On April 27, 2010, the United States Supreme Court issued an important decision interpreting the statutory limitations period in the Sarbanes-Oxley Act of 2002, 28 U.S.C. § 1658, requiring claims under the Securities Exchange Act of 1934 to be brought within the earlier of 2 years after “discovery of the facts constituting the violation” or 5 years after the violation. Affirming the decision of the Court of Appeals for the Third Circuit that the securities fraud action was timely, the Supreme Court held that the statute should be applied to start the clock running when, in the exercise of due diligence, a plaintiff could have discovered the relevant facts that constitute all of the elements of his claim, including fraudulent intent, or scienter. In its decision, the Court accepted the widely held premise that the term “discovery” in the statute refers to constructive discovery of facts that a reasonable investor should have discovered, but rejected the analysis of some courts of appeals that had held that the limitations period commences when a plaintiff is placed on “inquiry notice” by “storm warnings” that would have lead a reasonably diligent investor to investigate the possibility of fraud. Instead, as discussed below, the Court held that the statutory time period does not begin to run until that hypothetical investor could have discovered the facts that would reveal scienter. Thus, the trigger point is not when a reasonable investor should have discovered that a statement was false or misleading, but rather when that reasonably diligent plaintiff also should have known that the statement was made with the requisite intent to deceive.
The claim at issue was brought against pharmaceutical company Merck & Co. (“Merck”), alleging that Merck defrauded investors by concealing the risks of heart attack associated with the company’s pain relief drug, Vioxx. The complaint was filed on November 6, 2003, alleging securities fraud pursuant to § 10(b) of the Securities Act of 1934, 15 U.S.C. § 78j(b), and Rule 10b-5 promulgated thereunder. According to the complaint, Merck was aware as early as 1996 that there were serious safety issues associated with Vioxx, and that clinical trials in 1998 and studies comparing Vioxx to naproxen were linked to an increase in significant cardiovascular events, but concealed or failed to adequately disclose that information, by suggesting that the adverse incidents could be the result of the absence of a benefit from use of naproxen rather than harm caused by Vioxx. In October 2003, the Wall Street Journal published the results of Merck-funded study that concluded that those given Vioxx were more likely to have a heart attack than those who took another painkiller – or no painkiller at all. Merck withdrew Vioxx from the market in September 2004, claiming that the results of a new study confirming an increased risk of heart attack among Vioxx patients were “totally unexpected. Slip op. at 6. The critical issue was whether the plaintiffs should have discovered the facts constituting the violation by November 6, 2001—two years before their complaint was filed.
In 2007, the District Court for the District of New Jersey granted Merck’s motion to dismiss the complaint, accepting Merck’s argument that a publicly reported drug study in March 2001 revealing an increased incidence of heart attacks among patients taking Vioxx, and an FDA warning letter in September 2001 that claimed Merck’s marketing was “false, lacking in fair balance and misleading” with respect to disclosure of cardiovascular risks, placed investors on “inquiry notice” sufficient to trigger an obligation to exercise due diligence and investigate Merck’s conduct. These events would start the two-year discovery clock running no later than October 2001, rendering the suit untimely. On appeal, the Court of Appeals for the Third Circuit reversed the dismissal. The majority opinion of the court of appeals held that the events occurring before November 2001 were insufficient to put plaintiffs on inquiry notice because they did not suggest that Merck had made any statement with an intent to deceive.
Merck sought certiorari to resolve a split among the circuits over the proper interpretation of the statutory limitations period. The courts of appeals had taken various approaches to determine the date when a hypothetically reasonably diligent plaintiff should have discovered the facts constituting a securities violation:
- The Eleventh Circuit had held that the limitations period runs from the date that information exists to place plaintiffs on notice of the need for an investigation;
- The Second Circuit agreed, but also held that the period runs from the date that inquiry should have revealed the fraud; and
- The Sixth Circuit held that period always runs from when a reasonably diligent plaintiff, after being put on inquiry notice, should have discovered facts constituting the violation.
The Supreme Court granted Merck’s petition to resolve these conflicts.
As an initial point, the Supreme Court addressed the meaning of the term “discovery” as it is used in the applicable statute, 28 U.S.C. § 1658, and concluded that “discovery” is not limited to actual discovery of fraud, but rather refers to the point “when in the exercise of due diligence, it could have been discovered.” The Court agreed with both Merck and the plaintiffs that Congress intended the use of the word “discovery” in 28 U.S.C. § 1658 to refer not only to actual discovery of the facts, but also to the facts that a reasonably diligent person would have discovered. Indeed, every court of appeals to decide the issues has held that discovery includes constructive discovery, and the term “discovery” has long been interpreted to include discoveries of fraud that a reasonably diligent plaintiff should have made.
