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The price of Merck & Co.’s stock took a tumble in June 2001 after the Wall Street Journal reported that a Merck subsidiary had over-reported its revenues by more than $4.6 billion. Soon after investors filed a securities fraud suit alleging that Merck had hidden the truth about the accounting scandal for months. But the 3rd U.S. Circuit Court of Appeals has now ruled that the investors’ suit was properly dismissed because Merck had disclosed the nature of its subsidiary’s improper accounting practices in an April 2001 filing with the Securities & Exchange Commission, and that the Journal reporter “simply did the math.” Although the court was critical of Merck’s failure to disclose the actual figures in its SEC filing, it nonetheless found that the essential facts had been disclosed to investors and analysts. Since courts must assume that the stock market is “efficient,” the investors and analysts should not have needed the Journal‘s report — which was based on nothing more than public filings and some simple math — to realize the scope of the accounting improprieties, the unanimous three-judge panel said. “In effect, [the plaintiff] is arguing that investors and analysts stood in uncomprehending suspension for over two months until the Journal brought light to the market’s darkness,” U.S. Circuit Judge Thomas L. Ambro wrote in his 33-page opinion in In re Merck & Co. Inc. Securities Litigation. Ambro said he recognized that Merck was “treading a fine line” by failing to disclose the scope of the accounting improprieties. “Sunshine is a fine disinfectant, and Merck tried for too long to stay in the shade,” Ambro wrote in an opinion joined by 3rd Circuit Judge Samuel A. Alito Jr. and visiting Judge Jane A. Restani of the U.S. Court of International Trade. But Ambro concluded that Merck had not violated securities laws because “the facts were disclosed … and it is simply too much for us to say that every analyst following Merck, one of the largest companies in the world, was in the dark.” At issue in the suit are events surrounding Merck’s now-abandoned plan to spin off one of its subsidiaries — Medco Health Solutions Inc. — through an initial public offering of stock. Before the IPO was set to occur, however, information came to light about Medco’s revenue-recognition policy. Medco is a pharmacy benefits manager that saves its clients money by negotiating discount rates with pharmacies. When participants in a Medco plan obtain a prescription, they must make a co-payment, ranging from $5 to $15. Although the co-payments go directly to the pharmacy, Medco’s accounting procedures were designed to recognize the payments as Medco’s own revenue. In the late 1990s, Merck did not disclose Medco’s improper accounting policy. But after Merck changed auditors — and before it began making filings for the Medco IPO — it changed the language in its SEC forms. In April 2001, Merck disclosed for the first time that Medco had recognized as revenue the co-payments paid by consumers. But the SEC form did not disclose the total amount of co-payments recognized. On June 21, 2002, the Journal reported that Medco had been recognizing co-payments as revenue and estimated that in 2001 $4.6 billion in co-payments had been recognized. Later disclosures showed the actual number was about $5.5 billion. The stock market’s reaction was immediate. That day Merck’s stock lost $2.22 — dropping from $52.20 to $49.98. Six days later, Merck announced the postponement of the Medco IPO and suggested that it would drop Medco’s offering price. In a July 2002 SEC filing, Merck disclosed the full amount of co-payments that Medco had recognized as revenue — more than $12.4 billion over three years. In the securities fraud suit, plaintiffs lawyers argued that Merck’s April 2001 disclosure of Medco’s accounting procedures was “so opaque that it should not have counted as a disclosure.” Although Merck disclosed that Medco had recognized co-payments as revenue, they said, it did not disclose the sum total of those co-payments until July. As a result, they argued, Merck’s stock price did not drop until the Journal‘s report made public the estimated magnitude of the co-payment recognition. But Ambro found that the Journal’s report was based on nothing more than simple math. “The Journal reporter arrived at an estimate of $4.6 billion of co-payments recognized in 2001 by using one assumption and performing one subtraction and one multiplication on the information contained in the April [SEC filing],” Ambro wrote. “She determined the number of retail prescriptions filled (462 million) by subtracting home-delivery prescriptions filled (75 million) from total prescriptions filled (537 million). She then assumed an average $10 co-payment and multiplied that average co-payment by the number of retail prescriptions filled to get $4.6 billion.” Ambro found that the issue of whether Merck engaged in securities fraud depended on “whether needing this amount of mathematical proficiency to make sense of the disclosure negates the disclosure itself.” Since the Journal was able to uncover the scope of the accounting problem, Ambro said, the industry analysts who follow Merck should have been able to do the same. “If these analysts — all focused on revenue — were unable for two months to make a handful of calculations, how can we presume an efficient market at all?” Ambro wrote. Ambro said the plaintiffs were “trying to have it both ways: The market understood all the good things that Merck said about its revenue but was not smart enough to understand the co-payment disclosure.” The Journal reporter, Ambro said, “simply did the math.” But since courts assume that the stock market is efficient, the court must presume that “the market made these basic calculations months earlier.” Ambro also chided Merck, saying “we do not wish to reward opaqueness,” and that Merck was “treading a fine line with this delayed, piecemeal disclosure.” In its April 2001 SEC filings, Ambro said, Merck “should have disclosed the amount of co-payments recognized as revenue” and “it should have disclosed this revenue-recognition policy as soon as it was adopted.” But the plaintiffs’ securities fraud claim nonetheless failed, Ambro said, because they “failed to establish a material statement or omission by Merck.”

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