On August 18, 2017, a Ninth Circuit panel affirmed in part, reversed in part, and vacated in part the district court’s dismissal of the amended securities fraud class action complaint in In re Atossa Genetics, Inc. Securities Litigation before remanding for further proceedings. In re Atossa Genetics, Inc. Sec. Litig., 868 F.3d 784 (9th Cir. 2017). The complaint alleged that certain statements by Atossa and its CEO concerning the company’s breast cancer screening products were materially false or misleading—in particular, statements concerning U.S. Food and Drug Administration (“FDA”) clearance of one of its products. The district court found that each challenged statement either was not false or misleading or was not material; the Ninth Circuit, on the other hand, concluded that the complaint sufficiently alleged that some were materially false or misleading. There’s nothing groundbreaking about the panel’s analytical framework or approach here, which is consistent with previous case law, but the opinion is unusually clear and helpful in parsing exactly which sorts of statements in biotech cases are likely to survive motions to dismiss, and which are not.

Atossa develops and markets breast-cancer screening products. In 2009, it purchased the patent rights to the Mammary Aspirate Specimen Cytology Test System (“MASCT System”), a pump that extracts nipple aspirate fluid (“NAF”) from women’s breasts, which can then be tested for cancerous or pre-cancerous cells. Before Atossa acquired the MASCT system, the product had been cleared by the FDA through a “premarket notification/510(k) process” that allows companies to market devices that are “substantially equivalent” to devices already legally marketed in the U.S., as long as the FDA provides clearance by letter. The FDA cleared the MASCT system for use as a sample collection device, but the FDA did not clear the MASCT system for the screening or diagnosis of breast cancer.

Initially, Atossa marketed the MASCT system as a solo product, but later it started marketing it in combination with Atossa’s ForeCYTE test, a diagnostic tool that tested the NAF samples for cancer markers. Atossa never sought or obtained FDA clearance for either the ForeCYTE test or the combination of the MASCT system and the ForeCYTE test.

Following Atossa’s IPO in 2012, the company and its CEO made the following types of statements challenged in the litigation:

(1) statements describing the ForeCYTE test as FDA-cleared;

(2) statements describing the MASCT system as FDA-cleared;

(3) statements in a Form 8-K regarding a warning letter the company received from the FDA about the MASCT system and ForeCTYE test;

(4) statement in a Form 10-Q that Atossa was “reasonably confident in its responses” to the FDA’s warning letter; and

(5) a statement by the CEO that “2013 and 2014 are execution years, where FDA clearance risk has been achieved, patents have been obtained, clinical trials have been achieved, manufacturing has been achieved—so now it’s really a matter of going from less than 100 doctors doing our test to the expectation of thousands of doctors.” (emphasis added)

The panel carefully analyzed each of these categories of statements and concluded that most were in fact sufficiently alleged to be material and false or misleading. The court found this clearly to be the case with respect to the first category, since Atossa did not receive FDA clearance for either the ForeCTYE test or its combination with the MASCT system, and it would undoubtedly have been important to investors to know that one of Atossa’s main sources of revenue was not FDA-cleared. The court rejected the defendants’ argument that the market was aware at the time that the ForeCYTE test was not cleared: cautionary language in the IPO materials stating that the FDA likely would require premarket notification for certain lab tests in the future did not imply that the ForeCYTE test had not yet received clearance. And in any case, plaintiffs alleged direct reliance on these statements, in addition to “fraud on the market,” so it didn’t matter whether Atossa’s offering documents previously revealed that the ForeCYTE test was not cleared.

The panel found the second category straightforward too: unlike the ForeCYTE test, the MASCT system was cleared by the FDA, so statements to that effect were not false. Plaintiffs argued that the statements nonetheless were misleading in context, since a reasonable investor would have believed that the MASCT system was FDA-cleared not only for sample collection but also for breast cancer screening. The court disagreed, finding that Atossa marketed the MASCT system as a collection tool only, which was precisely the purpose for which it had been FDA-cleared.

The third category was more complicated as it involved allegedly misleading omissions. On February 20, 2013, Atossa received a warning letter from the FDA stating that it had discovered during a lab inspection that the MASCT system had been modified without obtaining a new 510(k) clearance. The FDA warned that this meant the MASCT system was misbranded and adulterated in violation of certain regulations. The FDA also specifically advised that the modified MASCT system required submission of a new 510(k) notification, that the ForeCTYE test required separate clearance, and that Atossa’s website and product labels were misleading because they described the MASCT system as “FDA-approved” and the ForeCYTE test as “FDA Cleared.”

Just a few days later, Atossa filed a Form 8-K stating that it had received a warning letter from the FDA explaining that the FDA believed that modifications to the MASCT system required new 510(k) clearance. However, the 8-K did not mention the FDA’s concerns regarding either the ForeCYTE test’s lack of FDA clearance or Atossa’s false or misleading marketing materials. In those regards, it stated only that:

“The Letter also raises certain issues with respect to the Company’s marketing of the [MASCT] System and the Company’s compliance with the FDA Good Manufacturing Practices regulations, among other things . . . Until these issues are resolved Atossa may be subject to additional regulatory action by the FDA . . . .”

The Ninth Circuit concluded that though not literally false, the complaint sufficiently alleged that these omissions were materially misleading: “In particular, the omissions gave the reasonable inference that the FDA had raised no concerns related to clearance for the ForeCYTE test, when, as alleged, the FDA had raised precisely that concern.” Nor did Atossa’s general disclaimer that it could be subject to future regulatory action from “other matters” cure the misleading nature of the filing since, as the district court had noted, the allegedly misleading part of the filing concerned only past facts, not statements about the future.

