Heightened Pleading Standards in Securities Fraud Class Actions
April 11, 2012
The First Circuit Court of Appeals and the District Court of Massachusetts have recently issued opinions in securities fraud class actions that were favorable to the issuer-defendants. A theme emerges from these cases: if an issuer makes timely public disclosure of material events, plaintiffs will have difficulty adequately pleading scienter under heightened pleading standards.
Smith & Wesson Case
In February 2012, the First Circuit affirmed summary judgment in favor of Smith & Wesson, the gun manufacturer, where it was alleged that the issuer made false or misleading public statements about the demand for its products in violation of the Exchange Act and Rule 10b-5. In re Smith & Wesson Holding Corp. Securities Litigation 2012 WL 516073 (CA.1(Mass.)).
In June 2007, S&W made statements about its strong performance for the final quarter of its 2007 fiscal year and the year overall, announcing that it was “raising [its] sales expectations for fiscal 2008 from $320 million to $330 million, which would represent a 40.5% increase over 2007 sales.” At the same time, it upwardly revised earnings guidance from $0.60 to $0.62 per share. These statements were accompanied by a clearly labeled “Safe Harbor” warning with regard to “forward-looking statements, including future sales income, income per share…demand for the company’s products….”
Three months later, in September 2007, S&W issued a press release reporting “Record First Quarter Revenues and Profits” reflecting “growth in our core handgun business.” S&W increased fiscal 2008 earnings guidance from $0.62 to $0.63 per share and said “that [we] expect second quarter revenue to increase by approximately 60% over revenue in the second quarter of fiscal 2007.” This press release also contained the standard “Safe Harbor” caution for forward-looking statements. Following the press release and S&W’s earnings call that day, its stock price rose about 5%.
However, at the end of October 2007, S&W disclosed disappointing preliminary financial results for the second quarter of fiscal 2008, attributed to “a combination of factors that emerged late in the quarter.” S&W revised its earnings guidance downward from $0.63 to $0.53 per share. Its stock price dropped 40 percent the next trading day. At the beginning of December 2007, S&W released its final results for the second quarter and further reduced its earnings guidance further, from $0.53 to $0.40 per share. The stock price dropped another 29% the next day.
The Lawsuit and Rulings
The plaintiffs then filed suit alleging (a) that S&W’s June and September 2007 press releases and accompanying statements falsely implied strong demand, (b) that S&W did not disclose that strong sales resulted from discounts pulling orders from future quarters and amounted to “channel stuffing,” and (c) that by July signs of declining demand were apparent and should have been disclosed in the September 2007 announcements.
The District Court was not moved by plaintiffs’ allegations and granted summary judgment for S&W, saying:
“But offering discounts to stimulate sales is not automatically manipulation and may well stimulate demand…Anyway here the plaintiffs’ case as to June rests on only three pull-in deals plus rhetoric, nothing shows the pull-ins were unusual, represented a significant percentage of reported sales for the quarter or were otherwise suspect.”
The Appeals Court affirmed the summary judgment ruling, although it found the revenue drop off in August 2007 to be more troubling:
“Still, even if we assume arguendo that bad present numbers should trump optimism and ought to have been disclosed or even that more should have been said about discounting, the present suit fails for lack of proof of scienter. Section 10(b) is primarily a fraud provision and “a showing of either conscious intent to defraud or a high degree of recklessness” is required… Recklessness in this context is:
“A highly unreasonable omission, involving not merely simple, or even inexcusable negligence, but an extreme departure from the standards of ordinary care, and which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious the actor must have been aware of it.”
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“Scienter is inherently a fact-intensive inquiry…and courts are normally cautious about granting summary judgment for the defense on this issue. But this hesitancy assumes that there is either some evidence of subjective bad intent, or, alternatively, misstatements or omissions so blatantly improper that bad intent or recklessness can be inferred …. There is no evidence of the former in this case and, at best, a thin and debatable case as to misstatements or omissions.”
In affirming summary judgment, the Appeals Court acknowledged that a public mea culpa may be a factor in determining scienter:
“Once the downward trend became clear with the second-quarter numbers, the company explicitly acknowledged that its forecasts had been undermined; as described at the outset, it offered preliminary negative figures in late October well before the final numbers were in hand, attributing the decline to ‘a combination of factors that emerged late in the quarter.’ Whether or not it was negligent to have remained too sanguine in early September, there is no evidence of anything close to fraud.”
On March 30, 2012, a federal district judge granted a motion to dismiss a securities fraud class action for failing to adequately plead scienter, the requisite intent to deceive for securities fraud. In re Genzyme Corp. Securities Litigation, USDC MA, Civil Action No 09-11299-GAO.
