The D & O Diary : Directors and Officers Liability and Insurance : The D & O Diary : Kevin LaCroix : Securities Laws, Corporate Fraud, D & O Litigation

In a April 26, 2010 opinion (here) that could have significant implications for motions to dismiss in the many subprime-related securities actions pending against the rating agencies, Southern District of New York Judge Schira Scheindlin rejected the arguments of Moody’s and S&P that the action investors in the Rhinebridge structured investment vehicle (SIV) should be dismissed because the investors’ losses were caused the global credit crisis rather than those firms’ investment ratings.

Background

The investor plaintiffs had filed a putative class action lawsuit for common law fraud in connection with the collapse of Rhinebridge. The action was brought against IKB Deutsche Industriebank AG and related entities; the rating agency defendants, including Moody’s and S&P; and certain individuals. (If IKB’s name sounds familiar, that is because it was one of the principal buyers in the now infamous Abacus transaction at the heart of the SEC’s action against Goldman Sachs.)

The plaintiffs contend that the defendants fraudulently misrepresented the value of Rhinbridge and its Senior Notes. These misrepresentations took the form of the high credit ratings assigned to the Notes. The Notes’ triple A ratings allegedly conveyed to investors that they were highly credit worthy and exceptionally strong, but also allegedly concealed that Rhinebridge’s portfolio actually consisted of toxic assets that were heavily concentrated in the structured finance and subprime mortgage industries. The Notes were downgraded in October, Rhinebridge entered receivership and the investors lost million of dollars.

S&P and Moody’s moved to dismiss on the grounds that plaintiffs allegations were insufficient to demonstrate loss causation, in that they failed to account for the global liquidity crisis that began in the summer of 2007.

The April 26 Opinion

Judge Scheindlin rejected the defendant rating agencies’ loss causation argument, observing that "to hold that plaintiffs failed to plead loss causation solely because the credit crisis occurred contemporaneously with Rhinebridge’s collapse would place too much weight on one single factor and would permit S&P and Moody’s to blame the asset-backed securities industry when the their alleged conduct plausibly caused at least some portion of plaintiffs’ losses."

She added that "even if the existence of the credit crisis—standing alone – could be enough to defeat a plaintiffs’ pleading of loss causation, it is not apparent that the credit crisis was the sole cause of Rhinebridge’s collapse."

Judge Scheindlin also noted that "S&P and Moody’s may yet prevail at a later stage in this case," adding that "if defendants ultimately prove that plaintiffs’ losses were, in fact, cause entirely by an intervening event, then defendants will prevail either at summary judgment or at trial."

Judge Scheidlin declined to find, as plaintiff had urged, that the rating agencies were "one of the major causes" of the global financial crisis. She observed that:

Blame for the financial crisis can be, and had been, spread globally – from the financial sector’s increasingly complex financial products, to mortgage originators, to the government’s loosened regulatory practices and its failure to respond to the collapse and substantial weakening of multiple financial powerhouses. While the Rating Agencies’ actions may have been a "substantial factor" causing the loss, that is not tantamount to labeling their conduct a "major cause" of the global financial crisis.

Discussion

While numerous subprime and credit crisis-related lawsuits have been filed against the rating agencies have been filed and are slowly working their way through the courts, the fundamental questions of whether and under what circumstances the rating agencies might be held liable to investors are yet to be worked out.

Even before those basic liability issues can be addressed, the threshold pleading issues still have to be sorted out. Judge Scheindlin emphatically did not hold that the rating agencies can be liable. However, her April 26 opinion does represent a strong signal that the rating agencies will not get off the hook merely because there was a larger financial crisis beyond the rating agencies’ actions in connection with the specific transactions.

To put everything under the heading of the credit crisis, Judge Scheindlin held, would be to permit the rating agencies to "blame the asset-backed securities industry when the alleged conduct plausibly caused at least some proportion of plaintiffs’ losses."

So it remains to be seen whether the rating agencies may be held liable. But Judge Scheindlin’s opinion suggests that the rating agencies will not be able to get the cases against them dismissed on the simple theory that the credit crisis and not their rating actions caused investor losses, where plaintiffs have plausibly alleged that the rating agencies cause some proportion of the losses.

This holding potentially removes at least one threshold barrier to the question of ultimate liability, at least for purposes of the pleading stages, and reduces the extent to which the rating agencies may be able to rely on the "coincidence" of the global credit crisis as an out from the cases against them.

For my discussion of Judge Scheindlin’s opinion in a separate subprime lawsuit against the rating agencies in which, on the facts alleged, she held that the rating agencies were not entitled to dismissal on the grounds that their ratings were protected by the First Amendment, refer here.

