On July 2, 2024, the United States Court of Appeals for the First Circuit affirmed the dismissal with prejudice of a putative class action asserting claims under the Securities Exchange Act of 1934 against a biotechnology company, its CEO, and its Chief Development Officer ("CDO"). Quinones v. Frequency Therapeutics, Inc., —F.4th—, 2024 WL 3275030 (1st Cir. 2024). Plaintiffs alleged the company made misrepresentations regarding clinical trials for the company's treatment for severe sensorineural hearing loss. The district court determined that plaintiffs' amended complaint adequately alleged certain misstatements but failed to demonstrate that those statements were made with the required degree of scienter, and on that basis dismissed the amended complaint. The First Circuit affirmed both rulings.
The Court explained that the alleged misstatements concerned the design of the company's Phase 2a clinical trial for its hearing loss treatment, and the company's alleged awareness that individuals with tinnitus, who believed without basis that the treatment could help them, could attempt to "fake their way into the study" by deliberately failing an initial word-recognition test needed to be included in the Phase 2a trial. Id. at *1–2. The Court agreed with the district court that the company's statements representing that all Phase 2a trial participants had "meaningful word recognition deficits" were adequately alleged to be false, based on a confidential witness statement that multiple patients were enrolled in the Phase 2a trial without meeting the eligibility criteria because they "fak[ed] being deaf." Id. at *3.
As to scienter, the Court first addressed the complaint's confidential witness allegations that clinicians had told the company's CDO of certain Phase 2a trial participants who reported being unable to hear certain sounds at the beginning of the study but said they could hear them at the end of the study. The Court noted that this allegation failed to state when that information was conveyed and did not explain why the information should have been concerning, given that clinicians could not have known in a double-blind study if the participants received a placebo or the real treatment, and reports of improved hearing would not have been inherently suspicious if participants received the real treatment. Id.
The Court further emphasized that the confidential witness offered no facts showing that defendants knew of the study results prior to the January 2021 investor presentation containing the challenged statements, and the Court rejected plaintiffs' assertion that the CDO must have known about online posts on a tinnitus-related website regarding eligibility criteria for the company's trial merely because he appeared on a podcast in July 2020 that was associated with the website. Id. at *4. Moreover, the Court noted that while the confidential witness helped oversee the Phase 2a trial and allegedly worked "hand-in-hand" with the CDO, there was no allegation that the witness ever said anything to the CDO about any concerns. Id.
The Court also rejected plaintiffs' theory of scienter based on alleged stock sales by the company's CEO. The Court held that these sales did not give rise to an inference of scienter because plaintiffs alleged only that the CDO, not the CEO, had knowledge of the flaws in the Phase 2a study, and there was no allegation of suspicious stock trading by the CDO. The Court explained that "'unusual sales by one insider do not give rise to a strong inference of scienter' when other insiders ha[ve] not engaged in suspicious trading during the class period." Id. The Court also observed that while the CEO allegedly sold 15% of his shares in the company, he also received additional shares during the same period and kept the vast majority of his holdings, which the Court concluded in its totality was insufficient to establish an inference of scienter. Id.
In addition, the Court rejected plaintiffs' argument under the so-called "core operations" doctrine that defendants must have been aware of problems with the Phase 2a study due to the treatment's importance to the company. While the Court agreed that it was reasonable to assume that senior management paid attention to information they received about the clinical trial and "would have been curious to know the results," that alone did not provide a basis to infer that defendants received contrary information "within the narrow timeframes at issue." Id. at *4–5. The Court emphasized that none of the confidential witness allegations specified whether supposed discrepancies were reported before the alleged misrepresentations were made. Id.
Ultimately, while plaintiffs urged the Court to view each factual allegation as "a brushstroke" that may form a compelling portrait of scienter when viewed in the aggregate, the Court cautioned that "plaintiffs cannot amalgamate a series of sketchy brushstrokes and call it a van Gogh." Id.
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