Securities Snapshot
May 23, 2017

First Circuit Affirms Dismissal of Securities Fraud Class Action Based on Inadequate Confidential Witness Allegations

First Circuit affirms dismissal of securities fraud class action based on confidential witness allegations; Second Circuit affirms dismissal of derivative action for failure to make a pre-suit demand; Ninth Circuit affirms securities class action dismissal where omissions regarding FTC compliance did not render 10-K misleading; Massachusetts federal court dismisses putative shareholder class action for failure adequately to plead scienter; California federal court dismisses shareholder suit for failure to show tender offer recommendation was misleading; Delaware Chancery Court dismisses derivative lawsuit for failure to show demand on the board was excused.


In In re Biogen Inc. Sec. Litig., the First Circuit affirmed the dismissal of a putative securities fraud class action, concluding that the complaint’s confidential witness allegations failed adequately to plead scienter. The suit, which asserted claims under Sections 10(b) and 20(a) of the Securities Exchange Act, alleged that Biogen executives concealed the fact that the growth of a particular drug (Tecfidera) had halted in the wake of a patient's death, and included allegations attributed to twelve confidential witnesses, including former Biogen employees. Although the patient death was not conclusively linked to Tecfidera, the FDA subsequently added language about the case to Tecfidera's warning label in November 2014.  The First Circuit found that the complaint’s confidential witness statements – which alleged that Tecfidera sales had dropped steeply following the announcement of the patient death and that Biogen executives knew of the decline – failed to precisely describe the size of the sales decline or its cause. Furthermore, the court found that the confidential witness statements did not prove that Biogen and its executives knew that their disclosures regarding Tecfidera were misleading when made. The court concluded that that the confidential witness statements, which “[did] not speak with specificity as to why the defendants’ alleged misstatements were untrue or misleading” and were “very often made about events occurring after the defendants’ statements at issue,” were “so lacking in connecting detail that they cannot give rise to a strong inference of scienter.” In reaching this conclusion, the First Circuit noted that the company’s then-CEO and other executives named in the suit had increased their Biogen stock holdings during the relevant period, undermining the claim that they acted deceptively. The Biogen decision is likely to be a leading decision on the adequacy of confidential witness allegations in the First Circuit going forward.


In F5 Capital v. Pappas, the Second Circuit applied Delaware law to conclude that F5 Capital, an investment corporation, failed to allege sufficient facts to excuse it from making a pre-suit demand in a derivative action on behalf of Star Bulk Carriers Corporation concerning Star Bulk’s alleged self-dealing transactions with affiliated entities. The complaint included four causes of action: three were derivative in nature, while the fourth was purportedly a direct class action claim for wrongful equity dilution following a merger transaction. However, the appeals court found the fourth cause of action to be derivative as well, reasoning that Delaware law permits a direct equity-dilution claim only in “limited circumstances involving controlling shareholders” and requires all other claims against non-controlling shareholders be brought as derivative suits. Although F5 argued that certain affiliated entities amounted to a single controlling shareholder when their shares were aggregated, the appeals court found the entities did not satisfy the definition of a controlling shareholder under Delaware law because a mere “shared interest in the successful consummation of the transaction is not sufficient to aggregate” shares, and in any event the combined shares of the entities remained below 50% of the total equity of Star Bulk. Having concluded that the complaint asserted only derivative claims, the appeals court went on to address F5’s position that it was excused from making demand on the board before asserting those claims. The court analyzed all of F5’s demand futility allegations and affirmed that F5 failed to allege sufficient facts excusing it from making pre-suit demand by creating a reasonable doubt that either: (1) the directors were disinterested and independent, or (2) the challenged transaction was otherwise the product of a valid exercise of business judgment.


In Gray v. LifeLock, Inc., the Ninth Circuit affirmed dismissal of a putative securities class action lawsuit, concluding that LifeLock’s alleged omissions regarding its compliance with an FTC settlement order did not render any of its disclosures misleading. The plaintiffs asserted claims against LifeLock and certain members of its senior management under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934, alleging that LifeLock’s Form 10-K was false and misleading when measured against its compliance with the order. In particular, Plaintiffs argued that because a deliberate company practice – “throttling” alerts to certain customers in order to reduce the strain placed on call centers – was not disclosed in the 10-K, the omission rendered LifeLock’s opinion that it was in compliance with the order misleading. In affirming the dismissal, the court noted that the Form 10-K’s reference to “our compliance” with the order was not misleading because it did not create an affirmative impression that LifeLock was actually in compliance with the order. Specifically, citing Ominicare, Inc. v. Laborers District Council Construction Industry Pension Fund, 135 S. Ct. 1318 (2015), the court concluded that LifeLock’s statement of belief regarding its “compliance” with the order was neither a statement of fact nor an actionable opinion. Moreover, LifeLock’s warning in the 10-K that the FTC and other regulatory agencies might open an investigation into its compliance with the order and other cautionary language in the Form 10-K meant that the statement about compliance would not be “misleading to a reasonable person reading the statement fairly and in context.” The Ninth Circuit therefore found that the facts allegedly omitted from the 10-K were immaterial, as a matter of law, and affirmed the district court’s dismissal of the action.


