What You Need to Know
Thanks to a recent Supreme Court decision, public companies may need to reconsider whether adverse information about their business—including reports of "adverse" product reactions by a statistically insignificant number of consumers—may be considered "material" by courts and regulators in subsequent shareholder lawsuits and government investigations.
In Matrixx Initiatives, Inc. v. Siracusano, the nation's top court unanimously rejected the use of a bright-line test of "statistical significance" for determining whether an investor-plaintiff in a securities fraud action has adequately pled the materiality of a misstatement or omission.1 Rather, in this pro-investor decision, the Supreme Court clarified its long-standing position that any nondisclosed information—statistically measurable or otherwise—that would "significantly alter the 'total mix' of information made available" in the eyes of a reasonable investor could well be material.2
Background of the Case
The Supreme Court's decision reinstated a shareholder class action against Matrixx Initiatives, Inc. for not disclosing several so-called "adverse event reports" that its cold drug Zicam Cold Remedy could cause "anosmia"—the loss of the sense of smell—in some users.3 Although the Supreme Court acknowledged that the securities laws "do not create an affirmative duty to disclose any and all information,"4 the problem was that Matrixx publicly denied any link between Zicam and anosmia at the same time the Company raised revenue guidance, projecting 50-80 percent top-line growth on the back of Zicam sales.5
Investors' enthusiasm for Matrixx was replaced by shareholder litigation after Good Morning America reported that a study linked Zicam to anosmia and noted that Matrixx was facing product liability lawsuits, triggering a one-day stock drop from $13.40 to $9.94 per share.6 Shortly thereafter, the Company acknowledged in a Form 8-K that it was reviewing the study.7
Matrixx shareholders predictably filed a class action in the U.S. District Court for the District of Arizona, claiming that the Company violated the §10(b) anti-fraud provisions of the Securities Exchange Act and related SEC Rule 10b-5 by making misstatements about Zicam's effects and by failing to disclose adverse event reports that would have rendered its statements not misleading.8
Matrixx scored an early victory in the case, persuading the District Court to dismiss the class action complaint on the ground that the investor-plaintiffs' failure to allege a "statistically significant" correlation between Zicam and anosmia necessarily foreclosed any finding that undisclosed adverse event reports were material.9 But on appeal, the U.S. Court of Appeals for the Ninth Circuit reversed the decision. It held that the District Court erred in requiring an allegation of statistical significance to establish materiality.10 Rather, under Basic v. Levinson, the question was whether the complaint adequately alleged the failure to disclose information that would have been significant to a reasonable investor.11
Supreme Court Rejects Bright-Line Test for Pleading Materiality
The Supreme Court affirmed the Ninth Circuit's decision on March 22, 2011. To prevail on a §10(b) claim, a plaintiff must show that the defendant made a statement that was "'misleading as to a material fact.'"12 Under precedent established in Basic v. Levinson, the Court said that "materiality required is satisfied when there is "'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.'"13
As a result, the Supreme Court rejected Matrixx's proposed "categorical" rule requiring an allegation of "statistical significance" to plead materiality.14 According to the Court, such a bright-line test would "artificially exclude information that would otherwise be considered significant to the trading decision of a reasonable investor."15 Not only are statistically significant data not always available,16 "assessing the materiality of [undisclosed information, such as adverse event reports] is a fact-specific inquiry ... that requires consideration of the source, content, and context of the reports."17
Decision Means Easier Pleading for Plaintiffs, Tough Questions for Public Issuers
The pro-investor decision may well make it easier for plaintiffs to avoid dismissal of securities fraud complaints at the motion to dismiss stage. Specifically, without a hard-line numbers test, aggrieved investors will contend that materiality is a "fact-specific" determination that cannot be easily resolved on the pleadings by reference to whether reported complaints or product problems were statistically significant. Indeed, plaintiffs' lawyers are heralding the decision as a victory.18
But the Court was nonetheless quick to make a number of things clear, each potentially limiting the increased exposure public companies face as a result of Matrixx.
First, the Court made plain that statistical significance (or the lack thereof) was not irrelevant—merely that it was not dispositive of the materiality analysis.19
Second, the Court emphasized that the criticality of Zicam to Matrixx—the product accounted for roughly 70% of its total sales—was important to its decision to allow the case to go forward, which is consistent with prior decisions involving allegations that an issuer misrepresented a key product or "core operations." The same logic would necessarily help reduce the exposure facing companies sued for misleading investors about a product or business segment that did not dominate an income statement in the same way that Zicam drove Matrixx's sales.
