On Aug. 13, a panel of the U.S. Court of Appeals for the Ninth Circuit issued an opinion in a securities fraud class action, Khoja v. Orexigen Therapeutics, No. 16-56069 2018 U.S. App. LEXIS 22371 (9th Cir. Aug. 13, 2018), which could dampen a defendant's use of judicial notice and incorporation-by-reference to aid in its motion to dismiss, especially in the securities class action setting.

For private securities class actions under the Private Securities Litigation Reform Act (PSLRA), the pleading standard is heightened, see Tellabs v. Makor Issues & Rights, 551 U.S. 308, 313 (2007). The PSLRA requires that plaintiffs “specify each statement alleged to have been misleading, the reason or reasons why the statement is misleading, and, if an allegation regarding the statement or omission is made on information and belief, the complaint shall state with particularity all facts on which that belief is formed.” Additionally, plaintiffs must “state with particularity facts giving rise to a strong inference that the defendant acted intentionally or recklessly,” 15 U.S.C. Section 78u-4.

For a motion to dismiss, the court generally may not consider material outside the complaint when assessing the sufficiency of the complaint at the pleadings stage. Courts have routinely noted two exceptions to this limitation—judicial notice and incorporation-by-reference.

In its decision, the Ninth Circuit affirmed in part and reversed in part the district court's dismissal of a proposed securities fraud class action. The panel held that a district court could take judicial notice of matters of public record without converting a motion to dismiss into a motion for summary judgment. However, the panel admonished that a district court cannot take judicial notice of disputed facts. The panel laid out the rules of the road for the use of judicial notice and incorporation-by-reference in the Ninth Circuit.

Use of Judicial Notice and Incorporation-By-Reference

Due to the heightened pleading standards of the PSLRA, plaintiffs' securities class action complaints alleging misrepresentations or omissions typically include countless paragraphs of excerpted statements taken from transcripts of investor calls or filings with the Securities and Exchange Commission. But rarely are those documents actually attached to the complaint. For years, defendants have supported their motions to dismiss by attaching these publicly available documents in order provide the court with a more complete picture than the alleged facts pleaded by plaintiffs. See e.g., Wolfe v. Aspenbio Pharma, 2012 WL 4040344 (D. Colo. Sept. 13, 2012); Carlucci v. Han, 2012 WL 3242618 (E.D. Va. Aug. 7, 2012); In re XenoPort Securities Litigation, 2011 WL 6153134 (N.D. Cal. Dec. 12, 2011); In re MBIA Securities Litigation, 700 F. Supp. 2d 566 (S.D.N.Y. 2010).

Specifically, in Keeney v. Larkin, the court considered on a motion to dismiss a number of documents, including securities analyst reports, that were offered to show that the market was aware of the exact information that plaintiffs alleged was not sufficiently disclosed, 306 F. Supp. 2d 522, 532 (D. Md. 2003), aff'd, 102 Fed. Appx. 787 (4th Cir. 2004). The plaintiffs alleged that defendants issued press releases and other public statements which falsely represented that the company had successfully integrated the operations of its many acquired companies. The defendants offered numerous public documents directly to the contrary in support of their motion to dismiss. The court held that it could consider documents not attached to the complaint if there were incorporated by reference or otherwise integral to the complaint. In so doing, the court held that the market was aware that the company may not be integrated. The court stated that analyst reports are part of the total mix of information available to the market and ultimately granted defendants' motion to dismiss with prejudice.

These types of documents have typically been introduced at the motion to dismiss phase by either an incorporation-by-reference theory or by judicial notice. Incorporation-by-reference is a judicially created doctrine that treats certain documents referenced in the complaint as if those documents were part of the complaint. This prevents plaintiffs from cherry-picking parts of documents and allows defendants to provide the court with the full picture or even with contrary facts. This permits a court to view and use the documents during the motion to dismiss phase, without converting the motion into one for summary judgment. Under Federal Rule of Evidence 201, a court may take judicial notice of a fact that is not subject to reasonable dispute because it: is generally known within the trial court's territorial jurisdiction; or can be accurately and readily determined from sources whose accuracy cannot reasonably be questioned.

