Bricker & Eckler LLP
April 2007

In Valeant Pharmaceuticals International v. Jerney (Del. Ct. Ch. New Castle No. 19947 March 1, 2007) 2007 Del. Ch. LEXIS 31) the Delaware Court of Chancery ordered Adam Jerney, the former president and director of this large pharmaceutical company, to disgorge a $3 million bonus that he and his 11 fellow directors had approved. The Court also ordered him to repay the legal fees incurred in his defense as well as his share of the investigation costs. This important case highlights the treacherous waters that directors must navigate when approving bonuses for themselves and others.

Facts

Valeant Pharmaceuticals International is a Delaware corporation whose principle executive offices are located in Costa Mesa, California. Founded as International Chemical and Nuclear Corporation in 1959, Valeant manufactures and markets pharmaceutical products worldwide. Valeant's most significant asset is an anti-viral medication known as Ribavirin, the sales of which represented around 60% of its value.

In response to shareholder criticism, Valeant decided to restructure itself by spinning-off Ribavirin into a separate company, Ribapharm, and splitting apart its remaining businesses into separate entities. Valeant's investment bankers estimated the value of Ribapharm at $2.25 billion, but noted that several positive quarters could cause this value to increase to $3 billion.

Based on a $3 billion value, Valeant, at the urging of its founder, Milan Panic, proposed to grant some 8 million options worth $53.7 million in Ribapharm to its management and directors; of this amount, 5 million options were to be awarded to Panic, 500,000 options were to be awarded to Jerney, and each outside director was to receive 50,000 options.

Disclosure of the planned option grants resulted in strong shareholder opposition that threatened the Ribapharm initial public offering. In an effort to save the proposed option grants, Panic referred the issue to Valeant's Compensation Committee. Each member of this committee, however, was also an outside director slated to receive Ribapharm options. In addition, two of the directors were long-term personal friends of Panic and were simultaneously negotiating consulting agreements with him.

The Compensation Committee did not hire its own compensation consultant, but was instead directed by Valeant to use Towers Perrin – a firm that management had previously engaged to justify the proposed option grants. Towers Perrin issued a report for the committee concluding that the $53.7 million value of the options was reasonable, based on an estimated $3 billion value of Ribapharm. The committee reported these findings to Valeant's Board of Directors, but also included an alternative proposal to create a cash bonus pool of $55 million for consideration. The Board elected to grant the cash bonuses rather than options, but reduced the total value of the bonuses slightly to $50 million.

The day after the Board approved the cash bonus plan, and one day before the Ribapharm IPO was to occur, the offering was repriced at $10 per share, from between $13 and $15. Although the IPO proceeded as planned, the value of Ribapharm through the IPO was reduced from $2.5 billion to $1.5 billion. Valeant's Board, however, never revisited the bonus plan in light of Ribapharm's diminished value. Ultimately, Panic received $33.5 million, Jerney received $3 million, and each outside director received $330,500 in bonuses.

Following the IPO, Valeant's corporate restructuring collapsed. Both Panic and Jerney resigned, the company abandoned its plans to spin-off Ribapharm, and lost money for several years. Valeant's shareholders initiated a derivative action against the company, which the company later assumed as plaintiff, challenging the Board's decision to pay bonuses to itself and management. Panic and all directors settled with the company, leaving Jerney as the only defendant.

The Court's Ruling

Based on these facts, the Court first concluded that Valeant's board and executives were not protected by the business judgment rule because of their interest in the bonuses that were to be paid. Significantly, the Court specifically ruled that the Compensation Committee members were "clearly and substantially interested" in the transaction they were asked to consider. Thus, the fact that the bonuses were approved by a Compensation Committee comprised of outside directors failed to remove the taint of self-interest from the transaction. As a result, the Court's review of the decisions to pay bonuses under these circumstances was for "fairness", rather than the far-less stringent "reasonableness" standard.

In order to have prevailed under a fairness analysis, Jerney needed to prove both that the process by which Valeant approved the bonuses was the product of fair dealing and that the amount of the bonuses was fair. The Court found that Jerney failed to carry either burden. In reaching its conclusion, the Court noted that:

• Panic, as Valeant's founder, dominated the process by which bonuses were to be awarded, making decisions to award bonuses and how bonuses were to be structured, even before the issue was considered by the Board;

• The outside directors serving on the Compensation Committee were interested in the transaction as potential recipients of bonuses, and at least two of the three members lacked independence from management;

• The Compensation Committee failed to act independently when it hired Towers Perrin as its compensation consultant at the direction of Valeant's management;

• The bonuses were based on a $3 billion value of Ribapharm that was substantially higher than its initial projected value of $2.25 billion, even before the IPO was repriced;

• The Board was never given the opportunity to reconsider the bonus structure, even after the Ribapharm IPO was repriced at $10 per share; and

• The Towers Perrin report was flawed, insofar as it failed to identify any comparable transactions, justified the amount of the bonuses by analogy to materially different circumstances and, moreover, omitted any discussion regarding the payment of cash bonuses.

The Court required that Jerney not only disgorge his entire $3 million bonus, but also reimburse Valeant for $1.875 million of the advances it provided for his defense and 1/12 of the costs of the investigation that led to the litigation.

Conclusions

The lesson to be taken from this case is that Boards of Directors should navigate carefully when considering and approving executive compensation and bonus payments. Boards should ensure that such payments are approved in advance by an independent compensation committee of disinterested directors to preserve the protections of the business judgment rule. This committee and the board itself should also seek the advice of independent compensation consultants, as well as outside counsel.

Had the directors in Valeant Pharmaceuticals followed these guidelines, the Court would not have required them to prove that their decision was entirely fair—they would only have needed to show that it was reasonable.