If at First You Don't Succeed: Fourth Circuit Revives Securities Fraud Claims

By Don Tucker, Cliff Brinson and Isaac Linnartz

The Fourth Circuit recently revived securities fraud claims against a pharmaceutical company, holding that the allegations that the company acted with wrongful intent were sufficient to proceed even under the heightened pleading standards of the Private Securities Litigation Reform Act (PSLRA). 

In Zak v. Chelsea Therapeutics International, Ltd., No. 13-2370 (4th Cir. March 16, 2015), the plaintiffs brought securities fraud claims against Chelsea Therapeutics based on its statements and omissions concerning the likelihood of FDA approval for its new drug, Northera. According to the complaint, Chelsea made public statements about the success of one efficacy study of Northera and said that the FDA had agreed that it could submit its new drug application based on that one successful study. At the same time, Chelsea failed to disclose the FDA’s warnings that at least two successful efficacy studies would likely be expected before it would approve the drug and also failed to disclose the fact that an FDA briefing document recommended against approval of Northera. 

The district court, applying the heightened pleading standards for securities fraud claims under the PSLRA, concluded that the plaintiffs failed to allege facts sufficient to show that Chelsea acted with scienter—that is, intent to deceive. On appeal, the Fourth Circuit disagreed. First, the court held that the district court erred in considering certain documents that were filed with the Securities and Exchange Commission (SEC) in deciding the motion to dismiss for failure to state a claim. The court explained that on a motion to dismiss, documents outside the complaint may generally only be considered when those documents are integral to and explicitly relied upon in the complaint and the plaintiffs do not challenge their authenticity. In dismissing the plaintiffs’ claims, the district court relied on SEC filings that were not referenced in the complaint to conclude that none of the individual defendants sold Chelsea stock during the relevant period. The Fourth Circuit held that the district court had no basis to consider these SEC filings, since the filings were not referenced in the complaint and there were no allegations of unusual stock sales. 

Second, the court held that the plaintiffs had sufficiently alleged that Chelsea acted with the requisite wrongful intent. Specifically, the court concluded that the plaintiffs had pled facts permitting a strong inference of scienter in alleging that Chelsea failed to disclose critical information about the weakness of its new drug application. In reaching this conclusion, the court considered the alleged omissions in the context of Chelsea’s public statements, reiterating that a company can control what information it must disclose based on the affirmative representations it makes. In other words, a company’s duty to disclose information depends on the context created by its other affirmative statements to the market. 

The Fourth Circuit’s decision in Zak identifies significant limitations on when a court may consider SEC filings on a motion to dismiss. Furthermore, according to the dissenting opinion, the case marks the first time since passage of the PSLRA that the Fourth Circuit has overturned a district court decision dismissing a case for failure to plead scienter. The case thus provides a rare and compelling example of the type of allegations that can survive the PSLRA’s heightened pleading standards for securities fraud claims.