In In Re Primedia, Inc. Shareholders Litigation Consolidated, C.A. No. 6511-VCL (Dec. 20, 2013), the Court of Chancery addressed defendants’ motion for a judgment on the pleadings in an action brought by minority shareholders of Primedia alleging that defendant directors of Primedia and Kohlberg Kravis Roberts & Co. L.P. (KKR), Primedia’s controlling shareholder, traded on inside information when purchasing shares of preferred stock of Primedia. At issue were purchases of stock which fell into two categories: (i) purchases made shortly before the public announcement of a sale of Primedia’s assets and (ii) purchases made before Primedia reported earnings that materially exceeded expectations. As to the first category, the Court granted the motion and as to the second, the Court denied the motion.
This opinion contains an excellent discussion about a Rule 12(b)(6) motion to dismiss and a Rule 12(c) motion for judgment on the pleadings and when the court could take judicial notice of information under Delaware Rules of Evidence 201 for purposes of a Rule 12(c) motion. An earlier post on this decision can be found here. There is also an excellent discussion on statute of limitations and equitable tolling which also factor prominently in the Court’s decision and are a recommended read for practitioners. However, due to space limitations, those topics are not discussed in detail in this post. Rather, the focus of this post is the Court’s discussion of the problems and hurdles stockholders face trying to survive the motion to dismiss stage on a claim for breach of fiduciary claim for insider trading especially in a situation where there is a controlling stockholder.
One of the determinations that the Court had to make concerned when a stockholder plaintiff is on inquiry notice for an insider trading claim that would survive a motion to dismiss. First, the Court looked to see if there was sufficient information available to arouse a reasonable stockholder’s suspicions. Second, the reasonable stockholder must be able to commence an investigation and discover the facts necessary to plead the claim and survive the motion to dismiss.
A Brophy claim (named after the Delaware Court of Chancery’s decision in Brophy v. Cities Serv. Co., 70 A.2d 5 (Del. Ch. 1949) is an action for breach of fiduciary duty premised on a fiduciary’s insider trading. For a plaintiff asserting a Brophy claim, to survive a motion to dismiss, the complaint must plead particularized facts sufficient to support a reasonable inference that: (1) the corporate fiduciary possessed material, nonpublic company information; and (2) the corporate fiduciary used that information improperly by making trades because the fiduciary was motivated, in whole or in part, by the substance of that information.
The Court discussed the burden on stockholders and the level of due diligence they must exercise when monitoring corporate filings for potential claims. The Court noted that stockholders are entitled to rely on the competence and good faith of a fiduciary but they are not entitled to ignore red flags. The Court said:
[T]he trusting plaintiff still must be reasonably attentive to his interests. Beneficiaries should not put on blinders to such obvious signals as publicly filed documents, annual and quarterly reports, proxy statements, and SEC filings. Once a plaintiff is on notice of facts that ought to make her suspect wrongdoing, she is obliged to diligently investigate.
With respect to the first category regarding purchases made before the public announcement of a material sale of assets, the Court identified several red flags. First, KKR was Primedia‘s controlling stockholder, and several KKR representatives served on Primedia‘s board. Second, the KKR Form 4s showed that KKR was purchasing large quantities of preferred stock just weeks before the public announcement of a material sale of assets. Third, in response to the public disclosure of the asset sale, the trading price of Primedia’s common stock increased by double digits, and the trading price of one of the series of preferred stock increased by a much greater amount. Based on those events, the Court found that a reasonable stockholder would have been suspicious, satisfying the first step of the test for inquiry notice.
The Court then focused its discussion on whether a reasonably suspicious stockholder could have conducted an investigation that would have uncovered the information necessary to file a complaint. A Primedia stockholder could have used Section 220 of the Delaware General Corporation Law to request board minutes concerning the sale which would have shown that the KKR directors were present at the meeting when the board approved the sale of assets subject to liabilities for approximately $115 million in cash. A reasonable investor reviewing those minutes would have focused on the fact that a KKR affiliate paid $8.5 million for preferred stock with a face value of $22.9 million on the same day that KKR representatives approved the sale. A reasonable investor also would have noted that, less than two weeks later, an entity formed by KKR as a vehicle for purchasing stock, paid an additional $30.7 million for preferred stock with a face value of $84.9 million, before the sale was announced publicly. A court may also infer scienter when a trade is sufficiently unusual in timing and amount. Under the circumstances, a stockholder plaintiff would be entitled to an inference that defendants acted with scienter. Thus, the Court found that a reasonable stockholder could have pled a Brophy claim that would have survived a motion to dismiss.
With respect to the second category regarding purchases made before Primedia reported earnings, the Court noted that a reasonable investor could have used Section 220 to request books and records showing what the KKR directors knew about Primedia‘s second quarter earnings and when they knew it. If an investor had made such a demand, Primedia could have provided the documents that would have confirmed what the public filings showed: KKR was interested in purchasing, and then in fact purchased, preferred stock during July. But these documents would not have revealed anything about the reasons for KKR’s purchases or suggested that KKR made its decision to acquire preferred stock based on inside information. The missing link would be an internal KKR memo, which Primedia did not have in its possession and therefore could not produce in response to a Section 220 demand. Without that memo, the Court noted that it is “perhaps possible, but unlikely, that a stockholder could have pled a viable Brophy claim relating to the July purchases.” Nothing in the Section 220 documents would have shed light on when the KKR representatives or the board learned of Primedia‘s better-than-expected earnings results. Nor would KKR’s purchases necessarily have given rise to an inference of scienter. KKR owned nearly 60% of Primedia’s common stock and purchased the entire Series J Preferred Stock issuance for $125 million in August 2001. Purchasing $30.5 million of another series of preferred stock might not be deemed sufficiently unusual in timing or amount to support a claim. Moreover, KKR purchased another $5 million of preferred stock on August 8, after the earnings release, which was an amount larger than the purchases on July 12, 15, and 26. Thus, without the internal KKR memo, a court might well think that it was unreasonable to draw the inferences necessary to support a Brophy claim.