Pfeffer v. Toll, C.A. No. 4140-VCL (Del. Ch. Mar. 3, 2010) (Laster, V.C.).
In an opinion by Vice Chancellor Laster, the Court of Chancery upheld the continuing validity of Brophy v. Cities Service Co., 70 A.2d 5 (Del. Ch. 1949) and the right of Delaware corporations to recover from corporate fiduciaries for harms caused by insider trading.
The plaintiff, Milton Pfeffer, is a stockholder of Toll Brothers, Inc. (“Toll Brothers”), a publicly traded Delaware corporation. The plaintiff sued the defendants, eight of the eleven members of the Toll Brothers board of directors, derivatively for alleged insider trading based upon the defendants’ significant sales of stock from December 2004 through September 2005. The plaintiff alleged the defendants sold this stock while possessing material, non-public information about Toll Brothers’ prospects and that the sales were motivated by this information.
In 2003 and 2004, Toll Brothers experienced record earnings due to a boom in the luxury real estate market. From December 2004 through December 2005, Toll Brothers’ management projected 20% growth in net income for 2006 and 2007. During the period of these projections, Toll Brothers’ stock price per share rose dramatically from $28.50 in December 2004 to $58.00 in July 2005. In December 2005, Toll Brothers revised the projections for 2006 downward, from 20% to 0.5%.
The plaintiff alleged the defendants knew during 2005 that there was no basis for the previously announced 20% projection for 2006. The plaintiff also alleged that from December 2004 to September 2005 the defendants collectively sold 14 million shares in Toll Brothers for over $615 million. Individually, each director sold between 29% and 93% of his holdings. These sales were alleged to be inconsistent with prior trading patterns. All of the director defendants were named defendants in a pending federal securities action concerning essentially the same allegations, and that action had survived a motion to dismiss at the time of this opinion.
The defendants all moved to dismiss the complaint. The defendants argued that the plaintiff had failed to make a pre-suit demand on the Toll Brothers board or to establish demand futility under Court of Chancery Rule 23.1; that the statute of limitations barred recovery; that a claim for breach of fiduciary duty had not been pled; and that Brophy should be rejected as an “outdated precedent.”
The Court first found that plaintiff had established demand futility, stating that “[t]he test is whether the plaintiffs have pled facts that show the directors face a sufficiently substantial threat of personal liability to compromise their ability to act impartially on a demand.” The Court reasoned the pending federal securities action prevented a majority of the board from acting impartially in considering this demand because if Toll Brothers pursued this action, then the defense of the pending federal securities action would be undercut or compromised.
The Court rejected the contention that the statute of limitations barred plaintiff’s claim. The Court noted that a three-year statute of limitations applies to breach of fiduciary duty claims, which could apply here where the complaint was filed in November 2008 and the last act of insider trading was alleged to have occurred in September 2005. However, applying the doctrine of laches, the Court held the statute of limitations did not bar these claims where a basis for equitable tolling had been alleged. Equitable tolling applies to claims of wrongful self-dealing, even absent fraudulent concealment, where a plaintiff reasonably relies on the competence and good faith of a fiduciary, such as where a fiduciary’s disclosures provide “no fair inquiry notice of claims.” The Court reasoned the plaintiff reasonably relied upon public disclosures by management, and ruled the statute of limitations was equitably tolled until December 8, 2005, the date management abandoned its 20% projection for 2006.
The Court also held the plaintiffs had alleged a Brophy claim for breach of the fiduciary duty of loyalty by insider trading. Pleading a Brophy claim requires allegations that a) a corporate fiduciary possessed material, nonpublic information about the corporation and b) a corporate fiduciary improperly used that information by trading that was motivated, in whole or in part, by that information. Thus, the Court reasoned the plaintiff’s allegations sufficiently alleged a Brophy claim where the defendants made and supported the 20% net income projections, while knowing core metrics of the corporation trended downwards signaling these projections could not be met, and the defendants, motivated by these core metrics, sold significant amounts of their stock inconsistent with past patterns of trading.
The Court noted that Brophy serves the critical Delaware public policy of policing violations of the fiduciary duty of loyalty and is consistent with and supports the federal regulation of insider trading. The Court emphasized that the requirements of a Brophy claim substantially track the requirements of a federal insider-trading claim because both claims depend on proof of scienter in trading the securities while in possession of material, nonpublic information. Moreover, Brophy is not a vehicle for recovering for the same losses as under the federal regime because Brophy addresses harm to the corporation and not harm to the market; therefore, the measure of damages is different. In fact, the federal regime parallels Brophy by purposely leaving room for breach of fiduciary duty claims asserted derivatively on behalf of the corporation. Importantly, the Court explained that the federal insider-trading regime actually requires the existence of fiduciary duties defined by state law to impose liability.