The Ninth Circuit affirmed dismissal of the claim in the fourth category, finding the statement that the company was “reasonably confident in its response” to the FDA warning letter to be “mere corporate optimism,” too unspecific and subjective to ground a claim.

Finally, the court analyzed the fifth category—the CEO’s statement that “FDA clearance risk has been achieved”—as a statement of opinion under Omnicare, and concluded that it was misleading by omission. Under Omnicare, “when a plaintiff relies on a theory of omission, the plaintiff must allege ‘facts going to the basis for the issuer’s opinion . . . whose omission makes the opinion statement at issue misleading to a reasonable person reading the statement fairly and in context.” (quoting City of Dearborn Heights, 856 F.3d 605, 616 (9th Cir. 2017)). The court concluded that the CEO’s statement minimizing FDA clearance risk was materially misleading:

“Here, saying that FDA clearance risk has been achieved is another way of expressing a belief that Atossa’s conduct mostly complies with FDA rules governing 510(k) clearance. And failing to disclose that the FDA gave a warning about the ForeCYTE Test not having 510(k) clearance is an omission concerning knowledge that the Federal Government has taken the opposite view concerning the lawfulness of Atossa’s alleged conduct.”

Ultimately, the Ninth Circuit’s careful analysis of each statement’s alleged falsity and materiality, or lack thereof, makes this a worthwhile read. The opinion also nicely illustrates a trend my co-authors and I identified with respect to motion to dismiss decisions in securities cases brought against young biotech companies bringing their first products to market, “Myths & Misconceptions of Biotech Securities Claims: An Analysis of Motion to Dismiss Results from 2005-2016.” As explained in that article, biotech companies are much more likely to get into trouble for statements describing or characterizing feedback from or interactions with the FDA—which concern past facts—than they are for nearly any other kind of statement, including optimistic predictions about drug trials or financial projections. In Atossa, the Ninth Circuit found a general statement of even ill-advised corporate optimism not to be actionable, but found several statements characterizing FDA feedback and the ForeCYTE test’s regulatory status to have been sufficiently alleged to be materially false and misleading. Biotech securities class actions go best when a company has tried to be as factual as possible when describing FDA feedback.

On July 28, the Ninth Circuit reversed the dismissal of a securities class action, and remanded to the Central District of California. In re Quality Sys., Inc. Sec. Litig., 865 F.3d 1130 (9th Cir. 2017). Quality Systems, which develops and markets electronic health records software, allegedly made false statements about its current and past sales “pipeline,” and used those statements to support public projections about the company’s future performance. Id. at 1135. The court addressed the application of the Private Securities Litigation Reform Act’s Safe Harbor for forward-looking statements—essentially predictions regarding future events or performance. The court announced a bright-line rule for “mixed” statements, which occur “[w]here a forward-looking statement is accompanied by a non-forward-looking factual statement that supports” it. Id. at 1146. The court held that “[i]f the non-forward-looking statement is materially false or misleading, it is likely that no cautionary language—short of an outright admission of the false or misleading nature of the non-forward-looking statement—would be ‘sufficiently meaningful’ to qualify the statement for the safe harbor.” Id. at 1146–47. The court further ruled that for “mixed” statements, whether “the non-forward-looking statements are, or may be, untrue is clearly an ‘important factor’ of which investors should be made aware.” Id. at 1148.

Doug Greene, Peter Hawkes, and I authored an amicus curiae brief on behalf of the Washington Legal Foundation, urging the Ninth Circuit to rehear the case en banc to replace the panel’s unduly constricted approach to the Safe Harbor with a context-driven standard that is consistent with Congress’s judgment in enacting the Safe Harbor. The brief first explains that the Safe Harbor was enacted to encourage companies to offer predictions about their future performance without the fear of crippling securities litigation if their predictions are not borne out by future events. To accomplish that, the Safe Harbor protects false or misleading forward-looking statements if they are identified as forward-looking and accompanied by “meaningful cautionary statements” identifying important risk factors that could affect future performance. The Safe Harbor offers an independent second prong that protects forward-looking statements if the speaker lacks actual knowledge that the statements are false. The brief shows that courts have been reluctant to apply the first prong of the Safe Harbor independently, fearing that it gives companies a “license to defraud.” By announcing an inflexible rule that, for “mixed statements,” cautionary language cannot be “meaningful” absent an admission of the falsity of any inaccurate statements of present or past fact—regardless of whether the company even knows they are false—the Ninth Circuit panel similarly nullifies the Safe Harbor’s first prong by ignoring disclosures of other “important” risk factors and holding companies strictly liable for innocent misstatements.

Overruling (or, at least, creatively re-characterizing) its own precedent, the Ninth Circuit held in Resh v. China Agritech, Inc., — F.3d —, 2017 WL 2261024 (9th Cir. May 24, 2017), that the pendency of an earlier uncertified class action tolls the statute of limitations not only for later-filed individual claims, but for subsequent class actions as well. The Ninth Circuit’s decision opens the door to the possibility of serial, successive attempts to certify a class in securities (and other) cases, potentially exposing defendants to an almost never-ending series of class action lawsuits.

