Delaware Supreme Court Reaffirms Disgorgement as Insider Trading Remedy
Disavowing recent Court of Chancery precedent, the Supreme Court of Delaware has held disgorgement to be an insider trading remedy, even where the corporation itself was not harmed. Kahn v. Kohlberg Kravis Roberts & Co., L.P., No. 436, 2010 (June 20, 2011). Kahn rejected two prior Chancery Court opinions narrowly construing Brophy, a 1949 Chancery Court decision, and remanded the case before it for a determination of whether dismissal was appropriate for reasons other than a lack of corporate injury. As a result, Brophy, which was thought to be of limited vitality, has been strongly reaffirmed. It is now clear that derivative suits alleging insider trading may proceed even in the absence of any injury to the corporation itself.
Shareholders sued Primedia, Inc. ("Primedia"), its directors, and Kolberg Kravis Roberts & Co., L.P. ("KKR"), Primedia's controlling shareholder, alleging breaches of fiduciary duty relating to KKR's purchase of Primedia preferred stock based on material, nonpublic information. KKR was alleged to have purchased Primedia shares after learning the company intended to sell one of its largest assets.
The Primedia Board then appointed a Special Litigation Committee consisting of two independent directors elected after the events at issue. The Special Litigation Committee reviewed 140,000 pages of documents, conducted more than 20 interviews, and held more than 20 formal meetings. Relying on consultant analyses, the Special Litigation Committee issued a lengthy report concluding that any nonpublic information received by KKR was immaterial because it did not affect the market price when disclosed and that KKR did not intend to profit wrongfully from the nonpublic information. The report also found that the stock purchases were not motivated by KKR's self-interest and that scienter was lacking. The Special Litigation Committee then moved to dismiss the lawsuit. Vice Chancellor J. Travis Laster, applying the two-prong Zapata test, granted the motion. In re Primedia Inc. Derivative Litig., C.A. No. 1808 (Del. Ch. Jun. 14, 2010) (Transcript).
Under Zapata, a court must first determine whether a special committee was acting independently and in good faith. If it finds that a committee acted properly, a court may then apply its own judgment to determine whether litigation would be appropriate. In an oral opinion, Vice Chancellor Laster found that the Special Litigation Committee had met its burden under the first Zapata prong. Addressing Zapata's discretionary second prong, Vice Chancellor Laster relied on his 2010 decision in Pfeiffer v. Toll, 989 A.2d 683 (Del. Ch. 2010), holding that a plaintiff must show that a corporation suffered actual harm before proceeding with a Brophy claim. Because no such injury was alleged in Primedia, the Chancery Court dismissed the case.
Pfeiffer had narrowly limited Brophy v. Cities Service Co., 70 A.2d 5 (Del. Ch. 1949). Although Pfeiffer apparently construed Brophy as not having addressed this issue, the Supreme Court found that the 1949 decision in fact held that public policy required an insider to disgorge profits obtained through the use of confidential corporate information, even if the corporation did not suffer a loss as a result of that insider trading. In his 2010 Pfeiffer decision, however, Vice Chancellor Laster, building on Vice Chancellor Leo E. Strine, Jr.'s decisions in Guttman v. Huang, 823A.2d 492, 499-507 (Del. Ch. 2003), In re Oracle Corp Derivative Litigation, 867 A.2d 904 (Del. Ch. 2004), aff'd, 872 A.2d 960 (Del. Ch. 2005), and In re American International Group Inc., 965 A.2d 763, 813 (Del. Ch. 2009), held that because the purpose of a Brophy claim is to remedy harm to the corporation, the disgorgement remedy must be limited to instances in which inside information was used to injure the company, for example to usurp a corporate opportunity or to compete with the corporation.
The Kahn Decision
The Delaware Supreme Court rejected Pfeiffer's, and thus Primedia's, interpretation of Brophy, holding that a corporation does not need to suffer actual harm for there to be a viable Brophy claim. The Court thus held that a derivative plaintiff must show only that a fiduciary (1) possessed material, nonpublic company information, and (2) executed trades motivated by the substance of that information. Kahn, No. 436, 2010, at 13-14, 19.
It is notable that the Supreme Court reached its decision notwithstanding plaintiffs' impending loss of standing to prosecute the case further because Primedia had recently announced that it would be acquired and, thus, the derivative plaintiffs would not have "continuous ownership" of Primedia shares. The Court proceeded nevertheless under the exception to the mootness doctrine for "matters of public importance that are capable of repetition yet may evade review."
The Court's decision was based on the Brophy policy of preventing unjust enrichment due to the misuse of confidential corporate information. Vice Chancellor Laster's restriction of disgorgement to the cases in which inside information is used to usurp a corporate opportunity or to compete with the corporation, the Court held, was not consistent with the rationale underlying Brophy and subsequent Delaware cases, including In re Oracle Corp. Derivative Litigation, 867 A.2d 904 (Del. Ch. 2004), aff'd, 872 A.2d 960 (Del. Ch. 2005) (Order), seeking to deter trading on inside information.
Reviewing the Court of Chancery's Zapata analysis, the Supreme Court agreed that the Special Litigation Committee had acted in good faith and had a reasonable basis to move for dismissal. The Supreme Court was convinced by the Special Litigation Committee's lengthy and well-documented report, revealing a thorough and balanced investigation of the claims. However, the Court remanded to the Chancery Court for further analysis of the second Zapata prong, namely, whether issues such as materiality, scienter, timeliness, and indemnification required dismissal.
Pfeiffer's holding that harm must fall to the corporation under Brophy was in part based on a perceived need to avoid duplicative Delaware remedies by differentiating Brophy claims from those brought under federal securities law. By rejecting Pfeiffer, the Delaware Supreme Court in Kahn signaled that claims under Delaware law for breach of fiduciary duty will remain available to plaintiffs for insider trading claims even when there is no actual harm to the corporation because a fiduciary wrongdoer should not be unjustly enriched. In addition, Kahn is consistent with Vice Chancellor Laster's pre-Pfeiffer decision in NACCO Industries Inc. v. Applica, 997 A.2d 1, 23 (Del. Ch. 2009), holding that Delaware common law fraud remedies are available for misstatements in Schedule 13D filings. Kahn specifically noted that Delaware remedies for insider trading are not restricted by parallel remedies under the federal securities laws.
You can download a copy of the full Kahn opinion by clicking here.
For further information, please contact your principal Firm representative or the lawyers listed below. General email messages may be sent using our "Contact Us" form, which can be found at www.jonesday.com.
Louis A. Chaiten
Michael L. Davitt
James P. Dougherty
Philip Le B. Douglas
Robert S. Faxon
Lyle G. Ganske
Andrew M. Levine
Robert C. Micheletto
Robert A. Profusek
Geoffrey J. Ritts
Jones Day publications should not be construed as legal advice on any specific facts or circumstances. The contents are intended for general information purposes only and may not be quoted or referred to in any other publication or proceeding without the prior written consent of the Firm, to be given or withheld at our discretion. To request reprint permission for any of our publications, please use our "Contact Us" form, which can be found on our web site at www.jonesday.com. The mailing of this publication is not intended to create, and receipt of it does not constitute, an attorney-client relationship. The views set forth herein are the personal views of the authors and do not necessarily reflect those of the Firm.