Securities Regulations

Case Brief

Steinberg v. Cephalon, Inc., Civil Action No. 96CV-633

United States District Court for the Eastern District of Pennsylvania

This brief summarizes the civil action lawsuit Steinberg v. Cephalon, Inc., Civil Action No. 96CV-633, filed on October 18, 1996 in the United States District Court for the Eastern District of Pennsylvania and the related filings including the Motion to Dismiss filed in the same court, and the court’s Memorandum and Order regarding the motion filed on August 29, 1997.

Facts

The class action suit against Cephalon, Inc. (hereafter Cephalon or the Company) was brought on behalf of all persons or entities which purchased the common stock of Cephalon during the Class Period of June 1, 1995 through and including January 19, 1996. Cephalon’s drug, Myotrophin, a treatment for ALS (Lou Gehrig’s Disease) was in Phase III trials during this period. Cephalon made 22 public statements during the time period at issue. One example is the statement by Michael F. Murphy, M.D., Ph.D. who announced at a press conference that the “study demonstrated that [Myotrophin] had highly statistically significant effects on clinically important measurements for patients with ALS, for whom no approved therapies currently exist.” These public statements and the structure, protocol design and results of the Phase III study are all relevant to the issues in this case.

Issues

The central issue is whether or not Cephalon violated Section 10(b) of the Exchange Act and Rule 10(b)-5.

Plaintiffs argue: (1) that the defendants’ knowingly and recklessly made false and misleading representations as to the trial methods and results of Myotrophin; (2) resulting in an artificially inflated stock price during the period noted above; (3) that plaintiffs purchased the Company stock during the period at inflated prices; (4) and upon truthful disclosure of a proper analysis of the results of the studies; (5) stock prices depreciated; (6) causing plaintiffs to suffer economic injury.

Defendants argue: (1) that plaintiffs have not proffered any contemporaneous facts in support of its claim of fraud (i.e. the false and misleading representations for the purpose of stock price inflation); (2) that the facts used by plaintiff are insufficient to prove that defendants’ statements were false or misleading; (3) that FRCP 9(b) requires that any pleading with regard to misrepresentation must be made with particularity (e.g. time and place of misleading statements); (4) that plaintiffs failed to plead scienter, one of the requisite elements of a fraud claim of action; (5) that plaintiffs have not met the heightened pleading requirements under the Private Securities Litigation Reform Act of 1995; and (6) that if and upon dismissal of the Federal claim that supplemental jurisdiction over the plaintiffs state claim should not be exercised and the state claims dismissed pursuant to FRCP 12(b)(1) (lack of jurisdiction over the subject matter may be pleaded by motion).

A secondary issue is the inclusion of Frank Baldino (“Baldino”)(former President, CEO and Chairman of Cephalon) and Bruce Peacock (“Peacock”)(former COO and Director of Cephalon) as defendants subject to joint and several liability under the “control person liability” framework of the Exchange Act §20(a).

Plaintiffs argue: that as senior officers of the company, Baldino and Peacock (1) were in possession of material information “adverse” to public information about the clinical trials, testing and methods used by the corporation; (2) acted to conceal information about the trials, testing, methods and results; and (3) such information was material; and (4) concealing the information was in violation of their duties and responsibilities as “controlling persons”.

Defendants argue: that an Exchange Act §20(a) claim is only viable as a derivative claim and because the Exchange Act §10(b) or Rule 10b-5 claim should be dismissed, the Exchange Act §20(a) claim should also be dismissed. the defendant does not refute the facts establishing Baldino and Peacock as “controlling persons”.

Decision

The only opinion available in the case is the court’s decision on the defendants’ motion to dismiss. In its opinion, the court summarizes the pleading standard for a claim under Exchange Act §10(b) and Rule 10b-5. A plaintiff must plead: “(1) a false misrepresentation of (2) a material (3) fact, (4) the defendant’s knowledge of its falsity and his intention that the plaintiff rely an (sic) it, (5) the plaintiff’s reasonable reliance on the representation, and (6) the plaintiff’s resulting loss.” (citing Shapiro v. UJB Finan. Corp., 964 F.2d 272, 280 (3d Cir.), cert. denied, 506 U.S. 934 (1992)).

