Securities fraud litigators view a recent decision from the 1st U.S. Circuit Court of Appeals as reducing the odds of investors being able to recover on claims that a company violated federal law by failing to disclose known risks to the value of the stock they purchased.
In Karth v. Keryx Biopharmaceuticals, a three-judge panel upheld a lower court judgment that, in effect, dismissed a putative class action brought by an investor who saw the value of his stock plummet shortly after he bought it in 2016.
According to the plaintiff, the defendant biopharmaceutical company violated federal securities law by failing to sufficiently warn investors of a serious risk to the availability of the company’s only product, the kidney disease drug Auryxia. That supply vulnerability arose from the fact that a critical step in the manufacturing process depended on a single manufacturer.
But the court in Karth concluded that the plaintiff could not proceed with a claim to recover from investment losses triggered by interruption in the supply of Auryxia when the key manufacturer suffered severe production problems.
More specifically, the court found that certain curative disclosures had remedied any misstatements of fact by the company in its original filings. Further, the 1st Circuit panel found the risk of a supply interruption was not so acute that it made the defendant’s public statements and alleged omissions false or misleading in violation of Section 10(b) of the Securities Exchange Act and Securities Exchange Commission Rule 10b-5.
“A risk disclosure is not fraudulent simply because a company makes reasonable assumptions that, in retrospect, prove incorrect,” Judge O. Rogeriee Thompson wrote for the panel.
The decision in Karth forecloses investor claims in the 1st Circuit premised on so-called “fraud by hindsight,” according to Boston attorney Laurence A. Schoen, who represented defendant Keryx Biopharmaceuticals in the case.
“If the court hadn’t ruled as it did, it would have set up an impossible standard for companies to meet,” Schoen said. “This was a classic attempted ‘fraud by hindsight’ claim that the court properly rejected.”
Schoen pointed to the court’s recognition that a company is not required to be “omniscient” in terms of assessing risk. That principle applied in Karth, he said, because his client had no way of knowing that what was first reported as an “isolated” production stoppage on the part of its key manufacturer would become a six-week shutdown that would later disrupt the supply of Auryxia and cause Keryx’s stock prices to tumble.
“If management has to immediately disclose events before their significance is known, then stock prices are going to have wild fluctuations and companies are going to be in an impossible position where they have to try to predict the future.”
— Laurence A. Schoen, lawyer for defendant biopharma co.
“It would set an unfair burden on companies [to require disclosure] the second you might have an issue but before you know how substantial it is,” Schoen said. “If management has to immediately disclose events before their significance is known, then stock prices are going to have wild fluctuations and companies are going to be in an impossible position where they have to try to predict the future.”
But the attorney for the plaintiff in Karth, Jeffrey C. Block, said the 1st Circuit decision curbs investor rights and remedies to a degree not permitted in other circuits.
“For people who invest within the 1st Circuit, I don’t think investors really get a full picture of what is going on in a company because they can really hide behind a generic risk disclosure,” the Boston lawyer said.
In light of Karth, 1st Circuit law on investment risk disclosure is “very different” from the law in other circuits, Block said.
“What the 1st Circuit seems to be saying is, ‘Until it actually hurts you, really you don’t have to say anything,’” he said. “In other circuits — like the 9th Circuit and the 2nd Circuit — you have to disclose that you are having problems, that [problems] are actually happening, [even though] there hasn’t been an impact yet.”
But Christian R. Jenner, a complex business litigator in Providence, Rhode Island, doesn’t see the 1st Circuit as an outlier on the investment risk disclosure issue.
“Nothing I read in the case exposes any daylight between the 1st Circuit statement of the rule and other courts of appeal,” Jenner said.
Instead, Jenner views 1st Circuit precedent as echoing the precedent in other circuits and giving effect to the heightened pleading standards under the Private Securities Litigation Reform Act.
As observed by the court in Karth, Congress enacted the PSLRA in 1995 to provide a mechanism for weeding out flawed or frivolous claims. To that end, the statute requires a plaintiff to “specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, [and to] state with particularity facts giving rise to a strong inference that the defendant acted with the required state of mind.”
Section 10(b) of the Securities Exchange Act makes it unlawful for any person to “use or employ, in connection with the purchase or sale of any security … any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe.”
In that regard, under SEC Rule 10b-5, it is unlawful to “make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, in the light of the circumstances under which they were made, not misleading.”
