In an opinion issued last week, Merck & Co v Reynolds, 559 US __ (2010), the Supreme Court significantly curtailed the ability of defendants to assert the statute of limitations as a defense to a securities fraud claim under § 10(b) of the Securities Exchange Act of 1934. The decision makes it less likely that courts will dismiss, on statute of limitations grounds, cases filed within five years of the alleged fraud.
The shareholder plaintiffs in Merck alleged that the Company defrauded them through its public statements defending the safety profile of the painkiller drug Vioxx. In 2001, Merck released the results of a Vioxx study comparing the drug to naproxen. The study disclosed that those taking Vioxx were four times as likely to suffer a heart attack as those taking naproxen. Although Merck acknowledged the possibility that Vioxx increased the risk of heart attacks, it publically defended a contrary position known as the “naproxen hypothesis”: that naproxen had the effect of lowering the risk of heart attacks rather than Vioxx increasing that risk. The plaintiffs filed a 10(b)-5 claim on November 6, 2003, alleging that Merck promoted the naproxen hypothesis knowing that it was false and that Merck’s statements artificially inflated the price of the Company’s stock.
The statute of limitations for private claims under § 10(b) of the Exchange Act provides that cases must be brought within “2 years after the discovery of the facts constituting the violation” or no later than 5 years after the violation. 28 U.S.C. § 1658(b). Relying heavily on news articles interpreting the 2001 Vioxx-naproxen study and an FDA warning letter criticizing Merck’s allegedly misleading promotion of the naproxen hypothesis, the District Court dismissed plaintiffs’ § 10(b)-5 claim holding that the limitations period began to run more than two years before the suit was filed. The Third Circuit reversed (with a dissenting judge) on the basis that the articles and FDA warning letter were not enough to put a reasonable investor on notice of a fraud claim, particularly in light of the minimal movement in Merck’s stock price in reaction to the articles and FDA warning letter cited by the District Court.
Supreme Court Decision
In a largely unanimous opinion, the Supreme Court affirmed the Third Circuit’s ruling that the plaintiffs had not discovered the facts of the violation more than two years before filing suit. The Court’s holding clarified the standards for determining when the statute of limitations under § 10(b) begins to run and resolved a split between the Courts of Appeals. The Court held that the limitations period begins to run when a plaintiff discovers or should have discovered with reasonable diligence the facts constituting the fraud, including facts showing scienter.
The Supreme Court resolved three discrete but related sub-issues. As an initial matter, the Court addressed the statutory phrase “after the discovery” to determine whether actual or constructive discovery starts the limitations clock. A six-justice majority held that “discovery of the facts constituting the violation” includes both actual discovery and constructive discovery, i.e, “facts that a reasonably diligent plaintiff would have discovered.”
The Court also addressed and rejected the concept of “inquiry notice.” Prior to Merck, some courts had held that the statute of limitations began to run when a plaintiff possessed a quantum of information sufficiently suggestive of wrongdoing that it should conduct further inquiry. A plaintiff might be on “inquiry notice” before actually discovering facts constituting fraud, making this a more defense-friendly standard. The Court held, however, that the concept of inquiry notice could not be reconciled with § 10(b), which makes actual “discovery” the triggering event.
Most importantly, the Court unanimously held that scienter-related facts (i.e., facts showing that an allegedly false or misleading statement was made knowingly or with reckless disregard for its truth) are among “the facts constituting the violation” that a plaintiff must discover. The limitations clock will not start running when a plaintiff simply becomes aware of a materially false statement. The Court emphasized that a materially false statement (such as an incorrect prediction of earnings) does not usually suggest scienter on its face and, thus, would not be enough.
Applying these principles in Merck, the entire Court agreed that the plaintiffs did not “discover” facts showing scienter more than two years before filing suit. The Court found that the FDA letter and articles questioning Merck’s naproxen hypothesis were not enough for a reasonable investor to “discover” facts constituting fraudulent intent.
Implications of the Decision
The Court’s holding that facts suggesting scienter are necessary to start the limitations period will likely have a significant impact on the ability of defendants seek dismissal of § 10(b) claims on statute of limitations grounds. Defendants will likely be uneasy about arguing that an investor should have been aware of facts showing scienter because the absence of scienter is usually a principal defense against a § 10(b) claim on motions to dismiss or for summary judgment. The scienter standard for a motion to dismiss (allegations raising a strong inference) and for summary judgment (evidence raising a genuine issue of material fact) are likely more rigorous than the level of facts sufficient to “show” or “reveal” scienter for purpose of starting the limitations period. But as a practical matter, a vigorous statute of limitations attack on a § 10(b) claim highlighting facts “showing” scienter may undermine an attempt to dismiss the claim for lack of scienter.
If there is a silver lining in the Merck opinion for potential defendants, it is in the Court’s holding that the FDA warning letter and the many articles debating Merck’s naproxen hypothesis were not enough for a reasonable investor to “discover” any fraudulent intent. The FDA warning letter was particularly strong in reprimanding Merck for its “incomprehensible” purported misrepresentations of Vioxx’s safety profile, even in the face of the FDA’s previous objections to Merck’s defense of the naproxen thesis as misleading. The Court’s unanimous holding that these facts did not “reveal” scienter seems to set a high standard for what constitutes scienter. Thus, while the Merck decision limits defendants’ ability to attack a § 10(b) claim on the basis of the statute of limitations, the Court’s view of scienter may enhance defendants’ already strong ability to challenge a complaint’s allegations of scienter at the motion to dismiss stage. Nevertheless, Merck will effectively permit shareholder plaintiffs to more freely assert potentially stale § 10(b) claims, with the five-year statute of repose as the only meaningful time bar.