (the business judgment rule relates to breach of fiduciary duty at common law and not statutory transgressions).

Given the current pressure to “make individuals liable” for corporate failures, particularly in derivative law suits, you rapidly reach the conclusion that the business judgment rule is under great pressure even in protecting directors, let alone applying it to the protection of corporate officers. (Indeed, there are strong arguments that the business judgment rule should not apply to officers, who generally are more involved in company affairs and thus might be chargeable with actually reaching the correct decision, not just trying hard.)

It may be that the Massachusetts statute, codifying a statement of officer conduct similar to the standard that satisfied the parameters of the court-invented business judgment rule, ultimately will prove among the more robust judicial protections afforded to corporate executives anywhere in the country.

Did you ever get a thirst for an adult beverage during a snow storm, only to find your larder bare? Along comes Drizly, an application that can get your alcohol delivered to you, at least if you are in a city, in twenty to forty minutes.

Nick Rellas, CEO and co-founder of four year old Drizly, explained how he applied technology to the historically staid liquor business. Drizly gives you an app for your phone or device. You use this app to order what you need. Drizly takes that order and sends it to a nearby liquor store under contract with Drizly. The liquor store delivers product, receives and keeps the entire payment.

How does Drizly make money? A monthly license fee from the liquor store. Drizly never touches the beverage, and never touches the money within the transaction. Now in fourteen markets including Boston and New York, Drizly is again raising capital and anticipates substantial expansion in the United States and Canada in the next twelve months.

An additional possible future revenue source could also be from manufacturers or importers, where advertisements could have a click-through button so that, if the consumer wants to buy the product, that information comes to Drizly and Drizly passes it to a retailer, thereby giving manufacturers or importers an immediate ability to themselves drive sales to consumers.

Drizly also has a compliance function wherein identification of persons authorized to place orders has been preprocessed, so as to avoid facilitating distribution to, for example, underage consumers.

Rellas provided his remarks to a breakfast meeting of the Association for Corporate Growth, held in Boston on January 15^th. His description of his business model and its application to the consumer marketplace is suggestive of the disruptive impact of web-based services that are reshaping business: Uber and Amazon spring to mind immediately. The founder (who is in his 20s) worked in a liquor store, noted the absence of technology, and applied his generation’s technological skills to the normally conservative liquor business.

During the time between year-end and the annual meeting, public boards are planning director elections, effecting audit review to conclude the annual financials, addressing 10K and proxy matters, evaluating shareholder proxy and other proposals from activists, and conducting intensified committee meetings which inevitably follow fiscal year-end. Key board issues for this period were highlighted at the January 13^th breakfast meeting of the New England Chapter of the National Association of Corporate Directors, where a panel of financial, legal and shareholder relations experts summarized the current state of play.

From a shareholder communications standpoint, directors shall be focusing on an evaluation of board members standing for reelection. Broader disclosures should be considered, aside from simply reciting education and work background. Consider proactive disclosure with respect to the reason that each individual has been elected to your board: diversity, different skill sets, domain experience, etc.

Management should be prepared to engage activist or institutional shareholders which are likely to have questions after year-end. Have you reviewed your corporate strategy against performance last year? How do you answer questions about your plans for capital expenditure and, particularly, use of excess cash which many corporations have been collecting? Is a share repurchase program actually the best use of company money, given recent analyses that suggest that shareholder value is not thereby enhanced, or is it simply a sign of lack of imagination as to how else to apply the capital?

This is also a good time to review your crisis plan, including identification of inside and outside teams, coverage of social media, and review of “hidden website” content which has been prepared to meet various crisis scenarios.

From a financial control standpoint, boards sometimes find themselves on a somewhat different wavelength from internal audit, which may be directing its attention to operational efficiency. The board’s role is to assure robust financial reporting. Has your board reached out to the internal audit function to make clear that internal financial control is to be given high priority? Has the board engaged its audit committee, or its risk committee, for a year-end review and projection of risks in context?

Other currently hot board topics include: should your CEO be your board chair or should the board chair position be independent (does your board want to undertake a renegotiation of the CEO contract which likely says that the CEO also is to serve as chair?); what is your board’s approach to term limits or “aging out” of directors (might your board be reviewing the European approach which views “independence” holistically, and suggest that ten years of service by definition renders any board member no longer “independent” in a meaningful way).

There will follow a post on the so-called SDX protocol, an organized effort to improve institutional investor access to independent board members.

What are the trends in funding early stage life science companies? A panel of seven investors speculated on the 2015 outlook, at a December 10^th Venture Summit held in Dedham yesterday.

Riding an increasingly robust funding of transactions at the seed and A-round levels, the investors anticipate continued strong deal flow, driven by a reduction in the funding generally sought by start-ups. They speculated that this reduction was driven by more refined pitches and reliance on internet tools that make start-ups more flexible and efficient. Not mentioned, but perhaps another factor, is the sea change in the manner in which bio and bio-pharma companies are developing their products, in reaction to the massive capital requirements which caused negative investor reaction several years ago.

Hot areas anticipated are oncology, ocular disease, orphan diseases and, in the long run, genetic modification. One panelist, interestingly, suggested that capital is being scared off mass drug development because of the risks of liability arising from continued application of drugs to larger numbers of people over a multi-year period.

What company attributes are attracting capital these days? Robust teams. Proof of recurring revenue. A crisp story presentation. Avoidance of undue complexity (blamed on the lawyers, of course). And, although it can come in many forms, that elusive quality known as “traction.”