Under American Pipe & Construction Co. v. Utah, 414 U.S. 538 (1974), and Crown, Cork & Seal Co. v. Parker, 462 U.S. 345 (1983), the pendency of a putative class action tolls the statute of limitations applicable to the individual claims of the putative class members. Thus, if the putative class action is timely brought, but class certification is later denied after the statute of limitations would have otherwise expired, putative class members would still be able to bring individual claims on their own behalf. The question in Resh was whether American Pipe tolling should apply to subsequent class actions as well.

The facts of Resh are relatively straightforward. In February 2011, a market research company raised questions about the accuracy of China Agritech’s financial reporting. Its stock price fell substantially. A few days later, a China Agritech shareholder filed a putative securities fraud class action complaint against the company and several of its managers and directors in the Central District of California. The court denied class certification, finding that, because plaintiffs had failed to establish the fraud-on-the-market presumption of reliance, issues common to the proposed class did not predominate over individual issues. Five months after that denial, and one year and eight months after the initial adverse press report, another shareholder filed a second putative securities class action in the District of Delaware. The case was transferred to the same judge in the Central District of California, who again denied class certification, this time on grounds of typicality and adequacy of the named plaintiffs.

Nine months later — and more than three years after the initial adverse press report — plaintiff Michael Resh filed yet another putative class action complaint alleging securities fraud against China Agritech and several individual defendants. A claim for securities fraud under the Exchange Act is subject to a two-year statute of limitations. Thus, if American Pipe tolling applied, the putative class action would be timely — only about 14 months had passed since the initial press report during which a putative class action was not pending. But if American Pipe tolling did not apply, the class action complaint was plainly time-barred.

The Ninth Circuit began its analysis by discarding one of its prior precedents. In Robbin v. Fluor Corp., 835 F.2d 213 (9th Cir. 1987), the Ninth Circuit had held that American Pipe tolling did not apply to a subsequent class action following a definitive determination of the inappropriateness of class certification. The Ninth Circuit dismissed Robbin as “a short opinion published 30 years ago” that had been “modified” in Catholic Social Services, Inc. v. INS, 232 F.3d 1139 (9th Cir. 2000) (en banc). 2017 WL 2261024, at *6.

In Catholic Social Services, the district court had certified a class, but had lost subject matter jurisdiction due to an intervening change in the law. See id. The Ninth Circuit held that American Pipe tolling applied to a subsequent class action in those circumstances. See id. But it also stated, “If class action certification had been denied in [an earlier case], and if plaintiffs in this action were seeking to relitigate the correctness of that denial, we would not permit plaintiffs to bring a class action.” Id. (quoting Catholic Social Services, 232 F.3d at 1147).

The Resh court found that interpreting that statement as forbidding the application of American Pipe tolling to subsequent class actions when class certification had previously been denied would be a “misreading” of Catholic Social Services. Id. at *6-*7. The court explained that it was not talking about American Pipe tolling at all. What it was actually talking about was issue preclusion — all it meant was that, if the same plaintiffs sought to bring a subsequent class action after certification had previously been denied, issue preclusion would bar them from doing so. Id. at *7.

That is, to say the least, an odd reading of Catholic Social Services. Other than the reference to “relitigat[ion],” nothing in Catholic Social Services’ analysis suggests that the court was thinking of issue preclusion. In particular, nothing in the quoted sentence indicates that, to be barred from “relitigat[ing]” class certification, the plaintiffs in the subsequent class action had to be the same plaintiffs who unsuccessfully litigated the first class action — a critical requirement for issue preclusion. In fact, the court actually cited Robbin in support of its statement, which was plainly made in the context of a discussion of the applicability of American Pipe tolling to subsequent class actions. See Catholic Social Services, 232 F.3d at 1145-49. Indeed, the Ninth Circuit expressly dealt with issue preclusion on a different issue in a separate portion of its opinion. Id. at 1151-53.

In any event, having reinterpreted Catholic Social Services as applying American Pipe tolling to subsequent class actions — regardless of the reason for the dismissal of the earlier class action — the Ninth Circuit went on to find support for its position in three recent Supreme Court precedents:

  • In Shady Grove Orthopedic Associates, P.A. v. Allstate Insurance Co., 559 U.S. 393 (2010), the Supreme Court held that Rule 23 empowers a federal court to certify a class in any type of case, not only those “made eligible for class treatment by some otherId. at 399 (emphasis in original). The Ninth Circuit concluded that to deny American Pipe tolling to subsequent class actions would essentially import “certification criteria” into Rule 23 from “some other law,” which Shady Grove forbids. 2017 WL 2261024, at *7.
  • In Smith v. Beyer Corp., 564 U.S. 299 (2011), the Supreme Court held that, after denying class certification, a federal court could not enjoin a state court from certifying a class under the “relitigation exception” to the Anti-Injunction Act because the state court action had different named plaintiffs who were not subject to claim or issue preclusion. The Court acknowledged the risk of “serial relitigation of class certification,” but found that risk was mitigated by principles of stare decisis and comity, as well as the possibility of removal under the Class Action Fairness Act (for state court actions) or MDL consolidation (for other federal actions). Id. at 316-18. The Ninth Circuit found that those considerations similarly ameliorated the unfairness of serial class certification litigation due to American Pipe 2017 WL 2261024, at *9.
  • Finally, in Tyson Foods, Inc. v. Bouaphakeo, 126 S.Ct. 1036 (2016), the Supreme Court noted that “use of the class device cannot ‘abridge…any substantive right.’” Id. at 1046 (quoting 28 U.S.C. 2072(b)). While acknowledging that Tyson Foods did not directly control, given that “statutes of limitation occupy a no-man’s land between substance and procedure,” the Ninth Circuit found that it “nonetheless reinforces our conclusion that the statute of limitations does not bar a class action brought by plaintiffs whose individual actions are not barred.” 2017 WL 2261024, at *8.

