The motion to dismiss phase is a critical stage in the life cycle of a securities class action lawsuit. If a case survives the dismissal motion, it likely will move toward settlement, as so few cases actually go to trial. The motion to dismiss in intended to test the sufficiency of the allegations in the plaintiff’s complaint. According to the rules, the court’s inquiry should be limited to the matter within the complaint. However, over time, rules have developed permitting courts to consider matter from outside the complaint, pursuant to the doctrines of judicial notice and incorporation by reference.
In a detailed August 13, 2018 opinion in which it largely reversed the dismissal of securities class action lawsuit involving the developmental stage pharmaceutical company Orexigen Therapeutics, the Ninth Circuit noted a “concerning pattern in securities cases” in which “overuse” of the doctrines has resulted in improper dismissal of securities suits at the pleading stage based on extraneous matter. The Ninth Circuit’s analysis of the judicial notice and incorporation by reference doctrines is interesting and could have a significant impact on courts’ consideration of matter outside of the complaint in future cases. The Ninth Circuit’s opinion in the Khoja v. Orexigen Therpeutics case can be found here.
Background Regarding Judicial Notice and Incorporation By Reference
Under the Federal Rules of Civil Procedure, courts may not consider material from outside the pleadings when assessing the sufficiency of a complaint in a motion to dismiss. If matter outside the pleadings is presented, the dismissal motion is converted into a motion for summary judgment, which looks at the broader question of whether or not there are disputed questions of material fact sufficient to require further discover before resolution or indicating that a trial is required.
There are two exceptions to these general rules, the judicially created incorporation by reference doctrine, and the judicial notice doctrine under Federal Rule of Evidence 201. Both of these doctrines allow the court to consider material outside the complaint, subject to applicable limitations.
In its Orexigen Therapeutics opinion, the Ninth Circuit noted a “concerning pattern” in securities cases, in which defendants are “exploiting these procedures to defeat what would otherwise constitute adequately stated claims.” Though the doctrines do have an important role to play, “the overuse and improper application of judicial notice and the incorporation by reference doctrine, however, can lead to unintended and harmful results.” The “unscrupulous use of extrinsic documents” to resolve competing theories “risks premature dismissals of plausible claims that may turn out to be valid after discovery.” This risk is “especially significant” in securities suits as there is a heightened pleading standard and the defendants possess materials to which the plaintiffs do not yet have access.
The appellate court noted that if defendants are permitted to “present their own version of the facts at the pleading stage – and the district courts accept those facts as true – it becomes near impossible for even the most aggrieved plaintiff to demonstrate a sufficiently ‘plausible’ claim for relief.”
The Ninth Circuit considered and clarified these judicial doctrines in light of the plaintiff’s appeal of the district court’s dismissal of the securities class action complaint the plaintiff had filed against Orexigen and certain of its directors and officers.
Background Regarding the Orexigen Lawsuit
The plaintiff’s complaint alleged that the defendants had made material misrepresentations and omissions with regard to the company’s clinical trials involving its developmental stage obesity drug candidate, Contrave. The trials, known as the Light Study, were designed to measure the risk of cardiovascular events using the drug.
The study’s initial results (the “25 percent interim results”) were unexpectedly positive. The plaintiff alleges that there were a series of leaks of the interim results that affected the company’s share price. The FDA imposed a number of requirements on the company as a result of the leaks. The FDA also emphasized to the company that the interim results have a “high degree of uncertainty.”
However, the company then filed a patent application in reliance on the interim results, and then the company requested that the patent office to publish the patent application, rescinding the company’s own earlier request to keep the application confidential. The company then attached the patent application – including the interim results – to an SEC filing on Form 8-K. Securities analysis reviewed the filing, and the company’s stock surged.
In March 2015, a senior FDA official advised the company that the agency was “very disappointed” by the company’s actions, warning that the 25 percent interim results should not be misinterpreted. An article in Forbes quoted an FDA official as saying the company’s SEC filing was “unreliable,” “misleading,” and likely false.
Two days later, the Light Study reached the 50 percent completion stage; the results no longer indicated a heart benefit from Contrave. The independent physician heading the study committee drafted a press release disclosing the updated results and the termination of the study. In subsequent SEC filings and in an investor call, the company’s executives did not refer to the 50 percent interim results or the termination of the study, referring rather to what the company might do if the study were to be terminated. Four days after the conference call, the independent physician heading the study issued a statement disclosing the 50 percent interim results and the termination of the study.
