On March 22, 2011 the U.S. Supreme Court ruled that reports about the adverse effects of a product may be “material” even when not statistically significant.  In a unanimous opinion, the high Court affirmed the Ninth Circuit’s decision and ruled that a class action securities fraud case may proceed against Matrixx Initiatives, Inc., the makers of Zicam, an over-the-counter cold remedy.

The plaintiffs brought suit against Matrixx pursuant to Section 10(b) of the Securities Exchange Act of 1934 and Securities and Exchange Commission Rule 10b-5, alleging that Matrixx committed securities fraud by failing to disclose reports that users of its Zicam product, which accounted for 70 percent of Matrixx’s sales, subsequently suffered from anosmia, a condition involving the loss of the sense of smell.  Such reports are referred to as adverse event reports; that is, reports that users of a drug experienced an adverse event during or after use of the drug.  The district court dismissed the complaint, finding that it failed to state a claim because the undisclosed information was not statistically significant and, therefore, not material.  The Ninth Circuit reversed and remanded, rejecting the lower court’s application of a bright-line rule that user complaints must be statistically significant to be material and finding that the court should have engaged in a fact-specific inquiry to determine whether the information would have been significant to a reasonable investor.  The Ninth Circuit’s opinion was contrary to decisions in the First, Second and Third Circuits that had all held that drug companies have no duty to disclose adverse event reports unless there is statistically significant evidence linking the drug to the adverse events.  The Supreme Court resolved this split among the Circuits in favor of the Ninth Circuit and the Matrixx plaintiffs, ruling that the materiality of adverse event reports is not subject to the application of a bright-line rule.

The plaintiffs are a class of shareholders who purchased Matrixx securities between October 22, 2003 and February 6, 2004.  The plaintiffs allege that Matrixx was aware that numerous users of its Zicam product, which uses zinc gluconate applied to the nasal cavity, reported anosmia, but that Matrixx nonetheless made statements during this period that failed to disclose this information or contradicted reports of anosmia in users.  When the television program Good Morning America did a story on Zicam and anosmia in February 2004, Matrixx’s stock fell by almost 24 percent in one day.

Matrixx had numerous warnings about the possible adverse effects of its product before the start of the class period.  Thereafter, Matrixx made numerous allegedly misleading statements.  In an October 2003 press release and conference call, Matrixx indicated that it expected significant revenue growth due to the success of Zicam.  In its 10-Q report for the third quarter of 2003, Matrixx discussed the prospect of significant costs associated with product liability claims, but did not disclose that a lawsuit claiming that Zicam had caused anosmia had already been filed.  When Dow Jones Newswires reported that the FDA was investigating the possibility that Zicam may cause a loss of the sense of smell, Matrixx’s stock fell from $13.55 to $11.97 per share.  Matrixx immediately issued a statement stressing that no loss of sense of smell had ever been reported in a clinical trial of Zicam and that Matrixx believed that any assertions that its product caused anosmia were “completely unfounded and misleading.”  After the press release, Matrixx’s stock price rose to $13.40 per share.

Two days later, Good Morning America aired a segment linking Zicam with anosmia and reporting the findings of one of the doctors who had previously contacted Matrixx regarding patients suffering from the condition after using Zicam.  Matrixx’s stock fell from $13.05 per share on February 5, 2004 to $9.94 per share on February 6, 2004.

In its case before the Supreme Court, Matrixx argued that the statistically significant standard should apply to prevent companies from feeling pressured to disclose all adverse event reports and thereby flood the market with unreliable and irrelevant information.  Such a result, according to Matrixx and its supporters, would defeat the purpose of disclosure by making it difficult for the investing public to distinguish what information is significant in making investing decisions.  Matrixx argued that reports that do not rise to the level of statistical significance do not sufficiently demonstrate a causal relationship to be material.

The Product Liability Advisory Council, Inc. (“PLAC”), which filed an amicus curiae brief in support of Matrixx, further argued that the Ninth Circuit’s holding could have consequences, not only for pharmaceutical companies, but also food companies and makers of medical devices because these companies are likewise regulated by the FDA and may have obligations to report adverse events to the FDA.  Furthermore, PLAC argued that the Ninth Circuit’s holding could be extended to other industries such as the automobile and consumer products industries.  This, according to PLAC, would overwhelm the investing public with essentially useless information.

The plaintiffs countered that reasonable investors are sophisticated enough to consider information that is not statistically significant and decide whether it should impact their investing decisions.  The United States, filing an amicus curiae brief in support of the plaintiffs, also noted that reports of adverse effects may signal potential regulatory activity, impact product sales and increase the likelihood of litigation, all of which may be material to investors.  Additionally, the government argued that companies would need to disclose reports of negative effects of products only where the company also makes positive statements about the products’ success and safety.

The Supreme Court, agreeing with the arguments advanced by the plaintiffs and the United States, unanimously affirmed the Ninth Circuit’s decision.  The Court, referencing its previous decision in Basic Inc. v. Levinson, began its analysis by noting that the standard for materiality is whether the reasonable investor would regard the omitted information as substantially likely to alter the “total mix” of information.  Matrixx had attempted to argue that evidence that failed to rise to the level of statistical significance was not a reliable indicator of causation.  The Court, however, found fault with this premise, observing that “medical professionals and regulators [like the FDA] act on the basis of evidence of causation that is not statistically significant” and consequently, “it stands to reason that in certain cases reasonable investors would as well.”  The determination of whether adverse event reports are material, according to the Court, requires a fact-intensive inquiry that considers “the source, content, and context of the reports.”  Applying this framework to Matrixx, the Court determined that “the allegations of the complaint as a whole . . . allege[d] facts suggesting a significant risk to the commercial viability of Matrixx’s leading product,” and were, therefore, sufficient to allow the plaintiffs to go forward with their case.

Despite its apparently pro-plaintiff decision, the Court was quick to point out that its ruling did not create a requirement for pharmaceutical manufacturers to disclose all adverse event reports.  The mere existence of adverse event reports alone does not require disclosure.  Rather, disclosure is necessary only where the failure to disclose renders statements made by the company misleading.  As the Court pointed out, “companies can control what they have to disclose under these provisions by controlling what they say to the market.”

Important to the Court’s decision was the fact that Matrixx had made several affirmative statements about its expected revenues and about the safety of its leading product.  Given these affirmative statements, the failure to disclose reports of adverse events made these statements misleading.  While the Matrixx decision clearly applies to pharmaceutical companies, it should prompt SEC-reporting companies to exercise caution in making affirmative statements where they have received reports of adverse events in connection with their products.