Brophy Revisited

Pfeiffer v. Toll

Toll Brothers is a publicly traded company that “designs, builds, markets, and arranges financing for single-family homes in luxury residential communities throughout the United States.” In 2003 and 2004, the luxury residential market saw “booming growth” and Toll Brothers experienced record financial performance.

By mid-2005, however, the markets “became worried about a housing bubble ' and began to question the ability of homebuilders [such as Toll Brothers] to maintain their red-hot performance.” Nevertheless, Toll Brothers continued to assure that it was on target for net income growth of 20% in both 2006 and 2007. The company also “rejected the notion that there was a 'housing bubble' that was about to pop,” boasting that “it catered to a niche market of luxury home buyers who were not affected by rising interest rates.”

During this period, Toll Brothers' stock price significantly outperformed the S&P Homebuilders Index, more than doubling. And Toll Brothers' directors profited personally from the strong market in the company's stock. From December 2004 through September 2005, and “particularly during the summer and fall of 2005,” the directors collectively sold 14 million shares (in some cases representing more than 80% of their individual holdings), generating proceeds exceeding $615 million.

It was not until November 2005 that the company publicly recognized the “softening demand” in the market and the “increasingly complex regulatory process” for opening new residential communities. One month later, Toll Brothers surprised the market by lowering projections for 2006 from net income growth of 20% to only 0.5%. The reaction was “profoundly negative,” and the stock price fell dramatically.

In addition to lawsuits filed under the federal securities laws, one Toll Brothers stockholder, Milton Pfeiffer, initiated a derivative action in the Court of Chancery against Toll Brothers' directors. Pfeiffer's lawsuit alleged, among other things, that “from December 2004 on, the defendants knew their representations about 2006 and 2007 had no reasonable basis in fact,” but they nevertheless engaged in sales of stock “while in the possession of material, non-public information about Toll Brothers' future prospects” in violation of their fiduciary duty under Brophy. The directors moved to dismiss on the ground, among others, that “Brophy is an outdated precedent that should be rejected.”

The Court of Chancery's Analysis

The Court of Chancery began its assessment of the adequacy of Pfeiffer's insider trading claim by noting the two required elements of a Brophy claim: “1) the corporate fiduciary possessed material, nonpublic company information; and 2) the corporate fiduciary used that information improperly by making trades because she was motivated, in whole or in part, by the substance of that information.” For purposes at least of the motion to dismiss before it, the Court of Chancery agreed that both of these elements were satisfied:

• With respect to the first element, the Court of Chancery determined that Pfeiffer had sufficiently pled “a reasonable basis” from which to infer that Toll Brothers' directors possessed material, nonpublic information about the company. In fact, because the directors reviewed reports and materials concerning core operations, the Court of Chancery observed that “[i]t would afford an ostrich-like immunity to directors not to grant the plaintiff ' [an] inference [for pleading purposes] that ' Director Defendants knew about core information of this type.”
• With respect to the second element, the Court of Chancery considered “the trades made by the ' [d]efendants as sufficiently unusual in timing and amount to support a pleading-stage inference that the sellers took advantage of confidential corporate information not yet available to the public to unload significant blocks of shares before the market's view of Toll Brothers' prospects dramatically changed.”

Furthermore, the Court of Chancery rejected the directors' characterization of Brophy as “a persistent anachronism from a time before the current federal insider trading regime.” To the contrary, the Court of Chancery noted that “[t]he history and nature of the federal regime ' supports the conclusion that a breach of fiduciary duty claim for harm to the corporation is preserved.” Moreover, because “the federal insider trading regime ' rests on a foundation of state law fiduciary duties,” the Court of Chancery explained that “[i]f Delaware were to hold that the fiduciary duties of directors and officers did not limit their insider trading, the cornerstone of the federal system would be removed.”

Notably, however, the Court of Chancery cited one other reason for preserving Brophy that potentially ' and ironically ' limited Brophy's reach. In the Court of Chancery's view, Brophy addressed “harm to the corporation” rather than serving as a device “to recover losses by contemporaneous traders,” which are available under the federal regime. The damages available under a Brophy claim, therefore, are “not measured by insider trading gains or reciprocal losses,” but instead by “costs and expenses for regulatory proceedings and investigations, fees paid to counsel and other professionals, fines paid to regulators, and judgments in litigation” incurred by the corporation. On this basis, the Court of Chancery rejected the directors' argument that Brophy was a “misguided vehicle for recovering the same trading losses that are addressed by the federal securities laws.”

