Oral argument: Nov. 30, 2009
Appealed from: United States Court of Appeals for the Third Circuit (Sept. 9, 2008)
SECURITIES EXCHANGE ACT, STATUTE OF LIMITATIONS, SCIENTER, Section 10(b)
Under 28 U.S.C. § 1658(b), a plaintiff must file a claim alleging violation of the Securities Exchange Act of 1934 no later than two years after the plaintiff discovers the facts constituting the violation. The Courts of Appeals are in general agreement that the two-year period of limitations begins when the plaintiff had, or should have had knowledge of the facts constituting the violation. What is at issue in this case is whether knowledge that defendant acted with the intent to deceive is a fact constituting the violation for purposes of triggering the two-year period of limitation. The Supreme Court’s decision will resolve this question of statutory interpretation and, in so doing, will determine the delicate balance between allowing plaintiffs with meritorious claims access to the federal courts and providing certainty and repose to potential securities fraud defendants.
Did the Third Circuit err in holding, in accord with the Ninth Circuit but in contrast to nine other Courts of Appeals, that under the "inquiry notice" standard applicable to federal securities fraud claims, the statute of limitations does not begin to run until an investor receives evidence of scienter without the benefit of any investigation?
Whether the two-year limitations period to bring a suit under the Securities Exchange Act begins when the plaintiff has obtained knowledge that the defendant acted with the intent to defraud, or simply when the plaintiff obtained general knowledge of facts pointing to potential fraud?
Under 28 U.S.C. § 1658, claims of “fraud, deceit, manipulation or contrivance” concerning the Securities Exchange Act of 1934 can be made either “[two] years after the discovery of the facts constituting the violation,” or “[five] years after such violation,” whichever is earlier. See 28 U.S.C. § 1658(b). Respondents, Reynolds, et. al., (“Reynolds”) filed their first complaint alleging securities fraud against Petitioner, Merck & Co., Inc. (“Merck”), in connection with the anti-inflammatory drug Vioxx, on November 3, 2003. See In re Merck & Co., Inc. Securities, Derivative and ERISA Litigation, 543 F.3d 150, 160 (3d Cir. 2008).
On May 9, 1999, the Food and Drug Administration (“FDA”) approved Vioxx, Merck’s new painkiller. See In re Merck, 543 F.3d at 153. Vioxx shared the anti-inflammatory properties of drugs like ibuprofen and naproxen, but did not carry the risk of gastrointestinal damage associated with those drugs. See id. Merck, through press releases and other public statements, emphasized the drug’s safety and its commercial prospects. See id.
Beginning in January 1999, Merck initiated the Vioxx Gastrointestinal Outcomes Research (“VIGOR”), which compared Vioxx to naproxen and publicized the results on March 27, 2000. See In re Merck, 543 F.3d at 154. The results showed that users taking Vioxx had a higher incidence of heart attacks than users of naproxen. See id. The results could be explained in one of two ways: either Vioxx increased the risk of heart attack, or, as Merck hypothesized, naproxen decreased the risk of heart attack (“naproxen hypothesis”), but neither theory was proven. See id.
On February 8, 2001, the FDA held a hearing that discussed the ongoing uncertainty of the VIGOR results regarding increased risk of heart attack. See In re Merck, 543 F.3d at 155. After the hearing, most securities analysts still forecast large future profits for Vioxx. See id. Later, on August 22, 2001, the Journal of the American Medical Association published the results of Vioxx clinical trials, noting a “cautionary flag” and that the use of drugs such as Vioxx might increase the risk of heart attack. See id. at 156. Most securities analysts interpreted the hearing and the article as nothing more than a reiteration of what was already known about Vioxx. See id.
