On Friday, in Cozzarelli v. Inspire Pharma. Inc.
, the Fourth Circuit rejected a securities fraud action. This is an important case on pleading requirements and the application of Tellabs, Inc. v. Makor Issues & Rights, Ltd.
, 127 S.Ct. 2499 (2007). Judge Wilkinson wrote the opinion for the Court.
Plaintiffs filed a class action complaint on behalf of purchasers of a pharmaceutical company's stock. They alleged that the company and three of its directors committed securities fraud, in violation of Section 10(b) of the Securities Exchange Act of 1934 and Rule 10b-5, by overstating the prospects for an experimental drug the company was developing. They also brought claims under the Securities Act of 1933 by contending that defendants made false or misleading statements in prospectuses.
I. Claims Under '34 Act
With respect to the fraud claims under the '34 Act, the Court stressed the exacting pleading requirements of the Private Securities Litigation Reform Act of 1995 (PSLRA
), in particular the scienter
requirement, which the Court confirmed is exceedingly difficult to satisfy through circumstantial allegations. Relying on Tellabs
, the Fourth Circuit emphasized that an inference of scienter
must be "compelling" and "powerful." And an inference of scienter
can be compelling and powerful only "when it is weighted against the opposing inferences that may be drawn from the facts in their entirety." When the facts as a whole more plausibly suggest that the defendant acted innocently or negligently rather than with intent or severe recklessness, the action must be dismissed.
The Court chided plaintiffs for stringing together in their complaint a series of isolated allegations divorced from context, including snippets from analyst reports that plaintiffs didn't attach to their complaint. Rejecting plaintiffs' argument that the Court should rely solely on the complaint's discrete allegations, the Court looked beyond the complaint to consider in full these reports. These reports allowed an inference supporting an innocent intent; that inference, the Court held, was more powerful than a competing inference that defendants acted with a nefarious intent.
In addressing plaintiffs' allegation that defendants had a motive to lie because the company needed to raise money to fund its operations, the Fourth Circuit held that "a strong inference of fraud does not arise merely from seeking capital to support a risky venture." "Indeed," the Court added, "the motivations to raise capital or increase one's own compensation are common to every company and thus add little to an inference of fraud." "If we inferred scienter
from every bullish statement by a pharmaceutical company that was trying to raise funds, we would choke off the lifeblood of innovation
in medicine by fueling frivolous litigation," the Court added.
The Court also rejected plaintiffs' contention that the defendant-directors' sales of stock supported an inference of scienter
. Those sales, the Court held, were not unusual or suspicious in light of the total number of shares and vested stock options held by defendants (information the Court obtained from SEC filings): the directors sold 13%, 12%, and 3% of their holdings, respectively.
II. Claims Under '33 Act
With respect to the separate claims for false or misleading
prospectuses under Sections 11 and 12(a)(2) of the '33 Act, the Court held that these claims are governed by FRCP
9(b)'s requirement that fraud must be pleaded with particularity, even though these claims aren't fraud claims. Sections 11 and 12(a)(2) prohibit materially false statements or omissions in prospectuses, without requiring proof of scienter
. Plaintiffs thus argued that those claims aren't fraud claims governed by Rule 9(b), but the Court disagreed. "Although claims under Rule 9(b) and 12(a)(2) may not have fraud as an element, Rule 9(b) refers to 'alleging fraud,' not to causes of action or elements of fraud," the Court observed. "When a plaintiff makes an allegation that has the substance of fraud, therefore, he cannot escape
the requirements of Rule 9(b) by adding a superficial label of negligence of strict liability."
Plaintiffs argued that Rule 9(b) shouldn't apply because the complaint "expressly exclude[s] and disclaim[s] any allegation that could be construed as alleging fraud" with respect to the '33 Act claims. The Fourth Circuit disagreed: "a conclusory
disclaimer cannot alter the substance of plaintiffs' allegations, which sound in fraud."
Applying Rule 9(b), the Court held that plaintiffs failed to plead with particularity how the statements in the prospectuses were false or misleading, and therefore the claims had to be dismissed. And the Court held that the district court didn't abuse its discretion in denying plaintiffs an opportunity to amend the complaint to plead with more particularity, in part because plaintiffs didn't move below for leave to amend but instead dropped a footnote in their district court brief contending that if their complaint is deficient they should be permitted to amend.