27 July 2022

Delaware Chancery Court Addresses Insider Trading Claims Under Brophy

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This post continues our prior discussion of Vice Chancellor Laster’s motion to dismiss denial in Goldstein v. Denner.  “Part II” of that decision focuses on interesting – and rarely addressed – matters relating to Delaware law insider trading claims pursuant to Brophy v. Cities Service Co, 70 A.2d 5 (Del. Ch. 1949).

Background

Alexander Denner was a board member of Bioverativ, a publicly-traded biotechnology firm, while at the same time leading an activist hedge fund called Sarissa Capital.  A healthcare company approached Denner and another board member and expressed interest in buying Bioverativ for a significant premium over the market price.  The complaint pleaded at least an “inference” that Denner and his colleague did not share this approach with the rest of the Board, but instead Denner caused his fund to buy more than a million shares of Bioverativ, which he also did not disclose.

Because Denner could not retain any “short-swing profits” in the event that Bioverativ was acquired within six months after his stock purchase, the complaint alleges that Denner’s “solution was to delay any engagement with [the buyer] so that the sale would take place after the short-swing period closed.”  When the short-swing period was about to expire, Denner proposed a single-bidder process and “acted unilaterally to put the Company in play.”  Bioverativ was then acquired, generating a profit for Denner and Sarissa of US$49.7 million.  The lawsuit alleges that the Board and certain officers breached their fiduciary duties during the sale process.

In an earlier decision (i.e., Part I), Vice Chancellor Laster declined to dismiss claims relating to the sale process and disclosures to stockholders.  Part II addresses the Plaintiff’s claims against Denner for breach of fiduciary duty under Brophy, and against Sarissa for aiding and abetting that breach.  The court refers to these as the “Insider Trading Claims.”  These claims also survived Defendants’ motion to dismiss.

The Insider Trading Claims

The court considered three primary arguments on the Defendants’ motion to dismiss:  whether (i) the buyer’s confidential expression of interest could be considered material, non-public information; (ii) it could be inferred at the pleading stage that Denner caused Sarissa to buy Bioverativ shares on the basis of that expression of interest; and (iii) Plaintiff lost standing to pursue the Insider Trading Claims when the transaction closed.

The court quickly dispatched with the first two arguments, holding that, “[a]t the pleading stage, it is reasonable to infer that the information was material and that Denner acted on it,” and that it was reasonably conceivable that Sarissa “aided and abetted the breach by carrying out Denner’s insider trading.”  The court commented that the argument that Plaintiff lost standing, however, was “far stronger” in that it implicated complicated questions of derivative standing.  Nonetheless, the court ultimately denied the motion to dismiss on this ground as well.

A so-called “Brophy claim” is considered to be a derivative claim, meaning that it is pursued by a plaintiff on behalf of – and to remedy harm to – the corporation “because it arises out of the misuse of confidential corporate information.”  But Delaware law imposes a “continuous ownership requirement” on derivative plaintiffs, meaning that they must “hold shares of the corporation continuously throughout the derivative action.”  Here, the fundamental question was whether the Plaintiff lost standing because the transaction resulted in the Plaintiff’s stock being converted into a right to receive cash.

The Plaintiff sought to evade this ownership requirement by asserting that he was not, in fact, pursuing the Insider Trading Claims as derivative claims, but “rather as vehicles for challenging” the transaction.  The Delaware Supreme Court’s decision in Parnes v. Bally allows for a plaintiff to “bring a direct claim challenging a merger that results, in whole or in part, from conduct that otherwise might be viewed as giving rise to a derivative claim.”  Such a plaintiff has standing if the would-be derivative claim affected “either the fairness of the merger price or the fairness of the process that led to the merger.”

The defendants argued that the Parnes exception was inapplicable because “the magnitude of the potential recovery on the Insider Trading Claims is immaterial in the context” of the transaction, but the court observed that this argument ignored the second avenue for standing, based on the “fairness of the process.”  The court found that it was “reasonably conceivable that the sale process fell outside the range of reasonableness because Denner maneuvered to secure a near-term sale that would lock in the profits from his insider trading.”

As the decision notes, “The Delaware Supreme Court has made clear that full disgorgement of profits is an available remedy under Brophy, regardless of whether the corporation has been harmed.”  This is notable in that it creates a necessary deterrent to an insider’s illicit use of a corporation’s confidential information, but also permits a measure of damages that is not directly tied to any tangible injury.  This decision further clarifies that such a remedy is potentially available even where the stockholder is no longer a stockholder.