First Circuit: Active Risk Disclosures Only Required for "Grand Canyon"-Sized Problems
In a recent First Circuit decision, Karth v. Keryx Biopharmaceuticals, Inc., the renal biopharmaceutical company Keryx scored a win while raising the bar for investors hoping to prove securities fraud based on inadequate risk disclosures.
The Boston-based company produces a single product, a drug called Auryxia, used to treat kidney disease. For all steps of the manufacturing process, Keryx used third-party contractors.
Issues In the Manufacturing Chain
In 2013, Keryx released a Form 10-Q, a comprehensive financial performance report required quarterly by the Securities Exchange Commission. In that report, Keryx warned investors of its reliance on third-party manufacturers, saying:
"If these third parties do not successfully manufacture and test our drug candidate, our business will be harmed."
2014 and 2015 brought quality control and production issues, leading Keryx to disclose in 2016 that "[i]f any of our suppliers were to limit or terminate production, or otherwise fail to meet the quality or delivery requirements needed...we could experience a loss of revenue which could materially and adversely impact our results of operations."
In early 2016, Keryx modified its risk disclosures and stated (for the first time) that it depended on a single supply source for Auryxia. Tim Karth purchased his Keryx stock in July 2016, shortly before the company issued a press release addressing an "imminent" supply interruption due to production issues.
In August 2016, the company's stock value plummeted by 36 percent. Karth filed a class action in the federal District of Massachusetts alleging violations of Section 10(b) of the Securities Exchange Act. He asserted that Keryx's disclosures, while accurate, understated the risk of relying on the contractor in light of repeated and then-undisclosed production issues. Karth later sought to amend his complaint, but Keryx opposed the motion, and the district court denied it. Karth appealed to the First Circuit.
First Circuit Finds a Ditch, Not a Canyon
The case's procedural history is extensive, but the First Circuit was tasked with answering only one question: Did the company give investors sufficient warning about the vulnerability of its manufacturing capabilities?
The short answer was "yes." However, Karth likely suffered the consequences of being stuck with his original complaint. The court pointed out that he had not pleaded a supply interruption had actually occurred by the time of disclosure or that Keryx had a “widely-accepted certainty of failure" leading up to the disclosures.
The circuit court compared disclosure violations under the SEA to warning a hiker about what dangers lie ahead. If a company understands a given risk has a "near certainty" of causing "financial disaster," this risk is comparable to a hiker approaching the Grand Canyon. The company cannot downplay the risk by telling the hiker that "a mere ditch lies up ahead."
The court reasoned that absent “widely-accepted certainty of failure" or a “comprehensive cover-up," the situation is only as risky as a "mere ditch." The company may describe it in hypothetical or speculative terms—even the risk later materializes.
Applying this standard to Keryx, the panel found the situation did not amount to a "Grand Canyon." Although the company experienced some production issues before the disclosures, they were not frequent or serious enough to affect their supply. Furthermore, the company did not realize until well after the disclosures that the production situation was becoming serious enough to lead to an imminent supply interruption.
Future corporate defendants may have difficulty matching their facts to Karth, but the holding does set a high bar for securities fraud claims based on inadequate disclosures. The implication is that where a company uses "meaningful cautionary language," this decision may shield it from liability. However, it is unclear at which point the line from "mere possibility" crosses to "near certainty" and at which point the level of anticipated harm is considered "serious" enough to warrant a more detailed disclosure.
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