The plaintiff filed a securities class action lawsuit alleging that the company and its executives had misrepresented or omitted material information about the Light Study and the interim results. The defendants filed a motion to dismiss. In connection with the motion to dismiss, the defendants asked the court to take judicial notice of or incorporate by reference 22 documents. The court granted the motion with respect to 21 of the 22 documents. The court also granted the defendants’ motion to dismiss and the plaintiff appealed.
The August 13 Opinion
Before reaching the merits of the trial court’s ruling on the motion to dismiss, the appellate court considered the trial court’s ruling on the defendants’ requests for judicial notice and incorporation by reference.
The district court had taken judicial notice of three documents: a transcript of the September 11, 2014 investors’ conference call; a December 18, 2014 European Medical Authority (EMA) report about contrive; and the historical record of the company’s patent application. The appellate court concluded that the court did not abuse its discretion in taking notice of the patent application, as the court had only relied on the application to determine the date of application. However, the court concluded that the trial court had abused its discretion in taking notice of the transcript and the EMA report, as the court did not indicate specifically what it was within these documents of which it was taking notice and as there is a reasonable dispute as to what these documents establish.
The appellate court then reviewed the documents that the trial court had considered as incorporated by reference. The documents included a number of blog posts and news articles; analyst reports; and SEC filings and attachments. In reviewing these materials, the appellate court noted that the standard under the judicially created doctrine for incorporation by reference requires that the complaint must have “extensively” referred to the materials in order for them to be incorporated. The court noted the difficulty of interpreting this standard. The court also noted the danger of an overly broad application of the doctrine as it could permit defendants to use the doctrine to “insert their own version of events into the complaint to defeat otherwise cognizable claims,” meaning that the doctrine can become “nothing more than another way of dispute the factual allegation in the complaint,” with the “perverse” added benefit that the plaintiff has no opportunity to dispute the defendant’s version of the facts.
Though the appellate court concluded that the trial court had appropriately incorporated by reference a number of the disputed documents that had been mentioned extensively in the complaint, the court also concluded that the trial court had abused its discretion in incorporating by reference a number of the documents that were only barely mentioned or mentioned not at all.
In commenting on its conclusion that the trial court had improperly incorporated by reference certain of the company’s SEC filings to which the complaint had not referred, the appellate court noted a particular danger of the incorporation by reference doctrine, which is its “overuse.” This danger can arise “when parties pile volumes of exhibits to their motion to dismiss,” making their submissions “needlessly unwieldy.” Simply reviewing these submissions “demands precious time.”
The appellate court then considered the trial court’s dismissal on its merits, in light of the revised record. The appellate court concluded that the trial court had erred in dismissing the plaintiff’s claim that the Form 8-K to which the patent application was attached was misleading. The court concluded that the plaintiff had a “plausible claim” that the company had a duty to disclose that the 25 percent interim results were “unreliable” and that the failure to disclose the unreliability was misleading.
The appellate court also considered the trial court’s dismissal of the plaintiff’s claims concerning the company’s press release in which the company said that the patent office had published the patent application. The plaintiff alleged that the company’s omission of the information that the company itself had originally requested that the patent application be confidential and that the company had subsequently requested that the patent office publish the application was misleading.
The appellate court said that the company did not have a duty to disclose that it had initially requested that the application be kept confidential. However the company’s statement that the patent office had “published” the patent application “gives rise to a duty to elaborate.” The statement gives the impression that the patent office published the application on its own, which could mislead investors about why the patent office published the patent and why it was not published sooner. The omission, the court said, is material, because the omitted information would have revealed the company’s role in disclosing the 25 percent interim results, which allegedly violated in the study’s confidentiality requirements and risked the integrity of the study. The court reversed the trial court’s ruling with respect to these allegations with leave for the plaintiff to amend his complaint.
Finally, the Court considered the company’s statements and SEC filings about the ongoing status of the Light Study, allegedly after the company knew the study had been terminated. Among other things, the appellate court concluded that the district court had erred in ruling that the termination of the study had been disclosed to the public in one of the analyst’s reports that the appellate court had concluded had improperly been incorporated by reference. The district court’s reasoning “again demonstrates the danger of incorporating by reference documents en masse.”
With the mass of documents, the district court faces “competing, often inconsistent versions of the facts.” Although incorporation by reference permits court to accept the truth of the incorporated documents, “we reiterate that it is improper to do so only to resolve factual disputes against the plaintiff’s well-plead complaint” – as for example determining the date on which the Light Study had been terminated and when the information about the termination was known to the investing public. The Court concluded that the district court had erred in dismissing the plaintiff’s complaint that the company’s May 2015 8-K, May 2015 10-Q, and May 2015 conference call misrepresented the status of the Light Study as continuing.
