Tag Archives: PSLRA pleading standard

4th Circuit Finds Section 10(b) Scienter Allegations Sufficient with No Motive in Zak v. Chelsea Therapeutics

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.

Straight Arrow

March 17, 2015

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1st Circuit: Scienter Not Alleged Where Materiality Is Questionable and Regulatory Violations Remain in Doubt

The recent First Circuit decision in Fire and Police Pension Ass’n v. Abiomed, Inc., No. 14-1502, is noteworthy for its unusual mix of scienter and materiality analysis to affirm dismissal of a section 10(b) securities class action.  Ultimately, the court affirmed dismissal for the lack of sufficient scienter allegations under the heightened pleading standard of the Private Litigation Securities Reform Act (PSLRA), but it was the court’s mixing of scienter and materiality considerations that provokes interest.  The court also made it clear that a securities fraud claim cannot be based on an alleged failure to disclose misconduct while the resolution of the matters at issue with regulators remain uncertain.  A copy of the opinion is available here: Fire and Police Pension Ass’n v. Abiomed Inc.

The claims were founded on allegations that Abiomed, Inc., which sells medical devices, made misrepresentations about the Impella 2.5, a micro heart pump, which was Abiomed’s most important product. The alleged misrepresentations and omissions related to interactions between Abiomed and the FDA regarding marketing used to promote the Impella 2.5, and the possible promotion of off “off-label” uses of the device, that is, uses for purposes beyond those approved by the FDA.

The gist of the complaint was that Abiomed failed to disclose in its SEC filings several FDA communications warning about possible marketing and advertising improprieties, and failed to disclose that its revenues from the sales of that device were achieved in violation of FDA rules.  After ongoing communications between Abiomed and the FDA in 2010-2012, two things occurred.  In November 2012, Abiomed disclosed that federal prosecutors were investigating Abiomed’s promotional and marketing practices and published revised revenue projections, which was followed by a significant decline in stock price.  And in February 2013, the FDA gave Abiomed a “Close-Out Letter” stating its concerns had been adequately addressed by the company, and afterward, the stock price recovered its earlier losses.

The court noted that although it was “far from clear” that “plaintiffs plausibly alleged that “defendants made false or misleading statements which had a material effect on Abiomed’s stock price,” it was affirming the district court’s ruling that the plaintiffs did not sufficiently allege that defendants made those statements with a “conscious intent to defraud or ‘a high degree of recklessness.’”  Slip op. at 4 (quoting ACA Fin. Guar. Corp. v. Advest, Inc., 512 F.3d 46, 58 (1st Cir. 2008)).

 The court’s consideration of the materiality of the alleged misstatements played a significant role in its scienter analysis. The court wrote:

We do address the strength of the materiality of the statements because “[t]he question of whether a plaintiff has pled facts supporting a strong inference of scienter has an obvious connection to the question of the extent to which the omitted information is material.” . . .   “If it is questionable whether a fact is material or its materiality is marginal, that tends to undercut the argument that defendants acted with the requisite intent or extreme recklessness in not disclosing the fact.” . . . The materiality of the impugned omission here — Abiomed’s failure to state that some of the increased revenues were due to off-label marketing — is marginal at best. Plaintiffs’ contention that the omission would have mattered to a reasonable investor depends on a long chain of inferences, most of which are not sufficiently substantiated by the allegations in the complaint.

Slip op. at 29 (citations omitted).  The court also took note that Abiomed’s disclosures explicitly warned about the FDA’s marketing concerns, including disclosures that concerns raised in FDA Warning Letters could have serious consequences.  Id. at 31-32.

Defense counsel should take particular note of the court’s response to the allegation that “Abiomed should have affirmatively admitted widespread wrongdoing rather than stating that the outcome of its regulatory back-and-forth with the FDA was uncertain.”  Slip op. at 32.  Class action complaints often allege fraud based on a failure to disclose that matters involving regulatory uncertainty (or other uncertainties) should have been disclosed as company shortcomings.  But the court here correctly noted that this approach would improperly mandate potentially misleading disclosures of uncertain future events:

That would be a perverse result; such an admission would have been misleading, since the off-label marketing issues had the potential to be resolved with no adverse action from the FDA.  We made a similar point in In re Boston Scientific Corp. Securities Litigation, 686 F.3d 21 (1st Cir. 2012), where we noted that “a company may behave ‘irresponsibly’ if it issues an ominous warning about an uncertain risk that ‘had not yet been adequately investigated.’” Id. at 31. … There must be some room for give and take between a regulated entity and its regulator.

 Id. at 32-33.

The opinion also addresses allegations of statements by so-called “confidential witnesses,” whose statements about the company’s operations did not support scienter because the alleged roles of these persons did not put them in a position to provide information about the knowledge and intent of company management. See id. at 35-36.  The court likewise found allegations of stock sales by insiders insufficient to support scienter because the facts alleged did not show unusual or suspicious trading. See id. at 36-38.

But the two key takeaways from this opinion are: (1) that even without showing alleged misrepresentations were immaterial as a matter of law – which is often tough on a motion to dismiss – defendants can use doubts about materiality to support arguments that scienter is not sufficiently supported under the PSLRA standard; and (2) that allegations of failure to disclose regulatory concerns fall short of fraud when the matters are being actively discussed with law enforcement authorities and it remains uncertain whether they can be resolved without any enforcement action.

Straight Arrow

January 12, 2005

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