Conditional Optimism or Securities Fraud? Appellate Court Affirms Dismissal of Class Action against Biopharmaceutical Company; Shows Importance of Communicating Adequate Caveats to Balance Optimistic Statements and Factual Omissions in Order to Avoid Finding of Scienter under Rule 10b-5

On August 22, 2017, the United States Court of Appeals for the First Circuit (the “Court”) affirmed the dismissal of a securities fraud class action against Sarepta Therapeutics, Inc. (the “Company”), a biopharmaceutical company focused on the discovery and development of therapies for the treatment of rare neuromuscular diseases, such as Duchenne muscular dystrophy (“DMD”), and certain of its current and former officers, that asserted violations of Section 10(b) and 20(a) of the Securities Exchange Act of 1934, as amended (the “Exchange Act”), and Rule 10b-5 enacted thereunder.

The complaint alleged that the Company and its officers deceived investors with their overly optimistic expectations regarding approval from the U.S. Food and Drug Administration (the “FDA”) of the Company’s lead product candidate, eteplirsen, a drug designed for the treatment of DMD. Specifically, the plaintiffs claim that the Company’s communications with investors were “misleadingly rosy” and failed to adequately disclose the likelihood, or lack thereof, that the FDA would accept the Company’s new drug application (“NDA”) for eteplirsen, as the FDA had initially expressed concerns regarding the Company’s analysis of its trial data.

After reviewing additional information from the Company about its trial data, the FDA indicated that it was “open to considering an NDA,” subject to certain conditions. The Company then issued a press release and held a conference call with investors regarding this development, noting that it was “very encouraged by the FDA feedback.” The Company continued to make statements that its progress with the FDA was “a tremendous achievement” and the “type of information that every company hopes for.”

In its de novo review of the lower court’s decision, the Court noted that the Company’s statements regarding its communications with the FDA were “opinion more than fact” and were “replete with caveats.” According to the Court, such caveats (for example, that the FDA needed additional information regarding the Company’s trial data and that the FDA did not offer any assurances that the Company’s NDA would be accepted), negate the inference of scienter, a necessary element of a securities fraud claim under Rule 10b-5. At most, the Court noted, the Company was too optimistic and underemphasized, perhaps negligently, the reservations of the FDA regarding the Company’s NDA.

The Court offered a few additional insights regarding an inference of scienter which, in a broad sense, are helpful for public biopharmaceutical companies navigating the FDA-approval process.

  • Simple or excusable negligence is insufficient. A company must consciously intend to defraud or act with a high degree of recklessness. 
  • A company should provide investors with adequate warnings regarding communications with the FDA, but is not obligated to keep the public apprised of every detail of such communication. 
  • Optimistic predictions about the future that prove to be off target are immunized unless plaintiffs demonstrate intentional deception. 
  • Pointing to omitted details and failing to explain how those details render a company’s disclosure misleading is insufficient to prove an intentional or reckless omission of material facts. 
  • A company’s need for essential funding and its officers’ desire to improve financial results is not strong evidence of motive that supports an inference of scienter.

AGG Observations and Recommendations

  1. Note that the Court, in dicta, mused that the defendants’ actions might have been more in line with a claim of negligence. As a result, issuers should be aware that disclosures in registration statements that are similar to those made by the Company and that are subject to potential liability under Section 11 of the Securities Act of 1933, as amended (the “Act”) (which generally calls for strict liability with respect to material misstatements or omissions in registration statements), could result in a finding of liability unless appropriate disclosure of all relevant material facts is made. 
  2. All circuit courts have held that recklessness satisfies the scienter requirement of a securities fraud claim under Rule 10b-5. Some require some degree of intentional or conscious misconduct while others have found scienter in cases of extreme recklessness. Inclusion of appropriate caveats and risk factors can potentially rebut allegations of scienter. 
  3. Although not relevant in the Sarepta Therapeutics litigation (presumably because the misstatements and omissions alleged involved both historical factual information as well as forward-looking statements), public issuers should always remember that, in a securities fraud action, “forward-looking statements” are protected by the safe harbor provided in the Private Securities Litigation Reform Act of 1995 (the “Reform Act”) if such statements are, among other things, identified as such and accompanied by meaningful cautionary statements identifying important factors that could cause actual results to differ materially from those in the forward-looking statement. Tailored – and not boilerplate – cautionary language is necessary for forward-looking statements to be protected under the Reform Act, but if the requirements of that Act are met, defendants will not be liable in a securities fraud claim under Rule 10b-5 unless the plaintiff is able to prove that the defendant had actual knowledge that the statements were false or misleading.