On September 21, 2001, the FDA issued a warning letter accusing Merck of downplaying the potential risks of Vioxx and of holding out the naproxen hypothesis as something more than an unproven explanation of the VIGOR study results. See In re Merck, 543 F.3d at 156–57. After the warning letter, Merck’s stock price fell briefly but quickly recovered, and securities analysts remained enthusiastic about the future of Vioxx. See id. at 157–58. On October 9, 2001, the New York Times published an article discussing the potential increased risk of heart attack associated with Vioxx. See id. at 158.
In October 2003, the Wall Street Journal published an article describing the results of a study linking the use of Vioxx with an increased risk of heart attack. See In re Merck, 543 F.3d at 158. During this time, Merck’s stock lost significant value amid concerns about the safety of Vioxx. See id. On September 30, 2004, Merck voluntarily withdrew Vioxx from the market. See id.
On November 3, 2003, Reynolds and other class members brought suit in the District of New Jersey, alleging that Petitioner violated the securities laws by misrepresenting the safety risks and commercial viability of Vioxx. See In re Merck, 543 F.3d at 160. Merck moved to dismiss on the ground that the two-year limitations period had already run, and the court granted the motion. See id. Reynolds appealed to the United States Court of Appeals for the Third Circuit, which reversed the district court, holding that Reynolds did not have sufficient knowledge of the facts constituting the claim on or before November 3, 2001, and that their claim could proceed. See id. at 172. The U.S. Supreme Court granted certiorari on May 26, 2009 to determine if Reynolds’ claim is time-barred. See Question Presented. This case turns on whether Reynolds knew, or should have known of the facts constituting Merck’s alleged violation of the securities laws more than two years before filing their complaint. If Reynolds knew or should have known of the relevant facts before November 3, 2001, the complaint is time-barred and must be dismissed.
The Supreme Court’s decision in this case is of great interest to both businesses and potential securities fraud plaintiffs. The Court will determine whether a potential plaintiff must have evidence of scienter before the two year period of limitations begins to run or whether more general knowledge of possible fraud is enough to start the clock. The need to strike a proper balance between ensuring that plaintiffs with meritorious securities fraud claims are able to bring suit and providing defendants with a certain and predictable time-frame, after which claims cannot be brought, is at the heart of this case.
Fairness to Plaintiffs and Defendants
Merck argues that allowing the period of limitations to run only when a potential securities-fraud plaintiff has evidence of scienter will result in unfairness to defendants by allowing plaintiffs to increase the settlement value of meritless claims. See Brief for Petitioner, Merck & Co. at 50. The Chamber of Commerce for the United States of America (“Chamber”) agrees, and argues that a scienter requirement would allow plaintiffs to unjustly increase the settlement value of a claim by waiting to file a complaint until the stock of the target company has dropped significantly, thereby increasing the losses that plaintiffs may claim as damages. See Brief of Amicus Curiae Chamber of Commerce of the United States in Support of Petitioner at 21–23. The Chamber contends that increased settlement values increase the pressure on defendants to settle and that this pressure would cause some defendants to settle otherwise meritless claims to avoid the costs of discovery. See id. Merck urges the Court that the limitation period should begin when plaintiffs have only a general knowledge of potential fraud, which will, on the one hand, encourage prompt investigation of potential claims, and on the other, discourage plaintiffs from using this “wait and see” approach. See Brief for Petitioner at 49–50.
The Council of Institutional Investors argues that if the period of limitations begins when a plaintiff has only general knowledge of a potential fraud, potential plaintiffs would be disadvantaged because there would be less time available to investigate potential claims that are often highly complex and difficult to detect. See Brief of Amicus Curiae the Council of Institutional Investors in Support of Respondent at 9–11. The National Association of Shareholder and Consumer Attorneys (“NASCAT”) argues that in light of the higher pleading requirements for securities actions under the Private Securities Litigation Reform Act, 15 U.S.C. § 78u-4(b)(2) (requiring a plaintiff to “state with particularity facts giving rise to a strong inference that the defendant acted with [scienter]”), the period of limitations should not run until a potential plaintiff has at least some evidence of scienter. See Brief of Amicus Curiae the National Association of Shareholder and Consumer Attorneys in Support of Respondent at 10. Holding that the period of limitations begins to run based on general knowledge of potential fraud, NASCAT argues, will drastically decrease the time a plaintiff has to investigate enough facts to file a complaint that will survive a motion to dismiss under the heightened pleading requirements. See id.