Kahn v. Kohlberg, Kravis, Roberts & Co., L.P.

Several months later, the prominent leveraged buyout firm Kohlberg, Kravis, Roberts & Co., L.P. (“KKR”) found itself defending a Brophy claim arising from its investment in Primedia, Inc. Not surprisingly, KKR seized upon Pfeiffer's limitation of the reach of Brophy in an attempt to avoid liability for its own alleged insider trading.

Background

In December 2001, the Board of Directors of Primedia, Inc., a publicly traded media company, approved a plan to redeem “up to $100 million of its preferred shares, at 50% to 60% of their redemption value, in exchange for common stock.” At that time, KKR owned approximately 60% of Primedia's outstanding common stock and had three designees on its Board. The Primedia Board increased this authorization by $100 million the following May.

Five days later, the three KKR directors “authored an advisory memo to KKR's Investment Committee and Portfolio Committee containing a [nonpublic] update on Primedia's second quarter performance and advocating the purchase of Primedia's preferred shares” by KKR. Soon thereafter, KKR requested “permission for KKR to purchase Primedia's preferred shares, as long as Primedia was not purchasing those shares in the market.” The Primedia Board determined that permitting KKR to purchase up to $50 million of preferred shares was “acceptable and not a usurpation of corporate opportunity.” Accordingly, between July 8 and Nov. 5, KKR engaged in open market purchases of Primedia preferred shares.

On Sept. 26, the Primedia Board “approved the sale of one of its biggest assets, the American Baby Group, for approximately $115 million in cash.” The sale was not disclosed to the public until Nov. 4. Of the preferred shares purchased by KKR, more than half were purchased during the interval between approval of the American Baby Group sale and its public announcement.

Subsequently, two Primedia stockholders filed a derivative action alleging that KKR's purchases were made on the basis of nonpublic information, including that: 1) “Primedia's earnings would be better than previously forecasted to the market” and 2) Primedia's unannounced sale of American Baby Group. According to the complaint, these purchases “were unfair to Primedia and resulted in the enrichment to KKR, at a cost to Primedia.” Relying on Brophy, these stockholders sought to recover KKR's sales profits for and on behalf of Primedia.

The Court of Chancery dismissed the complaint, holding that “disgorgement was not an available remedy for ' Brophy claims.” In the Court of Chancery's view, consistent with Pfeiffer, the purpose of a Brophy claim is to “remedy harm to the corporation,” meaning that “disgorgement is 'theoretically available' [only] in two circumstances: (1) 'when a fiduciary engages directly in actual fraud and benefits from trading on the basis of the fraudulent information;' and (2) 'if the insider used confidential corporate information to compete directly with the corporation.'” Given the absence of either of these circumstances, the Court of Chancery granted Primedia's motion to dismiss. Plaintiffs appealed.

The Supreme Court's Analysis

The Supreme Court saw no need to unduly narrow Brophy by requiring “an element of harm to the corporation before disgorgement is an available remedy.” To the contrary, the Supreme Court pointed out that Brophy “explicitly held that the corporation did not need to suffer an actual loss for there to be a viable claim.” As for the Pfeiffer court's “thoughtful, but unduly narrow interpretation of Brophy ',” the Supreme Court declared that “[t]o the extent Pfeiffer v. Toll conflicts with our current interpretation of Brophy v. Cities Co., Pfeiffer cannot be Delaware law.”

In support of its conclusion, the Supreme Court observed that Brophy was built on the “seminal Delaware decision” Guth v. Loft, Inc., 5 A.2d 503 (Del. 1939), in which the Supreme Court issued its “iconic warning” that “public policy will not permit an employee occupying a position of trust and confidence toward his employer to abuse that relation to his own profit, regardless of whether his employer suffers a loss” (emphasis added). In the Supreme Court's opinion, Brophy similarly “focused on preventing a fiduciary wrongdoer from being unjustly enriched” from insider trading. Having due regard to this precedent, the Supreme Court saw “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.” On this basis, the case was reversed and remanded to the Court of Chancery for further proceedings on the merits.

