267 F.3d 400 (5th Cir. 2001), 99-20449, Nathenson v Zonagen Inc.

Docket Nº:99-20449
Citation:267 F.3d 400
Party Name:JAMES M. NATHENSON, on behalf of himself and all others similarly situated; DSAM GLOBAL VALUE FUND LTD; JONATHAN MARGALIT; AMIT SANGHVI; JIANBO XIE; JOHN DEROSA; ROBERT STRASSMAN; DEAN HAGEN; ARNO HAUSMANN, Plaintiffs-Appellants, v. ZONAGEN INC; ET AL, Defendants, ZONAGEN INC; JOSEPH PODOLSKI; STEVEN BLASNIK; M SUTTER, Defendants-Appellees.
Case Date:September 25, 2001
Court:United States Courts of Appeals, Court of Appeals for the Fifth Circuit

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267 F.3d 400 (5th Cir. 2001)

JAMES M. NATHENSON, on behalf of himself and all others similarly situated; DSAM GLOBAL VALUE FUND LTD; JONATHAN MARGALIT; AMIT SANGHVI; JIANBO XIE; JOHN DEROSA; ROBERT STRASSMAN; DEAN HAGEN; ARNO HAUSMANN, Plaintiffs-Appellants,

v.

ZONAGEN INC; ET AL, Defendants,

ZONAGEN INC; JOSEPH PODOLSKI; STEVEN BLASNIK; M SUTTER, Defendants-Appellees.

No. 99-20449

IN THE UNITED STATES COURT OF Appeals, FOR THE FIFTH CIRCUIT

September 25, 2001

REVISED OCTOBER 15, 2001

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Appeal from the United States District Court for the Southern District of Texas, Houston

Before GARWOOD, DeMOSS, and PARKER, Circuit Judges.

GARWOOD, Circuit Judge:

Plaintiffs-appellants James Nathenson and others (collectively, the plaintiffs) filed this putative class action in the court below against defendants-appellants Zonagen, Inc. (Zonagen), Zonagen chief executive officer and director Joseph Podolski (Podolski) and Zonagen outside directors and major shareholders Steven Blasnik (Blasnik) and Martin Sutter (Sutter) (collectively, the defendants). In their complaint,

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the plaintiffs sought class certification and alleged violations of sections 10(b) and 20(a) of the Securities Exchange Act of 1934 (1934 Act) and Rule 10b-5 of the Securities Exchange Commission (SEC). The defendants moved to dismiss the complaint under Fed. R. Civ. P. 12(b)(6). The district court granted the motion in a memorandum opinion and in a separate document rendered judgment that "this action is dismissed with prejudice." The plaintiffs now appeal. Finding sufficient merit in one of plaintiffs' complaints on appeal, we vacate and remand.

Facts and Proceedings Below

This is a private securities fraud action brought by nine putative class representatives on behalf of purchasers of common stock in Zonagen, a biopharmaceutical company based in The Woodlands, Texas. The plaintiffs allege that during the class period,1 February 7, 1996, through January 9, 1998, the defendants-Zonagen, its president and CEO, Podolski, and two of its outside directors and major shareholders, Blasnik and Sutter, the latter being Chairman of the Board, engaged in a scheme to defraud their shareholders by issuing a series of public misrepresentations about two of Zonagen's potential products in order to inflate artificially the value of Zonagen's stock and sell $67.5 million in stock in July 1997 at an inflated price. The two potential products in question are "Vasomax," an oral treatment for male erectile dysfunction (MED), and "Immumax," an adjuvant2 for the delivery of animal and human vaccines.

In order to market a drug in the United States, developers must first obtain the approval of the Food and Drug Administration (FDA). This approval process involves, among other things, conducting a series of clinical trials to establish the safety and efficacy of the drug. The maker of the drug then submits the results of these trials to the FDA as part of its New Drug Application (NDA). Phase I trials test the safety, dosage tolerance, and other pharmacokinetic properties of the drug; they also identify the primary side-effects, if any, that the drug may cause. During Phase II trials, researchers test the drug in a limited patient population to gather information about efficacy, optimal dosage levels, adverse effects, and safety risks. Phase III trials test the efficacy and safety of the drug in an expanded patient population at geographically dispersed trial sites.

The broad contours of the events in question are as follows. In 1995, Zonagen completed its Phase I trials for Vasomax in Ireland and reported the results of these trials in a Form 10-K filed with the SEC that year. The company then initiated Phase II trials in Germany; these trials concluded in March 1996. On February 7, 1996, the first day of the class period, Zonagen shares traded at $12 3/8. On February 7 and 14, 1996, before the completion of the Phase II trials, two news items appeared in which Podolski indicated that the "preliminary" results of the Phase II trials were positive. Similar statements were made to analysts on March 5 and in a March 14, 1996 press release (similar

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statements were also made in Zonagen's April 1, 1996 10K for the year ended December 31, 1995). The stock traded at $16 a share on March 13, 1996. On May 9 and 16, 1996, Zonagen issued press releases that described the Phase II results in positive terms, the May 9 release unmistakably implying and the May 16 release expressly stating that the Phase II trials produced statistically significant results. As the district court noted, Zonagen shares after March 13, 1996 "fell steadily until reaching . . . less than $10 per share in early August."

