In recent years the Supreme Court has accrued a record overwhelmingly favoring defendants in securities class actions, so a few double takes were in order when, on April 27, the justices unanimously ruled in favor of the plaintiffs in Merck & Co., Inc. v. Reynolds.
"I was fall-off-the-chair stunned," says Adam Savett, director of Securities Class Action Services at RiskMetrics Group, an investment risk adviser. "It certainly is the first 'plaintiff-friendly' decision in a securities class action from the Supreme Court in quite some time."
The question before the court was when the statute of limitations begins to run in fraud cases brought under Section 10(b) of the Securities and Exchange Act. The relevant statute provides that plaintiffs must file such claims within two years of the discovery of "facts constituting the violation," or when reasonably diligent investors should have discovered such facts, as long as the claims are filed within five years of the violation.
The Reynolds plaintiffs filed suit against Merck in November 2003 alleging the pharmaceutical company had knowingly misled investors regarding the risk of heart attacks associated with its painkiller Vioxx--a risk that has led to hundreds of class actions over the since-withdrawn drug.
Merck argued that the investors' claims were invalid because they filed them more than two years after the investors should have been put on notice of any alleged fraud. Merck cited a number of public disclosures that surfaced two or more years before the Reynolds plaintiffs sued: Merck's release in 2000 of a study showing increased rates of heart attacks among participants taking Vioxx versus those who did not; a related products liability lawsuit; and a warning letter from the Food and Drug Administration (FDA) that called Merck's ads for Vioxx "misleading" in light of the drug's cardiovascular risks.
But the high court rejected Merck's contention that such events started the clock on the statute of limitations by putting the plaintiffs on inquiry notice, which occurs when the "plaintiff possesses a quantum of information sufficiently suggestive of wrongdoing that he should conduct an investigation." In fact, the court rejected inquiry notice as having any weight on when the limitations period begins to run.
Instead, the court established that scienter, or intent, is a critical part of a Section 10(b) fraud claim, and thus its presence is necessary to establish the running of the statute of limitations. The court's reading opens the possibility of plaintiffs being able to file more than two years after a misleading statement.
"Here the court said you get two years from the time you have discovery of the facts constituting the violation--including facts showing scienter. Until you have that, the statute doesn't even begin to run," says Jordan Eth, co-chair of Morrison Foerster's securities litigation, enforcement and white-collar defense group. "It's a higher standard for defendants to meet."
The good news for corporate defendants in Section 10(b) private securities class actions is that the impact of Merck will likely be narrow within the securities fraud realm due to the case's novel circumstances.
"In many securities fraud matters the plaintiffs bring their lawsuits shortly after the company makes an announcement that triggers a drop in the company's stock price," says Laurence Weiss, a partner at Hogan Lovells. "Plaintiffs don't normally wait long periods of time before bringing a lawsuit, so there generally isn't a statute of limitations argument available. That limits the impact of the decision somewhat."
Savett points out that the Merck case didn't come after the classic one-day stock drops seen in the majority of securities cases--rather, its stock price wandered up and down, the disclosures happened over a long amount of time, and in response to those disclosures Merck would reassure investors that its exposure was limited.
"That tempers it," Savett says. "You really need a perfect storm."
Where Merck could become an issue is in anticipating securities litigation.
"Say someone asks you, 'Our stock got hit three years ago. We're not going to get sued, are we?'" Eth says. "In the past, the odds were next to nothing, and in fact it's still true that if you don't get sued quickly, the odds of being sued are much lower. But they don't go to zero now."
Also tempering the overall plaintiff-friendly bent of the high court's ruling were a few lines of reasoning that could actually deliver some benefit to corporate defendants.
First was the fact that in the court's eyes, the existence of a scientific debate about the health and safety concerns of Vioxx did not give rise to a strong inference of scienter to trigger the statute of limitations.
"The FDA's warning letter ... shows little or nothing about the here-relevant scienter. ... The products-liability complaints' statements about Merck's knowledge [of the risks of Vioxx] show little more," the court wrote.
That could be a boon for defendants, particularly pharmaceutical companies, because in the past plaintiffs could point to the disagreement itself as evidence of scienter.
"Plaintiffs could argue that because others, outside the company, pointed to that evidence of the existence of a safety problem, then the company's statements to the contrary were evidence that the defendants must have knowingly lied about the product's safety," Weiss says. "The court in Merck said pretty clearly that those sort of scientific debates about product safety don't indicate anything about a defendant's intent
The court relied on a pleading standard it established in the landmark 2007 securities case Tellabs, Inc. v. Makor Issues & Rights, Ltd. In that case the court wrote plaintiffs must show facts from which "a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged."
The court's reasoning in Merck reaffirms that elevated hurdle for plaintiffs, Weiss says. "The pleading standard for alleging a defendant's scienter is in fact a heightened pleading standard," he says.
Another benefit to defendants is that the court didn't deliver as plaintiff-friendly a ruling as it could have, as evidenced by Justice Antonin Scalia's concurrence. In Justice Stephen Breyer's majority opinion, he establishes that in the statute of limitations context, the words "after the discovery of the facts constituting the violation" are generally taken to mean after the point at which the plaintiff actually discovered the facts or "with due diligence should know facts that will form the basis of an action"--defined as constructive discovery.
But in Scalia's concurrence, he makes it clear he would read "discovery" in the relevant statute only as actual discovery. In a footnote he writes, "[The court's] entire argument [over what 'discovery' means] rests on the meaning courts have ascribed to 'discovery' in other limitations provisions. ... Yet while the court considers that broader context, it provides no explanation for ignoring the more specific context of securities-fraud claims under the 1933 and 1934 Acts." In that context, he says, discovery cannot be read as encompassing constructive discovery.
"Had [Scalia's reasoning] been adopted, it would have been a much worse decision for defendants," says Jonathan Youngwood, a partner at Simpson Thacher & Bartlett. "The standard the court set wasn't as strict as it could have been. It could have been that the individual plaintiff had to have discovered all the potential facts that made up the claim--that would have been a mistake but it would have been a more plaintiff-friendly decision."