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NASAA Defends Ninth Circuit's Ruling on Pleading Scienter

By Jim Hamilton

The North American Securities Administrators Association (NASAA) has asked the U.S. Supreme Court to uphold a recent ruling of the Ninth Circuit Court of Appeals regarding the requirements for pleading scienter in securities fraud actions. Filing a joint amicus brief with AARP in the case of Matrixx Initiatives, Inc. v. Siracusano, NASAA urged the high court to affirm the Ninth Circuit's holding that the actions of the defendant issuer, a pharmaceutical company, gave rise to a strong inference of scienter, or intent to deceive, manipulate or defraud. NASAA argued that allegations in the complaint that the defendants were aware of anecdotal and scientific evidence raising questions about links between a nasal gel manufactured by the company and a loss of users' sense of smell were sufficiently particularized to satisfy the pleading standard for securities fraud. In NASAA's view, the assertion that the defendants sought to hide or refute this evidence with deliberate recklessness was at least as compelling as any plausible nonculpable explanation, thereby satisfying the pleading requirements for scienter set forth by the high court in Tellabs, Inc. v. Makor Issues & Rights, Ltd.

In NASAA's view, an analysis of evident inferences would present a picture that the defendants were on notice about consumer complaints of users of the nasal gel developing a loss of sense of smell, or anosmia, for several years prior to the filing of the suit. Although the company's own scientists could not disprove the existence of the link between the product and anosmia, the company refused to commission additional outside research. Then, in reacting to widespread media coverage of a link, the company issued intentionally misleading press releases that falsely implied to readers that two prior studies had tested for anosmia and returned negative results. Finally, the company's discussion of potential product liability litigation risks in its Form 10-Q filings with the SEC omitted the significant fact that an anosmia-related lawsuit had already been filed against the company.

NASAA argued that the Ninth Circuit properly applied the high court's ruling in Tellabs because, after a careful analysis of all factual allegations, the Ninth Circuit concluded that the complaint as a whole created a strong inference that the defendants acted with scienter in failing to disclose evidence of the link between the nasal gel and anosmia. The Ninth Circuit's opinion had stated that the inference of scienter was "cogent and at least as compelling" as any "plausible nonculpable explanation," reasoning that withholding reports of adverse effects of and lawsuits concerning the product responsible for the company's remarkable sales increase was "an extreme departure from the standards of ordinary care" and presented a "danger of misleading buyers or sellers." NASAA contended that, contrary to the defendants' argument, a court is not required to determine which inference is the "most cogent." Rather, Tellabs requires a court to look to whether the scienter inference is just as compelling as competing inferences. In NASAA's view, the Ninth Circuit's opinion emphasized this balance by considering the defendants' actions during the class period as a whole and determining that a strong, cogent, compelling inference of scienter existed.

NASAA also argued that the complaint supported a finding of a strong inference of scienter where SEC rules establishing a duty of disclosure were violated. The defendants contended that, under SEC reporting rules, the company was not required to report in Form 10-Q an existing lawsuit against the defendants until the following quarter. NASAA asserted, however, that the company's filing of Form 10-Q violated a significant body of case law that assigns a duty to speak completely on a subject once it has been addressed. The company engaged in an active deception, therefore, when it alluded to potential lawsuits in its SEC filings, but failed to speak honestly and completely about the subject matter, NASAA argued. Even though the company was not necessarily under an obligation to discuss the effect on its business of a product liability lawsuit, NASAA stated, once it did speak on the subject, it opened the door to an obligation to say more, namely, to reveal that such a lawsuit had been filed against the company.

Full post as published by Jim Hamilton's World of Securities Regulation on December 08, 2010 (boomark / email).