publication
Originally published in ALM's Delaware Business Court Insider
Over 75 years ago, the Delaware Court of Chancery recognized a common law cause of action for insider trading. Now known as a Brophy claim (so-named after the seminal decision), Brophy imposes fiduciary obligations on a corporate insider in possession of a company’s material, nonpublic information to not use that information in trading the company’s stock for personal gain. The wrinkle in the Court of Chancery’s Brophy decision was that the corporate insider was not a traditional fiduciary, like an officer or director, but an employee who had access to the corporation’s information. Notwithstanding, the court imposed liability on the employee for trading on insider information, because the court held the employee to a fiduciary standard.
As demonstrated in the Court of Chancery’s recent decision in Witmer v. Armistice Capital, this original Brophy wrinkle raises the question whether fiduciary obligations arise because the insider is a fiduciary or because the insider has access to the corporation’s material, nonpublic information. In the case of an investor with a board designee, the Court of Chancery in Witmer clarified that it must be both. Specifically, the court rejected the plaintiff’s claim that the investor’s access to material, nonpublic information alone, established a fiduciary duty to not trade on that information.
Background and the Court of Chancery’s Decision
Aytu Biopharma, Inc.’s (Aytu) largest investor was Armistice Capital, LLC (Armistice). In return for Armistice’s investment, Armistice received a designee on Aytu’s Board. Armistice designated its founder, Steven Boyd (Boyd).
On the heels of and in connection with two significant Aytu announcements, Armistice liquidated its Aytu investments. Over four days from March 9 through March 13, 2020, Aytu made an announcement regarding an exclusive distribution agreement that increased its stock price by 400%, and then made a second announcement regarding a dilutive financing arrangement, that lead to a decrease in Aytu’s stock price by 44%. In the period between the 400% increase and 44% decrease in Aytu’s stock price, Armistice liquidated its Aytu holding. Boyd, as Armistice’s Board designee, knew of the financing arrangements, in advance.
Based on these trades, an Aytu stockholder brought a Brophy insider trading claim against Armistice. The stockholder-plaintiff claimed that, through its Board designee Boyd, Armistice possessed material, nonpublic information regarding the financing arrangements, and used this information in trading Aytu’s stock. Further according to the plaintiff-stockholder, Armistice’s possession of Aytu’s material, nonpublic information created a relationship of trust, imposing a fiduciary duty on Armistice not to trade on Aytu’s information. On Armistice’s motion to dismiss, the Court of Chancery declined to adopt the plaintiff-stockholder’s theory of Brophy liability.
According to the court, a Brophy claim requires a “combination” of both a confidential relationship of trust and access to the corporation’s material, non-public information. Turning to the original facts of Brophy, the court reasoned that the corporation’s employee had a relationship of confidence and trust to begin with, which provided him with access to the company’s material, non-public information. It was, again, this “combination” of factors, which the court understood its predecessor in Brophy to find created a fiduciary duty not to trade on the confidential information.
Applied to Armistice, the Court of Chancery found that Armistice owed no fiduciary duties to Aytu as a mere investor, and its access to Aytu’s confidential information did not, alone, create a fiduciary relationship. The Court of Chancery went further to note the potential chilling effect on investment, if the fiduciary duties of an investor’s board designee could be imputed on to the investor. As a result, and without addressing whether Armistice had, in fact, traded on confidential information, the court held that Armistice owed no fiduciary duty preventing it from doing so.
Key Takeaways
For over 75 years, Brophy has stood as a unique form of breach of fiduciary duty claim. Because the defendant in the original Brophy case was not a traditional fiduciary, there remained an apparent wedge for the stockholder-plaintiffs to assert Brophy claims against corporate insiders other than directors and officers, who come into possession of confidential company information and subsequently trade company stock. The Court of Chancery here limited the pool of potential Brophy defendants, finding that an investor who had access to material, non-public information through its board designee, did not owe fiduciary duties merely because of its access. The court clarified that a Brophy defendant must, as a threshold matter, owe fiduciary duties, and the access to confidential information does not, by itself, create a fiduciary relationship. Critical to the court’s finding was that investors should not owe fiduciary duties, simply by virtue of having a board designee. Whether other types of corporate insiders may, in the future, be subject to a Brophy claim, remains to be seen.
The Court of Chancery here limited the pool of potential Brophy defendants, finding that an investor who had access to material, non-public information through its board designee, did not owe fiduciary duties merely because of its access.