The WSJ.com Law Blog’s post on Judge Scheindlin’s opinion can be found here. Andrew Longstreth’s April 27, 2010 Am Law Litigation Daily article about the decision can be found here. .

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On June 19, 2009, the Fifth Circuit, in a per curiam opinion (here) written by a panel that included retired Supreme Court Justice Sandra Day O’Connor sitting by designation, reversed and remanded the district court’s denial of class certification and entry of summary judgment in defendants’ favor in the Flowserve securities class action lawsuit.

CORRECTION: The original version of this post suggested that Justice O'Connor herself had written the June 18 opinion. In light of  reader comments (please see below) I have revised this post to reflect the fact that the Fifth Circui's decision was in the form of a per curiam opinion that does not indicate which member of the panel authored the opinion. The entire staff here at The D&O Diary apologizes for any confusion our original post may have caused.

With respect to the class certification issue, the Fifth Circuit vacated the district court’s refusal to certify the class based on what the Fifth Circuit found was the district court’s application of an erroneous standard on the loss causation issue, and remanded the case for further proceedings. In addition, the Fifth Circuit reversed the district court’s entry of summary judgment, essentially on the ground that the district court’s analysis on the loss causation issue for class certification purposes was not in any event dispositive of the loss causation issue on the merits, and therefore was not the appropriate basis for entry of summary judgment.

The Fifth Circuit’s opinion is noteworthy for a number of reasons. First, it represents a rare occasion where securities class action plaintiffs have succeeded, even if only provisionally and for the time being, in a circuit that is generally perceived as heavily defense oriented. It should be noted that there is nothing in the Fifth Circuit’s opinion that precludes the district court from ruling against the plaintiffs on either issue on remand; even with application of what the Fifth Circuit described as the correct legal standard, the district court could nonetheless again rule in the defendants’ favor.

Second, the Flowserve case represents the latest example of the Fifth Circuit’s struggles with the question of the proper consideration of loss causation issues at the class certification stage. These same or similar issues are presented in both the Belo securities case (about which refer here) and the Halliburton securities case (here), both of which are now also pending before the Fifth Circuit. Given the continuing controversy on these issues, it seems increasingly likely that these issues could wind up before the U.S. Supreme Court.

Finally, the opinion is perhaps most interesting for the final commentary provided in the opinion's concluding paragraph:  

To be successful, a securities class-action plaintiff must thread the eye of a needle made

smaller and smaller over the years by judicial decree and congressional action. Those ever higher hurdles are not, however, intended to prevent viable securities actions from being brought.

Whether or not these remarks perhaps represent an expression of concern with how far the pendulum had swung in the Fifth Circuit in these kinds of cases, these words undoubtedly will be repeated by plaintiffs’ counsel in future filings, both inside and outside the Fifth Circuit, in support of the claims.

Very special thanks to a loyal reader for providing a copy of the Fifth Circuit’s Flowserve opinion.

Speakers’ Corner: During the period June 21-23, 2009, I will be in Palo Alto, California, where I will be participating as a faculty member at the Stanford Law School Directors’ College. A summary agenda for the event can be found here.

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The heightened susceptibility of life sciences companies to securities class action lawsuits is a phenomenon that I and others have previously noted (refer here). But while life sciences companies may experience greater securities class action claim frequency, many of these lawsuits against life sciences companies are dismissed (as discussed here).

In a case the First Circuit itself called “paradigmatic” of securities cases involving life sciences companies, the appeals court recently affirmed the lower court’s dismissal of the securities lawsuit pending against Biogen Idec and certain of its directors and officers. The court’s analysis is noteworthy because of its emphasis of the issues that contribute to the vulnerability of these kinds of companies to securities lawsuits. But by way of contrast I also discuss below a recent Ninth Circuit opinion reversing the district court’s dismissal of a securities lawsuit involving Gilead Sciences.

The First Circuit’s Opinion in the Biogen Idec Case: On August 7, 2008, in an opinion written by Chief Judge Sandra L. Lynch, the First Circuit issued its opinion in New Jersey Carpenters Pension & Annuity Fund v. Biogen Idec (here). The case involves Biogen’s alleged misrepresentations and omissions pertaining to Tysabri, a new drug for multiple sclerosis and other autoimmune disorders.

In November 2004, the FDA granted accelerated approval of Tysabri. Less than three months later, on February 18, 2005, continuing clinical trials “revealed that two patients had contracted a type of infection perhaps associated with the drug.” One of the two patients died. On February 25, 2005, the company voluntarily withdrew the drug from the market. Its stock price dropped and several lawsuits were filed.

