On April 7, 2017, the United States Court of Appeals for the First Circuit affirmed the dismissal of a putative securities fraud class action against the biopharmaceutical developer Zafgen, Inc. (“Zafgen”) and its CEO. Brennan v. Zafgen, Inc., No. 16-2057, 2017 WL 1291194 (1st Cir. Apr. 7, 2017). Plaintiffs had asserted claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934 and Rule 10b-5 thereunder, alleging that in Zafgen’s IPO registration statement and other public statements defendants omitted information regarding adverse events during clinical trials for Zafgen’s only drug in development, the obesity drug Beloranib. The Court held that plaintiffs did not adequately plead scienter under the heightened requirements of the Private Securities Litigation Reform Act of 1995 (“PSLRA”), stressing that a defendant’s mere knowledge of omitted information is not sufficient to support a cogent and compelling inference of fraudulent intent.

Plaintiffs alleged that, although Zafgen’s April 2014 IPO registration statement disclosed two “serious” adverse events in the Phase II clinical trial for Beloranib, it omitted two “superficial” adverse events that had occurred during that trial. These events were not disclosed until October 16, 2015, following announcements that a patient had died during the Phase III clinical trial and the FDA had placed the drug on a partial clinical hold. In support of their scienter allegations, plaintiffs alleged that defendants (i) knew, or were reckless in not knowing, about news and scientific articles regarding a purported link between Beloranib and similar adverse events; and/or (ii) had a motive to commit securities fraud, as shown by insider sales and Zafgen’s compensation structure. The Court rejected both theories.

Considering the publications relied upon by plaintiffs, the Court stressed that the “key question” was not whether defendants had knowledge of undisclosed facts, but whether defendants knew or should have known that their failure to disclose those facts risked misleading investors. Here, the Court closely read the cited articles and determined that, although they suggested defendants had an awareness of some connection between Beloranib and adverse events, they did not “add much support” for the allegation that defendants knew, or were reckless in not knowing, that they risked misleading investors by failing to disclose the two superficial adverse events. The Court noted that this conclusion was “especially warranted” given that the complaint contained no specific facts about “warnings by subordinates or expressions of concern by executives” regarding the propriety of the allegedly deceptive disclosures.

Regarding plaintiffs’ motive allegations, the Court characterized the insider trading allegations as “marginal” given that (i) Zafgen’s CEO retained at least 93% of his holdings after accounting for his vested options (explaining that it was appropriate to consider not only the number of shares that were sold but also the number of shares that could have been sold through the exercise of options) and (ii) there were no allegations that insiders sold any shares after the occurrence of the patient death in the Phase III trial. The Court further held that Zafgen’s compensation structure—which allegedly tied “a significant portion” of its executives’ compensation to stock option awards and non-equity incentive plans that were in turn necessarily dependent upon the success of Beloranib—did not support an inference of fraudulent intent. The Court explained that “we find it difficult to infer fraudulent intent simply because the defendants’ compensation structure rewards the achievement of corporate goals.”

The Court also noted that other factors supported its conclusion that the complaint’s allegations did not give rise to a sufficiently strong inference of scienter. One was the “marginal materiality” of the two superficial adverse events. In this connection, the Court explained that, although under Matrixx Initiatives, Inc. v. Siracusano, 563 U.S. 27, 43-44 (2011), adverse event reports may be material even if they “d[o] not provide statistically significant evidence of a causal link,” nevertheless, “the mere existence of reports of adverse events—which says nothing in and of itself about whether the drug is causing the adverse events—will not satisfy” the materiality standard. Moreover, the fact that defendants had disclosed the two serious adverse events (i) rendered it unlikely that disclosure of the two superficial adverse events would have significantly altered the information available to investors, and (ii) supported a strong competing inference that defendants disclosed what they considered to be, at the time, the most relevant information about Beloranib’s clinical trials.

This decision will be useful to defendants in emphasizing that allegations of scienter regarding allegedly omitted information cannot be based solely on a defendant’s knowledge of the omitted information, particularly where the total mix of information disclosed undermines the materiality of the alleged omissions.

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