Robbins Umeda LLP* Discusses State Law Insider Trading Claims in The Recorder
In a recent decision, the Delaware Supreme Court re-established the validity of Brophy causes of action, explain Robbins Umeda LLP attorneys.
State Law Insider Trading Claims See New Light
Until earlier this month, state law insider trading claims, known as “Brophy” claims, after the seminal case Brophy v. Cities Serv., 70A.2d 5 (Del. Ch. 1949), if not dead, were on life support. Defense arguments that Brophy claims are outdated and redundant due tothe drastic changes in federal securities laws that have occurred in the 60-plus years since Brophy was decided had found a receptive ear. Further, a decision in Delaware Chancery Court on the viability of Brophy claims, while finding they still existed, removed one of their key components. In particular, the Delaware Chancery Court stated that in most circumstances, disgorgement of the profits from insider trading was not proper. On June 20, however, the Delaware Supreme Court resuscitated Brophy and reestablished its traditional interpretation.
The Delaware Chancery Court began to consider whether Brophy claims were still valid in 2004. That year, Chancellor Leo Strine issued his now famous ruling in In re Oracle, 867 A.2d 904 (Del. Ch. 2004). The plaintiffs in Oracle alleged that the company’s CEO and CFO sold large amounts of stock while knowing that the company would not meet its earnings and revenue projections. Defendants than moved for summary judgment, arguing (1) that Brophy was no longer good law and (2) even if it was, the executives did not have any knowledge of material inside information. In particular, the defendants argued that Brophy liability would be duplicative of any penalty the insiders would have to pay under the federal securities law and it unnecessarily encouraged duplicative state law suits that had little additional deterrent effect in light of the federal laws. Strine, however, did not rule on the validity of Brophy. Instead, he found that the insiders did not posses any insider information when they sold their stock, and decided that the policy consideration behind whether to apply Brophy could be “left to a later case in which the answer to that question is outcome-determinative.” It would be six years before the chancery court took up the issue directly.
In a shareholder derivative action brought on behalf of Toll Brothers Inc., Pfeiffer v. Toll, 989 A.2d 683 (Del Ch. 2010), the plaintiffalleged that the defendants made a half-billion dollars’ worth of insider sales while knowing that the company’s public statements that it expected 20 percent growth in net income were improper because the slowdown in the Toll Brothers’ business made such growth unachievable. The court first addressed a number of pleading issues, including whether the plaintiffs adequately stated a claim under Brophy. The court found that the nonpublic information to which the defendants had access was material and that their unusual trading — in terms of size and timing — was sufficient for pleading purposes to show that the defendants traded on the basis of this inside information. The court then turned to whether Brophy itself was still good law. After a thorough analysis of the history of state law causes of action for insider selling and the current state of the law, Vice Chancellor Travis Laster affirmed that there was indeed a claim for breach of fiduciary duty for trading the company’s stock on the basis of inside information. In particular, he stated that:
“Maintaining Brophy as a cause of action fulfills Delaware’s strong public policy of policing against loyalty violations by fiduciaries. It serves to protect the corporation’s interest in this confidential information and to ensure that the information is not misused for private gain. Eliminating the remedy would be equivalent to transferring ownership of information from the corporation to fiduciaries, which is contrary to Delaware law.” Id. at 707 (citation omitted).
The court in Pfeiffer, however, did not merely affirm the traditional view of a Brophy claim. Instead, it explained that in addition to misuse of inside information, the fiduciary’s use of this information must have damaged the company. This was different from the traditional view of Brophy that held a fiduciary must disgorge his profits from any transaction in which the fiduciary used inside information to this advantage. Disgorgement, according to Laster, was only appropriate in two narrow circumstances: (1) “[w]hen a fiduciary engages directly in actual fraud and benefits from trading on the basis of the fraudulent information”; or (2) “if the insider used confidential corporate information to compete directly with the corporation.” Thus, in upholding Brophy, the court took away one of its key features, the requirement that a fiduciary disgorge his profit whenever he acts disloyally.
The disgorgement aspect of Brophy again took center stage in Kahn v. Kohlberg Kravis Roberts & Co., 436, 2010 (Del. June 20, 2011). Primedia Inc. was controlled by Kohlberg Kravis Roberts through its ownership of 60 percent of the company’s stock and appointment of three board members. According to the plaintiffs, through this insider position, KKR was able to learn that Primedia planned to sell one of its biggest assets, which would result in a significantly better than expected earnings result. In addition, KKR knew that Primedia decided that it would start redeeming its outside preferred stock. Armed with this information before it became public, KKR set up an investment vehicle and purchased $75 million worth of Primedia’s preferred stock. The plaintiffs than sued KKR derivatively, seeking, among other things, that KKR disgorge its profits to Primedia. Consistent with his articulation of a Brophy claim in Pfeiffer, Laster held that since KKR was not competing with Primedia and therefore was not usurping a corporate opportunity, disgorgement was not an available remedy, making potential damages minimal. Laster ultimately dismissed the action. The plaintiffs appealed to the Delaware Supreme Court, arguing that the chancery court’s interpretation of Brophy, as set forth in Pfeiffer, was incorrect.
On June 20, the Delaware Supreme Court agreed with the plaintiffs, and held that Laster’s application of Brophy was too narrow. The court explicitly held that a corporation did not need to suffer an actual loss in order for there to be an insider trading claim, or any claim for a breach of the fiduciary’s duty of loyalty. As the Delaware Supreme Court explained, Brophy focused on preventing a fiduciary from being unjustly enriched and that Delaware has a long-standing policy of broadly interpreting the duty of loyalty and holding fiduciaries accountable for their breaches of that duty. The court approvingly cited to its 1939 decision, Guth v. Loft, 5 A.2d 503 (Del. 1939), for the proposition that its refusal to restrict the disgorgement remedy was based on the “wise public policy that, for the purpose of removing all temptation,” the remedy should “extinguish all possibility of profit flowing from a breach of the confidence imposed by the fiduciary relation.” In coming to its conclusion, the Delaware Supreme Court stated that it found “no reasonable public policy ground to restrict the scope of disgorgement remedy in Brophy cases — irrespective of arguably parallel remedies grounded in federal securities law.”
With the Delaware Supreme Court’s decision in Primedia, the law now reverts back to how state law insider trading claims were generally viewed prior to Pfeiffer. The notable difference, however, is that these two decisions (Primedia and Pfeiffer) put to rest any thought that the state law insider trading claims are not still valid, at least in Delaware. Because of Delaware’s considerable influence on corporate law matters, it is likely that other states will follow suit and agree that state law insider trading claims survive, even in light of the current federal regulatory scheme.
Reprinted with permission from the July 1, 2011 issue of The Recorder. © 2011 ALM Media Properties, LLC. Further duplication without permission is prohibited. All rights reserved.
* The firm name changed from Robbins Umeda LLP to Robbins Arroyo LLP on January 1, 2013.