Opinion ID: 203247
Heading Depth: 3
Heading Rank: 1

Heading: Manufacturing Change

Text: Plaintiff alleges that defendants failed to disclose information about the manufacturing change prior to July 2, 2004, and this information was material. The primary motive alleged for the delay is that defendants wanted to build up inventory before announcing product recalls. Under the requirements of section 10(b) and Rule 10b-5, plaintiff must demonstrate both that the defendants omitted material information and that they did so with the requisite scienter. Securities actions raise questions of what corporate managers knew and when they knew it. These issues are pertinent both to materiality and to scienter. Moreover, something may be material because of other information or explanations that have been given by defendants. Thus plaintiff does not need to rely on a theory that there was an independent duty to disclose the manufacturing change. Further, we do not reach the district court's reasoning on the materiality, standing alone, of either manufacturing changes or the receipt of FDA major deficiency letters. The existence of a material omission is usually a question for the trier of fact. See ACA Fin., 512 F.3d at 65 (citing Shaw v. Digital Equip. Corp., 82 F.3d 1194, 1217 (1st Cir.1996)). In this case, we cannot say that as a matter of law the complaint fails to raise a reasonable inference that this was a material omission. The company's own statements draw a connection between the manufacturing change and the resolution of the balloon non-deflation problems, whether or not the earlier product had a defect. Indeed, Boston Scientific's Form 10-Q for the quarter ending June 30, 2004 included the following statements: As a result of its investigation, the Company has implemented reviews of its manufacturing process, additional inspections, and an FDA-approved modification to the manufacturing process for [TAXUS and Express2 stents]. The Company believes these measures will be effective in reducing the occurrence of balloon non-deflation. Because the manufacturing change, in combination with other changes, would have the effect of reducing balloon non-deflation, a jury could find that the company's continuing assertions that reported problems about TAXUS in the United States resulted from doctor unfamiliarity with the product rather than any defect in the product were misleading unless accompanied by disclosure of the manufacturing change and its connection to the balloon non-deflation problem. See Cabletron, 311 F.3d at 36. Among other things, the existence of this manufacturing change was pertinent to the issue of potential recalls, and it would raise the question whether, if there were continuing problems or recalls, the company would have on hand sufficient new products incorporating the manufacturing change in order to allow the company to replace the original TAXUS stents and maintain market share. Assuming that a jury could find a material omission, the next requirement under section 10(b) and Rule 10b-5 is that defendants acted with the requisite scienter in not disclosing the manufacturing change sooner, i.e., prior to the first recall announced on July 2, 2004. Knowingly omitting material information is probative, although not determinative, of scienter. Aldridge, 284 F.3d at 83 ([T]he fact that the defendants published statements when they knew facts suggesting the statements were inaccurate or misleadingly incomplete is classic evidence of scienter.); see also ACA Fin., 512 F.3d at 65. Plaintiff alleges that at some point prior to the FDA approval of TAXUS in March 2004, defendants knew that the problem with TAXUS was not doctor unfamiliarity but rather a manufacturing defect, and the company had already determined how to fix that defect. Specifically, plaintiff alleges that prior to the U.S. launch of TAXUS, defendants knew of adverse reports from doctors in Europe about balloon non-deflation, and that they also knew that the Express2 metal stent, which used the same delivery system as TAXUS, had a history of significant problems. CAC ¶ 93. Plaintiff also alleges that defendants received numerous adverse reports in the spring of 2004 from U.S. doctors, which they minimized and misrepresented, and attributed to doctors' unfamiliarity with the new product. Id. Yet defendants proceeded with the U.S. launch of TAXUS and did not disclose this information until July 2, 2004. Plaintiff alleges that defendants withheld this information to allow the company to build up its inventory of new, non-defective products which had been made with the manufacturing change in place, in order to avoid loss of market share. [7] Plaintiff also alleges that several of the defendants engaged in insider trading during this lag period, benefitting from the delay. Inferences supporting plaintiff's allegations about defendants' knowledge can be drawn from statements in Boston Scientific's Form 10-Q for the quarter ending June 30, 2004, filed on August 9, 2004. The Form 10-Q discusses the