In its unanimous opinion in Matrixx Initiatives, Inc. v. Siracusano issued on March 22, the U.S. Supreme Court reaffirmed its long-established standard for determining materiality with respect to securities fraud claims under Section 10(b) of the Securities Exchange Act of 1934 and the SEC's Rule 10b-5. The Supreme Court resolved a split in federal circuit decisions relating to the materiality of adverse events associated with pharmaceutical products by rejecting a "bright-line" test for materiality based on the existence or absence of a "statistically significant number" of adverse events. Instead, the Court held that, as it had announced in past decisions, materiality will exist under the antifraud provisions of Section 10(b) and Rule 10b-5 only if there is a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the "total mix" of information made available to the investment community. The Court ruled that the "total mix" standard could be satisfied in the absence of statistically significant evidence of a causal link between reported adverse events and Matrixx's product.
As discussed below, the Matrixx decision has important implications for the public disclosure practices of public companies and their ability to obtain dismissal of some types of securities fraud lawsuits. The Supreme Court's decision is published at 2011 WL 977060 (U.S. Mar. 22, 2011).
The Matrixx decision arose from a securities fraud claim under Exchange Act Section 10(b) and Rule 10b-5 asserted on behalf of a class of investors against Matrixx Initiatives, Inc., a NASDAQ-listed company, and three of its executives. The plaintiffs asserted that the defendants had positively portrayed Matrixx's expected growth and revenue and the safety of its leading product — a cold remedy named Zicam that accounted for 70% of Matrixx's sales — while not disclosing evidence of a substantial risk that Zicam caused users to suffer a total and permanent loss of their sense of smell, a condition known as anosmia. The alleged evidence of this risk included fewer than two dozen adverse event reports of consumers suffering anosmia following Zicam use, as well as four product liability lawsuits relating to Zicam. After a television news broadcast reported that Zicam could cause anosmia, Matrixx's stock price fell and the plaintiffs sued.
The district court dismissed the plaintiffs' claim on the basis that the complaint failed to plead adequately the essential elements of materiality and scienter (intent to defraud) because the complaint did not allege that the defendants knew of a statistically significant number of adverse events that would have required disclosure of a possible causal link between Zicam and anosmia. The district court held that the facts in the complaint alleging such a link were too insubstantial and speculative to render Matrixx's public statements materially misleading. Relying on precedents from two federal circuit courts, the district court found that the defendants "must have statistically significant information before statements related to a product's drug safety become material." Siracusano v. Matrixx Initiatives, Inc., 2005 WL 3970117 (D. Ariz. Dec. 15, 2005).
The district court's decision was reversed by the Ninth Circuit Court of Appeals, which held that the district court's use of a "bright-line" statistical significance test was inappropriate and that the facts pled by the plaintiffs adequately alleged materiality. The Ninth Circuit also held that the defendants' alleged withholding of "reports of adverse effects of and lawsuits concerning the product responsible for the company's remarkable sales increase" raised a "strong inference" of "deliberate recklessness," thereby satisfying the scienter pleading standards of the Private Securities Litigation Reform Act (PSLRA). Siracusano v. Matrixx Initiatives, Inc., 585 F.3d 1167 (9th Cir. 2009).
Supreme Court's Matrixx decision
The Supreme Court affirmed the decision of the Ninth Circuit Court of Appeals, holding that the complaint in Matrixx appropriately alleged that the defendants had omitted or misrepresented material information relating to the causal link between Zicam and anosmia and had acted with scienter in making the misleading disclosures.
The Supreme Court rejected the defendants' request that the Court adopt a "bright-line" rule for materiality based on statistically significant evidence and that the Court conclude that, absent this evidence, the defendants could not be found to have omitted or misrepresented material information concerning the Matrixx product.
