Supreme Court Resolves Disagreement over the Limitations Period in Section 10(b) Claims
Securities Litigation Update
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On April 27, 2010, the United States Supreme Court handed down its decision in Merck & Co., Inc. v. Reynolds, resolving a longstanding disagreement among the federal courts of appeal over the interpretation of the two-year statute of limitations applicable to private securities fraud actions brought pursuant to section 10(b) of the Securities Exchange Act of 1934. The Court unanimously held that plaintiffs’ section 10(b) claim was timely, and in an opinion for a six-justice majority written by Justice Breyer, the Court held that the two-year limitations period does not begin to run until a plaintiff has discovered, or a reasonably diligent plaintiff would have discovered, the “facts constituting the violation,” including the “fact” that the defendant acted with scienter.
Background
In November of 2003, a group of investors filed suit against Merck alleging violations of section 10(b). In their amended complaint, plaintiffs alleged that Merck knowingly misrepresented the risks of heart attacks associated with the use of one of its drugs, Vioxx.
Merck moved to dismiss the complaint on the grounds that it was time-barred under the applicable statute of limitations, which required plaintiffs to file suit within “2 years after discovery of the facts constituting the violation” or “5 years after such violation.” 28 U.S.C. § 1658(b). The five-year statute of repose was not at issue. Merck contended that plaintiffs had discovered, or should have discovered, the “facts constituting the violation” more than two years before they filed their complaint because of publicly available information about cardiovascular risks of Vioxx included in a study comparing Vioxx and another painkiller, product liability lawsuits filed against Merck based on those risks, and a Food and Drug Administration (FDA) warning letter that characterized Merck’s marketing of Vioxx with respect to those risks as “false, lacking in fair balance, or otherwise misleading.” Throughout this period, Merck publicly asserted an alternative hypothesis to the theory that Vioxx increased the risk of heart attacks – namely that naproxen (the other drug in the study) lowered the rate of heart attacks.
The District Court for the District of New Jersey agreed with Merck and dismissed the suit as time-barred. The Court concluded that the public information should have alerted plaintiffs “to the possibility that Merck had knowingly misrepresented material facts,” and therefore plaintiffs were on “inquiry notice” by October 2001 to investigate further.
The Court of Appeals for the Third Circuit reversed, concluding that although the publicly available information constituted “storm warnings,” it did not suggest that Merck acted with scienter in making statements about the safety of Vioxx, and therefore it did not put plaintiffs on “inquiry notice.”
Opinion of the Supreme Court
The Clock Starts upon Actual or Constructive Discovery of the “Facts Constituting the Violation”
The Supreme Court first agreed with both parties, the Solicitor General, and lower courts, that the term “discovery” in section 1658(b)(1), which triggers the two-year limitations period, “refers not only to a plaintiff’s actual discovery of certain facts, but also to the facts that a reasonably diligent plaintiff would have discovered.” The Court held that the limitations period begins to run when a diligent plaintiff would have discovered the facts, notwithstanding the absence of any reference to such constructive discovery in section 1658(b)(1).
This holding was the only source of disagreement among an otherwise unanimous Court. Justice Scalia, joined by Justice Thomas, concurred in the judgment but disagreed with the majority’s interpretation of section 1658(b)(1); the two Justices instead would have held that because Congress included an explicit reference to constructive discovery in section 13 of the Securities Act of 1933, which governs sections 11 and 12 of the 1933 Act, and omitted any such reference in section 1658(b)(1), “discovery” in the latter statute refers only to “actual discovery” of the facts constituting the violation. Justice Stevens, concurring in judgment and agreeing with the majority in all other respects, believed that that the Court need not reach the issue of whether constructive notice triggered the running of the statute of limitations because, in the case at hand, there was “no difference” between the time at which plaintiffs actually discovered the facts constituting the violation and when a reasonably diligent plaintiff should have discovered them.
