On April 27, 2010, in a case of first impression, the U.S. Supreme Court issued a decision that raises the bar on defendants in federal securities fraud cases moving to dismiss in the early stages of litigation based on the expiration of the statute of limitations. In Merck & Co. v. Reynolds, the Court resolved that the limitations period in Section 10(b) cases begins to run only when the plaintiff actually discovers, or when a reasonably diligent plaintiff would have discovered, the facts constituting the violation, including the facts about the defendant’s scienter.1 In so holding, the U.S. Supreme Court also made clear that “inquiry notice” and “storm warnings,” though part of the analysis of a plaintiff’s reasonable conduct, are not sufficient in and of themselves to commence the limitations period.
History of the Case
The Merck case arose out of fraud-on-the-market claims brought by investors for losses incurred when the price of Merck’s stock plummeted following the company’s announcement that it was withdrawing from the market its “blockbuster” pain reliever, Vioxx, due to concerns that the drug caused an increased risk of heart attack. In a complaint filed on Nov. 6, 2003 in the U.S. District Court for the State of New Jersey pursuant to § 10(b) of the Securities Exchange Act, plaintiffs alleged that Merck had knowingly misrepresented the safety and commercial viability of Vioxx.
The District Court granted Merck’s motion to dismiss on the grounds that a number of events occurring more than two years prior to the filing of the complaint should have alerted investors to the possibility of the company’s alleged misrepresentations.2 Those events included:
- a March 2000 study comparing Vioxx with a competitor drug, naproxen, and observing possible harmful cardiovascular (CV) side-effects for Vioxx, but which Merck explained away as the result of naproxen’s anti-coagulating benefit (naproxen hypothesis);
- a September 2001 FDA warning letter acknowledging the naproxen hypothesis, but criticizing Merck’s promotional campaign minimizing Vioxx’s potentially serious CV risks as “false, lacking in fair balance, or otherwise misleading”; and
- an October 2001 New York Times article reporting that Merck knew the naproxen hypothesis was unproven and had admitted that Vioxx might have negative CV side effects.
On appeal, the Third Circuit Court of Appeals reversed, noting that none of these “storm warnings” revealed anything about Merck’s scienter – i.e., that Merck did not believe the naproxen hypothesis to be plausible and that it intended to deceive the public.3 As the Court pointed out, Merck continued to reassure the investing public about the viability of the naproxen hypothesis and many securities analysts maintained strong growth ratings for Vioxx at the same time its safety was being questioned – thus dissipating any “storm warnings” about the legitimacy of the company’s representations about Vioxx’s safety. In the Court’s view, Merck’s naproxen hypothesis had not been fully discredited until a later study in 2003 revealed an increased risk of heart attack in patients taking Vioxx compared to a competitor drug that did not include the platelet inhibitors of naproxen.4
The U.S. Supreme Court’s Decision
Merck sought review by the U.S. Supreme Court based on a Circuit split concerning whether the limitations period in Section 10(b) cases begins to run upon “inquiry notice” of the need to investigate, or later upon full discovery of each of the facts constituting the violation.5 The U.S. Supreme Court granted certiorari and, in a unanimous 9-0 decision, affirmed the Court of Appeals’ finding that the suit was timely. The Court held that the limitations period begins to run only when an investor actually “discovers,” or a reasonably diligent plaintiff would have discovered, the facts constituting the violation – whichever comes first.
Examining first whether “discovery,” as that term is used in Section 1658(b), includes both actual and constructive notice, Justice Breyer, writing for the majority, resolved that it does. Although evidence of “inquiry notice” and “storm warnings” may guide courts in pinpointing the time when a reasonably diligent plaintiff should have begun to investigate, they do not themselves constitute the level of “discovery” required by the statute. Applying this standard, the Court found that prior to November 2001, the Merck plaintiffs neither knew nor should have known of at least one essential fact constituting the violation – Merck’s scienter. To avoid dismissal under the heightened pleading requirements of the Private Securities Litigation Reform Act of 1995, a Section 10(b) plaintiff must allege facts in the complaint showing that it is more likely than not that the defendant acted with the relevant knowledge or intent. Thus, the Court pointed out, “[i]t would frustrate the very purpose of the discovery rule” if the limitations period began to run regardless of whether a plaintiff had discovered any facts suggesting scienter.
