• "Inquiry Notice" Sufficient to Trigger the Statute of Limitations Under California Securities Law
  • August 17, 2006
  • Law Firm: Gordon & Rees LLP - San Francisco Office
  • A recent decision of the California Court of Appeal holds that the one-year statute of limitations on claims of securities fraud under California Corporations Code § 25506 begins to run from the time plaintiffs gain "inquiry notice" of the facts underlying their claims -- or, in other words, discover facts that would lead a reasonably prudent person to "suspect" fraud. The decision also makes clear that disclosures on a corporation's website may not be sufficient to put investors on inquiry notice of possible securities fraud.

    In Deveny v. Entropin, Inc. (2006) 139 Cal. App. 4th 408, a plaintiff class of some 1,000 investors alleged securities fraud by Entropin, a pharmaceutical company whose sole business was to develop and market Esterom, a topical solution meant to treat impaired range of motion associated with shoulder and back injuries. Testing of the product began in 1997 and continued during Entropin's lucrative initial public offering in 2000. In 2002 Entropin announced that clinical trials had been a failure, the drug was ineffective and Entropin was abandoning the drug. The stock price then collapsed. Plaintiffs subsequently brought suit alleging that they had purchased shares in reliance on misrepresentations of the outcomes of clinical trials.

    When Entropin moved for summary judgment on a statute of limitations defense, the trial court ruled that plaintiffs' claims were time-barred under Corporations Code § 25506 because plaintiffs had reason to suspect securities fraud more than a year before filing their complaint. According to the lower court, inquiry notice arose by virtue of several 1999 disclosures on Entropin's website to the effect that the product was not absorbed in test subjects' bloodstreams. Entropin had referred potential investors to the site for general information. During the same time period Entropin had issued a series of press releases stating that the drug was safe and effective.

    On appeal, plaintiffs contended that only actual notice, and not inquiry notice, could trigger the limitations period. The statute as written refers only to the "discovery by the plaintiff of the facts constituting the violation…" In resolving the ambiguity of § 25506, the appellate court took notice that no other published California case had yet addressed the matter, but that several federal courts applying California law had found inquiry notice sufficient to commence the § 25506 limitation period. The court followed the federal cases, explaining that the inquiry notice standard strikes the proper balance "between the public policy favoring extinction of stale claims and [the competing policy] favoring resolution of disputes on their merits."

    In the securities context, the court wrote, inquiry notice arises when circumstances suggest to an investor of ordinary intelligence the possibility that he or she has been defrauded. In most cases, these suspicions are aroused by "storm warnings," or public disclosures about the corporation's condition that would tend to alert a reasonable person to the likelihood of fraud. If the investor makes no investigation once given reason to suspect fraud, the limitation period begins running on the date the investor was put on alert. If the investor does make an inquiry, the clock starts whenever a reasonable person would have discovered the fraud.

    Applying these standards to the facts before it, the appellate court held the evidence was insufficient to find as a matter of law that the plaintiff investors had been put on notice of possible fraud by the internet website. Entropin's mere posting of the test data on its website did not place investors on notice of the company's difficulties, particularly in view of Entropin's "rosy" press releases in a concurrent timeframe. The court noted that the information on the website may have been obscure and that there was no evidence that plaintiffs even had access to the internet. In any event, the court considered the absorption data scientifically "ambiguous" as to whether the drug trials were successful.

    Thus, the internet disclosure did not constitute the sort of "storm warning" necessary to convey inquiry notice to investors and start the clock running on plaintiff's claims. Summary judgment for Entropin was reversed.