Issues
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?
Under28 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.
Questions as Framed for the Court by the Parties
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?
Facts
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. 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.
On May 9, 1999, the Food and Drug Administration (“FDA”) approved Vioxx, Merck’s new painkiller. 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. Merck, through press releases and other public statements, emphasized the drug’s safety and its commercial prospects.
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. The results showed that users taking Vioxx had a higher incidence of heart attacks than users of naproxen. 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.
On February 8, 2001, the FDA held a hearing that discussed the ongoing uncertainty of the VIGOR results regarding increased risk of heart attack. After the hearing, most securities analysts still forecast large future profits for Vioxx. 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. Most securities analysts interpreted the hearing and the article as nothing more than a reiteration of what was already known about Vioxx.
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. After the warning letter, Merck’s stock price fell briefly but quickly recovered, and securities analysts remained enthusiastic about the future of Vioxx. On October 9, 2001, the New York Times published an article discussing the potential increased risk of heart attack associated with Vioxx.
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. During this time, Merck’s stock lost significant value amid concerns about the safety of Vioxx. On September 30, 2004, Merck voluntarily withdrew Vioxx from the market.
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. Merck moved to dismiss on the ground that the two-year limitations period had already run, and the court granted the motion. 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. The U.S. Supreme Court granted certiorari on May 26, 2009 to determine if Reynolds’ claim is time-barred. 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.
Analysis
Reynolds brought suit against Merck for alleged violations of Section 10(b) of the Securities Exchange Act of 1934. Because Section 10(b) did not expressly create a statutory private cause of action, it did not include a statute of limitations. 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.” 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.
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.” 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. Furthermore, both Merck and Reynolds recognize that the constructive discovery rule in Section 1658(b) also incorporates the doctrine of “inquiry notice.” 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. 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. 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].” 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. In so arguing, Merck draws analogies to Supreme Court precedent dealing with the contours of the discovery rule in other contexts. 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.” Therefore, Merck argues, the Supreme Court should extend the same reasoning to securities-fraud claims.
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.” First, Reynolds points to Supreme Court precedent for the principle that scienter is an essential element of a Section 10(b) violation. 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. 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. 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.
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. 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. Merck argues that the Third Circuit’s rule is therefore unworkable for two reasons. 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. The second reason draws attention to state and federal cases decided before and after Congress enacted § 1658. 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.
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. 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. 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. 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. 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. 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.”
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.
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. 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. Alternatively, Merck argues that upon inquiry notice, the statute of limitations should only be suspended if a plaintiff conducts a “reasonably diligent investigation.” 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.” 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.
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. 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. 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.
Discussion
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. 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. 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. 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.
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. 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. 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.
The Securities Industry and Financial Markets Association (“SIFMA”) contends that arguments relying on plaintiffs’ lack of time to investigate are unavailing. 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.” 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.
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. 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. NASCAT also points out that private verdicts or settlements are usually larger than SEC settlements and, therefore, more adequately compensate victims of securities fraud.
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. 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. 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. 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.
Conclusion
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.