The District Court's Decision

In Khoja, plaintiffs are a putative class of investors in Orexigen Therapeutics, Inc., a small biotechnology firm that develops obesity drugs. The drug in question was in the middle of a clinical study when the company, in the context of an SEC filing in March 2015 describing a patent application, improperly disclosed partial results of that study showing a positive clinical effect. The day before the revelation, the stock closed at $5.79 per share. After the revelation, the stock actively traded, peaking at $9.37 per share, and closing at $7.64 per share. Weeks later, in response to the improper disclosure of the partial results, the study was halted by the supervising committee. The halting of the study was not initially made public by the company. In May, over a month after the study was halted, the company filed a Form 8-K and its quarterly Form 10-Q. The Form 8-K mentioned the study and the Form 10-Q warned that additional information may produce negative or inconclusive results. However, neither document disclosed that the study had already been halted. At the same time as the SEC filings, the company hosted a conference call with securities analysts in which it discussed the study, but did not disclose that it had been halted. Four days later, the doctor in charge of the study issued a statement warning that the disclosure of the results was premature and the study had been halted.

A class action complaint was filed against the company and certain executives in August 2015. The complaint referenced the company's SEC filings, along with several partial quotes from the conference call with securities analysts. The quotes referenced the study and whether any changes to the results would be publicly available. The complaint alleged three counts of securities fraud. Count I alleged violations of Sections 10(b) of the Securities Exchange Act, 17 C.F.R. Section 240.10b-5, against the company and individually named executives. Count II alleged a fraudulent scheme under Section 10b-5(a) and (c). Count III was solely against the individual defendants for control person liability under § 20(a) of the Securities Exchange Act, 15 U.S.C. Section 78t.

The defendants moved to dismiss the complaint. In support of the motion, the defendants simultaneously moved the court to take judicial notice of or alternatively treat 22 documents as incorporated-by-reference. The district court granted the motion for all but one of the documents. Utilizing statements in the documents, the district court granted the motion to dismiss and ultimately dismissed the two claims under Count I with prejudice and granted leave to amend the other counts. The plaintiffs then requested that judgment be entered so they could pursue an immediate appeal.

The Ninth Circuit Decision

The three-judge panel (Robert E. Payne, U.S. District Judge for the Eastern District of Virginia sat by designation) stated that generally district courts may not consider materials outside the complaint when ruling on a motion to dismiss under Rule 12(b)(6). The two exceptions are the incorporation-by-reference doctrine and judicial notice. But the court noted “a concerning pattern in securities cases like this one: exploiting these procedures improperly to defeat what would otherwise constitute adequately stated claims at the pleading stage.”

The panel then discussed what it believes to be the proper use of judicial notice and incorporation-by-reference. The panel warned that a court may take judicial notice of facts “not subject to reasonable dispute,” but could not take judicial notice of disputed facts. For instance, a district court can properly take judicial notice of a transcript from an investor call, but the panel warned that the district court must go further and “identify” which particular facts it is noticing from the transcript. The panel determined that the district court below abused its discretion by failing to identify in its opinion which facts it judicially noticed from the transcript.

The defendants sought to use the transcript to demonstrate that investors were already told that another study would be used to assess the drug's capabilities. This fact would be used to negate plaintiffs' claim of misrepresentations regarding the halted study. However, upon closer inspection of the transcript, the panel determined it was “unclear” what exactly had been previously disclosed to investors about the halted study. The panel found the transcript open to varying interpretations and thus improper for judicial notice and impermissible to refute plaintiffs' allegations.

The panel then evaluated the district court's judicial notice of an European agency report. Again, the panel recognized the propriety of judicially noticing agency reports. However, the panel found reasonable dispute as to what exactly the report established. Therefore, the panel concluded that the district court abused its discretion by taking judicial notice of the report and inferring that its publication negated plaintiffs' scheme liability theory.