Applying this statutory and regulatory framework, the court in Karth relied on two prior 1st Circuit decisions: 2011’s Hill v. Gozani and 2016’s Tutor Perini Corp. v. Banc of America Securities LLC.
In Hill, the court affirmed the dismissal of an investor lawsuit alleging a medical device company failed to sufficiently warn investors of valid concerns that insurance companies would stop reimbursing physicians for the use of its product.
The Tutor Perini court ruled that a broker-dealer could not hide behind generic disclosures when pitching the purchase of auction-rate securities while knowing that that market was heading for a collapse.
According to Schoen, Tutor Perini is distinguishable from his client’s case in that the broker-dealer in Tutor Perini had a clear understanding that the investments at issue would fail and was trying to unload its own holdings in such investments for that very reason at the same time it was selling them to the plaintiff.
“Karth makes it extremely difficult, if not almost impossible, to sue a company for not telling investors the truth about not only the risk facing the company but what really is happening in a company — that things really aren’t going as well as they are portraying.”
— Jeffrey C. Block
But Block sees the court in Karth as reconciling Hill and Tutor Perini in a manner detrimental to the interests of investors.
“Karth makes it extremely difficult, if not almost impossible, to sue a company for not telling investors the truth about not only the risk facing the company but what really is happening in a company — that things really aren’t going as well as they are portraying,” Block said.
But according to Jenner, the 1st Circuit in Karth “faithfully” applied its prior precedent.
“It certainly breaks new ground in the sense that it applies principles of law to a new set of allegations and new facts [revealed] in discovery. But the court doesn’t purport to, nor does it in fact, abrogate any 1st Circuit precedent,” Jenner said.
‘Grand Canyon’ or ‘ditch’?
According to Jenner, one indication that the 1st Circuit has fallen in line with other circuits is its reliance on the “Grand Canyon metaphor” from the 2nd Circuit to resolve the ultimate question of whether a company’s risk disclosures sufficiently advised investors of potentially negative outcomes.
The Grand Canyon metaphor was formulated in a 1996 U.S. District Court decision from the Southern District of New York, In re Prudential Securities Inc. Limited Partnerships Litigation.
Applying the metaphor, an investment risk akin to the Grand Canyon renders a company’s disclosure misleading if it frames the risk as merely hypothetical.
“A securities fraud defendant is at the edge of the Grand Canyon where the alleged risk had a ‘near certainty’ of causing ‘financial disaster’ to the company,” Thompson wrote in Karth.
In contrast, Thompson said, liability for nondisclosure of a particular risk doesn’t attach when “a defendant company is merely approaching a ditch where, internally, there was no ‘widely-accepted certainty of failure’ or ‘comprehensive cover-up.’”
Jenner sees ambiguity in the Grand Canyon analogy that future courts will have to consider and resolve on a case-by-case basis.
“When Thelma and Louise are approaching the precipice, at what point would not disclosing their intentions be securities fraud under 1st Circuit precedent? It’s tough to say,” Jenner says. “In the movie, we have a clear statement of intent when they link up hands and press the gas pedal to the floor. But nobody is going to write that in [an SEC]10-K [report].”
Gauging duty of disclosure
Jenner said he foresees internal debate in company boardrooms as well as a focus in future litigation on whether investment risks qualify as Grand Canyons that trigger disclosure requirements or ditches that do not.
“Risk manifests itself in a number of different ways,” Jenner said. “There’s going to be analysis of the various components of risks. There’s upside risk and there’s downside risk. And it’s not just the risk itself. It’s also the company’s understanding of how that risk plays out.”
But Schoen said Karth provides clear guidance on the question of risk.
“The court makes clear that as long as you disclose this general category of risk and disclose what the implications could be, that’s where your obligation is,” Schoen said. “Until the risk either materializes or gets to the point of a near certainty, you don’t have a duty to disclose anything more.”
Block said he can see the question of disclosing investment risk playing out in a wide variety of ways. He pointed to the debate among securities attorneys concerning at what point Apple would have had an obligation to disclose Steve Jobs’ pancreatic cancer had he not done so himself in 2004 (Jobs died from the disease in 2011).
“Perhaps not when it was first diagnosed, but at some point when it started impacting his ability to be directly involved in the company, investors [had a right to know] because he was such an important figure for Apple,” Block said.