In Harrington v. Tetraphase Pharm. Inc., the District of Massachusetts granted a motion to dismiss a putative shareholder class action on grounds that the facts as alleged were insufficient to plead scienter. Plaintiffs had alleged that Tetraphase and three individual defendants (all members of Tetraphase senior management) had violated the Securities Exchange Act of 1934. In September 2015, Tetraphase had announced that the pivotal portion of its new synthetic tetracycline drug was not as effective as hoped. After the announcement, Tetraphase’s stock price dropped by 80% – a $1.3 billion loss. Plaintiffs alleged that the individual defendants, who had made large trades of Tetraphase stock under their 10b5-1 trading plans, knew that the drug they were testing would fail long before that information was released to the public – at least as early as April 2015. Judge Leo T. Sorokin dismissed the action, finding that the plaintiffs had failed adequately to plead scienter. The decision analyzed numerous bases on which plaintiffs attempted to demonstrate scienter. For example, the court found that there was nothing in the complaint indicating that Tetraphase had any idea of adverse results prior to May 6, 2015, and that a company statement made at that time aligned with the release date of the results. Furthermore, the court declined to find that the individual defendants’ trading activities demonstrated scienter. The court found that because Plaintiffs had failed to demonstrate that the fraudulent scheme began prior to the implementation of the 10b5-1 plans, which were established on March 13, 2015, the trading pursuant to the plans failed to support an inference of scienter. Finally, the court found that plaintiffs’ suggestion that Tetraphase concocted a scheme in order to maintain its rights to the drug was logically inconsistent with their allegation that defendants simultaneously knew it would prove to be ineffective and could not support the required inference of scienter.


In Manger v. Leapfrog Enterprises, Inc., a federal district court in the Northern District of California dismissed a shareholder derivative suit alleging that the LeapFrog board of directors had issued a false and misleading recommendation to LeapFrog shareholders in connection with a tender offer by VTech. In 2016, LeapFrog entered into a merger agreement and issued a statement recommending the VTech tender offer to its shareholders. In the recommendation, LeapFrog claimed to have a liquidity problem, among other financial issues. The plaintiff asserted claims under Section 14(e) of the Securities Exchange Act of 1934, alleging that the recommendation was false and misleading because LeapFrog was in stable financial form, had no debt obligations, and had access to a credit facility. The court dismissed the case, finding that the plaintiff “ha[d] not identified anything potentially false or misleading in the Recommendation Statement regarding the liquidity statements.” Judge William H. Orrick found that the plaintiff’s “real complaint” was that the directors had pushed one tender offer over another, “[b]ut [that] this case is not about the Board making wrong or imprudent business decisions. [This] case is about a false or misleading Recommendation Statement. That the Board made bad decisions either prior to or after the Statement was released does not mean the Recommendation Statement was false or misleading.” Therefore, because the plaintiff had failed to adequately plead the elements of his Section 14(e) claim (despite three amendments), the court dismissed the suit with prejudice.


In Ryan v. Armstrong, the Delaware Chancery Court dismissed a shareholder derivative lawsuit alleging breaches of fiduciary duty by the directors of The Williams Companies, Inc., concluding that the plaintiff had failed to show that pre-suit demand on the board was excused. The claims related to a decision by Williams to terminate an acquisition agreement (so that it could pursue another ultimately unsuccessful transaction), which caused Williams to pay a break-up fee of $410 million, as well as other expenses. The plaintiff asserted a single claim for breach of the duty of loyalty. The court did not address the merits of the breach of loyalty claim, instead finding that the derivative suit failed to allege specific facts indicating that the Williams directors were incapable of fairly assessing a demand because of the possibility that they could be held personally liable for the alleged breaches. The court found that the “complaint is bare of the type of director-specific pleading that would imply the risk of liability is substantial . . . . [T]he [c]omplaint lacks specific pleadings that, if true, create a reasonable doubt that a substantial likelihood of liability would cause a majority of directors to face liability, disabling their exercise of business judgment and excusing demand.” In particular, the complaint was “silent as to the individual directors’ motivations, interests and actions beyond its broad conclusory allegations.” On these grounds, the court found that demand under Delaware Court of Chancery Rule 23.1 was not excused and dismissed the derivative action in its entirety.