In Cozzarelli v. Inspire Pharmaceuticals, Inc., No. 07-1851, 2008 WL 5194311 (4th Cir. Dec. 12, 2008), the Fourth Circuit had its first opportunity to apply the pleading requirements for securities fraud actions set forth by the United States Supreme Court in Tellabs, Inc. v. Makor Issues & Rights, Ltd., 127 S. Ct. 2499 (2007). In Cozzarelli, the Fourth Circuit affirmed the prior dismissal of the complaint because the plaintiffs’ allegations failed to “raise the ‘strong inference’ of wrongful intent that is necessary to support their securities fraud claim.” Cozzarelli, 2008 WL 5194311, at *1.  

The Court of Appeals first acknowledged that, under Tellabs, “[a] complaint will survive . . . only if a reasonable person would deem the inference of scienter cogent and at least as compelling as any opposing inference one could draw from the facts alleged.” Id. at *4 (citing Tellabs, 127 S. Ct. at 2510). Thus, securities fraud claims cannot survive “when the facts as a whole more plausibly suggest that the defendant acted innocently–or even negligently–rather than with intent or severe recklessness.” Id. The court determined that the facts presented on appeal created an inference that Inspire Pharmaceuticals, Inc. (“Inspire”) acted with an innocent intent to protect its competitive interests. Because this inference was more compelling than plaintiffs’ inference that defendants acted with fraudulent intent to mislead investors, the court affirmed the district court’s dismissal of plaintiffs’ securities fraud claims.

Plaintiffs claimed that Inspire had violated the federal securities laws based on statements made regarding a clinical trial conducted to obtain Food and Drug Administration (“FDA”) approval to market its dry eye treatment, diquafosol. Id. at *3. Under plaintiffs’ theory, Inspire and its directors misrepresented that an additional clinical trial required by the FDA was likely to succeed and would result in FDA approval of diquafosol. Id. at *5. Although Inspire had publicly announced that it was conducting the additional clinical trial, it did not disclose the details of that trial in order to prevent competitors from learning of the FDA’s approval requirements for dry eye treatments. Id. at *2. Ultimately, diquafosol failed to meet the primary “endpoint,” or goal, of the clinical trial–a statistically significant amount of corneal clearing. When this outcome was announced, Inspire’s stock price dropped 44.5% and plaintiffs initiated the action. Id. at *3.

Plaintiffs alleged that defendants made statements that misled investors with respect to the endpoint of the clinical trial. Id. at *5. According to the plaintiffs, defendants’ statements that the clinical trial had “a corneal staining endpoint,” was a “confirmatory” trial, and was “very similar” to a previously successful trial were false and misleading. Id. The Fourth Circuit agreed with the district court’s determination that there was a “substantial question as to whether plaintiffs’ allegations of falsity were adequate” and also “it [was] quite clear . . . that plaintiffs failed to allege facts giving rise to a strong inference of scienter.” Id. at *5.

The court first observed that plaintiffs’ “proposed inference of scienter depends on stringing together a series of isolated allegations without considering the necessary context.” Id. at *6. For example, plaintiffs selectively quoted from certain analyst reports, but argued that the court should not consider the reports in full. The court, however, recognized that Tellabs “held that [it] should not decide the issue of scienter by viewing individual allegations in isolation,” but it “must examine the facts as a whole, including facts found in ‘documents incorporated into the complaint by reference.’” Id. Upon a review of full copies of the analyst reports, the court determined that they “demonstrated the fundamental weakness of plaintiffs’ case.” Id. According to these reports, Inspire “‘never confirmed the primary endpoint’” of the clinical trial publicly and expressly stated that it would not announce the specifics of the trial for “‘competitive reasons.’” Id.

Based on the facts elicited from the analyst reports, two competing inferences existed: 1) plaintiffs’ allegations of a nefarious intent to mislead in withholding information regarding the endpoint of the clinical trial and 2) an innocent intent to protect Inspire’s competitive interests in withholding information regarding the endpoint of the clinical trial. Id. The court held that Inspire’s decision not to divulge certain information to its rivals was a matter of business judgment and “a decision to seek a competitive advantage, whether wise or not, is quite different from an intent to deceive.” Id. Under Tellabs, the court was required to weigh the “competing inferences and determine whether plaintiffs’ inference of scienter is ‘cogent and at least as compelling’ as defendants’ inference of legitimate business judgment.” Id. at *7 (citing Tellabs, 127 S. Ct. at 2510). The court concluded that no strong inference of scienter existed under these facts because “the inference that defendants acted with the nonfraudulent intent to protect their competitive advantage is more powerful and compelling than the inference that defendants acted with an intent to deceive.” Id.

The court then addressed the specific arguments presented by plaintiffs in support of their theory of scienter. Plaintiffs’ theory of scienter depended primarily on a statement by Inspire’s CEO that the clinical trial had “‘a corneal staining endpoint,’” even though she allegedly knew that the endpoint of the trial was “corneal clearing.” Id. The court held that it was “difficult to infer intent to deceive from [] reference to the general phrase rather than the specific result . . . .” Id. The statement “supports at most an inference of imprecise or even negligent use of language, not an inference of scienter.” Id. Plaintiffs also argued that defendants knew that successfully achieving a corneal clearing endpoint for the clinical trial was “almost impossible.” Id. Although plaintiffs had statements from anonymous doctors who had worked on the diquafosol clinical trials, claiming that corneal clearing was nearly impossible to achieve, Inspire had achieved corneal clearing in previous clinical trials. Id. In fact, in Inspire’s initial clinical trial of diquafosol, a statistically significant number of patients actually exhibited corneal clearing. Id. at *1. Inspire’s previous success would more likely cause Inspire to believe it would succeed, not fail, in achieving corneal clearing in its clinical trial. Id. at *7.

The court also noted that “[i]t is improbable that Inspire would stake its existence on a drug and a clinical trial that the company thought was doomed to failure.” Id. “Plaintiffs’ inference of fraud based on the supposed impossibility of corneal clearing is thus not even plausible, much less convincing.” Id. The court further noted that allegations that the SEC was investigating Inspire and its CEO and that the CEO had lied when certifying Inspire’s financial statements under Sarbanes-Oxley did not allege scienter. Id. at *8, n.2. The assertions regarding an SEC investigation were “too speculative to add much, if anything, to an inference of scienter,” and “bare allegations [regarding Sarbanes Oxley certifications] do[] not provide independent support for an inference of scienter.” Id.

The Court also found that plaintiffs’ allegations of a financial “motive” to commit fraud and insider trading failed to establish scienter. Id. at *8. Plaintiffs alleged that Inspire was motivated to make overly optimistic public statements regarding diquafosol because it needed to raise money to fund its operations and that the CEO had an incentive to make such statements because her compensation was tied to Inspire’s performance. Id. The court held that “the motivations to raise capital or increase one’s own compensation are common to every company and thus add little to an inference of fraud.” Id. As for the alleged insider trading, the court found that the particular sales at issue were not unusual or suspicious as required to attempt to plead scienter.’” Id. Indeed, “the stock sales highlighted by plaintiffs were modest to de minimis,” and “the total holdings of each defendants increased while [the clinical trial] was ongoing, hardly suggesting that the defendants sought to dump their shares at an inflated price.” Id. Moreover, the court noted that two defendants resigned from Inspire around the time of their stock sales, which suggests that their sales may have been prompted by their departure rather than an intent to defraud. Id.