Yesterday the United States Supreme Court issued a significant opinion on the statute of limitations applicable to federal securities fraud claims under § 10(b) of the Securities Exchange Act of 1934. The Court’s decision will impact in important ways how motions to dismiss these claims are litigated and, in particular, plaintiffs’ ability to bring claims based on alleged misstatements that are more than two years old.
The Rule Announced in Merck
Under the applicable statute of limitations, cases by private plaintiffs under § 10(b) of the Securities Exchange Act must be brought no later than the earlier of “2 years after the discovery of the facts constituting the violation,” or 5 years after the violation. See 28 U.S.C. § 1658(b). In Merck & Co. v. Reynolds, the Supreme Court, in an opinion by Justice Breyer, addressed the 2-year portion of the statute.
The Court concluded that the 2-year clock starts to run either when a plaintiff actually discovers or when a “reasonably diligent plaintiff” discovers “facts constituting the violation,” including facts giving rise to a strong inference of scienter (i.e., fraudulent intent).
In Merck, the plaintiffs, who seek to represent a class of Merck shareholders, sued the company alleging that it had made materially false statements (or omissions) relating to the cardiovascular risk of its pain medication, Vioxx. The plaintiffs filed suit on November 6, 2003. Merck moved to dismiss, arguing that the plaintiffs’ claims were barred by the statute of limitations because their claims had accrued more than 2 years earlier. Merck based its argument on (1) a research study published in March 2000, which disclosed that participants who took Vioxx experienced an increased risk of heart attacks as compared to those who took a different pain medication; (2) products-liability suits filed against Merck in May 2001 asserting that patients who took Vioxx were at elevated risk of heart attack; and (3) a letter from the FDA published in September 2001, which faulted Merck for marketing Vioxx without adequately disclosing the possibility that Vioxx increased the risk of heart attack.
First, the Court held, based on legislative history and prior case law, that the word “discovery” in the statute includes not only the actual discovery of the facts constituting the violation, but also the constructive discovery of such facts. In other words, to establish a statute of limitations defense, a defendant need not establish that a particular plaintiff itself knew facts constituting a violation; it is enough that “a reasonably diligent plaintiff” would have discovered them. (Merck & Co., slip op. at pp. 8-12.)
Second, the Court held that “the facts constituting the violation” include the fact of scienter, an essential element of a § 10(b) claim. (Slip op. at pp. 12-14.) As the Court explained, because a plaintiff must allege facts giving rise to a strong inference of scienter merely to survive a motion to dismiss, a contrary holding would prevent plaintiffs from bringing any claims if the defendant was able to conceal for two years that it had made a misstatement with an intent to deceive. (Slip Op. at p. 13.)
Third, the Court rejected the concept of “inquiry notice” in § 10(b) claims. A line of Court of Appeals cases had previously held that a § 10(b) claim may accrue when a plaintiff was on “inquiry notice” of the claim – i.e., when it possessed sufficient information suggestive of wrongdoing that it should have begun to investigate. The Supreme Court in Merck held that this concept is inconsistent with the language of the statute, which provides that a cause of action accrues only upon actual or constructive “discovery” of the facts of the violation. (Slip Op. at pp. 15-16.)
Applying these principles, the Supreme Court concluded that the plaintiffs in Merck had not actually or constructively discovered facts indicating Merck’s alleged scienter more than 2 years before the case was filed. In particular, the Court rejected the notion that the May 2001 products-liability suit or the September 2001 FDA letter would suffice to plead Merck’s scienter with the specificity needed to survive a motion to dismiss. (Slip op. at 18.) According to the Court, “whether viewed separately or together,” these circumstances did not reveal any “facts” indicating scienter. (Slip op. at p. 19.)
Justice Scalia, concurring in part and in the judgment, favored a stricter reading of the statute’s language, and would have held that the 2-year limitations period commences only upon a plaintiff’s actual (and not constructive) discovery.
Implications of Merck
- By overruling several long-standing decisions from the federal Courts of Appeals that applied an “inquiry notice” standard, the Court limited the circumstances in which defendants may avail themselves of a statute of limitations defense in cases involving alleged misstatements that are more than 2 years old. Of course, as the Supreme Court noted, the 5-year statute of limitation is not subject to tolling, and this “unqualified bar on actions … should diminish the fear” that defendants could be subjected “to liability for acts taken long ago.” (Slip op. at p. 14.)
- The Court rejected the argument that a § 10(b) claim can be dismissed on the 2-year statute of limitations only if the specific plaintiff had itself actually discovered facts showing scienter at the beginning of the 2-year period. The Court’s acceptance of a constructive notice standard (i.e., what facts a “reasonably diligent plaintiff” would have discovered) means that motions to dismiss on statute of limitations grounds will likely continue to be litigated based on the objective facts in the public record. Although the actual knowledge of the particular plaintiff is an alternative way to support a limitations defense, that kind of fact-specific argument (which could be relevant to, among other things, class certification) would generally have less relevance on a motion to dismiss. Had the Court followed the more rigid “actual discovery only” approach advocated in Justice Scalia’s concurrence, it could have greatly altered the way in which these motions are litigated and decided.
- The Court reaffirmed the steepness of the burden that plaintiffs face in alleging scienter with sufficient specificity to survive a motion to dismiss. The Court confirmed that scienter cannot generally be inferred from the fact of a materially false statement. The Court explained specifically that some kinds of alleged misstatements – for example, an incorrect prediction regarding a firm’s future earnings – will not, standing alone, give rise to an inference of scienter. (Slip op. at p. 14.)
- The Court’s decision also gives insight into the kinds of facts necessary to show a strong inference of scienter. Specifically, the opinion made clear – consistent with the opinions of several lower courts – that, in the context of § 10(b) claims against pharmaceutical companies, the existence of a scientific debate about whether a company’s product causes harm or the existence of product liability lawsuits containing such allegations, are not sufficient, either alone or together, to give rise to a strong inference of scienter as to allegedly false statements or omissions about the product.
- The Court specifically reserved the question of whether a plaintiff must be on notice of facts relating to other elements of a private § 10(b) claim, such as economic loss, loss causation and reliance. As a practical matter, however, there are probably few circumstances in which a plaintiff could discover a material misstatement made with fraudulent intent, but would not otherwise be on constructive notice of facts that would satisfy these other elements.
- Merck is, of course, limited to the specific federal statutory context in which it was decided. It will not directly impact the limitations period applicable to state law claims that often accompany federal securities cases. For example, Merck will not change the application of an inquiry notice analysis to the 3-year limitations period for Delaware state law breach of fiduciary duty claims.
The Supreme Court’s opinion in Merck & Co. v. Reynolds, No. 08-905, is available here.