Despite the court’s insistence to the contrary, Resh represents a sharp break from prior law in the Ninth Circuit. Given that the court radically reinterpreted the en banc decision in Catholic Social Services, it will be interesting to see whether the Ninth Circuit elects to reconsider the Resh decision en banc.

In the meantime, Resh increases the pressure on defendants in putative class actions pending in the Ninth Circuit to settle, lest they be saddled with the costs of serially re-litigating class certification even after prevailing. The Resh court’s suggestion that plaintiffs’ counsel, whose fees are usually contingent on the outcome of the case, “at some point will be unwilling to assume the financial risk in bringing successive suits,” id. at *9, is sure to be cold comfort to class action defendants, for whom the cost of litigation is frequently the driving factor in deciding to settle a case.

Some relief may be forthcoming soon from the Supreme Court, however. The Court is currently considering whether American Pipe tolling applies to statutes of repose, in addition to statutes of limitations. See California Pub. Employees’ Retirement Sys. v. ANZ Securities, Inc., 137 S.Ct. 811 (2017) (granting writ of certiorari). If the Supreme Court affirms that American Pipe tolling does not apply to statutes of repose, that would at least put a hard backstop on serial re-litigation of class certification. And given that there is a clear circuit split on whether American Pipe tolling applies to subsequent class actions, see, e.g., Korwek v. Hunt, 827 F.2d 874, 879 (1987), the Supreme Court may eventually take up that issue as well.

In a matter of first impression in the Ninth Circuit, the court applied the Supreme Court’s Omnicare standard for pleading the falsity of a statement of opinion to a Section 10(b) claim in City of Dearborn Heights Act 345 Police & Fire Retirement System v. Align Technology, Inc., — F.3d —, 2017 WL 1753276 (9th Cir. May 5, 2017).

The litigation arose from Align’s $187.6 million acquisition of Cadent Holdings, Inc. in April 2011, and Align’s alleged failures to properly assess and write off the goodwill associated with the acquisition. Align’s statements regarding the fair value of goodwill, of course, were quintessential statements of opinion, because they were inherently subjective. In Omincare, the Supreme Court set the standard for pleading the falsity of an opinion claim under Section 11. Many practitioners, including Lane Powell’s securities litigation team, had opined—and the Second Circuit and other courts had held—that the rationale of Omnicare should equally apply to Section 10(b) claims, since the falsity element is the same. In Align, the Ninth Circuit agreed, and partially overturned a previous Ninth Circuit case that permitted plaintiffs to plead falsity by alleging that “there is no reasonable basis” for the defendant’s opinion.

Align’s accounting for the acquisition resulted in $135.5 million of goodwill, $76.9 million of which was attributable to one of Cadent’s business units (the “SCCS unit”). The plaintiffs alleged that the purchase price, and thus the goodwill, was inflated due to Cadent’s channel stuffing practices prior to the acquisition, and that the defendants must have known as much after performing their due diligence. Following the acquisition, the SCCS unit’s financial results suffered due to numerous factors. Nevertheless, at the end of 2011, Align found no impairment of its recorded goodwill. Align did not perform any interim goodwill testing in the first or second quarters of 2012. Id. at *2-3.

On October 17, 2012, Align finally announced it would be conducting an interim goodwill impairment test for the SCCS unit, which it said was triggered by the unit’s poor financial performance in the third quarter of 2012 and the termination of a distribution deal in Europe. That announcement led to a 20% hit to Align’s stock price. On November 9, 2012, Align announced a goodwill impairment charge of $24.7 million, and it announced subsequent goodwill charges in the following two quarters. Id. at *3. The plaintiffs alleged that the defendants made seven false and misleading statements concerning the goodwill valuation between January 30, 2012 and August 2, 2012. The plaintiffs’ allegation was that defendants deliberately overvalued the SCCS goodwill, thereby injecting falsity into statements concerning the goodwill estimates and the related financial statements. The district court dismissed the complaint with prejudice for failing to adequately plead falsity and scienter. Id. at *4.

At issue in the Ninth Circuit was whether the plaintiffs had adequately pled that Align’s statements were false. The first question was what analytic framework applied. The plaintiffs did not dispute that five of the seven statements at issue were pure statements of opinion. However, with respect to two statements, the plaintiffs alleged the opinions contained “embedded statements of fact.” Those statements were that “there were no facts and circumstances that indicated that the fair value of the reporting units may be less than their current carrying amount,” and that “no impairment needed to be recorded as the fair value of our reporting units were significantly in excess of the carrying value.” The Court held that the former statement was an opinion with an embedded statement of fact, but that the latter was an opinion. Id. at *5.

The Court also addressed the proper pleading standard for falsity of opinion statements. The panel concluded that Omnicare established three different standards depending on a plaintiff’s theory:

  1. Material misrepresentation. Plaintiffs must allege both subjective and objective falsity, i.e., that the speaker both did not hold the belief she professed, and that the belief was objectively untrue.
  2. Materially misleading statement of fact embedded in an opinion statement. Plaintiffs must allege that the embedded fact is untrue.
  3. Misleading opinion due to an omission of fact. Plaintiffs must allege that facts forming the basis for the issuer’s opinion, the omission of which makes the opinion statement at issue misleading to a reasonable person reading the statement fairly and in context.