Notwithstanding the consensus of all parties, Justice Scalia filed an opinion, joined by Justice Thomas, concurring in part and in the judgment, but arguing that “discovery” should be interpreted to refer only to actual discovery, based on the absence of any statutory language referring to a constructive discovery standard. The concurrence opinion specifically contrasted the language in the 1934 Act from the statutory limitations period in the Securities Act of 1933, which expressly provides that the one-year discovery period in that Act runs from “discovery of the untrue statement or omission, or after such discovery should have been made by the exercise of reasonable diligence. . . “ 15 U.S.C. § 77m. In contrast, Justice Scalia reasoned that the failure to include the constructive discovery language must have meant that Congress intended “discovery” to refer only to actual discovery.
The role of scienter
Scienter has always been an element of a securities fraud claim that a plaintiff is required to plead separately and specifically and prove. In the Private Securities Litigation Reform Act of 1995, Congress enacted heightened pleading requirements for scienter (15 U.S.C. § 78u-4(b)(2) (requiring a plaintiff to “state with particularity facts giving rise to a strong inference that the defendant acted with the requisite state of mind”). The Supreme Court recently held that the facts pleaded must show that it is more likely than not that the defendant acted with scienter, in Tellabs v. Makor Issues & Rights, Inc., 551 U.S. 308, 328 (2007).
In Merck, the Court specifically held that it is not enough that a reasonable investor should have known that a false statement was made; the discovery period would only begin to run when the investor should also have known that the statement was made with an intent to deceive. In explaining its rationale, the Court made an important distinction between statements whose falsity alone is sufficient to demonstrate that it was made with an intent to defraud, because the speaker had to have known the statement was false, and statements, such as unfulfilled earnings predictions, that do not merely by their ultimate inaccuracy suggest that they were fraudulent when made. According to the Court, it is the point at which a plaintiff discovers, or should discover, that the prediction lacked a reasonable basis or that a statement was made with an intent to deceive that the discovery period begins to run, because scienter is one of the facts constituting a violation of the securities laws. Indeed, the Court noted that the “state of a man’s mind is as much a fact as the state of his digestion” (quoting Postal Service Bd. of Governors v. Aikens, 460 U.S. 711, 716 (1983) [which quoted from the 1885 case of Edgington v. Fitzmaurice, 29 Ch. D. 459, 483]).
The treatment of inquiry notice
The Supreme Court ultimately rejected the “inquiry notice” analysis that many other courts had adopted as the starting point of the two-year discovery period. Citing the language of the statute, the Supreme Court held that the period begins to run when a plaintiff discovers, or a reasonably diligent plaintiff should have discovered, the facts that constitute the violation, including scienter. According to the Court, while “inquiry notice” and “storm warnings” can be helpful in determining the time when a prudent plaintiff would begin an investigation, the point of inquiry notice does not “automatically” signal the time at which the facts constituting the violation are “discovered,” as the statute requires, regardless of whether the actual plaintiff did undertake a reasonably diligent investigation.
Finally, in addressing the facts of the case at hand, the Court reviewed the various reports, letters and other information concerning Vioxx’s safety to determine whether the plaintiffs should have discovered the necessary facts prior to November 6, 2001. After review, the Court determined that the information available at the time did not reveal Merck’s scienter, because the FDA letter and public reports of studies did not negate Merck’s public explanation and hypotheses for the rise in cardiac incidents, and thus would not have revealed to a reasonably diligent plaintiff that Merck was acting with the requisite intent at that time.
This ruling clarifies the analysis to be used to decide the timeliness of securities fraud claims brought under the 1934 Act. The Court’s adoption of a constructive discovery standard is as important as its rejection of the “inquiry notice” analysis that several circuit courts of appeals had employed. The ruling is widely viewed as favoring plaintiffs, potentially extending the time frame to file securities fraud claims. It is certainly easy to conceive of situations, such as the present case, where a court could conclude that the point of “discovery of the facts constituting the violation” is after the date on which a plaintiff might have been deemed to have had a duty to inquire to determine whether a fraud had occurred. In such situations, the two-year discovery period will begin to run at the later date. Also importantly, the Court rejected Merck’s argument that the standard would be unworkable or too complicated to administer, indicating that courts have and should be able on motion to ask and answer what a reasonably diligent plaintiff should have done.