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Insider Trading Fiduciary Duty Claims: Pfeiffer v. Toll

May 3, 2010

In Pfeiffer v. Toll, C.A. No. 4140-VCL (Del. Ch. Mar. 3, 2010), the Delaware Court of Chancery reaffirmed the right of a Delaware corporation, under Brophy v. Cities Service Co., 70 A.2d 5 (Del. Ch. 1949), to recover from its fiduciaries for harm caused by insider trading, and rejected the defendants’ position that Brophy’s holding is both outdated and inconsistent with the current federal insider trading regime.

The plaintiff, Milton Pfeiffer, was a stockholder of Toll Brothers, Inc., a publicly traded Delaware corporation and the nominal defendant. The plaintiff sued the defendants, eight of the eleven members of the board of directors of Toll Brothers, derivatively to recover damages suffered by the company resulting from alleged insider trading by these eight director defendants. The plaintiff alleged that the defendants sold significant amounts of Toll Brothers stock during the period from December 2004 through September 2005 while they were in possession of material, non-public information about Toll Brothers’ future prospects.

In 2003 and 2004, Toll Brothers achieved record financial earnings due to booming growth in the luxury residential market. The plaintiff asserted that, against the backdrop of the record earnings, Toll Brothers predicted this success would continue. Specifically, Toll Brothers projected “at least 20%” growth in net income for 2006 and 2007, and allegedly rejected the notion that there was a “housing bubble” that was about to pop despite supposed signs to the contrary. By December 2005, however, Toll Brothers acknowledged that the housing market was “not as robust today as it was throughout 2004.” Management also lowered its annual growth projection for 2006 to 0.5 percent.

While Toll Brothers was publicly projecting 20 percent growth in net income for 2006 and 2007, its stock price grew from $28.50 in December 2004 to over $58.00 in July 2005. During this same period, it was alleged that the eight director defendants collectively sold 14 million shares of company stock for proceeds of over $615 million. The Court found that such trades were inconsistent with past trading patterns and suspicious in timing and amount.

The defendants moved to dismiss the plaintiff’s complaint on four grounds. The defendants argued that: (1) the plaintiff had failed to plead demand futility for purposes of Court of Chancery Rule 23.1; (2) the statute of limitations barred any claims based on the individual defendants’ stock sales; (3) the plaintiff failed to plead breach of fiduciary duty as to the outside director defendants; and (4) Brophy is an outdated precedent.

The Court first concluded that the complaint adequately pled demand futility, holding that, because all eight of the defendant directors are named defendants in a companion federal securities action, and because the federal action survived a motion to dismiss based in part on that court’s finding that the defendants’ trades raised a “powerful and cogent inference of scienter,” it was not possible for the defendants in the present case, who comprised a majority of the board when the suit was filed, to consider a demand impartially.

The Court next found that the complaint adequately pled a basis for tolling the statute of limitations, holding that the defendants’ reaffirmation of the company’s growth projections until December 2005 gave rise to a reasonable inference that the public did not have inquiry notice of the company’s true condition until management officially abandoned the 20 percent growth projection in a December 6, 2005 report. Therefore, the Court concluded that the statute of limitations should be equitably tolled such that the plaintiff’s filing of the action on November 4, 2008 was timely.

The Court also held that the complaint adequately pled that the outside director defendants breached their duty of loyalty based on insider trading. The Court found that the complaint turns on information concerning the core operations of Toll Brothers and the basis for the prior 20 percent growth projections -- information of which the defendant directors are automatically assumed aware. The Court concluded that the trades made by the outside directors during the time of the prior 20 percent growth projections were sufficiently unusual in timing and amount to raise the inference (at least at the motion to dismiss stage) that the directors may have sold significant blocks of shares based on confidential corporate information.

Finally, the Court rejected the defendants’ position that Brophy is outdated in light of the current federal securities regime. The Court articulated that “reasoned application of Brophy” serves the critical Delaware policy of policing against violations of the duty of loyalty. Notably, the Court explained that a Brophy claim is an important vehicle through which a recovery can be sought for harm caused to the corporation by insider trading, unlike federal claims where a recovery is sought to recover losses by contemporaneous traders or to force disgorgement of insider trading gains. The Court further found that the federal securities regime is based on the existence of fiduciary relationships created under state law, such that overruling Brophy would “fly in the face of the federal approach.” Thus, the Court denied the defendants’ motion to dismiss.

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