Importantly, the Ninth Circuit extended this Omnicare holding from the Section 11 context to the Section 10(b) and Rule 10b-5 claims at issue in Align. Id. at *7. In doing so, the Ninth Circuit joined the Second Circuit in extending Omnicare in this regard. See Tongue v. Sanofi, 816 F.3d 199, 209-10 (2d Cir. 2016). Finally, the court overruled part of its previous holding in Miller v. Gammie, 335 F.3d 889, 900 (9th Cir. 2003) (en banc), which allowed for pleading falsity by alleging that there was “no reasonable basis for the belief” under a material misrepresentation theory. City of Dearborn Heights, 2017 WL 1753276, at *7.

Applying this pleading standard to the Align facts, the Ninth Circuit concluded that the plaintiffs had not met their pleading burden. Because the plaintiffs did not allege the actual assumptions the defendants relied upon in conducting their goodwill analysis, the court could not infer that the defendants intentionally disregarded the relevant events and circumstances. Accordingly, six of the seven statements that relied on the material misrepresentation theory failed to allege subjective falsity and were properly dismissed. Likewise, the failure to allege the actual assumptions used by the defendants prevented plaintiffs from pleading objective falsity as to the one statement of fact embedded in an opinion statement. Id. at *8-10.

After concluding that the plaintiffs failed to allege falsity, the Ninth Circuit went on to hold that plaintiffs had not alleged scienter against the defendants, providing a second ground for dismissing the complaint. At most, the plaintiffs alleged that the defendants violated generally accepted accounting principles, but such a failure does not establish scienter. Likewise, the stock sale allegations, core operations inference, the temporal proximity between the challenged statements and the goodwill write-downs, the CFO’s resignation, and the magnitude of the goodwill write-downs did not create an inference of scienter. Id. at *10-13.

Judge Kleinfeld concurred in the judgment. He would have upheld the district court’s dismissal based on scienter alone, leaving the weightier issue of falsity described above to a future case where such a decision was necessary. Id. at *13-14 (Kleinfeld, J., concurring in the judgment).

Reversing a district court’s dismissal of a securities class action for failure to adequately allege scienter, the Ninth Circuit held in Schwartz v. Arena Pharmaceuticals, Inc. — F.3d —-, 2016 WL 6246875 (9th Cir. Oct. 26, 2016), that the facts alleged in the complaint gave rise to a strong inference of scienter where the defendants knew of the FDA’s concerns about the potential carcinogenic effects of a new drug based on animal studies, yet represented to investors that FDA approval was likely because all of the data gathered, including “animal studies,” were “favorable.”  The court reaffirmed that, while there is generally no affirmative duty to disclose material information to investors, such a duty arises when the information that is disclosed creates a misleading impression.  The court found that the defendants’ statements concerning “animal studies” were misleading in the absence of any disclosure about the FDA’s concerns.

Arena’s stock dropped sharply following the FDA’s disclosure of its concerns about the potential carcinogenic effects of lorcaserin, a weight-loss drug that Arena was developing.  The FDA based its concerns on testing of the drug in rats (the “Rat Study”).  While the rats developed cancer, Arena had proposed to the FDA an explanation for the carcinogenic mechanism based on the effect of the hormone prolactin, which made it irrelevant to humans.  The FDA did not halt the ongoing human clinical trials, but requested follow-up testing and bi-monthly reports on the rats’ prolactin levels, and later requested a final report on the Rat Study as soon as possible.  The complaint alleged that those requests were “highly unusual” and “out-of-process.”  However, following Arena’s discussions with the FDA in 2007 and 2008, Arena heard nothing further from the FDA on the Rat Study issue until September 2010.  Moreover, Arena’s February 2009 final report concluded that the follow-up studies substantiated the prolactin hypothesis.

Thereafter, Arena made a number of statements to its investors about its confidence in lorcaserin’s ultimate approval by the FDA.  In March 2009, Arena’s CEO told investors that confidence was based on both the preclinical and clinical data as well as the “animal studies” that had been completed.  In May 2009, Arena represented in an SEC filing that lorcaserin’s “safety and efficacy” has been “demonstrated” in part by carcinogenicity “animal studies.”  In September 2009, Arena’s Vice President of Clinical Development stated that lorcaserin showed “favorable results on everything we’ve compiled so far.”  Finally, in November 2009, Arena’s CEO stated that “all of the data in hand” would be included in Arena’s imminent FDA approval application, and that Arena was “not expecting any surprises” in the approval process.

In December 2009, Arena submitted is final application (which included the Rat Study conclusions) to the FDA.  In September 2010, the FDA published briefing documents in connection with Arena’s application that disclosed the existence of the Rat Study and the FDA’s concerns about lorcaserin’s potential carcinogenicity.  Following that disclosure, Arena’s stock plunged 40% in a single day.

Later, the FDA Advisory Committee voted against approval of lorcaserin based on its carcinogenicity concerns, and the FDA denied Arena’s drug approval application.  However, following further pathological review, the FDA ultimately approved lorcaserin, and it is currently on the market.