The Securities Industry and Financial Markets Association (“SIFMA”) contends that arguments relying on plaintiffs’ lack of time to investigate are unavailing. See Brief of Amicus Curiae the Securities Industry and Financial Markets Association in Support of Petitioner at 16. SIFMA points out that securities litigation is often driven not by individual investors, but by a highly sophisticated “plaintiffs’ firms that already conduct extensive pre-suit investigations.” See id. Therefore, SIFMA argues, by refusing to begin the limitations period only after a plaintiff has evidence of scienter, the Court would not be infringing on the ability of plaintiffs to bring suits in a timely manner. See id.
Protection of the Economy and Capital
In arguing that the Court should require evidence of scienter before starting the limitations period, NASCAT emphasizes the important role that private securities litigation plays in combating securities fraud. See Brief of NASCAT at 4–6. NASCAT argues that private securities actions fill in the enforcement gaps that exist because of the Securities and Exchange Commission’s (“SEC”) limited resources and its inability to detect and prosecute all federal securities law violations. See id. NASCAT also points out that private verdicts or settlements are usually larger than SEC settlements and, therefore, more adequately compensate victims of securities fraud. See id.
The Washington Legal Foundation argues investors would be harmed by the scienter requirement because it would enable plaintiffs to bring stale claims, which are more costly to defend, and that investors will eventually bear the burden of these increased costs through reduced profits. See Brief of Amicus Curiae the Washington Legal Foundation in Support of Petitioner at 25. SIFMA argues that the increased litigation risks posed by the scienter requirement harm the U.S. economy in general by raising the cost of access to U.S. capital markets, which will in turn make foreign capital markets with tighter restrictions on litigation a more attractive option for investors. See Brief of SIFMA at 27–28. Finally, the Pharmaceutical and Research Manufacturers of America (“PhRMA”) contends that Reynolds’ view of what triggers the limitation period would be especially harmful to the pharmaceutical industry because the costs and risks of developing new drugs are already very high. See Brief of Amicus Curiae Pharmaceutical and Research Manufacturers of America in Support of Petitioner at 9. PhRMA argues that any further increase in the cost of developing of new drugs posed by increased securities litigation may have a chilling effect on innovation in the industry. See id. at 9–10.
Reynolds brought suit against Merck for alleged violations of Section 10(b) of the Securities Exchange Act of 1934. See Brief for Petitioner, Merck & Co. at 17. Because Section 10(b) did not expressly create a statutory private cause of action, it did not include a statute of limitations. See Brief for Petitioner at 17. However, with the passage of 28 U.S.C. 1658(b), Congress incorporated into Section 10(b) a two-year limitations period that is triggered upon “discovery of the facts constituting the violation.” 28 U.S.C. § 1658(b)(1). The primary issue in this case concerns the precise meaning given to the terms “discovery” and “facts constituting the violation, ” and specifically, whether evidence of scienter is among these necessary facts. See Question Presented.
