(Article from Securities Law Alert, March 2015)
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On March 16, 2015, the Fourth Circuit found that the district court had “erred in taking judicial notice” of SEC filings submitted in support of defendants’ motion to dismiss a securities fraud action because the SEC filings “did not relate to the contents of the complaint.” Zak v. Chelsea Therapeutics International, 2015 WL 1137142 (4th Cir. 2015) (Keenan, J.). The Fourth Circuit further held that the district court’s “error was not harmless, because the court [had] incorrectly construed these [SEC filings] as supporting its holding that the plaintiffs’ allegations of scienter were legally insufficient.” The Fourth Circuit therefore reversed dismissal of plaintiffs’ suit.
Background
Plaintiffs contended that Chelsea Therapeutics International (“Chelsea”) and several of its corporate officers had made “dozens of allegedly misleading statements or material omissions” concerning the likelihood of FDA approval for Northera, a pharmaceutical treatment for a certain type of hypertension. The complaint stated “in general terms that, in investigating the case, plaintiffs’ counsel had reviewed the public filings submitted [by Chelsea] to the SEC.” Beyond this assertion, “the complaint did not otherwise refer to any SEC filings, or the contents of such filings, to support [ ] plaintiffs’ allegations.”
Defendants moved to dismiss plaintiffs’ complaint under Rule 12(b)(6). Defendants asked the court to take judicial notice of several exhibits, including SEC filings, attached to their motion. According to defendants, the company’s SEC filings demonstrated that “none of the Chelsea officers had sold any shares of Chelsea stock during the class period.” Defendants asserted “that the absence of such sales undermined any inference of scienter.”
The district court “took judicial notice of the SEC documents, and granted [ ] defendants’ motion to dismiss.” In “weighing the competing inferences regarding scienter,” the court relied on Chelsea’s SEC filings to find that “none of the individual defendants [had] sold stock during the class period.” The court determined that “the lack of stock sales ‘tip[ped] the scales in favor of defendant[s’] motion’ to dismiss.” Plaintiffs appealed.
Fourth Circuit Holds That the District Court Should Not Have Considered Defendants’ SEC Filings in Evaluating Plaintiffs’ Allegations Because the Complaint Did Not Explicitly Reference Those Filings
On appeal, the Fourth Circuit stated that “when a defendant moves to dismiss a complaint under Rule 12(b)(6), courts are limited to considering the sufficiency of allegations set forth in the complaint and the documents attached or incorporated into the complaint.” The Fourth Circuit stated that “[c]onsideration of a document attached to a motion to dismiss ordinarily is permitted only when the document is integral to and explicitly relied on in the complaint and when the plaintiffs do not challenge [the document’s] authenticity.”
Here, the Fourth Circuit found that defendants’ SEC filings “were not explicitly referenced in, or an integral part of, [ ] plaintiffs’ complaint.” Moreover, “the complaint did not contain any allegation suggesting that the individual defendants [had] made any sales or purchases of Chelsea stock during the class period,” nor were “such allegations . . . required to demonstrate a strong inference of scienter.” The Fourth Circuit therefore ruled that “the district court should not have considered [Chelsea’s SEC filings] in reviewing the sufficiency of . . . plaintiffs’ allegations.”
Fourth Circuit Finds That Even If It Had Been Proper for the District Court to Take Judicial Notice of Defendants’ SEC Filings, the District Court Had “Incorrectly Construed” Those Filings
The Fourth Circuit stated that there is a “narrow exception” pursuant to which courts may, at the motion to dismiss stage, consider “facts and documents” that are not “integral to” or “explicitly relied on” in the complaint. Pursuant to Federal Rule of Evidence 201, “courts at any stage of a proceeding may ‘judicially notice a fact that is not subject to reasonable dispute,’ provided that the fact is ‘generally known within the court’s territorial jurisdiction’ or ‘can be accurately and readily determined from sources whose accuracy cannot reasonably be questioned’” (quoting F.R.E. 201). The Fourth Circuit stated that “when a court considers relevant facts from the public record at the pleading stage” under Rule 201, “the court must construe such facts in the light most favorable to the plaintiffs.”
In the case before it, the Fourth Circuit determined that even if it had been proper for the district court to take judicial notice of Chelsea’s SEC filings pursuant to Rule 201, the district court had “incorrectly construed the information contained in [those] documents.” The Fourth Circuit found that Chelsea’s SEC filings “did not provide a factual basis for the [district] court’s conclusion that no individual defendant [had] sold Chelsea stock during the class period.” Moreover, the Fourth Circuit held that this error “was not harmless” because the court had placed great weight on “defendants’ purported failure to sell Chelsea stock during the class period” when evaluating plaintiffs’ scienter allegations.
Fourth Circuit Determines Plaintiffs Had Adequately Pled Scienter Based on Defendants’ Alleged Failure to Disclose Adverse FDA Guidance
Following a “de novo review” of plaintiffs’ scienter allegations, the Fourth Circuit found that “plaintiffs’ allegations . . . permit[ted] a strong inference that . . . defendants [had] either knowingly or recklessly misled investors by failing to disclose critical information received from the FDA during the new drug application process, while releasing less damaging information that they knew was incomplete.” The court concluded that plaintiffs had adequately pled scienter by alleging a “conflict[ ]” between the “material, non-public information known to [ ] defendants about the status of” the company’s application for FDA approval of Northera and “defendants’ public statements on those subjects.”
The Fourth Circuit “emphasize[d] that [its] conclusion [did] not stand for the proposition that a strong inference of scienter can arise merely based on a defendant’s failure to disclose information.” The court recognized that “Chelsea and its corporate officers may have lacked an independent, affirmative duty to disclose” adverse information received from the FDA in connection with the company’s application for FDA approval of Northera. However, the Fourth Circuit stated that “defendants’ failure” to disclose “must be viewed . . . in the context of the statements that they affirmatively elected to make” regarding the likelihood that the FDA would approve Northera. The Fourth Circuit noted that under Matrixx Initiatives, Inc. v. Siracusano, 131 S. Ct. 1309 (2011), “companies can control what they have to disclose under [Section 10(b) and Rule 10b-5(b)] by controlling what they say to the market” (quoting Matrixx, 131 S. Ct. 1309).
Judge Thacker, Dissenting, Finds That the Majority Applied Too Lenient of a Standard to Plaintiffs’ Scienter Allegations
Judge Thacker dissented from the Fourth Circuit’s majority opinion, finding that the majority had applied an overly lenient standard in evaluating plaintiffs’ scienter allegations. Judge Thacker stated that the Fourth Circuit’s decision in Cozzarelli v. Inspire Pharmaceuticals, Inc., 549 F.3d 618 (2008) “makes clear that pleading scienter – whether in the form of fraudulent intent or severe recklessness – requires a showing of ‘wrongful intent.’” She explained that “[t]his understanding of scienter . . . necessarily entails a ‘culpable state of mind.’” Judge Thacker emphasized that courts in the Fourth Circuit may “not infer scienter ‘from every bullish statement by a pharmaceutical company . . . trying to raise funds’” (quoting Cozzarelli, 549 F.3d 618). Judge Thacker stated that she would have affirmed the district court’s decision.