Following the September 2010 FDA disclosure, plaintiffs brought a putative class action suit against Arena and several of its officers, alleging that the defendants’ statements referring to the animal studies were misleading and made with scienter.  The district court dismissed the complaint for failure to adequately allege scienter.   The Ninth Circuit reversed.  Assuming that the challenged statements were misleading, the Ninth Circuit focused its opinion on what it described as a “simple” theory of scienter: because Defendants had referred to the animal studies when touting lorcaserin’s safety and likely approval, they were obligated to disclose the Rat Study’s existence to the market, and their failure to do so demonstrated scienter.  2016 WL 6246875, at *4.

While acknowledging that it was a “close case,” the Ninth Circuit ultimately agreed.  Id.  The court observed that, under Matrixx Initiatives, Inc. v. Siracusano, 563 U.S. 27 (2011), Defendants would have been under no affirmative duty to disclose the Rat Study in the absence of other statements they had made to the market.  However, as in Matrixx, once Defendants represented that “animal studies” supported lorcaserin’s safety and likely approval, they were bound to do so in a manner that would not mislead investors.  Id. at *5-*7.  The court found that, at the time those statements were made, “Arena knew the animal studies were the sticking point with the FDA[,]” and that it was simply untrue that all of those studies were “favorable.”  Id. at *7 (emphasis in original).

The Ninth Circuit also rejected Defendants’ attempt to analogize the case to In re AstraZeneca Sec. Litig., 559 F. Supp. 2d 453 (S.D.N.Y. 2008), where the court found that a “scientific disagreement” between the defendant company and the FDA regarding the safety profile of a proposed new drug did not give rise to an inference that the defendants did not honestly believe that the drug was safe.  The court observed that Schwartz’s “theory of fraud” was not that Defendants had misled the market as to lorcaserin’s objective safety, but rather that they had withheld information about the FDA’s concerns about its safety, which implicated its prospects for approval—regardless of whether those concerns were well-founded.  Id. at *8.

In some respects, the Ninth Circuit’s opinion seems rather harsh.  After all, while the FDA had initially expressed some concern about the Rat Study, Arena had ultimately concluded that the animal tests did not suggest that lorcaserin was carcinogenic to humans, and the FDA had not expressed disagreement with that conclusion at the time the challenged statements were made.  It seems plausible that, at the time they made those statements, Defendants actually believed that the Rat Study supported the drug’s safety and would not be a significant stumbling block in the approval process.

On the other hand, the FDA had not expressed that its concerns about the Rat Study had been mollified, either.  By expressly invoking “favorable animal studies” as a basis for Arena’s belief that lorcaserin would be approved, Defendants arguably created an impression that nothing in the animal studies would cause the FDA any concern—an arguably misleading impression, given that the FDA had already expressed its concern.  Had Arena simply stated its belief or confidence that lorcaserin would be approved, it likely would have avoided an inference of scienter.  But once it specifically referenced “animal studies” as a basis for that belief, the failure to disclose that those “animal studies” had actually given the FDA pause arguably created a misleading picture for investors.

From time to time, D&O Developments will take a closer look at an important issue decided in an appellate opinion.  In this post, I analyze In re ChinaCast Education Corp. Securities Litigation, 809 F.3d 471 (9th Cir. 2015), in which the Ninth Circuit reversed the dismissal of a securities class action against ChinaCast Education Corporation, a for-profit e-learning provider in China.  ChinaCast’s founder and CEO, Ron Chan, had bilked the company out of millions and, due to his failure to disclose the underlying fraud, made false and misleading statements in conference calls, press releases, and SEC filings.  Even though Chan’s conduct was contrary to ChinaCast’s interests, the court ruled that his fraudulent intent could be imputed to the company because he acted with apparent authority on the company’s behalf.

At first blush, the Ninth Circuit’s holding seems fair: why shouldn’t the company be liable for the false statements of its CEO?  Yet the holding reads the scienter element out of Section 10(b), and thus expands the scope of liability under that section, contrary to the Supreme Court’s direction that its implied right of action be narrowly construed.  The Ninth Circuit compounded its legal error with an incomplete analysis of public policy considerations.  Holding a defrauded corporation liable for the fraud committed against it by its officers simply re-victimizes the corporation, and rewards class-period purchasers of stock at the expense of current shareholders.

Factual and Procedural Background

At least on appeal, the parties didn’t dispute the details of the fraud.  ChinaCast was a successful, promising business.  But its March 2011 10-K filing disclosed that the company’s outside auditor, a Deloitte affiliate, had identified “serious internal control weaknesses” with respect to ChinaCast’s financial oversight.  Within a few months of that report, Chan began the process of sending some $120 million in company money to outside accounts that he or close associates controlled.  He also used millions of dollars of ChinaCast money to secure loans that had nothing to do with the business, and engaged in other unauthorized and illegal transfers of company assets to third parties.

All the while, Chan made statements about the company’s success and financial security in press releases and on investor calls, and signed SEC disclosures that didn’t mention his looting.  Though the board of directors uncovered Chan’s actions in spring 2012, removed him as CEO, and publicly disclosed that he and other senior officers had engaged in illegal conduct, the damage was done. Chan’s actions ruined the company financially.

Purchasers of ChinaCast stock sued Chan, ChinaCast, its Chief Financial Officer, and the company’s independent directors in the Central District of California in September 2012.  The district court dismissed the complaint with prejudice as to ChinaCast and the independent directors, holding that the complaint had not adequately alleged scienter.  Specifically, the district court reasoned that Chan’s rogue conduct could not be held against the company or its directors because he acted only in his own self-interest and there was nothing to suggest the company benefitted from his actions—what the law of agency calls the “adverse interest exception” to the general principle of holding companies responsible for their agents’ actions.  Id. at 474.  (Chan and the CFO had not been served and were not the subject of the motion to dismiss ruling.)

