February 5, 2014
Edward M. McNally
Delaware Business Court Insider

At the very end of 2013, the Delaware Court of Chancery issued a major insider-trading decision that has substantial implications for company officials selling their company stock. The decision in Silverberg v. Gold, Del. Ch. C.A. 7647-VCL (December 31, 2013), upholds using circumstantial evidence to establish that insiders were motivated by material nonpublic information to sell company stock. Silverberg's significance lies in the extent to which it draws inferences of wrongful conduct from some limited evidence. Thus, Silverberg may permit more insider-trading complaints to survive a motion to dismiss.

In Delaware, a claim for insider trading is called a Brophy claim. Brophy held that it is a breach of a director's fiduciary duty to use material nonpublic information to make trades in the director's company's stock. A director guilty of a Brophy violation may be required to disgorge his or her profits from the trades.

The first element of a Brophy claim is often not hard to prove—possession of material nonpublic information. After all, that information often comes to light when a company amends its U.S. Securities and Exchange Commission filings to disclose past events that later affect its stock price. When those later-disclosed facts finally are revealed, it will frequently be apparent that those facts must have been known to the directors at or around the time they occurred. A significant decline in a company's stock price following disclosure of information may well establish that information is material. Thus, possession of material nonpublic information will be established.

However, the second element of a Brophy claim is more difficult to establish. The valid Brophy complaint must also allege facts to show the directors acted with scienter. That is, the complaint must show the directors made their trades because they intended to benefit from the advantage they had through possession of the material nonpublic information. That is not so easy to prove.

The facts of Silverberg illustrate this difficulty in proving scienter. The directors involved in Silverberg sold much of their company stock soon after the company's announcement that its sole product was approved by the U.S. Food and Drug Administration. In one sense, it was perfectly natural for those sales to occur then. After years of waiting for the company to make good, it finally did so and its stock price only then reflected its success that the insiders might justifiably benefit from. Indeed, prior Delaware precedent recognizes that the timing and size of an insider's stock sales do not alone prove a Brophy case. Something more is needed.

An easy case to establish scienter might involve some single, obviously significant corporate event that only insiders know about and that is quickly followed by stock trades before that event is disclosed. The inference can then be drawn that the insiders' rush to trade was designed to beat the public disclosure that is soon to follow. But what happens when there is no single, major event that is both secret and closely tied in time to insider stock trading? Then the Brophy claim is harder to plead.

Silverberg involved just that sort of problem for the plaintiff. In Silverberg, the company involved, Dendreon Corp., made a high-price cancer treatment that doctors were required to pay for when the treatment started and then wait to be reimbursed. Once Dendreon set the price for its drug, it knew that some doctors would be reluctant to use it for fear of not being reimbursed, despite the drug's FDA approval. The directors were repeatedly told that reimbursement concerns might inhibit sales. Nonetheless, Dendreon continued to downplay any reimbursement concerns in its public statements. After the directors sold much of their Dendreon stock at the top of the market, Dendreon later announced that its earnings projections were not achieved because of doctors' reluctance to use its treatment when reimbursement for its cost was uncertain. Note that there was no actual impact on Dendreon's real earnings until after the directors sold their stock and when the effects of slow sales were finally realized. In short, the insiders knew of no single adverse event when they sold.

The Silverberg decision still held that the complaint stated a valid Brophy claim. Because Silverberg dealt with a motion to dismiss the complaint, the court was required to give the plaintiff any legal inferences favorable to him that supported misconduct by the defendants. The court concluded that the directors' knowledge of reimbursement concerns, coupled with Dendreon's overly optimistic statements, put the directors in the position of taking advantage of the public market's ignorance of the risks Dendreon faced in selling its product. That sort of "soft" information was enough to infer that the defendants acted with scienter to beat the decline in Dendreon's stock price that they expected would follow when it later released its sales results.

It is still unsettled whether the defendants will be able to defeat the Brophy claim at a trial. Silverberg just upheld the complaint at the motion to dismiss stage. However, the use of this sort of soft information to support a Brophy claim may permit more such claims to go forward. If so, Silverberg will significantly affect the law of insider trading. After all, risk management is now a major concern for boards of directors. They are constantly asking about risks to company profits. Does just knowing about those risks mean that insiders cannot sell their company stock absent detailed and possibly overly pessimistic public self-flagellation in company reports?

Silverberg should not be read that broadly. It is important to note that Silverberg involved public reassurances that doctors were not concerned about being reimbursed for Dendreon's drug. Those public statements permitted the stock price to climb upon FDA approval and the insiders to profit from the lack of disclosure of the truth. The combination of false statements and undisclosed sales risks led the court to conclude that the insiders' profits were actionable under a Brophy theory. Nonetheless, Silverberg is a warning to insiders trading in company stock.