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Merck: Difference Between Mutual Fund and Direct Investor Crucial in Resolving Motion to Dismiss
In Re Merck & Co., Inc. Securities, Derivative & "Erisa" Litigation
Posted: 08/14/2007
By: Josh Lawler, Esq.
Introduction
In this case, the court considers whether there is a difference between a mutual fund investor and a direct investor in determining whether or not a securities action should be dismissed for failing to heed a storm warning.
Detailed Commentary
BACKGROUND
This securities fraud class action alleged misrepresentations and omissions made by the defendants about the safety profile of their prescription drug VIOXX. Plaintiffs alleged that the defendants concealed information that suggested or demonstrated that VIOXX significantly increased the risk of heart attack or other cardiovascular event and made misleading statements about the drug’s safety. Plaintiffs, who purchased Merck securities, alleged that they bought the securities at prices that were artificially inflated due to defendants’ fraud. The earliest securities fraud complaint was filed on November 6, 2003.
Cause of Action Accrues Upon Inquiry Notice
Noting that Third Circuit jurisprudence required it to apply an “inquiry notice” standard in determining when plaintiffs’ securities fraud claims should have accrued, the court declared that plaintiffs need not have actual knowledge or know all of the details of the alleged fraud to trigger the limitations period. “Rather, inquiry notice exists when the plaintiffs discovered, or in the exercise of reasonable diligence should have discovered the general fraudulent scheme. It is at that point that the clock starts to run on the limitations period.”
The inquiry notice analysis, according to the court, is an objective one. The court must evaluate whether sufficient information of wrongdoing or “storm warnings” of culpable activity existed such that a “reasonable investor of ordinary intelligence would have discovered the information and recognized it as a storm warning.”
Storm warnings, wrote the court, may include “any financial, legal or other data that would alert a reasonable person to the probability that misleading statements or significant omissions had been made.” Once storm warnings give rise to inquiry notice and trigger the limitations period, plaintiffs have an obligation to investigate the basis for their claims. The court must charge them with constructive knowledge of all information discoverable through diligent research during that period.
DIRECT INVESTORS AND MUTUAL FUND INVESTORS ARE NOT EXPECTED TO RECOGNIZE STORM WARNINGS IDENTICALLY
Of particular relevance to this case is the Benak court’s acknowledgment of the difference between a direct investor and a mutual fund investor. In particular, for the purposes of the inquiry notice analysis, the court observed that whereas an investor who invests directly in a company would be charged with keeping abreast of information about the company, including its performance and possible troubles, a mutual fund investor stands in a disadvantaged position in terms of identifying information probative of problems affecting his or her investments.
The reason for the disadvantage is two-fold. First, a fund investor reasonably passes the responsibility for maintaining consistent knowledge of the condition of different companies on to the fund. Second, a fund investor may have little idea at any one time in what securities his or her money is invested. Contrasting the treatment of a direct investor and a mutual fund investor in the inquiry notice analysis, the court reasoned as follows:
Underneath the inquiry notice analysis made by the court was the assumption that a plaintiff either was or should have been able, in the exercise of reasonable diligence, to file an adequate securities fraud complaint as of an earlier date. According to the court, in the case of a direct investor—who one would assume has or can be deemed to have consistent knowledge of his or her securities holdings—the storm warning analysis becomes relatively simple. Upon reading news reports regarding the financial woes of a particular company and speculation regarding the management of that company, a direct investor immediately has reason for concern.
Moreover, in being responsible for his or her own investments, a direct investor has greater motivation—and therefore, one would assume, be more likely—to stay informed. Upon receiving such information and inquiring further regarding the accuracy of that information, a direct investor—again, knowing the amount and nature of his or her holdings—could file suit almost immediately.
If a defendant succeeds in establishing inquiry notice, the burden then shifts to the plaintiffs to demonstrate that they were unable to discover their injuries despite the exercise of reasonable due diligence. In other words, the plaintiffs must show that they undertook their duty to investigate the basis for their claims but nevertheless failed to discover information necessary to initiate a securities fraud action. Choosing not to investigate, however, is not a viable option, even in spite of protestations by plaintiffs that any efforts to acquire relevant information would have been difficult or fruitless. “[I]f storm warnings existed, and the plaintiffs choose not to investigate, we will deem them on inquiry notice of their claims.”
COURT HELD THAT THE TWO-YEAR STATUTE OF LIMITATIONS EXPIRED
In holding that the two-year limitation has expired, the court said the September 17, 2001 Warning Letter issued by the Food and Drug Administration against the drug did not exist in a vacuum, since months leading up to its issuance there were news publications already assailing the company for downplaying the possibility of an increased risk of heart attack with the use of the drug.
Words of Comfort Cannot Reasonably Be Relied Upon by Plaintiffs
As an added dampener for those waiting out for the ripe conditions when to file an action, the court said that it could not recognize a company’s reassurances about the safety of its product, done as an afterthought after all the negative publicity had already come out, in order to thwart an impending dismissal. An investor may not reasonably rely on words of comfort from management “when there are direct contradictions between the defendants’ representations and the other materials available to plaintiffs regarding the possibility of fraud.”
The In re Merck case is an application of the legal tenets laid down in Benak.
The difference though is that while the Benak case was decided under the Securities Exchange Act of 1934 which prescribes a one-year period from the time of discovery of the facts or three years from the time of violation within which the securities fraud action should be filed, in In Re Merck the rule that was applied regarding the period for initiating the suit was the one that was laid down in the Sarbanes-Oxley Act of 2002 which extended the time of limitation to two years from discovery or five years from the time of violation.
What is likewise significant about this case, another feature that sets it apart from the Benak case, is the court’s holding that assurances made by the company regarding its product generally can not be used as a shield to defeat the statute of limitations.
The instant case, therefore, makes it quite difficult to initiate an action for securities fraud against a company, as it set stricter standards or rules as to when the statute of limitation should accrue to prevent such an action to succeed.
The author, Josh Lawler, Esq., is a partner of Zuber & Taillieu LLP, specializing in corporate and securities transactions.
Law Summary
Read the related Law summary: In re Merck & Co., Inc. Securities, Derivative & “Erisa” Litigation
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