The Ninth Circuit’s Ruling

The Ninth Circuit reversed, holding that common law agency principles permitted ChinaCast to be held accountable for Chan’s fraud.  The panel explained that ordinarily, actions within the scope of an officer’s apparent authority are imputed to the company.  While there is an adverse interest exception to this principle, the exception itself has an exception, which the district court failed to recognize: an agent’s rogue conduct is imputed to the principal (the company) to protect innocent third parties who dealt with the principal in good faith.  When ChinaCast permitted Chan to speak on investor calls and through the press, the company gave him its stamp of approval.  Innocent shareholders understandably relied on those statements, and protecting their interests requires that Chan’s conduct be imputed to the company.  In this case, the company and board did nothing to beef up their oversight processes despite Deloitte’s warning about serious internal risks, and failed to adequately monitor Chan, who, as CEO, should have been subject to careful scrutiny.

The panel relied on a 2013 decision of the Third Circuit, which had rejected a corporate defendant’s adverse interest argument, and allowed a complaint to go forward where the company’s Ponzi-scheming employee acted within the scope of his apparent authority.  Id. at 477 (citing Belmont v. MB Inv. Partners, Inc., 708 F.3d 470, 496 (3d Cir. 2013)).

The opinion closed by acknowledging the consequences of its reasoning:

Assuming a well-pled complaint, we recognize that, as a practical matter, having a clean hands plaintiff eliminates the adverse interest exception in fraud on the market suits because a bona fide plaintiff will always be an innocent third party.

Id. at 479.  But the panel further concluded that this result is consistent with the securities laws’ purposes of protecting investors and promoting confidence in securities markets.  Id.

The ChinaCast Holding Is Inconsistent with Section 10(b)

Resort to agency law for guidance on federal securities law questions can be appropriate, if it doesn’t conflict with the underlying securities law.  But the Ninth Circuit’s agency-law analysis, even if correct, reads the scienter element out of Section 10(b).  Under the types of facts present in ChinaCast, the company can only disclose the underlying fraud through those who know about it.  But when the looter himself is the only one who knows about the fraud, the company is incapable of disclosing it—the looter has essentially gagged the company.  In such a situation, to say that the company “knew,” by imputing the looter’s state of mind to the company, is a dangerous fiction:  a company can’t defraud purchasers of its stock by omitting information of which it had no knowledge or ability to disclose other than through the looter.  Moreover, the company doesn’t benefit from being defrauded.  To the contrary, it is not only directly harmed by the theft, but may also develop legal liabilities due to the looting, and its interest is in preventing further looting and pursuing remedies against the wrongdoer to address those legal liabilities.

In making this error, the Ninth Circuit relied on “the public policy goals of both securities and agency law—namely, fair risk allocation and ensuring close and careful oversight of high-ranking corporate officials to deter securities fraud,” as a basis for refusing to apply the adverse interest exception.  ChinaCast, 809 F.3d at 478-79.  But expanding Section 10(b) liability on such grounds is not allowed.  The Supreme Court has consistently warned against expanding the scope of Section 10(b)’s implied private right of action without a clear statement from Congress.  See, e.g., Janus Capital Group, Inc. v. First Derivative Traders, 131 S. Ct. 2296, 2301-02 (2011); Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, 552 U.S. 148, 165 (2008).  This principle is especially relevant in the context of corporate scienter.  Under Section 10(b), liability is foreclosed absent scienter, e.g., Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193 (1976), and of course, scienter is required as to each defendant, including the company.

In contrast to Section 10(b), Congress has explicitly lowered the burden for plaintiffs in other provisions of the securities laws.  For example, Section 11 claims impose strict liability on issuers for misstatements in a registration statement.  See Ernst & Ernst, 425 U.S. at 200 (contrasting Section 10(b) to other liability provisions in the securities laws, including Section 11).  Congress designed Section 11’s lower burden “to assure compliance with the disclosure provisions of the Act by imposing a stringent standard of liability on the parties who play a direct role in a registered offering.”  Herman & MacLean v. Huddleston, 459 U.S. 375, 381-82 (1983).  Thus, where Congress intends to allocate risk among market participants, it does so explicitly, and there has been no similar allocation in the Section 10(b) context.

Moreover, the Ninth Circuit incorrectly calibrated its fairness analysis.  If an executive loots the company in secret and then prevents it from fulfilling its obligations under the securities laws to make accurate public disclosures, imposing liability on the company would further harm and thus re-victimize the company and its shareholders.  Indeed, holding the company liable rewards only class-period purchasers of stock, who may or may not be current shareholders, at the expense of the company and its current shareholders.

It is important for courts to remain faithful to the structure of the securities laws in cases that present facts similar to ChinaCast.  Although such cases are thankfully rare, they are cases in which there are many victims of the fraud—including the corporation itself, as well as innocent officers and directors.

The Ninth Circuit Court of Appeals clarified an important question surrounding the “corrective disclosure” pleading requirement in Lloyd v. CVB Financial Corporation, 811 F.3d 1200 (9th Cir. 2016), finding that disclosure of an SEC investigation can constitute a partial corrective disclosure, but only if there is a follow-on disclosure that specifically corrects a prior misstatement.

