Eight (out of 11) members of Toll Brothers board of directors sold significant amounts of the company’s stock between December 2004 and September 2005. Plaintiff sued derivatively on behalf of the corporation, claiming that the defendants had sold “while in possession of material, non-public information about Toll Brothers’ future prospects.” Pfeiffer v. Toll, C.A. No. 4140-VCL, slip op. (Del. Ch. Mar. 3, 2010).
We normally think of insider trading as being a matter of federal securities law. The insider trading prohibition originated in state corporate law, however, and the state rules remain on the books. See generally Stephen M. Bainbridge, Securities Law: Insider Trading 15-16 (2d ed. 2007), cited in Pfeiffer v. Toll, C.A. No. 4140-VCL, slip op. at 35, 36, 41 (Del. Ch. Mar. 3, 2010).
Toll Brothers is a leading home builder. During the relevant period, Toll Brothers was putting out lots of positive investor statements. In particular, Toll Brothers repeatedly sought to assure investors
Allegedly, the defendants knew that this information was false, which was why they were selling their holdings of Toll Brothers stock. (Note that there’s federal securities fraud claims all over the statement of facts. Indeed, a federal suit is pending in parallel to the state suit.) Certainly, the defendants seemed to have been in a hurry to get out of Toll Brothers stock. “The eight defendants collectively sold 14 million shares for proceeds of over $615 million.” Some sold as much as 90% or more of their holdings.
The Court explained:
The Complaint sets forth two counts. Count I asserts a claim for breach of fiduciary duty under Brophy v. Cities Service Co., 70 A.2d 5 (Del. Ch. 1949), which recognized the right of a Delaware corporation to recover from its fiduciaries for harm caused by insider trading. Count II asserts a generalized claim for contribution and indemnification. The defendants (including Toll Brothers as nominal defendant) have moved to dismiss these claims. First, all defendants contend that the Complaint fails to plead demand futility for purposes of Court of Chancery Rule 23.1. Second, all defendants contend that the statute of limitations bars any claims based on the individual defendants’ stock sales. Third, the Outside Director Defendants argue that a claim for breach of fiduciary duty has not been pled as to them. Finally, and most boldly, the defendants argue that Delaware should abandon its traditional role of policing against breaches of the duty of loyalty by fiduciaries of Delaware corporations, at least where the underlying wrong involves insider trading, and that Brophy is an outdated precedent that should be rejected.
Toll, slip op. at 11.
I propose to focus on count I and the last two defenses raised thereto.
In Brophy, the defendant insider traded on the basis of information about a stock repurchase program the corporation was about to undertake. Stephen M. Bainbridge, Securities Law: Insider Trading 20-21 (2d ed. 2007). In a very real sense, the insider was competing with the corporation, which both agency law and corporate law clearly proscribe. Indeed, the insider’s conduct in fact directly threatened the corporation’s interests. If his purchases caused a rise in the stock price, the corporation would be injured by having to pay more for its own purchases. A derivative suit seeking redress for that potential injury thus was quite proper.
In Toll, the Court defined a Brophy claim as follows:
“[A] plaintiff seeking to prevail on a Brophy claim ultimately must show that: 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.” In re Oracle Corp., 867 A.2d 904, 934 (Del. Ch. 2004) (hereinafter “Oracle”), aff’d, 872 A.2d 960 (Del. 2005) (TABLE).
Toll, slip op. at 16.
The Chancery Court found plenty of circumstantial evidence that the first prong of the test was satisfied, quipping that:
A senior executive can be bullish about his company without sounding like he is auditioning to replace Jim Cramer on Mad Money. Juxtaposed against the allegations about the underlying trends in Toll Brothers’ business, these statements are striking. Coupled with massive sales of securities, they amount to a red flag. They are sufficient to plead a claim for breach of fiduciary duty ….