In press releases, as well as in its public filings with the SEC, Zonagen represented not only that the Phase II trials had positive results, but also that Zonagen had acquired the rights to a "method of use" patent, known as the Zorgniotti patent, which covered the administration of phentolamine, the active ingredient in Vasomax. In addition, Zonagen used its press releases and public filings of 1996-97 to state its belief that it had "discovered" a "new" adjuvant, which it called Immumax.

In November 1996, Zonagen began Phase III trials for Vasomax in the United States. Soon after, Zonagen began issuing press releases discussing these trials and expressing its hope that the results would enable Zonagen to file an NDA by June 1997. In its public filings with the SEC, it made similar statements about the Phase III trials in the United States. On November 14, 1996, Zonagen filed a Form S-3 with the SEC in connection with the proposed sale by some of its shareholders of Zonagen shares not previously publicly offered. In the Form S-3, Zonagen disclosed that the Phase II trials had not yielded statistically significant results and that the other patent (the Lowrey patent) it had hoped would cover Vasomax had been rejected in a non-final first office action by the United States Patent and Trademark Office.

In 1997, Zonagen's press releases and public filings noted the positive results of the Phase III trials. On June 11, 1997, Zonagen filed a Form S-3 with the SEC seeking registration of two million shares of Zonagen stock for sale by the company. The Form S-3 stated that the Phase III trials had yielded statistically significant results, and also discussed the "discovery" of Immumax and the Zorgniotti patent respecting Vasomax. On June 13, 1997, Zonagen issued a press release announcing the successful completion of its Phase III trials. On May 23, 1997, the last day of trading before the announcement, the price per share of Zonagen stock was $17. On May 27, the day of the announcement, the price per share rose to $24½. On July 18, 1997, after no further announcements, Zonagen's share price closed at $32¼. On July 22, 1997, Zonagen filed a prospectus with the SEC which commenced its secondary offering of common stock. In a press release issued that same day, the company announced that it had raised $67.5 million in gross proceeds from the sale of 2.25 million shares sold at a price of $30 per share. Zonagen shares rendered a high of 44 3/8 on October 13, 1997. On January 12, 1998, the Monday following January 9, 1998, the last day of the class period, the stock closed at 13 15/16. The average closing price of Zonagen shares in the ninety days following the last day of the class period (January 9, 1998 through April 10, 1998) was $20 1/5. On June 2, 1998, the stock traded at $36 3/4 per share; by June 12, 1998, it had fallen to $24 3/4 per share.3

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On June 19, 1998, the plaintiffs filed their Consolidated Amended Complaint (complaint) seeking class certification and alleging that the defendants had violated section 10(b)4 of the 1934 Act and Rule 10b-55 promulgated thereunder by the SEC (an original complaint was filed March 9, 1998). The plaintiffs also contended that the three individual defendants were liable as "controlling persons" under section 20(a)6 of the 1934 Act. As noted above, the complaint primarily charges that the defendants made a series of misrepresentations about their Vasomax and Immumax potential products in order to artificially inflate the company's share price, and then sold a large amount of stock at an inflated price. On August 3, 1998, the defendants moved to dismiss the complaint pursuant to Fed. R. Civ. P. 12(b)(6). On March 31, 1999, the district court granted the motion and dismissed the "action" with prejudice. The plaintiffs now appeal.

Discussion

On appeal, the plaintiffs maintain that the district court erred in dismissing their complaint.

This Court reviews a district court's dismissal under Rule 12(b)(6) de novo. See Rubenstein v. Collins, 20 F.3d 160, 166 (5th Cir. 1994). In doing so, we will accept the facts alleged in the complaint as true and construe the allegations in the light most favorable to the plaintiffs. See id. (citing Scheuer v. Rhodes, 94 S.Ct. 1683, 1686 (1974)).

I. Private Securities Litigation Reform Act

As a preliminary matter, we note that this case presents us with the occasion to apply the Private Securities Litigation Reform Act of 1995 (PSLRA), Pub. L. 104-67, 109 Stat. 737 (December 22, 1995), which Congress passed to prevent the abuse of federal securities laws by private plaintiffs. The statute purports to increase the pleading requirement for plaintiffs alleging section 10(b)/Rule 10b-5 claims.

A. "Strong" Inference of Scienter

In order to state a claim under section 10(b) of the 1934 Act and Rule 10b-5, a plaintiff must allege, in connection with the purchase or sale of securities, "(1) a misstatement or an omission (2) of material

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fact (3) made with scienter (4) on which plaintiff relied (5) that proximately caused [the...

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