Conclusion

Kahn's broad reading of Brophy re-establishes the right of Delaware stockholders to sue corporate fiduciaries to disgorge profits from insider trading ' regardless of harm to the corporation, and regardless of the avenues provided by federal securities laws to address insider trading claims. The availability of a state law claim under Brophy for insider trading will preserve for stockholders ' especially stockholders of private corporations who are less likely to pursue federal securities law claims than stockholders of public corporations ' a useful litigation tool. And, clearly, Kahn serves as a reminder that the Delaware Supreme Court will not lightly accept an argument that its corporate law is pre-empted by a federal regulatory scheme.

Robert S. Reder, a member of this newsletter's Board of Editors, is serving as a consulting attorney for Milbank, Tweed, Hadley & McCloy LLP in New York City since his retirement as a partner with that firm in March 2011. David Schwartz is Of Counsel and Roxana Azizi is an associate in Milbank's Global Corporate Group, both located in New York City.

A current “hot button” issue in corporate law is the extent to which federal law can ' or should ' pre-empt state corporate law regimes. Due to its prominence as the state of incorporation for so many U.S.-domiciled corporations, Delaware has frequently found itself at the epicenter of this debate. One area in which this tension recently flared is in the context of insider trading. When one thinks of insider trading actions, ' 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5 promulgated thereunder naturally come to mind. However, as long ago as 1949, in “the venerable case” Brophy v. Cities Service Co. , 70 A.2d 5 (Del. Ch. 1949), the Delaware Court of Chancery recognized the right of Delaware stockholders to sue corporate fiduciaries derivatively to recover profits derived from insider trading on the basis of “confidential corporate information.” According to the Brophy court, “[e]ven if the corporation did not experience actual harm, equity requires disgorgement of that profit.”

In 2010, the Court of Chancery had the opportunity to re-visit the continued viability of Brophy . In Pfeiffer v. Toll , 989 A.2d 683 (Del. Ch. 2010), the Court of Chancery rejected the argument that Brophy is a “misguided vehicle for recovering the same trading losses that are addressed by the federal securities laws.” Instead, the Court of Chancery declared, the “federal insider trading regime as currently structured rests on a foundation of state law fiduciary duties.” However, in so ruling, the Pfeiffer court limited Brophy by observing that the harm addressed is “not measured by insider trading gains or reciprocal losses,” as under the federal regime, but rather by “harm to the corporation ” measured by its “ costs and expenses for regulatory proceedings and investigations, fees paid to counsel and other professionals, fines paid to regulators, and judgments in litigation.”

Then, in June 2011, the Delaware Supreme Court was called upon to consider whether Pfeiffer correctly limited Brophy to an action to recover only such litigation and regulatory-related “costs and expenses.” In Kahn v. Kohlberg, Kravis, Roberts & Co., L.P. , 23 A.3d 831 (Del. 2011), the Supreme Court rejected Pfeiffer 's application of Brophy , concluding instead that Brophy claims should be analyzed “without any assumption that an element of harm to the corporation must exist before a disgorgement equitable remedy is available” against a fiduciary for improperly trading on material, nonpublic information. In so ruling, the Delaware Supreme Court not only re-established that Brophy permits a corporate fiduciary to be sued for insider trading ' without proof of harm to the corporation ' but re-asserted the Delaware courts' role in an area that is more often associated with actions under the federal securities laws.

Pfeiffer v. Toll

Toll Brothers is a publicly traded company that “designs, builds, markets, and arranges financing for single-family homes in luxury residential communities throughout the United States.” In 2003 and 2004, the luxury residential market saw “booming growth” and Toll Brothers experienced record financial performance.

By mid-2005, however, the markets “became worried about a housing bubble ' and began to question the ability of homebuilders [such as Toll Brothers] to maintain their red-hot performance.” Nevertheless, Toll Brothers continued to assure that it was on target for net income growth of 20% in both 2006 and 2007. The company also “rejected the notion that there was a 'housing bubble' that was about to pop,” boasting that “it catered to a niche market of luxury home buyers who were not affected by rising interest rates.”

During this period, Toll Brothers' stock price significantly outperformed the S&P Homebuilders Index, more than doubling. And Toll Brothers' directors profited personally from the strong market in the company's stock. From December 2004 through September 2005, and “particularly during the summer and fall of 2005,” the directors collectively sold 14 million shares (in some cases representing more than 80% of their individual holdings), generating proceeds exceeding $615 million.