company's voluntary recall of the TAXUS Express2 stent due to characteristics in the delivery catheters that have the potential to impede balloon deflation during a coronary angioplasty procedure. Further analysis and investigation of the TAXUS Express2 (paclitaxel-eluting) and Express2 (bare metal) stent systems, both of which share the same delivery catheter, revealed that certain additional production lots exhibited these same characteristics. This statement acknowledges a connection between the balloon non-deflation problem and the characteristics of the delivery catheter. The statement also acknowledges that the company had been conducting ongoing analysis and investigation of the problem and as a result voluntarily expanded its recall on July 16. The statement goes on to say that the company would continue to work with the FDA to monitor the non-deflation problem. Tellingly, the statement also says that  [a]s a result of its investigation, the Company has implemented . . . an FDA-approved modification to the manufacturing process. (Emphasis added.) To the extent the company may be arguing that there was no connection between the manufacturing change and any characteristics of the catheter, defendants' own statements can be read to say that they implemented the manufacturing change in response to adverse reports, not independent of them. Defendants made a similar statement in the press release announcing the July 16 expanded recall. After noting that the company had conducted further analysis and investigation that demonstrated the need for an expanded recall, the press release states: The Company implemented review of its manufacturing process, additional inspections, and an FDA-approved modification to the manufacturing process for these products. The current and future production are not expected to experience similar balloon deflation problems. Defendants make a different argument, addressed below, that even if the manufacturing change did solve the problem by preventing balloon non-deflation, that does not mean they knew the connection or were obliged to disclose it earlier. Plaintiff gave a reason why defendants withheld information: so that they could build up an inventory of new TAXUS stents prior to announcing the recalls, thereby minimizing supply disruptions and maximizing profit. In support of this theory is the fact that defendants asserted in their Form 10-Q for the quarter ending June 30, 2004 that they had been able to use their existing supply of coronary stents not subject to the recall to replenish the U.S. market, although they also noted that they were unable to replenish the European market with existing stock and were hoping to do so during the third quarter of 2004. Similarly, in the press release announcing the July 16 recall, defendant James Tobin stated that, We're fortunate that current TAXUS inventory levels will minimize service disruption in the United States, but we do expect some disruption internationally. Plaintiff's proposed inferences are that defendants knew about the connection between adverse reports and the manufacturing change well before July 2, and withheld that information in order to build up inventory prior to announcing recalls. Under the PSLRA these inferences must be strong and must be weighed against competing ones. Defendants' inferences are that the manufacturing change was implemented for innocuous reasons not owing to any defect in the product, and that they did not know of a connection between the manufacturing change and the adverse reports they were receiving from U.S. doctors until the time of the first recall. Defendants' inferences are supported by the fact that balloon non-deflation complaints that defendants received from doctors in Europe in 2003 faded over time, indicating that such complaints were in fact tied to doctor unfamiliarity. Additionally, defendants' press releases and Form 10-Q for the quarter ending June 30, 2004 stated that it was not the manufacturing change alone but rather this change in combination with others, including an improved inspection process, that would prevent non-deflation in the future. At no point did defendants communicate that the manufacturing change alone would fix the non-deflation problem. Given these allegations, the district court held that plaintiff failed to plead facts providing a strong inference that at the time of the manufacturing change, defendants had the requisite scienter. In re Boston Scientific, 490 F.Supp.2d at 160. It reasoned that the manufacturing change was implemented with the FDA's knowledge and approval, at a time when the company had received only a limited number of complaints from Europe which had tapered off after the product's release. Id. Moreover, defendants asserted and plaintiff did not dispute that the manufacturing change would have been put into place regardless of whether the company received complaints from doctors in the United States. Id. The district court did not address the key question of inferences about whether defendants