Corporate Governance

The Supreme Court and the Mission to Restrict Investor Protection: Merck v. Reynolds (Part 5: An Initial Assessment of the Arguments)

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.

We take a minute to discuss the implications of the analysis put forward by the defendants in this case.  They, along with the district court and Judge Roth on the Third Circuit, would presumably begin the statute of limitations at the time when investors became aware that the statements by Merck concerning the naproxen hypothesis might be wrong. 

The market knew in 2000 when Merck released the results of the study that the naproxen hypothesis was unsubstantiated and could ultimately be proved incorrect.  Most of the rest of the evidence put forth as storm warnings merely reiterated this point.  Even the letter from the FDA took Merck to task not for relying on the naproxen hypothesis but for failing to give adequate attention to other explanations of the health effects of Vioxx.  In other words, plaintiffs knew in 2000 that the statement might be incorrect.  What they didn't know was whether the misrepresentation was deliberate.

The position puts plaintiffs in an untenable position and produces harmful results.  For one thing, one has to wonder whether a fraud suit brought against Merck without any evidence of actual falsity would have been dismissed (motions to dismiss toll discovery) and fees assessed under Rule 11.  In other words, there has to be some evidence that a lie was told before a suit can be filed.  See In re Ramada Inns Sec. Litigation, 550 F. Supp. 1127, 1134 (D. Del. 1982)("Nevertheless, Rule 11 would be stripped of any meaning if plaintiffs in situations like this were not required to articulate some rational basis for a belief that the defendants deliberately misled the market.").

In addition, the approach would require plaintiffs to file suit very quickly.  As soon as Merck for the first time contended that the health effects in the VIGOR study resulted from the naproxen hypothesis, the issue was lodged as to whether the Company honestly believed the statement or was deliberately misleading the market.  Under the reasoning of defendants and Judge Roth, the stop watch had begun to run almost at the outset.  Essentially, the position requires plaintiffs to sue within two years of the expression of any unsubstantiated assertion since the statement can always be motivated by proper or improper reasons.

For reasons that we will come to in later posts, it is actually inconsistent with the statutory framework to start the statute merely upon a showing of the "possibility" of fraud, at least where the "possibility" must be followed by an obligation to inquire.  Yet aside from that position, even the defendants concede that "possibility" of fraud requires some evidence of falsity.  As the cert brief notes:

• Until recently, courts following both approaches agreed that an investor's duty to investigate potential fraud is triggered when the investor knows, or has reason to know, that a representation on which it relied was false.

It is the evidence of falsity that plaintiffs allege is missing from the purported storm warnings put out by Merck.

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 19, 2009 (boomark / email).