It was not until November 2005 that the company publicly recognized the “softening demand” in the market and the “increasingly complex regulatory process” for opening new residential communities. One month later, Toll Brothers surprised the market by lowering projections for 2006 from net income growth of 20% to only 0.5%. The reaction was “profoundly negative,” and the stock price fell dramatically.

In addition to lawsuits filed under the federal securities laws, one Toll Brothers stockholder, Milton Pfeiffer, initiated a derivative action in the Court of Chancery against Toll Brothers' directors. Pfeiffer's lawsuit alleged, among other things, that “from December 2004 on, the defendants knew their representations about 2006 and 2007 had no reasonable basis in fact,” but they nevertheless engaged in sales of stock “while in the possession of material, non-public information about Toll Brothers' future prospects” in violation of their fiduciary duty under Brophy. The directors moved to dismiss on the ground, among others, that “Brophy is an outdated precedent that should be rejected.”

The Court of Chancery's Analysis

The Court of Chancery began its assessment of the adequacy of Pfeiffer's insider trading claim by noting the two required elements of a Brophy claim: “1) the corporate fiduciary possessed material, nonpublic company information; and 2) the corporate fiduciary used that information improperly by making trades because she was motivated, in whole or in part, by the substance of that information.” For purposes at least of the motion to dismiss before it, the Court of Chancery agreed that both of these elements were satisfied:

• With respect to the first element, the Court of Chancery determined that Pfeiffer had sufficiently pled “a reasonable basis” from which to infer that Toll Brothers' directors possessed material, nonpublic information about the company. In fact, because the directors reviewed reports and materials concerning core operations, the Court of Chancery observed that “[i]t would afford an ostrich-like immunity to directors not to grant the plaintiff ' [an] inference [for pleading purposes] that ' Director Defendants knew about core information of this type.”
• With respect to the second element, the Court of Chancery considered “the trades made by the ' [d]efendants as sufficiently unusual in timing and amount to support a pleading-stage inference that the sellers took advantage of confidential corporate information not yet available to the public to unload significant blocks of shares before the market's view of Toll Brothers' prospects dramatically changed.”

Furthermore, the Court of Chancery rejected the directors' characterization of Brophy as “a persistent anachronism from a time before the current federal insider trading regime.” To the contrary, the Court of Chancery noted that “[t]he history and nature of the federal regime ' supports the conclusion that a breach of fiduciary duty claim for harm to the corporation is preserved.” Moreover, because “the federal insider trading regime ' rests on a foundation of state law fiduciary duties,” the Court of Chancery explained that “[i]f Delaware were to hold that the fiduciary duties of directors and officers did not limit their insider trading, the cornerstone of the federal system would be removed.”

Notably, however, the Court of Chancery cited one other reason for preserving Brophy that potentially ' and ironically ' limited Brophy's reach. In the Court of Chancery's view, Brophy addressed “harm to the corporation” rather than serving as a device “to recover losses by contemporaneous traders,” which are available under the federal regime. The damages available under a Brophy claim, therefore, are “not measured by insider trading gains or reciprocal losses,” but instead by “costs and expenses for regulatory proceedings and investigations, fees paid to counsel and other professionals, fines paid to regulators, and judgments in litigation” incurred by the corporation. On this basis, the Court of Chancery rejected the directors' argument that Brophy was a “misguided vehicle for recovering the same trading losses that are addressed by the federal securities laws.”

Kahn v. Kohlberg, Kravis, Roberts & Co., L.P.

Several months later, the prominent leveraged buyout firm Kohlberg, Kravis, Roberts & Co., L.P. (“KKR”) found itself defending a Brophy claim arising from its investment in Primedia, Inc. Not surprisingly, KKR seized upon Pfeiffer's limitation of the reach of Brophy in an attempt to avoid liability for its own alleged insider trading.

Background

In December 2001, the Board of Directors of Primedia, Inc., a publicly traded media company, approved a plan to redeem “up to $100 million of its preferred shares, at 50% to 60% of their redemption value, in exchange for common stock.” At that time, KKR owned approximately 60% of Primedia's outstanding common stock and had three designees on its Board. The Primedia Board increased this authorization by $100 million the following May.