The Court began its analysis by reaffirming its long-standing materiality standard, as formulated in Basic Inc. v. Levinson in 1988, which provides that materiality is satisfied when there is a "'a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the "total mix" of information made available'" (quoting TSC Industries, Inc. v. Northway, Inc., decided by the Court in 1976). The Court observed in Matrixx that it had rejected a bright-line rule for materiality in the Basic case because materiality is an "inherently fact-specific finding" and that any approach that "designates a single fact or occurrence as always determinative" of materiality "must necessarily be overinclusive or underinclusive." The Court held that the same considerations warranted rejection of the defendants' position in Matrixx, which the Court found rested on the assumption that "reasonable investors" would not be interested in adverse event reports unless statistically significant evidence established a causal relation between the adverse events and the company's product. The Court concluded that because "medical professionals and regulators act on the basis of evidence of causation that is not statistically significant," reasonable investors in some cases also could act on the basis of this type of evidence in making their investment decisions.
Having rejected a bright-line rule, the Court addressed whether the complaint adequately pled materiality. The Court approached that analysis using the pleading standard it announced in Bell Atlantic Corp. v. Twombly in 2007, under which, to plead materiality, the plaintiffs need only allege "enough facts to state a claim to relief that is plausible on its face." In evaluating the Matrixx pleading, the Court employed a calculus announced in the Basic decision that balances the "probability that the event will occur" against the "anticipated magnitude of the event in light of the totality of the company activity." Based on the facts pled, the Court found it "plausible" that there existed "a reliable causal link between Zicam and anosmia," which was the event on which the materiality determination turned.
In considering the second half of the materiality equation — the anticipated magnitude of the event — the Court found that reasonable investors would want to know about the Zicam/anosmia link because of consumers' likely negative response upon learning of the anosmia risk and because Zicam accounted for 70% of Matrixx's sales. The Court held that the omitted facts relating to the Zicam/anosmia link were material because they suggested "a significant risk to the commercial viability of Matrixx's leading product."
The Supreme Court broke no new ground in finding that the complaint adequately pled the scienter element of the Matrixx plaintiffs' securities fraud claim. Because the defendants did not raise the issue, the Court assumed, but did not decide, that "recklessness" is sufficient to establish scienter under Exchange Act Section 10(b) and Rule 10b-5. Moreover, the Court did not further expand on its interpretation of the PSLRA pleadings standards for scienter which it had announced in Tellabs, Inc. v. Makor Issues & Rights, Ltd. in 2007. Nonetheless, the Court's application of that standard in Matrixx is illuminating.
Most notably, the Court did not find that the defendants' mere possession of the adverse event reports (and other undisclosed information) raised a strong inference of scienter. Rather, the Court focused on what could be inferred from the facts pled about the defendants' understanding of the materiality of the data they possessed. In the Court's view, it was possible to infer either that the defendants believed that the undisclosed adverse events data were material or, alternatively, "simply thought the reports did not indicate anything meaningful about adverse reactions" to the use of Zicam.
In weighing these competing inferences, the Court rejected the defendants' argument that the absence of statistically significant evidence of causation precluded any inference of scienter, holding that defendants' proposed bright-line rule for scienter was "just as flawed as its approach to materiality." Instead, the Court focused on facts suggesting that the defendants were "concerned" about the possibility of a Zicam/anosmia link. For example, the Court noted that Matrixx had responded to the adverse event reports by taking various actions, including hiring a consultant to review Zicam, inviting a researcher to participate in animal studies of Zicam, convening a panel of physicians and scientists to consider researchers' presentation of a Zicam/anosmia link, and preventing those researchers from using Zicam's name in their presentation.
Those steps could have been viewed as consistent with Matrixx not having reached any conclusion about a possible Zicam/anosmia link. In this view, the steps could have reflected a reasonable desire by the defendants to investigate the possibility of causality and, in the interim, to protect Zicam's good name from unjustified attacks. The Supreme Court held, however, that additional alleged facts tipped the scales in favor of scienter. The most significant step identified by the Court was Matrixx's issuance of a misleading press release, in response to press reports of an FDA investigation of a Zicam/anosmia link, which misstated Zicam's supposed safety. The misleading press release, coupled with other evidence of the defendants' concern about a Zicam/anosmia link, was sufficient to support an inference that "Matrixx elected not to disclose the reports of adverse events not because it believed they were meaningless but because it understood their likely effect on the market."
