In March, the Second Circuit issued the first appellate opinion applying the Supreme Court’s landmark 2015 Omnicare decision. Through that opinion and two subsequent opinions—one addressing the trigger for Item 303 disclosure, and the other addressing the standard for pleading auditor scienter— the Second Circuit has refined the pleading standards for securities fraud cases and given defendants new tools to gain dismissal.

Sanofi shows the practical impact of Omnicare.

In Omnicare, the Supreme Court held that a statement of opinion, even if believed by the speaker, may be actionable if the speaker “omits material facts about the issuer's inquiry into or knowledge concerning [the] statement of opinion ... if those facts conflict with what a reasonable investor would take from the statement itself.” We provided a full analysis of this opinion after it was released, which can be found here.

The Second Circuit’s ruling in Sanofi clarifies how Omnicare will be applied. Sanofi, a pharmaceutical company, made public statements opining that there was a 90% chance the FDA would approve the company’s new multiple sclerosis drug by a certain date. It was publicly known that the drug was being tested using single-blind studies, but in non-public communications the FDA expressed concern about the use of single-blind testing— “strongly recommend[ing]” that double-blind studies be used, but stating that single-blind testing “may be adequate if the effect is large.” Notwithstanding this feedback, the FDA permitted patients to be enrolled in single-blind studies.

When the FDA later rejected the initial application for approval of the drug, investors sued. The Second Circuit held that Sanofi’s statement of opinion that there was a 90% chance the drug would be approved on time was not misleading, even though Sanofi had not disclosed the allegedly mixed feedback from the FDA.

The court pointed to two principles from Omnicare that guided its decision. First, under Omnicare omitted facts are not false or misleading unless they “conflict with what a reasonable investor would take from the statement.” The undisclosed FDA feedback expressed some pessimism that the single-blind study would be accepted, but stated that it may be accepted “if the effect was large”; the plaintiff admitted that the study did in fact reveal a “large” treatment effect.

Second, the court noted that Omnicare did not create liability for statements of opinion merely because the company did not disclose some facts “cutting the other way.” The court emphasized that a company is not obligated to disclose all “information that ran counter to an opinion.”

Many public statements that form the basis for securities fraud actions are not statements of pure fact, but rather opinions along the lines of Sanofi’s belief that FDA approval was forthcoming. As a result Sanofi, like Omnicare, will likely play an important role in a broad range of securities fraud suits for years to come.

Actual knowledge of a trend or uncertainty is required to trigger the disclosure requirement under SEC Item 303.

In Indiana Public Retirement System v. SAIC, the Second Circuit refined the standard for when a securities plaintiff may state a claim for failure to disclose trends or uncertainties. The plaintiff claimed that SAIC failed to disclose that an employee had participated in a kick-back scheme involving overbilling the City of New York for consulting services, and that the company could be required to repay the City over $600 million as a result. The plaintiff argued that SAIC was required to disclose the potential repayment under SEC Regulation S-K, Item 303, which requires registrants to describe “known trends or uncertainties” that may have a material impact on the company’s financial position. The Second Circuit previously held that failure to make an Item 303 disclosure can serve as a basis for a 10(b) securities fraud claim. Not all circuits have addressed this issue. Notably, the Ninth Circuit has taken the opposing view and held that Item 303 does not create a duty under 10(b).

Prior to the SAIC opinion, the Second Circuit had never addressed whether a claim for failure to comply with Item 303 requires actual knowledge by the company of the trend or uncertainty, or if the company’s recklessness or negligence in not identifying such a trend or uncertainty would suffice to state a claim. The court held that the higher standard of actual knowledge by the company is required. In the case at bar, however, the court found that the plaintiff had sufficiently alleged that SAIC did have actual knowledge of both its employee’s fraud and the potential that this fraud could result in a substantial loss, and thus stated a claim.

Pleading auditor scienter continues to be difficult.

In Special Situations Fund III QP v. Deloitte, the Second Circuit reinforced the high standard for pleading a securities fraud claim against outside auditors, particularly with regards to the element of scienter. In this case, Deloitte’s client disclosed that its executives had committed fraud against the company by misstating financial statements and embezzling funds. The plaintiff claimed Deloitte acted recklessly in missing two types of red flags during the audit that would have revealed the executives’ wrongdoing.

First, the plaintiff claimed Deloitte should have confirmed the validity of certain of its client’s large transactions, and alleged that if Deloitte had done so it would have discovered the fraud. The court held that this was not sufficient to show scienter because the plaintiff did not allege that Deloitte was actually required to conduct the testing that may have revealed the fraud.

Second, the plaintiff claimed that certain transactions between the company’s subsidiaries and third parties constituted red flags because these subsidiaries normally only transacted with other subsidiaries within the same family of companies. Here, the court noted that information in the company’s public filings could have led the auditors to believe that such transactions were legitimate. Specifically, the company’s public filings stated that the subsidiaries in question were in the business of providing the type of services that would justify transactions with third parties. The court held that these supposed red flags were only red flags in hindsight, which is insufficient to establish scienter. Dismissal was affirmed.

Linked together, these decisions show the Second Circuit continues to be an influential leader in defense-oriented law in shareholder litigation.