knew that the manufacturing change was related to non-deflation complaints at some point prior to the July 2 recall, not just when they first initiated the change. [8] The district court did not have the benefit of the Tellabs opinion, which reversed a higher standard for scienter imposed by the prior law of this circuit. We apply Tellabs and that leads us to a different result. While there is support for defendants' inferences, we think, at this stage, that plaintiff's inferences are at least equally strong. First, there is a very reasonable inference that defendants initiated the manufacturing change as a result of non-deflation complaints it had received from Europe, even if these complaints had tapered off over time. Other inferences may be drawn favorable to plaintiff by proper recognition of the limits of the doctrine of fraud by hindsight. Fraud by hindsight refers to allegations that assert no more than that because something eventually went wrong, defendants must have known about the problem earlier. [A] plaintiff may not simply contrast a defendant's past optimism with less favorable actual results, and then `contend[] that the difference must be attributable to fraud.' Shaw, 82 F.3d at 1223 (quoting DiLeo v. Ernst & Young, 901 F.2d 624, 627 (7th Cir.1990)). The doctrine has been applied in a number of different situations. We recognize that the effect of use of the doctrine at the Rule 12(b)(6) dismissal stage is to cut off the case as a matter of law, without further factual development. As some commentators have stated, [A]t this stage, a court must be cautious. The case has not yet developed. In cutting off the case on the pleadings by citing hindsight, the court is essentially making a prediction that the discovery process will yield only evidence that requires the benefit of the hindsight bias to seem adequate [to support the allegations]. M. Gulati, J. Rachlinski & D. Langevoort, Fraud by Hindsight, 98 Nw. L.Rev. 773, 787 (2004). Meanwhile, at the pleadings stage, a bad outcome truly is relevant to the likelihood of fraud. Id. at 815. Indeed, this court has held that in determining the adequacy of a complaint. . . we cannot hold plaintiffs to a standard that would effectively require them, pre-discovery, to plead evidence. Shaw, 82 F.3d at 1225. The law proscribes the pleading of `fraud by hindsight,' but neither can plaintiffs be expected to plead fraud with complete insight. Id. (quoting Denny v. Barber, 576 F.2d 465, 470 (2d Cir.1978) (Friendly, J.)). In Shaw, we held that the doctrine did not apply when plaintiffs provided a series of factual allegations relating to a combination of developments known to the company . . . that could have provided a basis for advance knowledge of the information which was eventually disclosed. Id. at 1224. We held that these allegations of developments known to the company, along with (admittedly weak) evidence of insider trading and the temporal proximity between the date of the alleged omission and the eventual disclosure (less than a month), were sufficient to survive a motion to dismiss. [9] Id. at 1225. Defendants in this case urged, and the district court accepted, that plaintiff's allegations amounted to nothing more than an allegation of fraud by hindsight: that simply because the manufacturing change eventually was linked as a remedy for the balloon non-deflation problem, defendants must have known about the connection earlier. This approach fails to consider the other allegations that plaintiff made from supporting documents. For instance, there is no dispute that the manufacturing change related to the laser welding of the delivery catheter and balloon, and it may be inferred this addressed the same problem which resulted in the recalls. It is also clear that defendants had received non-deflation reports from doctors in Europe before instituting the manufacturing change, as well as numerous non-deflation complaints from U.S. doctors while the company was in the process of implementing the change. Moreover, defendants' own SEC filings and press releases reveal that they reassured the public that they had implemented the manufacturing change in response to complaints of non-deflation, so that the new TAXUS would not suffer from the same problems. The company said it had been monitoring, analyzing, and investigating the problem and appropriate responses. It is fair to infer the company has highly effective information systems. Cf. id. at 1224 n. 38. Defendants are in a highly regulated industry and the company, it can be inferred, constantly monitors reports of patient injury and death and looks for prompt solutions to such problems. This is not the classic fraud by hindsight case where a plaintiff alleges that the fact that something turned out badly must mean defendant knew earlier that it would turn out badly. Denny, 576 F.2d at 470. Nor is this a case where there is no contemporaneous evidence at all that defendants knew earlier what they chose not to disclose until later. DiLeo, 901 F.2d at 626-7.