Does a whiff of a problem equal securities fraud?

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During lively oral arguments in a case that could have implications far beyond the securities fraud sphere, the justices of the U.S. Supreme Court tried to determine just what constitutes material information that should be disclosed to shareholders.

At issue in Matrixx Initiatives Inc. v. Siracusano: Whether the makers of the over-the-counter cold remedy Zicam should have notified its shareholders about reports that the nasal spray version of the product caused some consumers to complain of anosmia — losing their sense of smell.

The case stems from a class action brought by drug maker Matrixx Initiatives’ investors alleging that the company violated the Securities Exchange Act by failing to disclose reports of adverse health events and pending lawsuits involving Zicam nasal spray.

After the first lawsuits were filed, Matrixx issued a press release indicating that sales of the drug jumped 164 percent in 2002, and were poised to continue growing during the cold and flu season.

News of the lawsuits and the study linking Zicam to anosmia were reported by national media outlets, and Matrixx issued a press release reaffirming the product’s safety. But the stock dropped, losing nearly a quarter of its value.

Matrixx filed a report with the Securities and Exchange Commission stating that there was “insufficient evidence” linking Zicam spray to anosmia. Five years later, after the Food and Drug Administration issued a warning letter to Matrixx, the company pulled the spray from the market.

Matrixx moved to dismiss the shareholders’ claims of a violation §10(b) by arguing that the complaint failed to state the requisite scienter and materiality. The district court agreed and dismissed the case, but the Ninth Circuit reversed, holding that questions of scienter and materiality were for a factfinder to decide at trial.

The ruling created a split in the circuits, and the Supreme Court granted Matrixx Initiatives’ request for certiorari.

Raising the ‘ex ante’

Jonathan Hacker, a partner in the Washington office of O’Melveny & Myers, argued for Matrixx that incidental reports — that may have no bearing on the safety of a product — should not create a duty to warn shareholders of potential market loss.

“All drug companies receive on an almost daily basis anecdotal hearsay reports about alleged adverse health events following the use of their products,” Hacker argued.

But Justice Ruth Bader Ginsburg pointed out that the case only reached the pleadings stage.

“So … let’s say, there has been discovery,” Justice Ginsburg said. “They might have been able through discovery to find that there were many more [reports of adverse events.] Why shouldn’t that determination be deferred until there’s discovery, and then we can know how many reports there really were?”

“Because it’s incumbent on a plaintiff to come to court with a case and to plead the facts necessary to establish all of the elements of a claim,” Hacker said.

Chief Justice John G. Roberts Jr. tried to determine the parameters of materiality.

“[If] I’m an investor in Matrixx, I worry whether my stock price is going to go down,” Chief Justice Roberts said. “You can have some psychic come out and say ‘Zicam is going to cause a disease’ with no support whatsoever, but if it causes the stock to go down 20 percent, it seems to me that’s material.”

“That’s not the kind of information a real investor would rely on,” Hacker said. “The law doesn’t respond to irrational, unpredictable or unreasonable investors.”

“A reasonable investor is going to worry about the fact that thousands of unreasonable investors are going to dump their Matrixx stock,” Chief Justice Roberts said. “I mean, there’s nothing unreasonable about that.”

“So how does it work where we in fact just don’t know whether this does or [does] not arise above the background noise of a drug company?” asked Justice Stephen Breyer.

“We think the answer is statistical significance,” Hacker said.

“Oh, no, it can’t be,” Justice Breyer said, drawing laughter. “I’m sorry — I don’t mean to take a position yet.”

‘Statistical significance’ or ‘satanic susceptibility’?

David Frederick, a partner in the Washington office of Kellogg, Huber, Hansen, Todd, Evans & Figel, argued on behalf of the shareholders that adverse reports constitute information that investors should have to allow them to make informed decisions.

“All of these things go into the contextual mix that investors would regard as important in making an investment decision,” Frederick said.

That argument didn’t seem to pass the sniff test with Justice Antonin Scalia.

“Five adverse reports out of 10 million?” Justice Scalia said. “If that’s the only product they make, [in the] totality of the circumstances, that may be enough?”

“That very well might if the probability and the magnitude of the harm … might be … relevant … information that investors might want to take into account,” Frederick said.

When Justice Sonia Sotomayor asked how companies are supposed to determine whether such information is credible, Frederick said: “It really depends.”

“I don’t mean to be evasive, but if there is a product, say, that has some link to satanic influences, and there is some reason to think that a large body of followers [may believe that], a cautious, reasonably prudent investor might want to know that on the basis … that [such] information that most of us would regard as irrational might affect the stock price,” Frederick said.

“I don’t know what kind of product has particular satanic susceptibility,” Chief Justice Roberts said to laughter. “Are you saying it matters if it’s something that Satan’s not going to be interested in? I don’t understand.”

“Well, Your Honor, there are people who follow those things, and they spend money and they buy stocks,” Frederick said.

Justice Scalia was still not convinced.

“It seems to me ridiculous to hold companies to irrational standards,” he said.

A decision from the court is expected later this term.