In their amended complaint, the plaintiffs alleged that, in order to facilitate their sale of shares of company stock at inflated prices, the defendants misrepresented the safety and efficacy of the drug. As the First Circuit summarized the case, the “key theme” of the lawsuit is that the defendants were “aware or at least recklessly unaware of greater safety risks with TYSABRI for opportunistic infections, particularly in combination with other MS therapies, than had been announced to the public,” and that defendants “intentionally failed to disclose this information in order to keep the share price high.”

The district court dismissed the complaint, finding that while the plaintiffs had alleged material misrepresentations and omissions with appropriate specificity, they had not alleged scienter with appropriate specificity. The plaintiffs appealed.

In evaluating the plaintiffs’ allegations, the allegations relating to the timing of defendants’ receipt of information were critical, because, as the First Circuit noted, “defendants cannot have committed fraud if they did not know at the time that the failure to provide additional information was misleading.” In that regard, the First Circuit found that “plaintiffs’ amended complaint fails to allege facts both (1) as to when defendant had information about non-PML opportunistic infection and (2) that the information available sufficiently suggested a causal connection between TYSABRI and non-PML opportunistic infections.”

The First Circuit expressed its willingness to consider factual allegations supported only by confidential sources, but the confidential sources’ allegations did not create a strong inference of scienter, because the allegations do not indicate when during the clinical trials information about infections became known.

The court also found plaintiffs’ allegations that defendants had fraudulently failed to disclose dangers of use of Tysabri in combination with other drug therapies were insufficient. Plaintiffs’ allegations that defendants had no reasonable basis to say that Tysabri was safe in combination with other drug therapies, the First Circuit found, were “not nearly so compelling as opposing inferences from the undisputed facts in the record.”

Because the First Circuit concluded that the plaintiffs had not “sufficiently alleged … that defendants had any reason to know their statements were misleading before February 18, 2005,” the Court disregarded all insider trading prior to that date. Only one insider sale was alleged on or after that date, a February 18 sale by the company’s General Counsel. But the General Counsel was not a defendant to the Section 10(b) claim, and the First Circuit held that based solely on the General Counsel’s trading “a strong inference of scienter on the part of Biogen and other individual defendants cannot be drawn.”

The First Circuit found that the plaintiffs’ allegations of scienter were not sufficient to support an alleged violation of Section 10(b), and affirmed the district court.

The court’s opinion was informed by its observations of the peculiar characteristics of securities lawsuits filed against companies involved in the drug and device development business:

The situation here is paradigmatic of securities fraud cases against drug companies where a promising drug or medical device is approved by the FDA and then later proves to have health risks which affect the market for the drug.

The court also noted that disclosures about regulatory developments provide an important context within which sudden stock price changes can occur:

The investing public is well aware drug trials are exactly that: trials to determine the safety and efficacy of experimental drugs. And so trading in the shares of companies whose financial fortunes may turn on the outcome of such experimental drug trials inherently carry more risk than some other investments.

With these comments, the First Circuit recognized the circumstances that make life sciences companies susceptible to securities lawsuits. These companies have volatile share prices that are vulnerable to sudden shocks due to the uncertainty of the regulatory process or to unexpected safety concerns. All too often these reverses result in securities lawsuits, supported only by allegations that the reverses occurred and therefore company management must have known about the problems from which the reverses arose.

The First Circuit’s opinion also evinced an appreciation of the fact that merely because a company has encountered these types of setbacks does not mean that the company has committed securities fraud. The First Circuit’s analysis helps explain why both life sciences may find themselves accused of securities fraud more frequently than other kinds of companies, and also why these cases are frequently dismissed.

Ninth Circuit Reverses Dismissal of Gilead Science Case: But while a number of the securities lawsuits filed against life sciences companies may be dismissed, that certainly does not mean that life sciences companies inevitably prevail. Indeed, there have been a number of significant settlements in securities cases involving life sciences companies (particularly large pharmaceutical companies).

Life sciences companies also face the same challenges involved in securities claims against any corporate defendant, including the possibility that a victory at the trial court level can be reversed at the appellate level. That is exactly what happened in the securities litigation involved Gilead Sciences. In an opinion dated August 11, 2008 (here), the Ninth Circuit reversed the lower court’s ruling dismissing the case for failure to adequately plead loss causation.

Gilead’s flagship produce, Viread, is an agent used with other drugs to treat HIV. The complaint alleges that the company actively marketed the drug for off-label uses, in violation of FDA rules. The company received a Warning Letter from the FDA on this topic, which the company disclosed on August 8, 2003. The company’s share price did not decline in response to this news; in fact, the share price was higher on the following trading days.

In order to address the absence of any share price decline, the plaintiffs alleged that it was not until October 28, 2003 that the public “finally realized the impact of the off-label marketing and the Warning Letter.” After market close that day, the company disclosed that Viread sales had fallen below expectations due to wholesaler overstocking during the quarter. Market analysts attributed the sales decline to “lower end-user demand.” The plaintiffs alleged that the reduced demand was “a direct result” of the Warning Letter, which exposed Gilead’s off-label marketing.