The Discovery Rule & Inquiry Notice
Both Merck and Reynolds agree that the triggering of the two-year limitations period in Section 1658(b) does not require actual “discovery of the facts constituting the violation.” See Brief for Petitioner at 18; Brief for Respondent, Reynolds, et al. at 25. Rather, the limitations period can be triggered upon constructive discovery—that is, the point at which a plaintiff should reasonably know of the facts constituting the violation, irrespective of the plaintiff’s actual awareness. See Brief for Petitioner at 18; Brief for Respondent at 25. Furthermore, both Merck and Reynolds recognize that the constructive discovery rule in Section 1658(b) also incorporates the doctrine of “inquiry notice.” See Brief for Petitioner at 20; Brief for Respondent at 27. Inquiry notice essentially means that once a plaintiff, either actually or constructively, becomes aware of facts that suggest wrongdoing, a duty arises to inquire further to determine whether or not a valid claim exists. See Brief for Petitioner at 18–20; Brief for Respondent at 27–28. In the context of securities-fraud claims under Section 1658(b), both parties agree that a plaintiff is on inquiry notice when he receives “storm warnings,” that is, facts that would alert a reasonable investor to suspect the possibility that the defendant has engaged in securities fraud. See Brief for Petitioner at 21; Brief for Respondent at 28–29. The parties disagree, however, as to the nature and sufficiency of facts that effectively trigger the limitations period of Section 1658(b).
Does a Plaintiff Need to Possess Evidence of Scienter Before the Limitation Period is Triggered?
The dispute between Merck and Reynolds turns on whether a plaintiff needs to posses information pertinent to each element of a violation, as opposed to information that generally suggests a violation. In its decision below, the Court of Appeals for the Third Circuit stated that “whether the plaintiffs, in the exercise of reasonable diligence, should have known of the basis for their claims depends upon whether they had sufficient information of possible wrongdoing to place them on inquiry notice or to excite storm warnings of culpable activity [i.e. scienter].” In re Merck, 543 F.3d at 164 (quoting Benak ex rel. Alliance Premier Growth Fund v. Alliance Capital Mgmt., L.P., 435 F.3d 396, 401 n. 15 (3d Cir. 2006)) (internal quotations and citations omitted). Merck argues, however, that a plaintiff may receive “storm warnings” sufficient to trigger the limitations period even without possessing information that bears on each element of an offense, including the element of scienter in securities-fraud cases. See Brief for Petitioner at 20–21. In so arguing, Merck draws analogies to Supreme Court precedent dealing with the contours of the discovery rule in other contexts. See id. at 21. For example, Merck asserts that in TRW Inc. v. Andrews, the Supreme Court recognized that a plaintiff bringing an action under the Fair Credit Reporting Act could be on inquiry notice after having been denied credit, even without possessing “information that a credit agency had made improper disclosures.” See id. at 21–22. Therefore, Merck argues, the Supreme Court should extend the same reasoning to securities-fraud claims. See id. at 22.
Reynolds, however, makes a much stricter statutory argument. By focusing on the well-established elements of a Section 10(b) violation, Reynolds argues that the “facts constituting the violation” must bear on each individual element of the underlying violation, noting that “§10(b) is violated when a defendant has (1) made a misrepresentation (2) that is material, (3) with scienter, (4) in connection with the purchase or sale of securities.” See Brief for Respondent at 21–23. First, Reynolds points to Supreme Court precedent for the principle that scienter is an essential element of a Section 10(b) violation. See id. at 22. Next, Reynolds discusses Court precedent and historical usage concerning the term “facts constituting,” arguing that they point towards a reading of Section 1658(b) that requires the plaintiff to possess information bearing on each element of a Section 10(b) violation, including scienter. See id. at 23–24. Therefore, Reynolds argues, the two-year limitations period under Section 1658(b) is not triggered until an investor possesses, actually or constructively, information bearing on each element—including scienter—of the underlying violation. See id. at 25. Reynolds claims that reasonable investors possessed neither actual nor constructive knowledge of any information bearing on scienter before November 6, 2001, and as such, they were not on inquiry notice and the statute of limitations had not yet been triggered. See id. at 47–48.