The court deals with the sufficiency and particularity of the facts asserted by the plaintiff in support of its claim of false misrepresentation. The court acknowledges that the Reform Act requires “some precision in alleging facts” but the court is careful to opine that this precision standard does not require the pleading of “all of the evidence and proof thereunder supporting a plaintiff’s claim.”

In interpreting the sufficiency of the pleading, the court construes the allegations by plaintiff as true and in the light most favorable to them (applying the standard for a motion to dismissH.J. Inc. v. Northwestern Bell Tel. Co., 492 U.S. 226, 249 (1989); Rocks v. City of Phila., 868 F.2d 644, 645 (3d Cir. 1989)). In doing so, this court finds that the 55 page consolidated class action complaint containing 109 paragraphs which set forth the time, place and manner of the defendants’ alleged misleading statements persuasive and rules that the plaintiffs have sufficiently plead to withstand the motion to dismiss.

The court disagrees with the defendants and finds that the complaint does in fact set forth contemporaneous facts. The court does not, however, address the defendants’ assertions regarding the pleading of scienter. It is unclear whether the court deliberately intended to omit any reference to the scienter argument or whether the scienter issue is addressed in language that simply defines the plaintiffs pleadings sufficient.

The court denies the defendants’ argument for dismissal of plaintiffs’ §20(a) claim because it is not dismissing the §10(b) claim.

Legal Rule

The legal rule applied by the court is Exchange Act §10(b) and Rule 10b-5. In the motion to dismiss, the court is asked to rule on questions pertaining only to the elements of the fraud claim (discussed below) even though other gating issues are incorporated in the plaintiffs claim. Those other issues relevant to Exchange Act §10(b) are whether there has been (1) the use of a manipulative or deceptive device or contrivance, (2) in connection with the purchase or sale of any security, (3) by any person connected with the transaction, and whether there is (4) proper jurisdiction arising out of the commerce clause (i.e. interstate commerce), and/or (5) proper venue in the federal court as prescribed by the Exchange Act §27 (exclusive jurisdiction of “violations of this Act [Exchange Act §10(b)] or the rules and regulations thereunder”).

The court is asked in the motion to dismiss to rule on the procedural limitations imposed by the Private Securities Litigation Reform Act of 1995 (“PSLRA”). The PSLRA is intended to discourage frivolous litigation and sets forth a number of standards for the pleadings. The court declines to read the PSLRA requirement for pleading misrepresentation with particularity to require the pleading of every fact in support of the asserted claim.

Underscoring the entire action are the elements of the fraud claim: (1) a false misrepresentation of (2) a material (3) fact, (4) the defendant’s knowledge of its falsity and his intention that the plaintiff rely on it, (5) the plaintiff’s reasonable reliance on the representation, and (6) the plaintiff’s resulting economic loss.

Analysis

The Plaintiffs’ case rests on the determination as to whether or not the statements and omissions by defendant regarding its disclosure of information pertaining to the Phase III clinical trial of Myotrophin were knowingly and recklessly false. That the information is material or fact and whether or not the plaintiffs reasonably relied on the information or suffered economic loss are not at issue in the case.

The Plaintiff thoroughly identifies numerous disclosures by defendants on the results of the clinical study. These disclosures can all be characterized as positive reports on the progress of the study, on the effectiveness of the dosing regimen, on the tolerability of the dosage in terms of reported side effects, on the novelty of the pharmaceutical approach, on the credibility of the study protocol and on the similarity of results between the North American and European studies.

The Plaintiffs then point to numerous disclosures, all subsequent to the disclosures described above that can be characterized as analyst criticism of the study design, FDA concerns about the study, and denial of requests to expand the study based on concerns about the trial data. Most importantly, Plaintiffs suggest, the Company failed to disclose the mortality statistics of the studies.

Defendants assert that in any FDA or scientific trial or study, there is bound to be scientific disputes as to the most appropriate methodology or the “best practices” and that these scientific debates cannot form the basis of a fraud claim. In essence, these debates highlight a difference of opinion.