Third, the Court distinguished its materiality analysis from plaintiffs' separate burden to plead that the Company had a duty to reveal the information in the first instance. In so doing, the Court reaffirmed that "[s]ilence, absent a duty to disclose, is not misleading[.]"20 In Matrixx, the Company was found to have violated its public reporting obligations by both affirmatively misrepresenting facts (by publicly denying the link between the product and anosmia) and telling half-truths (by increasing product sales guidance without disclosing facts that jeopardized such dramatic sales growth).21 Absent such a duty to speak, however, the case would not proceed.
Fourth, although the Court rejected a "bright line" statistical materiality analysis in the context of the product safety issues presented in Matrixx, it conspicuously avoided any suggestion—and certainly did not repudiate—the long line of precedent dismissing shareholder class actions based on accounting errors deemed too small to be material. Thus, public issuers who restate previously reported financials should retain good materiality defenses to post-hoc litigation if the corrected error does not exceed widely recognized materiality thresholds.22
Fifth, recognizing the risk that public companies would overdisclose, the Court cautioned that adverse event reports in and of themselves are not per se material; "[s]omething more is needed, but that something more is not limited to statistical significance and can come from the source, content, and context of the reports[.]"23
The Court did not define what that "something more" is, and that was precisely the point: undisclosed information is material if a reasonable investor viewed it as having "significantly altered the 'total mix' of information made available." Here, plaintiffs alleged that Matrixx received information that "plausibly indicated a reliable causal link between Zicam and anosmia."24 And that was good enough to plead materiality under the Basic standard.
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That said, public issuers—especially those in industries that rely on statistical reporting to evaluate the safety and utility of their products—will need to consider carefully whether to take the preemptive step of disclosing anecdotal or statistically insignificant reports in public communications concerning those products' safety and utility. Matrixx, as a case involving an over-the-counter medication, will almost certainly make drug companies more cautious in such disclosures. But the decision is likely to raise questions in other industries as well. For example, do automakers need to disclose statistically insignificant reports of brake failures? Must food and beverage companies disclose anecdotal links between their products and consumer health issues? In light of Matrixx, issuers should pay particular attention to the nature and reliability of adverse event reports and the relationship of those reports to the company's public statements about the business or products at issue in making the difficult judgments about what to disclose.
1Matrixx Initiatives, Inc. v. Siracusano, No. 09-1156, 563 U.S. ---, Slip Op. at 11 (Mar. 22, 2011).
2Id. at 15 (citing Basic v. Levinson, 485 U.S. 224, 232 (1988) (quoting TSC Industries v. Northway, 426 U.S. 438, 449 (1976))).
3Matrixx, at 2-3.
4Id. at 16.
5Id. at 4-6.
6Id. at 6.
7Id. at 7.
10Id. at 8.
12Id. at 9 (quoting Basic, 485 U.S. at 238).
13Matrixx, at 10 (quoting Basic, 485 U.S. at 231-32 (quoting TSC, 426 U.S. at 449)).
14Id. at 11.
15Id. at 11 (internal quotations omitted).
16Id. at 12.
17Id. at 15 (internal citations and quotations omitted).
18See Evan Weinberger, "Matrixx Opens Door for Plaintiffs, But Only a Crack," Law360 (Mar. 22, 2011), available atwww.law360.com/topnews/articles/233924/matrixx-opens-door-for-plaintiffs-but-only-a-crack ("Rejecting such a 'bright line' test for materiality was necessary to prevent defendants from hiding behind a lack of statistics, according to Christopher J. Keller, a partner at Labaton Sucharow LLP. 'Whenever you put down a bright-line test, there's always going to be an attempt to game the system,' he said. 'And I think this avoids it.'").
19Matrixx, at 15.
20Basic, 485 U.S. at 239 n.17.
21Matrixx, at 16-19.
22See, e.g., In re First Union Corp. Sec. Litig., 128 F. Supp. 2d 871, 895 (W.D.N.C. 2001) (deeming immaterial alleged understatement of losses amounting to only 2.1% of operating earnings and 2.8% of earnings); Parnes v. Gateway 2000, Inc., 122 F.3d 539, 547 (8th Cir. 1997) (finding alleged misrepresentations with regard to 2% of total assets were immaterial as a matter of law); In re Westinghouse Sec. Litig., 90 F.3d 696, 715 (3d Cir. 1996) (stating that a misstatement was immaterial where only 1% of assets was allegedly misclassified); SEC v. Stedman, 967 F.2d 636, 643 (D.C. Cir. 1992) (recognizing a 5% standard for materiality); but see Landmen Partners, Inc. v. The Blackstone Group, L.P., No. 09-4426-cv, at 19-20 (2d Cir. Feb. 10, 2011) (rejecting a "formulaic" approach, and noting that a 5% numerical threshold is merely a "good starting place" for assessing materiality).
23Matrixx, at 16.
24Id. at 17.