Shareholders may state a derivative claim for insider trading without alleging injury to the company--so held the Delaware Supreme Court in an opinion it recently issued in Kahn v. Kolberg Kravis Roberts & Co., L.P., No. 436, 2010 (June 20, 2011) ("In re Primedia"). Following the In re Primedia decision, plaintiffs can be expected to rely increasingly on derivative actions as a means of pursuing insider trading claims. Although they would be subject to the requirements for asserting derivative claims, plaintiffs may exploit state law to evade many limitations that Congress has imposed on claims under the federal securities laws, including the heightened standard for pleading scienter under the Private Securities Litigation Reform Act of 1995. Significantly, derivative actions may not be removed to federal court under the Securities Litigation Uniform Standards Act of 1998.
The facts of In re Primedia are straightforward. Two shareholders of Primedia, Inc. filed a derivative action on behalf of the company in the Delaware Court of Chancery. The plaintiffs alleged breaches of fiduciary duties by the company's directors and majority shareholder. Primedia appointed a special litigation committee to review the claims and determine whether it was in the company's best interest to pursue them. After the special litigation committee completed its investigation, the plaintiffs presented a new claim to the committee's counsel: that Primedia's majority shareholder purchased more than $75 million of Primedia's preferred stock in reliance on material, nonpublic information that it obtained from its representatives on the company's board of directors. The special litigation committee then reopened its investigation, thoroughly examined the claims, including the insider trading claim, and issued a 347-page report. As detailed in the report, the committee concluded that it was not in the company's best interest to pursue the claims. Accordingly, the committee moved to dismiss the case.
The Court of Chancery granted that motion on July 14, 2010. In consideration of the special litigation committee's motion, the Court of Chancery applied the two-part test set forth in Zapata Corp. v. Maldonado. The first step of the Zapata test examines the integrity of the committee's investigation and conclusions. The second step of the Zapata test is discretionary and permits the court to apply its own business judgment to determine whether the company should pursue a claim that "may be sustainable" when its special litigation committee decides against pursuing that claim.
The Delaware Supreme Court reversed, even though it acknowledged that a pending acquisition would likely moot the issues presented on appeal. Regarding the first step of the Zapata test, the Delaware Supreme Court affirmed the Court of Chancery's finding that dismissal was appropriate because there was no genuine issue of material fact about the independence and good faith of the special litigation committee, the thoroughness of its investigation, or the reasonableness of its conclusions.
The Delaware Supreme Court found fault-or at least potential fault-however, with the Court of Chancery's application of the second step of the Zapata test. In particular, it expressed doubt about the Court of Chancery's reasoning regarding duty of loyalty claims that are based on allegations of insider trading. As the Delaware Supreme Court noted, the Vice Chancellor had recently held in Pfeiffer v. Toll that "in most circumstances a corporation would only be able to recover for 'actual harm causally related (in both the actual and proximate sense) to the breach of the duty of loyalty.'" The Vice Chancellor had recognized only two exceptions to that rule: he reasoned that disgorgement, as opposed to damages, could be available as a remedy to the corporation if (1) the fiduciary had engaged in "actual fraud" and benefited from "trading on the basis of the fraudulent information"; or (2) "the insider used confidential corporate information to compete directly with the corporation," such as by purchasing stock that the company sought to purchase. The Delaware Supreme Court rejected this reasoning.
In so doing, it explicitly adopted the rule of Brophy v. Cities Service Co. as the law of Delaware. More than six decades ago (long before Congress enacted numerous reforms to curb frivolous claims under the federal securities laws), Chancellor Harrington held that a Delaware corporation may sue its fiduciaries and even "mere employee[s]" who profit by trading in the corporation's stock based on insider information. Chancellor Harrington squarely rejected the defendant's contention that such claims must plead actual harm to the company; he reasoned that "[p]ublic 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." Characterizing Brophy as a "venerable" decision, the Delaware Supreme Court held that "actual harm to the corporation is not required" for a plaintiff to state a claim based on insider trading; a corporation may seek disgorgement of profits obtained through the use of such information even if it suffers no actual injury. Insofar as Pfeiffer v. Toll held otherwise, the court concluded, it "cannot be Delaware law."
Noting that it was uncertain whether the Vice Chancellor relied on Pfeiffer in dismissing the Primedia case, the Delaware Supreme Court remanded the case, instructing the Vice Chancellor to reanalyze the insider trading claim "without any assumption that an element of harm to the corporation must exist before a disgorgement equitable remedy is available." The court's reasoning was unaffected by the "arguably parallel remedies grounded in federal securities law" or the limitations Congress has imposed on those remedies.
The Primedia decision counsels in favor of reinforcing efforts to manage insider trading liability, which can be particularly risky for several reasons. First, plaintiffs are likely to argue that the reasoning of Brophy, now expressly adopted by the Delaware Supreme Court, suggests that liability is not limited to directors and officers; it may extend even to rank-and-file employees. Second, plaintiffs routinely argue that defendants engage in insider trading by selling stock whenever their company has allegedly failed to disclose a misleading statement or omission. Therefore, plaintiffs can-and often do-re-characterize federal securities claims as insider trading claims in "tag-along" derivative actions. Third, the availability of insurance coverage can be less certain when plaintiffs seek disgorgement from individual defendants, rather than seeking damages for actual harm they may have caused to the company.
In light of these risks, corporations should be reminded of the following precautions:
- Directors and officers should utilize Rule 10b5-1 trading plans or similar plans that are designed to prevent them from deciding when to sell stock.
- All employees should be trained about the illegality of insider trading and ways to avoid wrongdoing.
- Investors with representatives on a corporation's board must implement strict procedures to ensure that they do not rely on nonpublic information in making decisions to trade in the company's stock.
- Special litigation committees considering whether it is in the best interests of a corporation to pursue insider trading claims should assume that the corporation may recover even if it has not suffered actual harm from the trading.
It is unclear what effect, if any, the Primedia decision will have on the special litigation committee mechanism under Delaware law. As the Delaware Supreme Court acknowledged, the second step of the Zapata test remains discretionary, and on remand the Vice Chancellor may find that the derivative action was properly dismissed under the first step of Zapata.