U.S. Supreme Court to Decide the Scope of Materiality under Federal Securities Laws

July 15, 2010

On June 14, 2010, the United States Supreme Court granted a writ of certiorari to review the decision of the Ninth Circuit in Siracusano v. Matrixx Initiatives, Inc., 585 F.3d 1167 (9th Cir. 2009).  In this case, the Ninth Circuit reversed the District of Arizona’s grant of a motion to dismiss plaintiffs’ complaint alleging violations of Section 10(b) of the Securities Exchange Act of 1934, holding that the plaintiffs had adequately pled materiality, and that the lack of statistical significance of patient complaints regarding a product was not a proper basis to find that the alleged omissions were not material. The Ninth Circuit held that courts are required to consider whether the undisclosed information available to the defendants would be material to a reasonable investor even if there was no statistically significant evidence that the product was unsafe.

The Ninth Circuit’s decision creates a split of authority with the First, Second, and Third Circuits, which have held that drug companies have no duty to disclose adverse event reports until those reports provide statistically significant evidence that the adverse events may be caused by, and are not simply randomly associated with, a drug’s use.  See, e.g., N.J. Carpenters Pension & Annuity Funds v. Biogen IDEC Inc., 537 F.3d 35, 50 (1st Cir. 2008); In re Carter-Wallace, Inc. Securities Litigation, 220 F.3d 36, 41-42 (2d Cir. 2000) (“Carter-Wallace I“); In re Carter-Wallace, Inc. Sec. Litig., 150 F.3d 153, 157 (2d Cir. 1998) (“Carter-Wallace II“); Oran v. Stafford, 226 F.3d 275, 284 (3d Cir. 2000).

The direct question presented by the cert. petition to the Supreme Court is whether a plaintiff can state a claim under Section 10(b) of the Securities Exchange Act and SEC Rule 10b-5 based on a pharmaceutical company’s nondisclosure of adverse event reports, even though the reports are not alleged to be statistically significant.  The broader question, however, is how the Supreme Court will view the role of statistical significance and materiality in securities fraud cases more generally.  As the Court’s June 2010 ruling in Morrison v. National Australia Bank (Case No. 08-1191) suggests, the Court may address the issue before it more expansively than it was strictly framed by the lower courts.

Summary of Siracusano

In Siracusano, plaintiffs alleged that Matrixx and three individual defendants failed to disclose reports that its product, Zicam, could cause anosmia (loss of smell).  The allegations stated that, as early as December 1999, Matrixx was aware of reports linking anosmia to Zicam use.  The Neurological Director of the Smell & Taste Treatment and Research Foundation, Ltd., called Matrixx’s customer service line and reported that at least one of his patients had developed the condition after using Zicam.  He also told the Zicam representative that “other studies had indicated potential problems with ‘intranasal application of zinc.'”  585 F.3d at 1170.

In September 2002, another doctor reported that his patient had lost the sense of smell after using Zicam and was allegedly told by an individual defendant that Matrixx had received other, similar complaints.  The individual defendant told the doctor that the company “had hired a consultant to review the product.”  Id.

In September 2003, a researcher contacted Matrixx about a presentation he would be making at a medical conference discussing the cases of several individuals who claimed to have lost their sense of smell after using the drug.  Matrixx management forbade the researcher from referring to Zicam or Matrixx in the presentation.

On October 14, 2003, the first of several products liability cases was filed.  However, Matrixx was not served until October 23, 2003, the day of an earnings conference call in which Matrixx expressed “optimism” for the future.  Id. at 1172.  The Company’s 10-Q, filed in November 2003, discussed the risk of products liability litigation but did not discuss the lawsuit that had been filed or reveal that numerous claims of anosmia related to Zicam use had been brought to the company’s attention.  In January 24, 2004, Matrixx upwardly revised its earnings guidance for that year.

On January 30, 2004, there were news reports that the FDA was investigating Zicam in light of at least three products liability suits.  Plaintiffs alleged that Matrixx’s stock price declined following the report.  The Company issued a press release three days later stating that the assertions that “intranasal Zicam products cause anosmia … are completely unfounded and misleading” and attacking the credibility of the reporter.  585 F.3d at 1173.  In doing so, it cited two studies of Zicam’s safety and efficacy.

On February 6, 2004, Good Morning America televised a story about Zicam, reporting one of the researchers’ findings and that lawsuits had been filed.  Again, Matrixx’s stock price is alleged to have “plummeted, falling from $13.05 per share on February 5, 2004, to close at $9.94 per share on February 6–a one-day drop of 23.8% on unusually heavy trading volume.”  Id. at 1174.  The company responded by assuring their customers that their products were manufactured according to FDA standards and that no study had linked anosmia and Zicam use.  Less than two weeks later, Matrixx convened a panel of experts that determined that there was insufficient evidence to determine whether Zicam could cause anosmia.

Plaintiffs allege that by October 2004, Matrixx was sued by approximately 284 individuals in 19 separate lawsuits alleging that Zicam had damaged their sense of smell.

The Ninth Circuit Decision

The District of Arizona dismissed the complaint, reasoning that the allegations regarding Zicam users’ claims were not material because they were not statistically significant.  It determined that the complaint failed properly to allege materiality “absent allegations Defendants knew there was a definitive and statistically significant link between Zicam and anosmia during the Class Period that was ‘sufficiently serious and frequent to affect future earnings.'”  585 F.3d at 1177 (emphasis in original) (internal quotations omitted).