Under Section 141(a) of the General Corporation Law, directors have the statutory power and responsibility to direct and oversee the business and affairs of the corporation. 8 Del. C. § 141(a). It would afford an ostrich-like immunity to directors not to grant the plaintiff a Rule 12(b)(6) inference that the Outside Director Defendants knew about core information of this type. …
I also regard the trades made by the Outside Director Defendants 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. I thus find that the Complaint supports an inference that all of the individual defendants, including the Outside Director Defendants, made trades that were motivated, in whole or in part, by their knowledge of Toll Brothers’ prospects.
Toll, slip op. at 19-21 (emphasis in original).
There are a couple of noteworthy points here. First, in recent years Delaware courts have been emphasizing the duty of directors to be informed both about the specifics of a particular transaction (see Van Gorkom and its progeny) and, more generally, about the state of the corporation’s business (see Caremark and its progeny). See generally Stephen M. Bainbridge, Corporation Law 116-22, 130-31 (2d ed. 2009). Here, that duty is used to create an inference that the directors complied with the duty and therefore knew that the projections Toll Brothers were making were wrong. It’s not exactly bootstrapping, but it’s close.
Second, note that the trading itself is taken as evidence that the directors committed insider trading. This is bootstrapping. It is consistent with how federal courts often use the fact that insiders traded as evidence that the trades were illegal, however. Typically, this is done via the materiality element:
A major issue in insider trading cases is whether the allegedly illegal insider trading behavior can serve as proof that the facts on which the insider traded were material. The problem, of course, is the potential for bootstrapping: if the allegedly illegal trade proves that the information is material, the materiality requirement becomes meaningless—all information in the defendant’s possession when he or she traded would be material. Nonetheless, a footnote in the Supreme Court’s Basic opinion flatly stated that “trading and profit making by insiders can serve as an indication of materiality.”
Stephen M. Bainbridge, Securities Law: Insider Trading 36 (2d ed. 2007).
The Chancery Court then reaffirmed that Brophy remains good law:
I must confront their assertion that Brophy is no longer good law. The defendants characterize Brophy as a persistent anachronism from a time before the current federal insider trading regime, when this Court felt compelled to address insider trading because of the absence of any other remedy. The defendants thus view Brophy as a well-meaning stretch that is no longer needed and, worse, conflicts with federal policies and enforcement mechanisms. These are views I do not share.
Toll, slip op. at 23.
It is certainly true that state insider trading law is not preempted by federal law. As the Toll opinion amply demonstrates, moreover, it is clear that Brophy remains good law in Delaware. Id. at 26 (citing cases).
But should it? Remember that we are talking about a derivative suit, which necessarily must be premised on harm to the corporation.
Curiously, the Toll court did not discuss Diamond v. Oreamuno, 248 N.E.2d 910 (N.Y. 1969), the leading insider trading derivative case (albeit a New York not Delaware precedent). In Diamond, defendants Oreamuno and Gonzalez were respectively the Chairman of the Board and President of Management Assistance, Inc. (“MAI”). MAI was in the computer leasing business. It sub-contracted maintenance of leased systems to IBM. As a result of an increase in IBM’s charges, MAI’s earnings fell precipitously. Before these facts were made public, Oreamuno and Gonzalez sold off 56,500 shares of MAI stock at the then-prevailing price of $28 per share. Once the information was made public, MAI’s stock price fell to $11 per share. A shareholder sued derivatively, seeking an order that defendants disgorge their allegedly ill-gotten gains to the corporation. The court held that a derivative suit was proper in this context and, moreover, that insider trading by corporate officers and directors violated their fiduciary duties to the corporation.
Diamond has proven quite controversial. A number of leading opinions in other jurisdictions have squarely rejected its holdings. See, e.g., Freeman v. Decio, 584 F.2d 186 (7th Cir. 1978) (Indiana law); Schein v. Chasen, 313 So.2d 739, 746 (Fla. 1975).
