In Zak v. Chelsea Therapeutics Int’l, No. 13-2370, a split Fourth Circuit panel found allegations of securities fraud sufficient in a putative section 10(b) class action. The district court dismissed the complaint for failing to make allegations sufficient to support a strong inference of scienter under the Private Securities Litigation Reform Act (PSLRA) standard. The majority of the panel reversed, despite an apparent lack of facts showing any real objective for the alleged fraud. The opinion is available here: Zak v. Chelsea Therapeutics Intl.
The case involved a now-common fact situation in securities class actions against pharmaceutical companies. Chelsea was trying to gain approval for a drug treatment for “symptomatic neurogenic orthostatic hypotension,” which is “a condition in which a dramatic drop in blood pressure occurs when a person stands.” During the course of testing for the efficacy of the drug, Chelsea executives expressed optimism about how the tests were going, and for the prospect of getting the drug approved by the FDA. At the same time, the actual testing showed mixed results. One trial was successful and others were inconclusive. All of the trial results were disclosed, however. A meeting with FDA officials was also inconclusive — they indicated that the application for the drug could move forward on the basis of the one study, which was short-term, but that it was an obstacle to approval that other studies had not shown the drug’s efficacy over a longer period. Management optimistically described this conversation as the officials agreeing that the application could move forward on the basis of the one successful trial.
There were other instances of management expressing overly-optimistic views on the approval of the drug, without also acknowledging that there were serious obstacles. One of these included the contents of an FDA staff report. Management received this report, in which a staffer recommended that the drug not be approved, 8 days before it was publicly disclosed. The company’s published description of the report said it raised questions about the sufficiency of the support for approval of the drug, but failed to state that the staffer recommended against approval. The stock price nevertheless declined 38%. The press release also provided the web address to obtain to actual report when it was released by the FDA, which occurred 8 days later. At that time, the stock price declined an additional 21%.
Three days later, an FDA advisory committee recommended approval of the drug in a non-binding recommendation. The FDA itself, however, ultimately declined to approve the drug a little over a month later.
One interesting aspect of the case is the district court’s use of Chelsea’s public SEC filings in its consideration of whether these facts adequately pled scienter under the PSLRA. The defendants submitted SEC proxy and Form 4 filings to show that there was no evidence that management or directors tried to take advantage of any arguably misleading statements by cashing out their stock. Although the complaint did not plead insider stock sales as a motive for the fraud, the court took judicial notice of the SEC filings and based its decision in part on the lack of evidence of efforts to profit on any of the alleged misrepresentations or omissions in the complaint.
The entire 4th Circuit panel agreed that this was improper. The opinion acknowledges the commonly accepted rule that on a motion to dismiss, the court can consider materials outside of the complaint if they are incorporated by reference or implicated by the allegations in the complaint. But, since insider stock trading was never alleged in the complaint, it found judicial notice of materials addressed to that issue was improper.
The majority of the panel went on the conclude that the allegations of repeatedly optimistic statements about the drug approval process which left out key developments suggesting approval was in doubt were enough to support the required strong inference of scienter. Two things are important about this. First, it comes from the 4th Circuit, which rarely sees a class action complaint it thinks is sufficient. Second, it allows a complaint to proceed on the basis of a fraud which, at least from the descriptions in the opinion, shows absolutely to motivation for committing the alleged fraud. Usually, fraudulent misrepresentations or omissions are part of an effort to obtain some advantage from the misleading disclosures. Here, there is no such apparent motive. That may be why the district court went beyond the complaint to the trading data. Surely a fraud must have an objective — but none is apparent here. This is especially so as to the most troublesome of the alleged misleading disclosures: the misleading description of the staff report about possible approval of the drug. Since the report itself was going to be published about a week after the company’s press release about it, and the press release provided the web address for someone to read the actual report one week later, what is the purported object of a fraudulent description of that document, which would last only a week. There appears to be none, since no action during that period suggests an effort to take advantage of the misleading disclosure.
Perhaps this goes more to the issue of materiality than scienter, which, as we have seen before, can be interrelated (see 1st Circuit: Scienter Not Alleged Where Materiality Is Questionable and Regulatory Violations Remain in Doubt). But it would seem to encompass both; how do you find a strong inference of intent to defraud in the absence of any apparent motive?
Dissenting Judge Thacker certainly had problems with finding fraudulent conduct alleged here. He reminded the court that even if recklessness can be sufficient to support scienter — and he reiterated that the Supreme Court still has not accepted that theory (slip op. at 33 n.2) — in the 4th Circuit i”we insist that the recklessness must be ‘severe’ — that is, ‘a slightly lesser species of intentional misconduct.'” Slip op. at 35. He argued that the company’s statements were not “literally” inaccurate, and there was enough support for management to express an optimistic view without committing fraud. He concluded : “Today’s decision clears the way for more litigation, heightening the risk that shareholders will exploit the judicial process to extract settlements from corporations they chose to fund. This is exactly what Congress sought to prevent when it enacted the PSLRA.” Slip op. at 43.
This case is a very close call. Based on the fact descriptions in the opinion, it looks like management erred on the side of optimism, and may have elevated wish above reality, putting the best light on everything while hoping for approval of the drug. It should give us pause on the fraud issue that the advisory committee actually did recommend approval of the drug, even with the alleged shortcomings of the trial studies. In the end, it is the absence of any apparent planned gain or advantage from the alleged misleading disclosures that suggests to me that whatever happened here, intentional fraud was not what it was about, especially under the high scienter pleading standard of the PSLRA.
In any event, the class plaintiffs seem to have some serious uphill fighting on the materiality front.
March 17, 2015
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