Of further note are the separate concurring opinions authored by Justice Stevens and Justice Scalia. Both Justices declined to accept the majority’s holding that § 1658(b) may be satisfied by constructive notice. Justice Stevens noted that in the Merck case neither constructive nor actual notice had been found and, therefore, this question should have been left for another case in which the conflict was present. In a separate and even more pointed concurring opinion, Justice Scalia, joined by Justice Thomas, wrote that it is clear from the plain language of the statute that only actual notice will do.
Ramifications
Following the U.S. Supreme Court’s clarification in Merck of the effect of “inquiry notice” and “storm warnings” on the beginning of the limitations period, defendants in securities fraud actions have a high threshold to meet in order to show that plaintiffs failed to bring their claims within the two-year period set forth in § 1658(b). Defendants must show that the plaintiffs actually discovered, or a reasonable plaintiff should have discovered, the facts constituting the violation, including scienter. Pleading scienter, of course, requires more than simply alleging facts that tend to show a materially false or misleading statement or omission.
While the reasonable plaintiff constructive notice standard still leaves the door open for motions to dismiss to the extent facts can be demonstrated using publicly-available information or other undisputed facts appearing in the pleadings, this fact-intensive defense may require discovery and a motion for summary judgment. It was perhaps this reality that led Merck to argue that such a high burden would encourage stale claims. In response to this concern, however, the U.S. Supreme Court’s decision emphasizes that the five-year “unqualified bar” on actions remains a backstop to the extent that the two-year discovery period cannot be established.
Illustrating the immediate ramifications of the Court’s decision in Merck, on April 27, 2010, the same day the Merck decision was announced, the U.S. District Court for the Southern District of New York issued an Order dismissing without prejudice a pending motion to dismiss based on the statute of limitations and granting the plaintiff leave to re-plead scienter (because neither party had addressed the issue of scienter in their briefs).6 Defendants in other federal securities fraud cases are likely to encounter similar rulings as courts implement the U.S. Supreme Court’s decision in Merck.
1 Merck & Co., Inc. v. Reynolds, No. 08-905, 2010 WL 1655827 (Apr. 27, 2010).
2 A securities fraud complaint is timely if filed no more than “two years after the discovery of the facts constituting the violation” or five years after the violation. 28 U.S.C. § 1658(b).
3 In re Merck & Co., Inc. Securities, Derivative & “ERISA” Litigation, 543 F.3d 150 (3d Cir. 2008).
4 The dissenting judge stated that he believed the September 2001 FDA warning letter alone constituted a sufficient “storm warning” to put investors on inquiry notice of their claims.
5 Compare Theoharous v. Fong, 256 F.3d 1219, 1228 (11th Cir. 2001) (limitations period begins to run when information puts plaintiffs on “inquiry notice” of need for investigation), with Shah v. Meeker, 435 F.3d 244, 249 (2d Cir. 2006) (same; but if plaintiff does investigate, period runs “from the date such inquiry should have revealed the fraud”), and New England Health Care Employees Pension Fund v. Ernst & Young, LLP, 336 F.3d 495, 501 (6th Cir. 2003) (limitations period always begins to run only when a reasonably diligent plaintiff, after in being put on “inquiry notice,” should have discovered facts constituting violation).
6 In re: Citigroup Auction Rate Securities Litigation (American Eagle Outfitters, Inc.), No. 09-5406 (S.D.N.Y. Apr. 27, 2010).
Joshua R. Dutill assisted on this article.
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