On June 20, 2011, the Delaware Supreme Court in Kahn v. Kolberg Kravis Roberts & Co., L.P., No. 436,2010 (June 20, 2011), reversed and remanded a decision by the Court of Chancery interpreting “a Brophy claim as explained in Pfeiffer.” Read opinion here. For those readers who do not practice in the Court of Chancery on a regular basis, the issue before the Court was whether a stockholder had to show that the company had suffered actual harm before bringing a breach of loyalty claim that a fiduciary improperly used the company’s material, non-public information (a Brophy claim).  The Supreme Court also rejected that part of the Court of Chancery’s decision in Pfeiffer v. Toll, 989 A. 2d 683 (Del. Ch. 2010), which required a showing of actual harm to the company. 

The plaintiffs are shareholders of Primedia, Inc., who appealed the Court of Chancery’s decision granting the Primedia Special Litigation Committee’s (“SLC”) Motion to Dismiss claims arising out of a series of alleged violations of fiduciary duty by defendants, Kohlberg, Kravis, Roberts & Co. (“KKR”), Primedia, Inc., and other Primedia officers and directors. In particular, the plaintiffs challenged the redemption of Primedia’s preferred stock.  The defendants moved to dismiss (which the Court denied) and then Primedia formed an SLC.  Thereafter, the litigation was stayed pending the SLC’s investigation. When the SLC investigation was completed the plaintiffs presented a new claim that the KKR defendants breached their fiduciary duty to Primedia by purchasing the preferred stock at a time when they possessed material, non-public information. The Court granted the SLC’s Motion to Dismiss and the stockholders appealed.  On appeal. the stockholders argued that the Court of Chancery erroneously held that, among other things, “disgorgement was not an available remedy for its Brophy claims, consistent with Pfeiffer’s holding.”

In discussing the Court of Chancery’s Zapata analysis (the standard that applies to an SLC’s motion to dismiss) the Supreme Court focused on the discretionary second prong of Zapata where the Supreme Court stated that “the Court of Chancery’s function under Zapata’s second prong is to “strik[e] a balance between ‘legitimate corporate claims’ as expressed in the derivative shareholder suit and the corporation’s best interest as ascertained by the Special Litigation Committee.” In reviewing the lower court decision, the Supreme Court noted that the Vice Chancellor started from “the proposition that there is a Brophy claim [] that would blow by a motion to dismiss on failure to state a claim.” Then the Vice Chancellor held that “under the law, as explained in Pfeiffer v. Toll, disgorgement is not an available remedy for most of the Brophy claims.° But, Pfeiffer’s holding which requires a plaintiff to show that the corporation suffered actual harm before bringing a Brophy claim—is not a correct statement of our law. To the extent Pfeiffer v. Toll conflicts with our current interpretation of Brophy v. Cities Service Co., Pfeiffer cannot be Delaware law.”

The Supreme Court went on to note that as “recognized in Brophy, it is inequitable to permit the fiduciary to profit from using confidential corporate information. Even if the corporation did not suffer actual harm, equity requires disgorgement of that profit.”  The Supreme Court also noted that it has previously cited Brophy approvingly when discussing how the duty of loyalty governs the misuse of confidential corporate information by fiduciaries in In re Oracle Corp. Deriv. Litig.867 A. 2d 904 (Del. Ch. 2004).  There the Supreme Court affirmed the Court of Chancery’s articulation of the elements essential for a plaintiff to prevail on a Brophy claim: “1) the corporate fiduciary possessed material, nonpublic company information; and 2) the corporate fiduciary used that information improperly by making trades because she was motivated, in whole or in part, by the substance of that information.”

In the end, the Supreme Court explained that it:

“decline[d] to adopt Pfeiffer’s thoughtful, but unduly narrow, interpretation of Brophy and its progeny. We also disagree with the Pfeiffer court’s conclusion that the purpose of Brophy is to ‘remedy harm to the corporation.’ In fact, Brophy explicitly held that the corporation did not need to suffer an actual loss for there to be a viable claim. Importantly, Brophy focused on preventing a fiduciary wrongdoer from being unjustly enriched.  Moreover, we have found no cases requiring that the corporation suffer actual harm for a plaintiff to bring a Brophy claim.  To read Brophy as applying only where the corporation has suffered actual harm improperly limits its holding….We decline to adopt Pfeiffer’s interpretation that would limit the disgorgement remedy to a usurpation of corporate opportunity or cases where the insider used confidential corporate information to compete directly with the corporation. Brophy was not premised on either of those rationales. Rather, Brophy focused on the public policy of preventing unjust enrichment based on the misuse of confidential corporate information.”

This summary was prepared by Kevin F. Brady of Connolly Bove Lodge & Hutz LLP.

Supplement: Professor Stephen Bainbridge, a noted corporate law expert, kindly links to this post here, and provides his own scholarly analysis of this case here. A review of the case on The Harvard Law School Corporate Governance Blog is available here.