Defendants further argue that the process of FDA approval and study design often involves the use of study methodologies that do not satisfy everyone and that the underperformance of a drug in trials should not be combined with the existence of a difference of opinion on methodology to create the basis of a claim.

In our opinion, the case should be decided on the basis of the materiality of the information that ran counter to the public disclosures by the Company. For example, that a particular doctor, even if he or she were the head of the Muscular Dystrophy Association would not be material because this individual is not acting with the authority to affect the viability of the study results (at least in the eyes of the FDA, although he or she may have significant influence in the physician universe that could ultimately affect prescribing habits).

On the other hand, the decision by the FDA to deny expansion of the trial on the grounds that it had concerns about the integrity of the study data and questions about the appropriateness of the study methodology would be material as the information is an insight into the FDA’s posture on the strength of the study results which influences its approval decision which has a definite affect upon the value of the firm.

Most persuasive to us is the omission of the data on the mortality rate in the study. When one of the side effects of a drug is “death,” the FDA, physician population, patient advocacy groups and the patients themselves take note. Evidence is proffered in the complaint and uncontested by the defendants, that the design of the study protocol required that patients who died during the study period were to be removed from the data set. This requirement alone assures that the Company knew of the number of deaths in the trial, knew or should have know the relative significance of the number or proportion of deaths and knew or should have known the negative impact of that information of the perception of the success or failure of the ongoing studies.

The numerous and consistent disclosures touting the positive results of the studies while concurrently obfuscating the negative data associated with the mortality rates is, in our opinion, an omission of material fact necessary to make its other disclosures non-misleading.

We feel that the other elements of the fraud action are present. Scienter, although not argued anywhere in the filings, seems present given the position of the individual defendants and their knowing omissions. Reliance is based on the fraud-on-the-market doctrine (reliance is presumed if the company’s shares were traded on an efficient market). Damages are clear if the result of the disclosures and omissions resulted in an inflated stock price which we feel is evident given the decline in stock price upon truthful and corrective disclosure highlighted in the complaint.

We would rule in favor of the Plaintiffs.

We would, however, shorten the Class Period which is currently defined as June 1, 1995 to January 19, 1996 to be defined as any person who purchased Cephalon common stock at any time from June 10, 1995 through and including January 19, 1996. June 10, 1995 is the date of the first disclosure of the results of the Phase III clinical trial in North America, at which time the company knew or should have known the significance of the mortality data.

Dear [students] –

I reviewed your “case brief” assignment, which summarized the litigation in Steinberg v. Cephalon, Inc (ED Pa 1996)

In general, you did a good job of laying out the case. The facts are nicely summarized. The issues, however, were not clear. What were the questions the court faced? And then in describing the court’s decision, it was unclear how it had resolved the issues to come to the ultimate conclusion the allegations were sufficient. (You were right to notice the importance of the court’s failure to address scienter - a glaring oversight.) Your analysis section begins with the issue: “whether defendants’ statements on the Phase III clinical trials of Myotophin were knowingly or recklessly false” - a perfect statement of the issue. The court held that these statements were actionable, not merely opinion, and that they were material misstatements. Although the defendants had pointed out the lack of scienter pleading, the court got lost in its opinion of materiality and falsehood.

Your analysis is top notch. You showed a good understanding of the important issues – from an investor’s perspective – and why they were material. You also showed a good sense for when a statement is a half-truth.

In evaluating your work, I considered the following factors:

4/5 – description of FACTS (nature of misrepresentation / summary of plaintiff’s claim)

4/5 – ISSUES presented (what questions did court have to answer / parties’ arguments)

4/5 – court’s RULING or holding (how court resolved issues / rule that court applied)

5/5 – court’s ANALYSIS holding (how court explained its ruling / statute, precedent, logic)

5/5 – your CONCLUSION (your evaluation of the case - the arguments, the result, the big picture)

23/25 – overall

I looked in particular for your understanding of US securities fraud litigation: What were the specific claims in the case? What arguments did the parties make? How did the court resolve the issues? How did the court explain itself? Were you convinced?

Alan Palmiter

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