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April 2010

U.S. Supreme Court Holds That The Time For Filing A Securities Fraud Lawsuit Does Not Begin Running Until Plaintiffs Have Actual Knowledge Of Defendant's Intent To Mislead Investors

Merck & Co., Inc. v. Reynolds, (No. 08-905)

In Merck & Co., Inc. v. Reynolds, the United States Supreme Court clarified the application of the two year statute of limitations for securities fraud lawsuits, holding that the limitations period in 28 U.S.C. §1658(b)(1) begins to run when a plaintiff actually discovers, or with reasonable diligence should have discovered, the facts constituting the violation. The Court affirmed the Third Circuit's reversal of the District Court, which had held that the limitations period begins to run when a plaintiff is put on notice of a potential violation.

The lawsuit arose when certain investors learned that Merck & Co. allegedly knowingly misrepresented to investors the heart-attack risks associated with the drug Vioxx. On November 6, 2003 the plaintiff investors filed a securities fraud action under §10(b) of the Securities Exchange Act of 1934 based on the alleged misrepresentations. Under 28 U.S.C. §1658(b), a securities fraud claim is timely if filed no more than "2 years after the discovery of the facts constituting the violation" or "5 years after such violation."

Based on this statute, the District Court dismissed the complaint as untimely, holding that the plaintiffs failed to undertake a reasonably diligent investigation after they were alerted to the possibility of Merck's misrepresentations prior to November 2001. The District Court reasoned that several circumstances should have placed the plaintiffs on notice of the alleged misrepresentations, including:

  1. A March 2000 "VIGOR" study comparing Vioxx with the painkiller naproxen, showing adverse cardiovascular results for Vioxx, and showing Merck's "Naproxen Hypothesis" which suggested that the results were due to Naproxen's failures rather than Vioxx's;

  2. An FDA warning letter, released to the public on September 21, 2001, saying that Merck's Vioxx marketing with regard to the cardiovascular results was "false, lacking in fair balance, or otherwise misleading"; and

  3. Pleadings filed in products liability actions in September and October 2001 alleging that Merck had concealed information about Vioxx and intentionally downplayed its risks.

The Third Circuit reversed, holding that the circumstances described above did not suggest that Merck acted with scienter or intent to deceive, an element of a §10(b) violation, and therefore these events did not trigger the running of the limitations period. The U.S. Supreme Court granted certiorari.

The Supreme Court unanimously affirmed the Third Circuit's holding, and held that the statute of limitations had not run and that the plaintiff investors' securities fraud claim could proceed in federal court. The Court analyzed the legislative intent of §1658, and held that the limitations period in §1658(b)(1) begins to run once a plaintiff actually discovers or a reasonably diligent plaintiff would have "discover[ed] the facts constituting the violation" — whichever comes first. In a securities fraud action, the "facts constituting the violation" include facts showing that the defendant had scienter, or intent to mislead. The Court distinguished between facts sufficient only to place plaintiffs on "inquiry notice" of potential violations and actual discovery of facts "constituting the violation." The limitations period, the Court held, does not begin at the time when plaintiffs become aware of facts that may have prompted a reasonably diligent investigation, but when the plaintiffs thereafter actually discover, or should with reasonable diligence have discovered, the facts constituting the violation. Indeed, holding that the limitations period begins to run in the former scenario would force plaintiffs to file a lawsuit without specific facts to support the allegations, which would be impermissible under the special heightened pleading requirements for fraud complaints. See 15 U.S.C. §78u–4(b)(2). The Court reasoned that it would frustrate the very purpose of the discovery rule codified in §1658(b)(1) if the limitations period began to run regardless of whether a plaintiff had actually discovered facts suggesting scienter.

The Court held that the facts set forth above were not "facts constituting the violation." First, the FDA's September 2001 warning letter showed little or nothing about whether Merck had fraudulent intent in putting forth the Naproxen Hypothesis. Indeed, the FDA itself described the hypothesis as a "possible explanation" for the VIGOR results, faulting Merck only for failing sufficiently to publicize the less favorable alternative, that Vioxx might be harmful. Finally, the products liability complaints made only general statements about Merck's state of mind.

Because the plaintiffs did not actually discover "facts constituting the violation," and Merck failed to show that they should have discovered such facts with reasonable diligence, before November 6, 2001, the plaintiffs' complaint was timely.

While the impact of the Supreme Court's decision will only be determined over time, investor plaintiffs will likely argue that it affords them additional time to formulate allegations and claims against the companies in which they have invested. Corporations, in turn, will argue that not much has changed and class claims are still barred if not filed within two years of actual discovery of (or the time at which plaintiffs with reasonable diligence should have discovered) facts amounting to a securities violation. What remains clear is that each case will have to be determined on its own specific facts.

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