BNA (sub. req'd) reports that:
The Delaware Supreme Court June 20 revived claims by minority shareholders of Primedia Inc. that Kohlberg Kravis Roberts & Co. LLP, its controlling shareholder, bought up large blocks of preferred stock on the open market when the price was low and later caused Primedia to redeem the shares at full value (Kahn v. Kohlberg Kravis Roberts & Co. LLP, Del.. No. 436, 2010, 6/20/11). ...
In this lawsuit, the shareholders contended that KKR and certain Primedia officers and/or directors breached their duty of loyalty by causing Primedia to call hundreds of millions of dollars of preferred stock that it was not yet obligated to redeem, enriching KKR at Primedia's expense. The complaint was amended several times—most recently to add a Brophy claim that the KKR defendants breached their fiduciary duties to Primedia by purchasing the preferred stock at a time they possessed material nonpublic information.
Specifically, the court said, according to the complaint, KKR knew that Primedia's earnings would be better than previously forecast and that at some point, it—Primedia—planned to redeem its outstanding preferred stock. KKR allegedly traded on the information.
In June 2010, the Chancery Court granted a dismissal motion by Primedia's Special Litigation Committee. Citing Pfeiffer v. Toll, 989 A.2d 683 (Del. Ch. 2010), it concluded that because the corporation was not actually harmed, disgorgement was not an available remedy for the plaintiffs' Brophy claims.
BNA further reports that:
In a decision by Chief Justice Myron T. Steele, the court disagreed with the Delaware Chancery Court's interpretation of Brophy v. Cities Serv. Co., 70 A.2d 5 (Del. Ch. 1949), which addressed the availability of disgorgement as a remedy. ...
The court explained that in Brophy, a corporate employee acquired inside information that the plaintiff issuer was about to enter the market and purchase its own shares. The employee, who was not an officer, bought a large block of shares and resold them at a profit after the corporation's purchases caused their price to rise.
The court concluded that because the employee had a position of trust and confidence within the corporation, his relationship was analogous to that of a fiduciary. The defendant argued that the corporation failed to state a claim because it suffered no loss through the purchase of its stock, but the court disagreed. “Thus,” the high court recapped, “actual harm to the corporation is not required for a plaintiff to state a claim under Brophy.”
It explained that the Brophy court relied on principles of equity and restitution for the proposition that a fiduciary cannot use confidential corporate information for his or her own benefit. “Even if the corporation did not suffer actual harm, equity requires disgorgement of that profit.” ...
In June 2010, the Chancery Court granted a dismissal motion by Primedia's Special Litigation Committee. Citing Pfeiffer v. Toll, 989 A.2d 683 (Del. Ch. 2010), it concluded that because the corporation was not actually harmed, disgorgement was not an available remedy for the plaintiffs' Brophy claims.
Reversing, the state high court concluded that Pfeiffer—pursuant to which a plaintiff must show that the corporation suffered actual harm in order to bring a Brophy claim—“is not a correct statement of our law. To the extent Pfeiffer v. Toll conflicts with our current interpretation of [Brophy], Pfeiffer cannot be Delaware law.”
Pity. I thought Pfeiffer got it basically right, at least on this issue. As I explained at the time:
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). [Neither did the Del Sup Ct here.] 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).
