Narrowly construing the judicial notice rule in Federal Rule of Evidence 201 and the judicial doctrine of incorporation-by-reference, a federal appellate court in Khoja v. Orexigen Therapeutics, Inc. reversed a district court’s dismissal of a securities fraud action.
The circuit court determined that the district court improperly considered documents outside the plaintiff’s complaint in granting dismissal. Given the heightened pleading requirement in securities fraud actions, some ABA Section of Litigation leaders believe Khoja may be a step too far.
Disclosure of Test Results Impacts Market
The defendant, a biotechnology company, developed an obesity drug that the Food and Drug Administration (FDA) required be tested and studied. Once 25 percent of a predetermined amount of patient obesity risk was found, an interim analysis would determine whether the drug would impact obese patients more so than a placebo. The FDA oversaw the testing and required that the results of the study remain confidential. The defendant leaked the result of the study, however, when it applied for a patent on the drug with the U.S. Patent and Trademark Office and requested the patent application be published. The defendant also filed a Form 8-K and Form 10-Q with the Securities Exchange Commission, which again disclosed the 25 percent interim test results.
Financial analysts responded positively to the disclosure of the test results, and the defendant’s stock price surged. Subsequently, a newspaper quoted the FDA as stating that the interim results were “unreliable” and “likely false.” The defendant’s stock price then plummeted, and the plaintiff filed a securities class action lawsuit in the U.S. District Court for the Southern District of California.
The plaintiff was an investor in the defendant who represented a class of similarly-situated investors. He alleged three violations of securities laws based on public statements made or omitted by the defendant in news releases, investor call transcripts, and public filings relating to the 25 percent interim test results. The district court granted the defendant’s motion to dismiss for failure to state a claim based, in part, on documents that were not part of the plaintiff’s complaint.
No Judicial Notice of Disputed Facts
The U.S. Court of Appeals for the Ninth Circuit observed that matters outside a pleading typically convert a motion to dismiss into a motion for summary judgment, save for two circumstances: the incorporation-by-reference doctrine and judicial notice under Rule 201. The district court had taken judicial notice of, or incorporated-by-reference, 21 separate documents. Citing Tellabs, Inc. v. Makor Issues & Rights, Ltd., the Ninth Circuit observed a “concerning pattern” by defendants in securities fraud actions to defeat an otherwise well-plead complaint by relying on extraneous documents.
According to the court, overuse of the rule and doctrine “can lead to unintended and harmful results.” Noting that a court may take judicial notice of public records, the Ninth Circuit observed that the rule does not apply to “disputed facts” in such documents. Because the district court did not specify the facts it judicially noticed in certain public documents, the court reversed as to those public documents.
For some Section of Litigation leaders, the Ninth Circuit’s rejection of extraneous documents in evaluating a motion to dismiss is incompatible with a plaintiff’s pleading requirements in securities litigation. “The Ninth Circuit got it wrong. The holding cannot be reconciled with Tellabs’s mandate to consider context in the evaluation of whether a securities complaint has adequately pleaded scienter. And under the Rules Enabling Act, the Private Securities Litigation Reform Act—as interpreted in Tellabs—cannot be abridged by a procedural rule,” says Patrick F. Linehan, Washington, D.C., cochair of the White Collar Subcommittee of the Section’s Securities Litigation Committee.
One important factor is the distinction between the information reflected in a particular document and the document itself. “The court seemed to confuse the requirement that judicially noticed information be beyond reasonable dispute with the question of whether differing inferences could be drawn from that information,” says Blanca F. Young, San Francisco, CA, former cochair of the Section’s Trial Evidence Committee. “The court seems to blur these distinct questions together, finding that it was an abuse of discretion for the district court to take judicial notice of a transcript where the statements made during the call were open to different interpretations,” opines Young.
A court’s willingness and ability to consider documents outside the pleadings may also depend on whether those documents have been otherwise challenged or questioned. “Absent some highly publicized event or pending government investigation, courts are more willing to consider documents that are immune from dispute on a 12(b)(6) motion,” says Linehan.
Incorporation by Reference Requires Extensive Reference or Reliance
The Ninth Circuit observed that the incorporation-by-reference doctrine allows courts to treat documents referenced or relied on “extensively” by a plaintiff in its complaint as if incorporated in the complaint itself. Accordingly, the court reversed the district court’s inclusion and reliance on documents that were not “extensively” referenced or relied on by the plaintiff. “Although one might be tempted to construe the court’s decision as hostile to the notion of appending documents to a motion to dismiss, I think that is a gross mischaracterization,” says Helen B. Kim, Los Angeles, CA, former cochair of the Section’s Securities Litigation Committee. “Defendants simply have to be more careful about what documents they are seeking to have incorporated by reference, and for what purpose,” Kim explains.
Kelso L. Anderson is an associate editor for Litigation News.
Hashtags: #incorporationbyreference #motiontodismiss #judicialnotice
- Andrew J. Kennedy, “Court Eases Requirement to Plead Securities Fraud Claim,” Sec. Lit. Comm. Practice Points (Feb. 18, 2015).
- Sean T. Carnathan, “Fraud-on-the-Market Theory Questioned,” Lit. News (Jun. 27, 2017).
- Erin L. Palmer, “Ninth Circuit Applies Heightened Pleading for Securities Fraud,” Lit. News (Oct. 24, 2017).
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