Why? No one contends that officers or directors never can be held liable for using information learned in their corporate capacities for personal profit. An officer who uses information learned on the job to compete with his corporate employer, or to usurp a corporate opportunity, for example, readily can be held liable for doing so. Insider trading differs in an important way from these cases, however. Recall that derivative litigation is intended to redress an injury to the corporate entity. Where an employee uses inside information to compete with her corporate employer, the injury to the employer is obvious. In Diamond, however, the employees did not use their knowledge to compete with the firm, but rather to trade in its securities. The injury, if any, to the corporation is far less obvious in such cases. Unlike most types of tangible property, information can be used by more than one person without necessarily lowering its value. If an officer who has just negotiated a major contract for her corporation thereafter buys some of the firm’s stock, for example, it is far from obvious that her trading necessarily reduced the contract’s value to the firm.
Unlike Brophy, where the insider’s conduct in fact directly threatened the corporation’s interests, the Diamond insiders’ conduct involved neither competition with the corporation nor a direct threat of harm to it. The information in question related to a historical fact. As such, it simply was not information MAI could use. Indeed, the only imaginable use to which MAI could put this information would be to itself buy or sell its own securities before announcing the decline in earnings. Under the federal securities laws, however, MAI could not lawfully make such trades.
The Diamond court made two moves to evade this problem. First, it asserted that proof of injury was not legally necessary, which seems inconsistent with the notion that derivative suits are a vehicle for redressing injuries done to the corporation. Second, the court inferred that MAI might have suffered some harm as a result of the defendants’ conduct, even though the complaint failed to allege any such harm. In particular, the court surmised that the defendants’ conduct might have injured MAI’s reputation. As I’ve explained elsewhere, however, this is not a very likely source of corporate injury. Stephen M. Bainbridge, Securities Law: Insider Trading 166-72 (2d ed. 2007) (discussing possible ways insider trading might harm the issuer).
In Toll, the Chancery Court correctly stated that:
A Brophy claim does not exist to recover losses by contemporaneous traders, nor to force automatic disgorgement of reciprocal insider trading gains. The purpose of a Brophy claim is to remedy harm to the corporation.
Toll, slip op. at 29 (emphasis in original).
This passage leads into to instructive discussion as to when disgorgement would be an appropriate remedy. The normal remedy for a breach of the duty of loyalty is a constructive trust on the defendants’ ill-gotten gains. In this case, however, the Court argues that disgorgement only rarely will be an appropriate remedy for insider trading.
Instead, the Court explained that:
In the typical scenario in which an insider trades based on material information that allegedly was not disclosed to stockholders, a corporation can recover for actual harm causally related (in both the actual and proximate sense) to the breach of the duty of loyalty. Without limiting the types of harm that could be related causally to a loyalty breach, the obvious candidates are costs and expenses for regulatory proceedings and internal investigations, fees paid to counsel and other professionals, fines paid to regulators, and judgments in litigation.
Id. at 36.
There is one curious aspect to the passage just quoted, however. Note that the Chancery Court requires proof of both actual and proximate causation. How do we square that requirement with the Delaware Supreme Court’s decision in Cede & Co. v. Technicolor, Inc., 634 A.2d 345 (Del. 1993), which held that “the measure of any recoverable loss … under an entire fairness standard of review is not necessarily limited to the difference between the price offered and the “true” value as determined under appraisal proceedings.” Id. at 371. As the Chancery Court observed in O'Reilly v. Transworld Healthcare, Inc., 745 A.2d 902 (Del.Ch. 1999), the Delaware Supreme Court has held that “[a]n action for a breach of fiduciary duty arising out of disclosure violations in connection with a request for stockholder action does not include the elements of reliance, causation and actual quantifiable monetary damages.” Id. at 917 (emphasis supplied). The status of causation as an element of fiduciary duty claims thus is somewhat uncertain. the best solution would be for the Delaware Supreme Court to finally admit that it was wrong in Technicolor, for the reasons I have explained elsewhere. See Stephen M. Bainbridge, Corporation Law 126-28 (2d ed. 2009).
A subsequent post will deal with aspects of the case relevant to the federal prohibition of insider trading.