The Ninth Circuit reversed, holding that the district court improperly relied on a statistical significance standard to determine that the plaintiffs’ complaint did not allege “a material misrepresentation or omission of fact.”  Id. at 1178.  Instead of determining that the omitted information relating to patient complaints regarding anosmia was immaterial as a matter of law, the Ninth Circuit held that the district court should have allowed the finder of fact to conduct a fact-specific inquiry in order to determine whether the information would have been material to a reasonable investor.

The First, Second and Third Circuits

In N.J. Carpenters Pension & Annuity Funds v. Biogen IDEC Inc., ten days after two participants died from “opportunistic infections” in a clinical trial of a drug developed to combat multiple sclerosis and other autoimmune disorders, the defendant drug manufacturer announced that it was suspending all clinical trials and withdrawing the drug from the market.  537 F.3d at 37.  Securities actions were filed immediately following the announcement.  Id. at 47.  However, because the incidence of opportunistic infections in clinical trials was small, there was no basis to conclude that those results were statistically significant.  Id. at 50-51.  The First Circuit held that, where there was no allegation that defendants were aware of a “causal relationship” between the deaths and defendant’s product, plaintiffs had not adequately alleged scienter.  Id. at 49.

Similarly, the Second Circuit, in Carter-Wallace I, held that a drug company’s statements failing to disclose deaths alleged to be related to its anti-epileptic medication were not materially misleading, because the company had no information that the number of deaths linked to its product were statistically significant.  150 F.3d at 157.  The Second Circuit held that “[d]rug companies need not disclose isolated reports of illnesses suffered by users of their drugs until those reports provide statistically significant evidence that the ill effects may be caused by–rather than randomly associated with–use of the drugs and are sufficiently serious to affect future earnings.”  Id.  In a subsequent appeal arising from that litigation, the Second Circuit again applied the statistical significance standard in determining that plaintiffs had not alleged scienter adequately, because it was not “reckless” for defendants not to disclose statistically insignificant reports of drug-related deaths.  Carter-Wallace II, 220 F.3d at 41-42.

The Third Circuit has held likewise.  In an opinion authored by then-Circuit Judge Samuel Alito, the Third Circuit in Oran v. Stafford considered whether the maker of weight loss drugs made material representations and omissions regarding the safety of those drugs when they did not disclose several studies linking the drugs to heart valve damage.  226 F.3d at 279-80.  In affirming the district court’s dismissal of the claim, the Third Circuit held that where “plaintiffs never clearly explain how the accumulation of additional anecdotal data, short of the point of statistical significance, would have added anything” to previous disclosures, and “the link between the two drugs and heart-valve disorders was never definitively established,” the disclosure of that data “would not have significantly altered the ‘total mix’ of information” available to investors.  Id. at 284.

Consideration by the Supreme Court

In taking this case, the Supreme Court will resolve the conflict over whether statistical significance is a prerequisite to the required disclosure of event reports under the securities laws.  Although the case is important for the pharmaceutical industry, medical device manufacturers, and others subject to the FDA premarket approval and reporting regime, it will also have implications for industries subject to analogously pervasive federal or state regulation.

More broadly, the case gives the Court the opportunity to clarify the standards for materiality in securities cases.  There is little guidance in this area other than TSC Indus. Inc. v. Northway, Inc., 426 U.S. 438 (1976), which stands for the threshold proposition that “[a]n omitted fact is material if there is a substantial likelihood that a reasonable shareholder would consider it important in deciding how to vote,” or, put differently, that materiality requires a “substantial likelihood that the disclosure would have been viewed by the reasonable investor as having significantly altered the ‘total mix’ of information made available.”  Id. at 449.  However, the Court also has recognized that too much disclosure can be counterproductive as investors and others are overwhelmed by irrelevant information.  See, e.g., TSC Indus., 426 U.S. at 448-49 (“management’s fear of exposing itself to substantial liability may cause it simply to bury the shareholders in an avalanche of trivial information[,] a result that is hardly conducive to informed decision-making”); see also Buckman Co. v. Plaintiffs’ Legal Committee, 531 U.S. 341, 351 (2001).  Thus, the case should be of interest to issuers and other participants in the primary and secondary securities markets charged with disclosure obligations, including accountants and lawyers.

Gibson, Dunn & Crutcher lawyers are available to assist in addressing any questions you may have regarding these issues. Please contact the Gibson Dunn lawyer with whom you work or any of the following members of the Securities Litigation Practice Group:

Jonathan C. Dickey – Practice Co-Chair, New York (212-351-2399, [email protected])
Robert F. Serio – Practice Co-Chair, New York (212-351-3917, [email protected])
Wayne W. Smith – Practice Co-Chair, Orange County (949-451-4108, [email protected])
Paul J. Collins – Bay Area (650-849-5309, [email protected])
George B. Curtis – Denver (303-298-5743, [email protected])
Ethan Dettmer – San Francisco (415-393-8292, [email protected])
Gareth T. Evans – Los Angeles (213-229-7734, [email protected])
Daniel S. Floyd – Los Angeles (213-229-7148, [email protected])
Barry R. Goldsmith – Washington, D.C. (202-955-8580, [email protected])
Mark A. Kirsch – New York (212-351-2662, [email protected])
John C. Millian – Washington, D.C. (202-955-8213, [email protected])
John H. Sturc – Washington, D.C. (202-955-8243, [email protected])
M. Byron Wilder – Dallas (214-698-3231, [email protected])
Meryl L. Young – Orange County (949-451-4229, [email protected])

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