The panel then analyzed when it is proper for a district court to permit a document to be noticed for incorporation-by-reference. Incorporation-by-reference is generally used to incorporate a document from which a plaintiff may have cherry picked favorable facts and deliberately omitted portions of the document that weaken or even negate the claims. According to the panel, the plaintiff must “extensively” refer to the document. In the Ninth Circuit, that means more than the mere mentioning of the document. The more difficult analysis focuses on when the document itself “forms the basis of the plaintiff's claim.” The panel warned that, if the document merely creates a defense to well-pleaded allegations, the document does not form the basis of the complaint. The panel noted that incorporation-by-reference was designed to prevent artful pleading by plaintiffs but is not a tool for defendants to short-circuit the resolution of a well pleaded claim.

From this context, the panel analyzed several different documents the district court utilized to determine whether they were properly incorporated-by-reference. The panel agreed with some of the district court's rulings (blog post, analyst reports, Forbes articles, Form S-8 Registration Statement, FDA agency report), and disagreed with others (a different blog post, SEC Form 10-K, SEC filing requesting executive compensation, agency press release, and a patent file history). The court determined that these latter documents were either not referenced at all, or not sufficiently referenced to meet the standard for incorporation-by-reference.

Once the panel clarified the proper use for judicial notice and incorporation-by-reference it then determined which rulings by the district court were proper. The panel affirmed in part, and reversed in part, the district court's dismissal of the complaint, and remanded with instructions regarding the judicial notice and incorporation-by-reference of defendants' exhibits to its motion to dismiss. As to Counts I and II, the panel affirmed the district court's dismissal, but permitted leave to amend. As to Count III, the panel reversed and instructed the district court to reconsider those claims in light of the panel's decision and in light of the amendments to the complaint.

Implications

Post-PSLRA, motion to dismiss practice in securities litigation has taken on a rhythm distinct from motion to dismiss practice in other types of cases. In order to meet the heightened pleading requirements of the PSLRA, the plaintiffs will typically quote extensively, but often selectively, from a company's SEC filings, analyst calls, and analyst reports. To counter-balance the selectivity of the averments in the complaint, defendants in their motion to dismiss have typically asked the court to take judicial notice of or incorporate-by-reference information in publicly available documents to provide context to or outright negate the plaintiff's averments. This is consistent with the fraud-on-the-market doctrine endorsed in Basic Inc. v. Levinson, 485 U.S. 224 (1988), which recognizes that publicly available information is quickly reflected in the price of a security trading in an efficient market. When a district court has a complete set of publicly available information before it, it then has an appropriate record on which to rule on the motion to dismiss.

While the court in Khoja pays lip service to a district court's ability to use judicial notice and incorporation-by-reference to supplement the record in deciding motions to dismiss in securities class actions, the decision appears to reflect a greater hostility to the use of these doctrines than had previously been the case. The court went out of its way to state:

“The overuse and improper application of judicial notice and the incorporation-by-reference doctrine, however, can lead to unintended and harmful results. The defendants face an alluring temptation to pile on numerous documents to their motions to dismiss to undermine the complaint, and hopefully dismiss the case at an early stage.”

The same can be said about plaintiffs' “alluring temptation” to selectively and misleadingly excerpt documents and transcripts in the complaint in order to state a claim. The district courts are in the best position to determine which documents should be the subject of judicial notice or incorporation-by-reference in deciding a securities class action motion to dismiss. Any decision limiting the discretion of the district courts in this regard will undermine the balance between plaintiffs' pleading practices and defendants' motion to dismiss arguments that has heretofore existed in securities litigation under the PSLRA.

It is yet to be seen whether other circuits will follow the rules of the road the Ninth Circuit presented in Khoja v. Orexigen Therapeutics. If they do, it will likely change the balance of outcomes with respect to securities litigation motions to dismiss. It will also be interesting to see if this case, or another similarly decided, becomes the subject of U.S. Supreme Court review. The Supreme Court in recent years has often disagreed with the decisions of the Ninth Circuit.

Robert L. Hickok is a partner in the trial and dispute resolution practice group of Pepper Hamilton. Contact him at 215-981-4583 or [email protected].

Jay A. Dubow is a partner in the white collar litigation and investigations practice group and is co-chair of the securities and financial services enforcement group. Contact him at 215-981-4713 or [email protected].

Matthew D. Foster is a senior attorney in the trial and dispute resolution practice group of Pepper Hamilton. Contact him at 202-220-1235 or [email protected].