Implications of Matrixx
The Matrixx decision has important implications for public companies both with respect to their public disclosures and their ability to obtain dismissal of securities fraud litigation in some cases.
Matrixx offers the following lessons to public companies in administering their disclosure policies:
- Adverse product-related reports — Most directly, for pharmaceutical, biotechnology, medical device, and other life sciences companies, the Supreme Court's rejection of a bright-line statistical significance rule requires companies, upon becoming aware of adverse event reports related to their products, to engage in a highly contextual analysis of such reports and any related facts to determine materiality. As with other materiality determinations, the threshold standard set forth in the Basic case will control, which is whether a reasonable investor would view the new information as significantly altering the "total mix" of information previously made available to the investment community.
The Court's rejection of the bright-line statistical significance rule also has relevance to public companies in other industries, including, in particular, consumer goods and other product manufacturers. The receipt of product defect and other adverse product-related reports will require these public companies to engage in the same contextual analysis under the Basic "total mix" standard to determine the materiality of the reports.
- Reliable evidence of causation — The Supreme Court's refusal to define the factors constituting "reliable evidence of causation" for purposes of making materiality judgments about adverse events will require a more nuanced assessment of product data and the implications of the adverse events when crafting public disclosures. It is possible to glean from the Court's decision a few guidelines for public disclosure of information about adverse events by companies selling FDA-regulated products and possibly other types of products:
- "all reports of adverse events" need not be disclosed because the mere existence of such reports "says nothing in and of itself about whether the drug is causing the adverse events";
- "statistical significance (or the lack thereof)" is not "irrelevant" but "it is not dispositive of every case"; and
- plausible evidence of causation can come from consideration of "the source, content, and context of the [adverse event] reports."
The foregoing assessment of adverse event reports must include consideration of whether the available evidence suggests a "reliable causal relation" between the product and any adverse health consequences, which, in the case of FDA-regulated products, could encompass the numerous factors that medical researchers and FDA regulators examine to evaluate causation. Moreover, for purposes of making materiality judgments, evidence of possible causality must be balanced against the likely magnitude of a causality finding on the company's business, including the possible effect on product sales, potential product liability exposure, and profitability.
- Full and accurate disclosure — As always, public companies must keep in mind that, as the Supreme Court emphasized in Matrixx, Exchange Act Section 10(b) and Rule 10b-5 do "not create an affirmative duty to disclose any and all material information," but once they make public disclosures, companies are required to disclose all information necessary to avoid making false or misleading statements. To ensure the quality of their public disclosures and to limit the potential for litigation, every public company should enforce procedures to control the public disclosure of information in the company's name, to evaluate the scope and content of public statements, and to obtain the maximum protection afforded by common law and statutory safe harbors for forward-looking statements (which were not at issue in Matrixx) by ensuring that risk factor disclosures and other cautionary statements about the forward-looking statements are sufficiently detailed and timely updated to be meaningful to investors.
Pleading requirements in securities fraud lawsuits
The Matrixx ruling likely will make it easier to plead a securities claim in certain respects. Most obviously, the Supreme Court's rejection of a bright-line materiality test will ease the pleading burden in pharmaceutical cases in those federal circuit courts that had adopted a statistical significance rule. More generally, the Court's assessment of materiality under the relatively lenient "facial plausibility" standard articulated in the Twombly case affords plaintiffs a better chance of defeating pleading motions challenging the materiality element of a Section 10(b) claim.
On the other hand, as a result of the Supreme Court's scienter analysis, it is unlikely that the Matrixx decision will open the floodgates to a new wave of securities litigation. The Court's focus on facts suggesting that defendants understood the materiality of the information they failed to disclose, rather than that they simply possessed the information, avoids collapsing the pleading of materiality with that of scienter. Moreover, because the plaintiffs' allegations must raise a "strong inference" of scienter, which is a standard distinctly higher than mere plausibility, the adequate pleading of materiality offers no assurance that scienter can be properly alleged.