Reversing a district court’s dismissal of a securities class action for failure to adequately allege scienter, the Ninth Circuit held in Schwartz v. Arena Pharmaceuticals, Inc. — F.3d —-, 2016 WL 6246875 (9th Cir. Oct. 26, 2016), that the facts alleged in the complaint gave rise to a strong inference of scienter where the defendants knew of the FDA’s concerns about the potential carcinogenic effects of a new drug based on animal studies, yet represented to investors that FDA approval was likely because all of the data gathered, including “animal studies,” were “favorable.” The court reaffirmed that, while there is generally no affirmative duty to disclose material information to investors, such a duty arises when the information that is disclosed creates a misleading impression. The court found that the defendants’ statements concerning “animal studies” were misleading in the absence of any disclosure about the FDA’s concerns.

Arena’s stock dropped sharply following the FDA’s disclosure of its concerns about the potential carcinogenic effects of lorcaserin, a weight-loss drug that Arena was developing. The FDA based its concerns on testing of the drug in rats (the “Rat Study”). While the rats developed cancer, Arena had proposed to the FDA an explanation for the carcinogenic mechanism based on the effect of the hormone prolactin, which made it irrelevant to humans. The FDA did not halt the ongoing human clinical trials, but requested follow-up testing and bi-monthly reports on the rats’ prolactin levels, and later requested a final report on the Rat Study as soon as possible. The complaint alleged that those requests were “highly unusual” and “out-of-process.” However, following Arena’s discussions with the FDA in 2007 and 2008, Arena heard nothing further from the FDA on the Rat Study issue until September 2010. Moreover, Arena’s February 2009 final report concluded that the follow-up studies substantiated the prolactin hypothesis.

Thereafter, Arena made a number of statements to its investors about its confidence in lorcaserin’s ultimate approval by the FDA. In March 2009, Arena’s CEO told investors that confidence was based on both the preclinical and clinical data as well as the “animal studies” that had been completed. In May 2009, Arena represented in an SEC filing that lorcaserin’s “safety and efficacy” has been “demonstrated” in part by carcinogenicity “animal studies.” In September 2009, Arena’s Vice President of Clinical Development stated that lorcaserin showed “favorable results on everything we’ve compiled so far.” Finally, in November 2009, Arena’s CEO stated that “all of the data in hand” would be included in Arena’s imminent FDA approval application, and that Arena was “not expecting any surprises” in the approval process.

In December 2009, Arena submitted is final application (which included the Rat Study conclusions) to the FDA. In September 2010, the FDA published briefing documents in connection with Arena’s application that disclosed the existence of the Rat Study and the FDA’s concerns about lorcaserin’s potential carcinogenicity. Following that disclosure, Arena’s stock plunged 40% in a single day.

Later, the FDA Advisory Committee voted against approval of lorcaserin based on its carcinogenicity concerns, and the FDA denied Arena’s drug approval application. However, following further pathological review, the FDA ultimately approved lorcaserin, and it is currently on the market.

Following the September 2010 FDA disclosure, plaintiffs brought a putative class action suit against Arena and several of its officers, alleging that the defendants’ statements referring to the animal studies were misleading and made with scienter. The district court dismissed the complaint for failure to adequately allege scienter. The Ninth Circuit reversed. Assuming that the challenged statements were misleading, the Ninth Circuit focused its opinion on what it described as a “simple” theory of scienter: because Defendants had referred to the animal studies when touting lorcaserin’s safety and likely approval, they were obligated to disclose the Rat Study’s existence to the market, and their failure to do so demonstrated scienter. 2016 WL 6246875, at *4.

While acknowledging that it was a “close case,” the Ninth Circuit ultimately agreed. Id. The court observed that, under Matrixx Initiatives, Inc. v. Siracusano, 563 U.S. 27 (2011), Defendants would have been under no affirmative duty to disclose the Rat Study in the absence of other statements they had made to the market. However, as in Matrixx, once Defendants represented that “animal studies” supported lorcaserin’s safety and likely approval, they were bound to do so in a manner that would not mislead investors. Id. at *5-*7. The court found that, at the time those statements were made, “Arena knew the animal studies were the sticking point with the FDA[,]” and that it was simply untrue that all of those studies were “favorable.” Id. at *7 (emphasis in original).

The Ninth Circuit also rejected Defendants’ attempt to analogize the case to In re AstraZeneca Sec. Litig., 559 F. Supp. 2d 453 (S.D.N.Y. 2008), where the court found that a “scientific disagreement” between the defendant company and the FDA regarding the safety profile of a proposed new drug did not give rise to an inference that the defendants did not honestly believe that the drug was safe. The court observed that Schwartz’s “theory of fraud” was not that Defendants had misled the market as to lorcaserin’s objective safety, but rather that they had withheld information about the FDA’s concerns about its safety, which implicated its prospects for approval—regardless of whether those concerns were well-founded. Id. at *8.

In some respects, the Ninth Circuit’s opinion seems rather harsh. After all, while the FDA had initially expressed some concern about the Rat Study, Arena had ultimately concluded that the animal tests did not suggest that lorcaserin was carcinogenic to humans, and the FDA had not expressed disagreement with that conclusion at the time the challenged statements were made. It seems plausible that, at the time they made those statements, Defendants actually believed that the Rat Study supported the drug’s safety and would not be a significant stumbling block in the approval process.

On the other hand, the FDA had not expressed that its concerns about the Rat Study had been mollified, either. By expressly invoking “favorable animal studies” as a basis for Arena’s belief that lorcaserin would be approved, Defendants arguably created an impression that nothing in the animal studies would cause the FDA any concern—an arguably misleading impression, given that the FDA had already expressed its concern. Had Arena simply stated its belief or confidence that lorcaserin would be approved, it likely would have avoided an inference of scienter. But once it specifically referenced “animal studies” as a basis for that belief, the failure to disclose that those “animal studies” had actually given the FDA pause arguably created a misleading picture for investors.