(Article from Securities Law Alert, October 2016)
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On October 3, 2016, the First Circuit affirmed dismissal of a securities fraud action alleging that Vertex Pharmaceuticals and several of its executives “turned a blind eye” to “study results that seemed too good to be true” in order to reap “a windfall on the sale of their stock.” Local No. 8 IBEW Ret. Plan & Trust v. Vertex Pharmaceuticals, 2016 WL 5682548 (1st Cir. 2016) (Kayatta, J.). The First Circuit found no allegations to support plaintiffs’ contention that defendants knowingly or recklessly “announced interim results that overstated the improvement in lung function” of patients taking an experimental drug combination for the treatment of cystic fibrosis.
Plaintiffs’ Allegations Failed to Raise a Strong Inference of Scienter
The First Circuit noted that “Vertex’s public description” of its interim clinical study results allegedly “contained an error that made unexpectedly good results look even better than they were.” However, the court found the inference that Vertex knowingly or recklessly published the inaccurate study results was not “strong enough to equal the alternative inference that Vertex was negligent in viewing very good results as being even better than they in fact were.”
Interim Study Results Were Neither Implausible Nor Obviously Wrong
With respect to plaintiffs’ contention that Vertex itself described the study results as “unexpected,” the First Circuit explained that “many studies of new pharmaceutical products result in surprises, both good and bad.” The court reasoned that “Vertex made the investment necessary to design and perform a study testing” the experimental drug combination because the company “must have thought that positive results were possible, even if not probable.”
As to plaintiffs’ claim that “it was obvious that there was something wrong with the [interim] results,” the First Circuit found no allegations “that scientists in general, much less those at Vertex, regarded the interim results as implausible.” The court also noted that plaintiffs did “not allege that anybody at Vertex responsible for receiving, reviewing, and reporting the results had actually spotted the error in the interpretation of the results before the discovery that led to” Vertex’s announcement of corrected study results.
The First Circuit rejected plaintiffs’ argument that it would be “‘absurd’ to suggest that [d]efendants were not aware of the suspect nature of the results” given the importance of the study to the company. The court stated that “the importance of a particular item can support an inference that the defendant is paying close attention to that item.” However, the court explained that “[s]uch an inference . . . is only helpful in establishing scienter if that close attention would have revealed an incongruity so glaring as to make the need for further inquiry obvious.” Here, the court found no allegation of “such an obvious incongruity” between the expected interim results and the reported interim results.
The First Circuit found similarly meritless plaintiffs’ contention that defendants should have cross-checked the interim results against the raw data, which allegedly would have uncovered the error in question. The court found the complaint’s allegations “insufficient to establish that the erroneously interpreted end results . . . were themselves so obviously suspect that [the court could] draw a strong inference that the defendants were reckless in failing to consult the raw data themselves for verification.” The court further noted that plaintiffs pointed to no “legal requirement, or any undertaking by Vertex, that obligated the company to double-check the interim results before announcing them.”
Defendants Had No Financial Motive to Report Overstated Interim Results
The First Circuit also “considered” and rejected plaintiffs’ theory that “defendants had a financial motive to ‘turn[] a blind eye’ to the erroneous interpretation of the interim results because of the stock price spike precipitated by the error.” First, the court observed that Vertex’s CEO did not sell any stock during the class period, and found the CEO had “no motive to ignore an error that was obvious and that would therefore soon become known.” The court explained that “[a]nnouncing good results on such a study would have been clearly better for Vertex than announcing great results only to reduce them to good by shortly thereafter confessing error, thereby harming the company’s credibility and its reputation for competence.”
As to the allegation that five Vertex employees “sold almost $32 million worth of stock following release of the overstated interim results,” the First Circuit stated that “insider trading in suspicious amounts or at suspicious times may be probative of scienter.” In this case, however, the court observed that neither the current CEO nor the company’s former CEO who now serves on the board of directors allegedly “engage[d] in any inconsistent trading behavior during the class period.” The court found that in order “to regard the stock sales as either motive for the fraud or evidence of the defendants’ knowledge that the interim study results had been misinterpreted,” it would have to “hypothesize either that the error was obvious only to those defendants who made unprecedented sales, or that it was obvious to all, yet the company’s current and former CEOs nevertheless went along with announcing obviously flawed results.” The court explained that the complaint “offers no fact suggesting that the sellers knew more than the nonsellers.”
The First Circuit found that there was “a simple alternative explanation” for the insiders’ stock sales. Following announcement of the interim results, Vertex’s stock price “suddenly jumped a large amount” following “a long period of steady or dropping stock prices.” The court reasoned that “[s]uch an increase—no matter what its cause—creates a substantial incentive for holders to sell unless they believe the price will continue to rise and are willing to wait.”
The court concluded that plaintiffs’ allegations did “not paint the required strong inference of scienter,” and affirmed dismissal of plaintiffs’ complaint.