Corporate Governance

The Supreme Court and the Mission to Restrict Investor Protection: Merck v. Reynolds (Part 3: The Third Circuit Decision)

By J. Robert Brown

We are discussing the decision by the Supreme Court to grant cert in Merck v. Reynolds to address the statute of limitations under Rule 10b-5.

The district court dismissed the case, concluding that plaintiffs had been on inquiry notice at least since the date of the FDA letter.  On appeal, the Third Circuit reversed in a sharply divided opinion.

The majority first articulated the relevant legal standards.  The issue was whether plaintiffs "in the exercise of reasonable diligence, should have known of the basis for their claims".  That in turn depended upon whether plaintiffs had sufficient information of possible wrongdoing "to excite 'storm warnings' of culpable activity."  Upon a showing of "storm warnings," the burden shifted to plaintiffs "to show that they exercised reasonable due diligence and yet were unable to discover their injuries."

The court first determined that inquiry notice could be triggered by facts demonstrating the possibility, rather than the probability, of wrongdoing.  As the court noted:

• "we reaffirm that 'whether the plaintiffs, in the exercise of reasonable diligence, should have known of the basis for their claims depends on whether they had sufficient information of possible wrongdoing to place them on inquiry notice or to excidt storm warnings of culpable activity.'" 

The storm warnings/inquiry notice issue, however, turned on the basis for the statements made by Merck about the health effects of Vioxx.  The plaintiffs asserted that Merck misstated the harm from Vioxx, in part through the use of the naproxen hypothesis (that the "harmful effect" was really a reflection of the benefits of naproxen).   As the Fifth Amended Complaint alleged:  

• However, as defendant Scolnick's internal March 9, 2000 email confirms, unbeknownst to investors Merck actually believed that the increased CV events in VIGOR were caused by VIOXX, and as detailed below Merck concocted and advanced the 'naproxen hypothesis' to protect VIOXX's commercial viability.

Although the market knew that the explanation was "hypothetical" and unproven, the court concluded that "market analysts, scientists, the press and even the FDA agreed that the naproxen hypothesis was plausible at the very least."  Only later did the market receive information suggesting that the naproxen hypothesis was wrong.  See Merck v. Reynolds (2003 study done by Harvard affiliate provided data that "for the first time belied Merck's repeated assurances that naproxen was responsible for the disparity in [cardiovascular] events in VIGOR"). 

The opinion also emphasized that most of the "storm warnings" relied upon by the district court did not cause significant and/or sustained drops in share prices.  Moreover, they did not disturb the analyst community enough to result in a collective change in recommendations on the Company's share prices.  Thus, when the FDA letter was published, Merck's share prices hardly changed.  As the majority observed:  "Although the lack of significant movement in Merck's stock price following the FDA warning letter is not conclusive, it supports a conclusion that the letter to did not constitute a sufficient suggestion of securities fraud to trigger a storm warning of culpable activity under the securities laws."

The dissent vigorously disagreed and concluded that the letter from the FDA alone was enough to provide the requisite storm warnings.  The letter, according to the dissent, challenged the Company for "publicly endorsing the naproxen hypothesis as the sole explanation for the higher rate of cardiovascular events in VIGOR study participants" and for downplaying "potential safety problems in failing to disclose the possibility that Vioxx increases the risk of heart attack."

The letter did not dispute the naproxen hypothesis, noting that "the exact reason for the increased rate of MIs observed in the Vioxx treatment group is unknown" and that the naproxen hypothesis was "a possible explanation."  Instead, the letter was about balance in the advertisements.  Thus, Merck could not selectively present the naproxen hypothesis while "minimizing" the other potential risks.

The cert petition and other primary materials can be found on the DU Corporate Governance web site.

Full post as published by The Race to the Bottom on June 17, 2009 (boomark / email).