The Lloyd loss causation holding, while clarifying the law to some degree, requires a fact-specific inquiry. In order to find loss causation in an analogous situation, courts would need to piece together several facts: (1) disclosure of a government investigation resulting in a stock drop; (2) market perception that the investigation related to a previous misstatement; (3) a follow-on disclosure confirming the previous misstatement; and (4) a minimal market reaction to the follow-on confirming disclosure.

Factual Background and Procedural History

The litigation arose from pre-recession loans that issuer defendant CVB Financial Corporation (“CVB”) made to the Garrett Group (“Garrett”), a commercial real estate company. In 2008, Garrett informed CVB that it would be laying off employees and reducing salaries, and that it could not make loan payments due to CVB. CVB agreed to restructure the loans, and loaned an additional $10 million to avoid a Garrett default. In 2009, CVB refinanced Garrett’s loans again, providing an additional $53 million and agreeing to other loan modifications. Despite these efforts, in 2010 Garrett again informed CVB that it was unable to fulfill its payment obligations and was then considering filing bankruptcy. Id. at 1203.

During this time, Garrett was CVB’s largest borrower and the loans in question were material to CVB’s balance sheet. Despite Garrett’s struggles and the materiality of the loans, CVB stated in its SEC filings that it was “not aware” of any “known credit problems of the borrower [that] would cause serious doubts” about Garrett’s ability to repay the loans. In July 2010, the SEC served CVB with a subpoena seeking information about its underwriting and loan loss methodologies. The next month, in its Form 10-Q, CVB disclosed the subpoena and that the SEC inquiry regarded CVB’s underwriting and allowance for credit and loan losses and related areas. The next day CVB’s stock fell 22%. Analysts following CVB noted that the subpoena was likely related to the Garrett loans. One month later, CVB finally wrote down $34 million in Garrett loans and reclassified the remaining $48 million of Garrett loans as non-performing. Following this disclosure, CVB’s stock price dropped only six cents to $6.99. Id. at 1204-05.

Plaintiffs brought a securities class action alleging Section 10(b) and Rule 10b-5 claims. The district court concluded that the challenged statements were not made with scienter and did not cause the plaintiffs’ alleged losses, and granted CVB’s motion to dismiss the complaint.

Ninth Circuit’s Ruling

The complaint alleged four types of CVB misstatements: (1) touting of loan underwriting and quality of loan portfolio; (2) a statement that the deteriorating real estate market “could” harm its borrowers’ ability to repay; (3) violations of GAAP in financial statements; and (4) assurances in SEC filings that it was “not aware of any other loans . . . for which known credit problems of the borrower would cause serious doubts as to the ability of such borrowers to comply with their loan repayment terms.” Id. at 1206.

The Ninth Circuit quickly concluded that the first three categories of alleged misstatements were not actionable, finding that the first category of statements were vague puffery, the second category was not misleading when placed in context, and the third category of GAAP failures, without more, did not establish scienter. Id. at 1206-07. However, with respect to the last category, the court concluded that some of these statements were false and made with knowledge or recklessness, and reversed the district court’s decision. The court found that the complaint had adequately alleged that CVB, prior to making those statements, had been alerted to facts that “would cause serious doubts” about Garrett’s ability to repay its loans.  Id. at 1207-09.

Finding one category of misstatements actionable, the court then moved to the question of loss causation, examining Supreme Court and Ninth Circuit law in this area. Under the Supreme Court’s decision in Halliburton, the “burden of pleading loss causation is typically satisfied by allegations that the defendant revealed the truth through ‘corrective disclosures’ which ‘caused the company’s stock price to drop and investors to lose money.’” Id. at 1209 (quoting Halliburton Co. v. Erica P. John Fund, Inc., 134 S. Ct. 2398 (2014)). The court also revisited an open question from its recent decision in Loos v. Immersion Corporation, in which it held that “the announcement of an investigation, standing alone and without any subsequent disclosure of actual wrongdoing, does not reveal to the market the pertinent truth of anything, and therefore does not qualify as a corrective disclosure.” Id. at 1209-10 (quoting 762 F.3d 880, 890 n.3 (9th Cir. 2014)).

However, the court noted that the Loos court had reserved judgment on the question of whether the announcement of an investigation, such as CVB’s announcement of the SEC subpoena, could “form the basis for a viable loss causation theory” if the plaintiff also alleged a subsequent corrective disclosure. Lloyd, 811 F.3d at 1210. The Lloyd court then answered that question in the affirmative.

The disclosure of the SEC subpoena in July resulted in a 20% stock drop. Under Loos, the court found, that disclosure alone would not qualify as a corrective disclosure. However, just one month later, CVB disclosed that it had written off millions in Garrett’s loans. This second “bombshell” disclosure resulted in hardly any market reaction. However, the court concluded from this chain of events that investors correctly understood that the disclosure of the SEC subpoena was a partial corrective disclosure acknowledging the falsity of the prior “no serious doubts” statements. Id. at 1210-11. These two disclosures, when viewed together, constituted a sufficient corrective disclosure. The court reasoned: “Indeed, any other rule would allow a defendant to escape liability by first announcing a government investigation and then waiting until the market reacted before revealing that prior representations under investigation were false.” Id. at 1210. In making its ruling, the Court noted its holding was consistent with the Fifth Circuit’s decision in Public Employees’ Retirement System of Mississippi v. Amedisys, Inc., 769 F.3d 313 (5th Cir. 2014).