The “Facts Constituting the Violation” Include the “Fact” of Scienter
The Court next held that the two-year limitations period does not begin to run upon the mere discovery of the falsity of a material statement, but rather it begins to run when a plaintiff learns of facts showing that the defendant made the misstatement with scienter. The Court reasoned that the mental state constitutes “an important and necessary element of a § 10(b) violation” and a plaintiff “cannot recover without proving that a defendant made a material misstatement with an intent to deceive.” Citing the language from the Private Securities Litigation Reform Act (PSLRA) requiring plaintiffs to “state with particularly facts giving rise to a strong inference” of scienter to survive a motion to dismiss and its recent decision in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U. S. 308 (2007), the Court noted that it would “frustrate the purpose of the discovery rule” if the limitations period were to begin before a plaintiff discovered facts regarding scienter sufficient to survive a motion to dismiss. Notably, however, the Court specifically declined to address whether the limitations period begins to run before a plaintiff discovers “facts” that relate solely to elements of private section 10(b) damages claims, such as reliance, loss, and loss causation. In response to Merck’s argument that the discovery of facts related to falsity will “ordinarily” establish scienter, the Court noted that although the fact of falsity may establish scienter in some cases, the relationship of “factual falsity and state of mind is more context specific,” citing as an example a company’s incorrect prediction about future earnings which may be either an innocent error or a deliberate lie.
Resolving the Circuit Split on the Application of “Inquiry Notice”
The Court also resolved a disagreement among the courts of appeal regarding whether the two-year limitations period for section 10(b) claims begins to run when the plaintiff is on “inquiry notice,” i.e., “the point where the facts would lead a reasonably diligent plaintiff to investigate further.”
The Supreme Court rejected each articulation of the “inquiry notice” standard advanced by Merck and its amici, holding that the statute “contains no indication that the limitation period should occur at some earlier moment before ‘discovery.’” Thus, in the context of a section 10(b) violation, “discovery of the facts constituting the violation” occurs at the point at which a reasonably diligent plaintiff would have discovered them, not at the point at which the plaintiff should have begun investigating them – regardless of whether the plaintiff did, in fact, investigate to obtain the necessary facts.
Application of the Discovery Standard
Finally, in applying the standard it had articulated to the facts of the case, the Court held that the information that was publicly available before November 2001 (two years before plaintiffs filed their complaint), “whether viewed separately or together,” revealed the “facts” of Merck’s misrepresentations but did not reveal “‘facts’ indicating” scienter. According to the Court, the public information revealed only that Merck’s claims regarding the safety of Vioxx were potentially wrong, but it did not reveal that Merck promoted it with knowledge that its statements were false.
Implications of the Opinion
Plaintiffs in private securities fraud actions are likely to view the decision as a victory, as the Court made clear that the limitations period on section 10(b) claims does not begin to run until the point at which they would have discovered, with reasonable diligence, facts demonstrating that a defendant acted with scienter. Plaintiffs may attempt to file complaints more than two years after notice of a misstatement, arguing that they had discovered facts of scienter well after they learned of the misstatement. Moreover, where a complaint survives a motion to dismiss and the automatic stay of discovery under the PSLRA is lifted, plaintiffs may attempt to propound discovery on other potential defendants, such as bankers, auditors or other advisors, and then attempt to name those entities as defendants, arguing that plaintiffs had not “discovered” facts as to the scienter of those defendants. Finally, plaintiffs may also attempt to refile claims that had been dismissed for failure to allege scienter, with new “facts” as to scienter, arguing that dismissal meant that the two-year statute of limitations had not yet begun to run.
From the defense perspective, the Court shed some helpful light on interpreting the pleading standard in private securities fraud actions and its Tellabs decision by holding that the publicly-announced studies, product liability lawsuits, and the FDA warning letter were not “facts” constituting scienter sufficient to trigger the running of the statute of limitations. The application of the Tellabs standard to the facts in Merck is a warning to plaintiffs that they cannot survive a motion to dismiss without including in their complaint reference to “specific information suggesting the fraud.” Defendants should also consider whether they can argue effectively that plaintiffs have not adequately alleged facts establishing a strong inference of scienter, but, even if they have, those facts were known to – or should have been known to – plaintiffs more than two years before filing their complaint, making it time-barred. Finally, given that the loss causation standard turns on the disclosure of concealed facts to the market, defendants should continue to look at coupling loss causation and other viable arguments with scienter arguments on a motion to dismiss, particularly given courts’ increasing willingness to take a hard look at loss causation in the wake of the Supreme Court’s decision in Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336, 342 (2005).
For further information regarding this Update, please contact:
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Daniel A. McLaughlin
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Chicago
David F. Graham
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Hille R. Sheppard
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Los Angeles
Michael C. Kelley
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Washington, D.C. Michael D. Warden
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San Francisco Sara B. Brody
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