Corporate Governance

The Supreme Court and the Mission to Restrict Investor Protection: Merck v. Reynolds (Part 4: The Arguments on Appeal)

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.

Merck sought cert and argued that there was considerable dispute among the assorted circuits about the standard for commencing the statute of limitations under Rule 10b-5.  The actual question presented to the Court was, however, more surgical.  Merck phrased the question as:

• Did the Third Circuit err in holding, in accord with the Ninth Circuit but in contrast to nine other Courts of Appeals, that under the 'inquiry notice' standard applicable to federal securities fraud claims, the statute of limitations does not begin to run until an investor receives evidence of scienter without the benefit of any investigation?

The brief conceded that the circuits had a common standard that first required evidence of facts that suggested the "possibility" of wrongdoing.  Merck, however, contended that the circuits were split on what to do after such a showing.  

• Some Courts of Appeals held that the statute of limitations begins to run from the moment a potential plaintiff possesses enough facts to suggest the possibility that it has been defrauded. Other Courts of Appeals, in contrast, held that the statute of limitations begins to run on what might be a significantly later date: when a reasonable investor, alerted to the possibility of fraud and under a duty to investigate, would have discovered facts sufficient to bring suit.

Neither of these issues were, however, at issue in Merck v. Reynolds.  Because the majority opinion found that there had been no storm warnings, the statute hadn't commenced under either standard.  

Instead, Merck argued that the Third Circuit (along with the 9th Circuit) effectively applied an incorrect definition of storm warnings.  The majority required evidence of scienter before storm warning occurred and a duty to inquire was triggered.  As the brief noted:

• In reversing the District Court's dismissal of respondents' claims as timebarred, the Third Circuit – over a vigorous dissent (and, later, four votes for rehearing en banc) – joined the Ninth Circuit in holding that an investor must possess evidence of scienter before a duty to investigate is triggered. Indeed, the Third Circuit went even farther than the Ninth Circuit in holding that some kind of investor reaction to the disclosed information – namely, a change in analyst ratings for acompany's stock or a significant drop in its stock price – is required before a duty to inquire arises. In so holding, the Third Circuit has excused an investor from asking a single question until it has evidence not just of scienter, but of materiality and loss causation as well.

Predictably, plaintiffs disagreed and urged the Court not to take certiorari.  The case, according to their brief, was little more than a garden variety case involving a highly factual question about the onsent of "storm warnings."  As the brief noted:

• The circuits uniformly hold that a plaintiff is not on 'inquiry notice' until there are sufficient facts available to the plaintiff – 'storm warnings' – that would arouse suspicions of the alleged fraud in a reasonable investor. Only after concluding that this first prong of the statute of limitations test is satisfied – i.e., sufficiently suspicious facts exist to trigger a duty to investigate – do courts consider the second prong, namely, whether the plaintiff conducted a reasonable investigation and whether such investigation would have uncovered enough information to bring suit. This case involves only the uncontroverted first prong of this analysis: the 'storm warnings' prong.

We will share some thoughts on the legal analysis in the next few posts. 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 18, 2009 (boomark / email).