Beginning in October 2007, Genzyme publicly announced that FDA approval for manufacturing Lumizyme at Genzyme’s Allston, MA plant was on track, a statement reiterated in Genzyme’s Form 10-K filed in February 2008. In the fall of 2008, Genzyme manufacturing facilities in Europe and Allston experienced bioreactor failures, attributed to a rare virus, slowing production. At about that time, the FDA inspected the Allston plant, identifying sixteen deviations from Current Good Manufacturing Practices (CGMP) in a Form 483 letter issued on October 10, 2008. Also at that time, an FDA advisory committee affirmed a study establishing the clinical effectiveness of Lumizyme. At an October earnings call, Genzyme’s executives shared the news of the FDA advisory panel as to Lumizyme’s effectiveness without mentioning the Form 483 letter.
In February 2009, Genzyme received a formal warning letter from the FDA regarding the Allston plant stating:
“During the inspection the FDA investigators documented significant deviations from current good manufacturing practice in the manufacture of licensed therapeutic drug products, bulk drug substances, and drug components. These products include Fabrazyme, Cerezyme, and Myozyme. These deviations from GMP include non-compliance with section 501(a)(2)(B) of the Federal Food, Drug and Cosmetic Act, the requirements of your biologics license application approved under 351 of the Public Health Service Act, and Title 21, Code of Federal Regulations Parts 210 and 211. At the close of the inspection the investigators issued a form FDA 483, Inspectional Observations, which describe a number of significant objectionable conditions relating to your firm’s compliance with CGMP….”
The FDA advised that the various violations identified constituted grounds to withhold the approval of any pending new drug application.
Genzyme concurrently received a Complete Response Letter from the FDA, withholding approval of Lumizyme until certain items were addressed. The Complete Response Letter did not reference the February 2008 warning letter, the October 2008 Form 483 or Genzyme’s responses.
Promptly thereafter, Genzyme issued a press release disclosing receipt of the warning letter, the receipt of the Complete Response Letter and the October 2008 Form 483, and added to the disclosures in its Form 10-K for year ended December 31, 2008. Genzyme continued to maintain that it was on track to resolve issues with FDA within three to six months, with Lumizyme on schedule for approval in the second or third quarter of 2009.
In mid-June 2009, Genzyme announced that it had detected a viral contamination outbreak at its Allston plant, and the two viral outbreaks in 2008, and that as a result of the Allston plant would be shut for up to two months. On November 13, 2009 the FDA issued a second Form 483 and a Complete Response Letter withholding Lumizyme approval. Genzyme promptly disclosed these communications from FDA and in January 2010 announced that many functions performed at the Allston plant would be moved to other Genzyme facilities and to contract manufacturers.
On May 24, 2010, the FDA filed a complaint in federal court to permanently enjoin Genzyme from committing further violations of the Food, Drug, and Cosmetics Act. That same day, the parties entered into a consent decree requiring, among other things, Genzyme to pay a civil penalty of $175 million, to transfer fill/finish operations out of the Allston facility, and to implement a comprehensive remediation plan under the oversight of an independent expert approved by the FDA.
The Lawsuit and Rulings
Plaintiffs brought suit in July 2009 against Genzyme and six of its senior executives, alleging that defendants (a) failed to disclose material adverse facts about FDA compliance issues and pervasive problems affecting Genzyme’s manufacturing facilities and (b) falsely assured investors that FDA approval for a new product, Lumizyme, was on track despite those problems.
Plaintiffs’ allegations essentially claim fraudulent misrepresentations (and omissions) involving three themes: (a) bioreactor failures at facilities in Europe and Allston; (b) FDA inspections and responses at the Allston facility; and (c) the Lumizyme approval process. The Court analyzed the facts related to these themes, including the nature and timing of the public disclosures by Genzyme and found that a compelling inference of scienter could not be made.
“What is missing, though, is any substantial link between the three factual threads. Instead of alleging specific connections between the various happenings, the plaintiffs rely only on general assertions that the defendants “knew” (or were reckless in not knowing) they were misleading investors by not saying more about some or all of the events. With respect to the element of scienter, however, “[t]he key question…is not whether the defendants had knowledge of certain undisclosed facts, but rather whether defendants knew or should have known that their failure to disclose those facts present[ed] a danger of misleading buyers to sellers…. When this second question is addressed, the complaint’s deficiencies become clear.”
The Court found the inference supporting a non-culpable explanation for defendant’s actions was stronger.
“That is, more compelling instead is the inference that Genzyme was attempting to develop a biologic that the defendants considered to be beneficial and that they believed was progressing, if fitfully at times, towards FDA approval for Lumizyme, and that they reasonably did not expect that the setbacks the company experienced in various ways would have a significant impact on the ultimate approval so as to require more disclosure than there had been.”
Finally, the Court recognized Genzyme’s repeated and timely disclosures of those facts material to investors.
“The disclosure of the February 2009 Warning Letter, the July 2009 FDA letter, the November 2009 Form 483, the February 2009 Complete Response Letter, the November 2009 Complete Response Letter, and the May 2009 delay of the FDUFA date all establish Genzyme’s transparency throughout the class period. These repeated and timely disclosures of material information seriously undermine an inference of intent to deceive.”
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