Merck responds by arguing that when an investor knows, or reasonably should know, of a material misstatement—in this case, Merck’s representation that Vioxx was not harmful—he or she should, at the very least, suspect that the defendant did so with scienter. See Brief for Petitioner at 22. In so arguing, Merck points to the Supreme Court’s observation that in securities-fraud cases, scienter is often proved through inferences stemming from other information, including the misstatement itself. See id. Merck argues that the Third Circuit’s rule is therefore unworkable for two reasons. See id. at 22–-23. The first is logical: despite using evidence of a misstatement to infer a mental state, an investor may never possess information bearing directly on scienter and, thus, will never trigger the limitations period, effectively crippling the discovery rule and inquiry notice. See id. at 22–23. The second reason draws attention to state and federal cases decided before and after Congress enacted § 1658. See id. Merck argues that examination of these cases will show that the rule adopted by the Third Circuit is an outlier, running astray of the majority rule that does not require an investor to have knowledge of scienter for the limitations period to trigger. See id. at 23–25.
Reynolds rejects Merck’s argument that circumstances surrounding the misstatement are themselves sufficient to give rise to an inference of scienter, which would, as Merck argues, trigger the limitations period. See Brief for Respondent at 43–44. Reynolds concedes that in some circumstances, the misstatement itself could reasonably give rise to a suspicion of fraud or deceit, but that this is not always the case. See id. Reynolds points to the facts of the instant case, arguing that the circumstances surrounding Merck’s misstatement to the public regarding their belief that Vioxx was not harmful does not indicate that Merck intended to deceive. See id. Reynolds also argues that the plaintiff must possess the ability to discover facts pertaining to scienter before it can be charged with being on inquiry notice and triggering the limitations period. See id. at 35. Reynolds argues that Merck’s standard has no support in case law, and that it would require plaintiffs to inquire into information relating to scienter that may be impossible to discover. See id. Thus, Reynolds concludes, it would be unfair and unreasonable to penalize plaintiffs—by virtue of beginning the running of the limitations period before a plaintiff has information bearing on scienter—to engage in “an objectively futile inquiry.” See id.
What Duty Does Inquiry Notice Give Rise To?
Although the issue does not explicitly appear to be before the Court under a plain reading of the question presented in this case, both parties advance arguments relating to the contours of the plaintiff’s duty that inquiry notice gives rise to. See Question Presented; Brief for Petitioner at 39.
Merck argues for two alternative approaches. Primarily, Merck argues for a categorical approach that would require the running of the statute of limitations from the date an investor is on inquiry notice. See Brief for Petitioner at 39–40. Thus, Merck argues that once a plaintiff receives “storm warnings” of possible wrongdoing, a plaintiff is on inquiry notice and the statute of limitations begins to run. See id. Alternatively, Merck argues that upon inquiry notice, the statute of limitations should only be suspended if a plaintiff conducts a “reasonably diligent investigation.” See id. at 43. In other words, Merck argues that “once a plaintiff is on inquiry notice, the limitations period will begin to run unless the plaintiff conducts a further inquiry of his own.” Id. at 44. Merck argues that Respondents never contended that they engaged in any type of investigation and that, therefore, their claim is time-barred under either approach. See id. at 48.
Reynolds responds to Merck’s position by arguing that a plaintiff must have the means of discovering the potential fraud before a duty of inquiry can arise. See Brief for Respondent at 35. Reynolds argues that it is unfair and illogical to trigger the limitations period because a plaintiff failed to engage in an inquiry that objectively could not have led to discovery of fraud. See id. By arguing that regular investors in Merck did not have access to information before November 6, 2001 that would have led to discovery of each element of fraud, including scienter, Reynolds concludes that the statute of limitations was not exhausted before the filing of his suit. See id at 54.
The outcome of this case has potentially far-reaching effects. If the Court decides that the limitations period is only triggered once a plaintiff is aware of information bearing on scienter, there is a concern that plaintiffs will “sit on their rights” in order to increase the settlement value of potentially meritless claims. However, should the Court decide that general awareness of potential fraud is sufficient to trigger the limitations period, there is the possibility that plaintiffs may be unable to discover facts quickly enough to file a complaint that can withstand a motion to dismiss.
Edited by: Joseph Rancour