The Ninth Circuit’s opinion is long (58 pages) and unusually detailed. The court covers a lot of ground, and its opinion requires a close reading. In its depth and specificity, the appellate court is making a point. The appellate court is clearly concerned that the doctrines of judicial notice and incorporation by reference are being applied (and were applied here) loosely and in ways inconsistent with the strict pleadings only requirements at the motion to dismiss stage.
As a former federal district court law clerk, I have a life-long respect for the importance of the law’s procedural requirements, and in particular the critical difference between a motion to dismiss (in which only the pleadings may be considered) and a motion for summary judgment (in which matter outside the complaint may be considered in order to determine whether there are any material factual disputes remaining). I have long been uneasy with district courts’ broad willingness to consider extensive matter outside the pleadings in ruling on motions to dismiss. Based on my former law clerk’s instincts I was surprised that a defendant might seek to rely on 22 different documents outside of the pleadings in a motion to dismiss.
It is pretty clear that the Ninth Circuit had pretty much the same reaction. The opinion reads like a broadside announcement that this practice has gotten out of hand, which the court expressly notes has evolved into a “concerning pattern” that has been subject to “overuse” and “improper application.” The appellate court’s painstaking review of each of the disputed documents is meant to send a message to the district courts (at least within the Ninth Circuit) of what is required before a court may properly take judicial notice of or incorporation by reference material from outside the pleadings.
I can imagine a defense-side attorney objecting that the real problem is that securities class actions can be horrendously expensive to defend, and it a plaintiff can just get past the motion to dismiss, the threat of ruinous defense costs puts so much pressure on the defendants that they are forced to settle, even if they believe that the plaintiff’s allegations are completely without merit. If the plaintiff’s allegations can be shown to be bogus simply by allowing the court to see critically important material the plaintiff omitted to include in his or her complaint, this abusive and wasteful process can be shortcut, to the benefit of the defendant companies and their shareholders.
At one level, I am sympathetic to these kinds of concerns. I find the amount of money expended on these kinds lawsuits appalling, and I am well aware the pressures these expenses can put on the defense. However, it is not as if the defendants are forced into the field of battle without strong defensive weapons. The heightened pleading standard and the stay of discovery are important advantages for the defense at the motion to dismiss stage. Given the purpose of the exercise – that is, to consider the sufficiency of the plaintiff’s complaint – the defendants ought not, as the Ninth Circuit said, to be able to insert their own version of events or to try to urge the court to consider the complaint that the defendants think the plaintiff should have filed.
Even more to the point, and returning to my former law clerk’s instincts, the rule at the motion to dismiss stage is that the court is required to consider the sufficiency of the pleading, not to make a comprehensive review of the factual record. For that reason, I think the Ninth Circuit’s analysis of the judicial notice and incorporation by reference documents is important. It is underscores the point of the exercise in which the court is to engage at the motion to dismiss stage.
The Ninth Circuit’s message could have an impact. As the Ninth Circuit suggested in its opinion, the district court here is not the only court that has gone overboard in allowing matter from outside the pleadings to come into the record at the motion to dismiss stage. To the extent district courts, even if just within the Ninth Circuit, tighten up on the material that is considered at the motion to dismiss stage, it could result in fewer dismissals, or at least fewer dismissals with prejudice. Indeed, the Ninth Circuit was very express about its concern that over reliance on extraneous matter to defeat claims that would otherwise survive the motion to dismiss; the clear inference is that more restrained application of the judicial notice and incorporation by reference doctrine would result in fewer dismissals.
There is one more aspect of the Ninth Circuit’s opinion that potentially could be quite significant as well. In its analysis of the plaintiff’s allegation that the defendants had omitted to note that the company itself had requested that the patent office publish the company’s patent application, the appellate court said the company’s reference to the patent office’s publication “gives rise to a duty to elaborate.” This is a very interesting and significant observation, suggestion that even entirely truthful statements could be misleading and actionable in the absence of further elaboration required to make the statement not misleading. As significant as are the court’s statements about judicial notice and incorporation by reference, the court’s identification of this “duty to elaborate” could prove to be even more significant.
Here at The D&O Diary, we read a lot of judicial opinions. Even though the Ninth Circuit’s opinion in this case is quite long, it is one of the more interesting opinions we have had occasion to review for quite some time. It warrants reading at length and in full. In particular, it should make for interesting reading for any professional involved in advising companies about their disclosures, particularly for developmental stage pharmaceutical companies.
Special thanks to a loyal reader for providing me with a copy of the Ninth Circuit’s opinion.