Five days later, the three KKR directors “authored an advisory memo to KKR's Investment Committee and Portfolio Committee containing a [nonpublic] update on Primedia's second quarter performance and advocating the purchase of Primedia's preferred shares” by KKR. Soon thereafter, KKR requested “permission for KKR to purchase Primedia's preferred shares, as long as Primedia was not purchasing those shares in the market.” The Primedia Board determined that permitting KKR to purchase up to $50 million of preferred shares was “acceptable and not a usurpation of corporate opportunity.” Accordingly, between July 8 and Nov. 5, KKR engaged in open market purchases of Primedia preferred shares.

On Sept. 26, the Primedia Board “approved the sale of one of its biggest assets, the American Baby Group, for approximately $115 million in cash.” The sale was not disclosed to the public until Nov. 4. Of the preferred shares purchased by KKR, more than half were purchased during the interval between approval of the American Baby Group sale and its public announcement.

Subsequently, two Primedia stockholders filed a derivative action alleging that KKR's purchases were made on the basis of nonpublic information, including that: 1) “Primedia's earnings would be better than previously forecasted to the market” and 2) Primedia's unannounced sale of American Baby Group. According to the complaint, these purchases “were unfair to Primedia and resulted in the enrichment to KKR, at a cost to Primedia.” Relying on Brophy, these stockholders sought to recover KKR's sales profits for and on behalf of Primedia.

The Court of Chancery dismissed the complaint, holding that “disgorgement was not an available remedy for ' Brophy claims.” In the Court of Chancery's view, consistent with Pfeiffer, the purpose of a Brophy claim is to “remedy harm to the corporation,” meaning that “disgorgement is 'theoretically available' [only] in two circumstances: (1) 'when a fiduciary engages directly in actual fraud and benefits from trading on the basis of the fraudulent information;' and (2) 'if the insider used confidential corporate information to compete directly with the corporation.'” Given the absence of either of these circumstances, the Court of Chancery granted Primedia's motion to dismiss. Plaintiffs appealed.

The Supreme Court's Analysis

The Supreme Court saw no need to unduly narrow Brophy by requiring “an element of harm to the corporation before disgorgement is an available remedy.” To the contrary, the Supreme Court pointed out that Brophy “explicitly held that the corporation did not need to suffer an actual loss for there to be a viable claim.” As for the Pfeiffer court's “thoughtful, but unduly narrow interpretation of Brophy ',” the Supreme Court declared that “[t]o the extent Pfeiffer v. Toll conflicts with our current interpretation of Brophy v. Cities Co., Pfeiffer cannot be Delaware law.”

In support of its conclusion, the Supreme Court observed that Brophy was built on the “seminal Delaware decision” Guth v. Loft, Inc. , 5 A.2d 503 (Del. 1939), in which the Supreme Court issued its “iconic warning” that “public policy will not permit an employee occupying a position of trust and confidence toward his employer to abuse that relation to his own profit, regardless of whether his employer suffers a loss ” (emphasis added). In the Supreme Court's opinion, Brophy similarly “focused on preventing a fiduciary wrongdoer from being unjustly enriched” from insider trading. Having due regard to this precedent, the Supreme Court saw “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.” On this basis, the case was reversed and remanded to the Court of Chancery for further proceedings on the merits.

Conclusion

Kahn's broad reading of Brophy re-establishes the right of Delaware stockholders to sue corporate fiduciaries to disgorge profits from insider trading ' regardless of harm to the corporation, and regardless of the avenues provided by federal securities laws to address insider trading claims. The availability of a state law claim under Brophy for insider trading will preserve for stockholders ' especially stockholders of private corporations who are less likely to pursue federal securities law claims than stockholders of public corporations ' a useful litigation tool. And, clearly, Kahn serves as a reminder that the Delaware Supreme Court will not lightly accept an argument that its corporate law is pre-empted by a federal regulatory scheme.

Robert S. Reder, a member of this newsletter's Board of Editors, is serving as a consulting attorney for Milbank, Tweed, Hadley & McCloy LLP in New York City since his retirement as a partner with that firm in March 2011. David Schwartz is Of Counsel and Roxana Azizi is an associate in Milbank's Global Corporate Group, both located in New York City.