The Emperor’s New Clothes

The U.S. Court of Appeals for the Third Circuit has issued a notable decision on the application of the statute of limitations in securities cases. In In re Merck & Co., Inc. Sec., Derivative & ERISA Lit., Nos. 07-2431, 07-2432 (3rd Cir. Sept. 9, 2008), the court considered whether Merck investors were on inquiry notice of their securities claims relating to Vioxx disclosures more than two years before the case was filed. If so, the plaintiffs’ claims would be barred by the statute of limitations. The decision has a number of interesting holdings:

(1) There has been some ambiguity in the Third Circuit over whether inquiry notice is triggered by evidence alerting an investor to the “possibility” or the “probability” of wrongdoing. The decision clarified that the Third Circuit’s standard is: “whether the plaintiffs, in the exercise of reasonable diligence, should have knows of the basis for their claims depends on whether they had sufficient information of possible wrongdoing to place them on inquiry notice or to excite storm warnings of culpable activity.” Although the court adopted the lower “possibility” standard, it emphasized that the evidence must be substantial, especially in light of the PSLRA’s heightened pleading standards.

(2) The district court found the existence of inquiry notice based upon a public FDA warning letter stating that Merck was misrepresenting the safety profile of Vioxx, press and scholarly articles about the risk of heart attack associated with the drug, and various lawsuits filed against Merck over Vioxx safety issues. On appeal, however, the court found that these “storm warnings” were dissipated by Merck’s reassuring statements to the market or undermined by the failure of the disclosures to have any significant impact on Merck’s stock price or projections by analysts. In particular, the court focused on the fact that Merck put forward an alternative hypothesis as to why the relevant clinical study showed increased heart attack risks associated with Vioxx that may have led to the limited stock price reaction. Also, none of the lawsuits alleged securities fraud.

(3) In a vigorous dissent, Judge Roth argued that the FDA warning letter, by itself, was a sufficient storm warning that Merck had engaged in misrepresentations concerning Vioxx. Moreover, the subsequent press coverage and consumer lawsuits should have led investors to an awareness “of the possibility that Merck had been fraudulently misrepresenting the cardiovascular safety of Vioxx.”

(4) The majority’s footnote response to the dissent appears ill-considered: “It is ironic that the dissent, although noting what might be viewed as Merck’s misrepresentations, would apply the statute of limitations to deprive plaintiffs of the opportunity to prove a viable case against Merck for such misrepresentations.” Bad facts make for bad law? After all, as The 10b-5 Daily has noted before, an inquiry notice argument presupposes the possibility of misrepresentations and the statute of limitations can limit liability even where misconduct has occurred.

Holding: Reversed and remanded.

Quote of note (majority opinion): “Merck’s stock price dipped slightly following the disclosure of the FDA warning letter before closing higher than it did before that disclosure just a week and a half later. Although the lack of significant movement in Merck’s stock price following the FDA warning letter is not conclusive, it supports a conclusion that the letter did not constitute a sufficient suggestion of securities fraud to trigger a storm warning of culpable activity under the securities laws. This conclusion is also supported by the fact that more than a half-dozen securities analysts continued to maintain their ratings for Merck stock and/or project increased future revenues for Vioxx after the warning letter was made public.”

Quote of note (dissent): “In applying the above inquiry notice standard to the instant case, I am reminded of a classic fairytale: The Emperor’s New Clothes, by Danish author and poet, Hans Christian Anderson. As the child in The Emperor’s New Clothes saw – that the Emperor walked naked down the street – any reasonable investor reading the FDA’s September 17, 2001, warning letter could see the problem with Vioxx – the misrepresentation of its safety profile and the ‘possibility’ that Merck had fraudulently misrepresented the cardiovascular safety of its ‘blockbuster’ product.”

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