The district court found that the complaint failed to “connect the chain of events” between the failure to disclose the off-label marketing; that the decline in demand for Viread was due to the Warning Letter; and that the reduced sales caused a decrease in Gilead’s share price. The district court said there were “too many logical and factual gaps.” The district court said it could not make “the unreasonable inference that a public revelation caused a price drop three months later.” The district court dismissed the complaint for failure to adequately plead loss causation.

The Ninth Circuit, by contrast, found “the complaint sufficiently alleges a causal relationship between (1) the increase in sales resulting from the off-label marketing, (2) the Warning Letter’s effects on Viread orders, and (3) the Warning Letter’s effect on Gilead’s share price.”

The Ninth Circuit went on to observe that “perhaps what truly motivated the dismissal was the district court’s incredulity.” The Ninth Circuit said that a district court ruling on a motion to dismiss “is not sitting as a trier of fact,” and as long as plaintiffs allege a theory that “is not facially implausible, the court’s skepticism is best reserved for later stages … when the plaintiffs’ case can be rejected on evidentiary grounds.” The Ninth Circuit concluded that “a limited temporal gap between the time of the misrepresentation is publicly revealed and the subsequent decline…does not render a plaintiffs’ theory of loss causation per se implausible.”

The Ninth Circuit said the market “did react immediately to the corrective disclosure” which the plaintiffs claims to be the October 28 press release, the date on which it is alleged the market had complete information to process the revelations about off-label marketing.

It is hardly my place to comment on the merits of a judicial opinion. Suffice it to say that reasonable minds may differ whether the district court was guilty of “incredulity” or the Ninth Circuit of “credulity.” Reasonable minds may also differ whether the three months’ lapse between the disclosure of the Warning Letter and the stock price drop is a “limited temporal gap.” Reasonable minds may also differ whether plaintiffs’ Rube Goldberg explanation for the delayed market reaction “is not facially implausible.”

On the other hand, it seems apparent that the allegation of off-label marketing troubled the Ninth Circuit and it is certainly true that a company whose alleged reverses are not due to unexpected regulatory developments or unanticipated clinical outcomes but rather to marketing activities is in a less sympathetic postion. That is obviously why the plaintiffs strained so hard to try to make the stock price drop relate back to the off-label marketing Warning Letter, because that supposed connection put the defendants in a less favorable light. Regardless, I suppose, of whether or not the stock price drop was due to the wholesaler overstocking.

The one thing that is clear is that all litigants are susceptible to the vicissitudes of the litigation process, life sciences companies as well as any other kind of company. The plaintiffs in Gilead certainly established the value of continuing to fight, as you never know when an initially disfavored hand might still be just enough to take a trick. Of course, the plaintiffs must now go back to the district court and face a court whose skepticism even the Ninth Circuit acknowledged could justify rejecting plaintiffs’ case later.

The SEC Actions Blog has an excellent lawyerly analysis critical of the Ninth Circuit's opinion in Gilead, here.

More Drug News: Biogen Idec’s drug, Tysabri, which the FDA permitted the company to reintroduce to the market in July 2006, was back in the news recently. According to an August 1, 2008 Wall Street Journal article (here), two MS patients treated with the drug have recently contracted a potentially deadly brain infection. The article stated that the company “had no plans to recall the drug or restrict its use.”

The WSJ.com Health Blog also has a post (here) discussing this development. The comments following the post make for interesting reading. It is all too easy to consider these legal issues in a vacuum, but there are real patients whose only hope is the use of these kinds of drug therapies. The eloquent pleas of these patients for the drugs to remain available are moving and impressive.

But the adverse developments cannot be minimized, and in that regard it should also be noted that Biogen Idec also faces a lawsuit from the estate of one of the deceased patients. Recent procedural developments in the case were also discussed recently on the WSJ.com Health Blog (here).

All of that said,  this about business too, and it may come as no surprise that Carl Ichan viewed the stock price drop following Biogen’s recent advserse news as an opportunity to increase his holdings in the company’s shares, perhaps to advance his agenda of getting the company to sell itself, as discussed here.

There is a Balm in Gilead: Perhaps I am presuming too much, but for me the name Gilead Sciences evokes Jeremiah, Chapter 8, Verse 22: “Is there no balm in Gilead? Is there no physician there? Why then has the health of my poor people not been restored?” (New Revised Standard Version).

This line is memorably recalled in the African-American spiritual, There is a Balm in Gilead, whose refrain captures the soothing power of the song:

There is a balm in Gilead

To make the wounded whole;

There is a balm in Gilead

To heal the sin-sick soul.

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