SCOTUS clarifies materiality standard for corporate disclosure

The recent US Supreme Court decision in Matrixx Initiatives, Inc. v. Siracusano clarifies the materiality standard for corporate disclosure, and will be relevant to Canadian issuers.

The case was an appeal of a motion to dismiss a securities fraud class action on the basis that the alleged misleading statements concerning Matrixx's leading cold remedy were not material. The District Court granted the motion to dismiss and was overturned by the Ninth Circuit Court of Appeal.

As the case concerned a motion to dismiss before trial, the court assumed that the facts alleged in the plaintiff's pleadings were true.

Background

Matrixx is a manufacturer of over-the-counter pharmaceuticals. One of these, Zicam Cold Remedy, accounted for about 70% of Matrixx's sales. The active ingredient in Zicam was zinc gluconate.

In 1999, Matrixx became aware of a possible link between Zicam and a loss of the sense of smell for users. In 2002, Matrixx's vice president for research and development received a number of complaints about a loss of sense of smell and was given abstracts of studies done in the 1930s and 1980s confirming "zinc's toxicity." Matrixx had done no studies of its own. In 2003, Matrixx learned that two doctors were planning to present findings about Zicam at a meeting of the American Rhinologic Society and warned them that they did not have permission to use Matrixx's or Zicam's names in their presentation. The doctors deleted the references.

One month after the doctors' presentation, the first of four class action lawsuits claiming Zicam caused a loss of smell were filed.

In October 2003, after the presentation, Matrixx issued a statement that Zicam "was poised for growth" and the company had "very strong momentum" with revenues increasing by 50% and earnings per share increasing by 25-30%.

In November 2003 Matrixx filed a Form 10-Q stating that product liability claims may result in a material adverse effect, whether or not proven valid. The form did not disclose that litigation had been commenced.

In January, 2004, Matrixx revised its revenue and earnings targets upward. On January 30, news reports stated that the Food and Drug Administration was looking into complaints about Zicam. The stock fell from $13.55 to $11.97 on the news. Matrixx issued a press release denying a link between its product and a loss of sense of smell. The stock rebounded, but fell again after a Good Morning America broadcast highlighted the issue and noted that four class actions had been launched. A new class action, this time on behalf of purchasers of Matrixx stock, followed.

The basis for the motion to dismiss

Matrixx argued that the plaintiffs had not alleged a "statistically significant correlation" between the use of Zicam and loss of smell to make a failure to publicly disclose the complaints or the earlier studies a material omission. They also argued that the plaintiffs had not stated with particularity facts giving rise to a strong inference of scienter (an intent to deceive, manipulate or defraud), which is a requirement in securities fraud litigation.

The court decision

In a unanimous opinion delivered by Justice Sotomayor (as far as I'm aware, her first) the court upheld the Ninth Circuit decision.

Sotomayor, J. noted that the test for materiality is whether there is a substantial likelihood that a reasonable investor would consider disclosure of a fact to significantly alter the "total mix" of available information. Matrixx was proposing a bright-line test of statistical significance that would "artificially exclude" information that would be significant to trading decisions. Both medical professionals and the FDA consider evidence of causation that isn't statistically significant, and it is reasonable to assume investors would as well.

The court noted that its decision is not a requirement to disclose all adverse drug effects, but ones that reasonable investors would consider to alter the total mix of information must be disclosed. The mere existence of adverse effect reports is not sufficient to support a securities fraud claim. More is required, but the reports do not have to be statistically significant. In this case, consumers would likely be wary of Zantac as the risk of losing the sense of smell outweighed any benefit from the product, especially given the number of cold remedies on the market.

With respect to scienter, the court noted that Matrixx had dismissed "out of hand" findings of a link between Zicam and loss of smell despite having done no studies of its own. It had no basis for making such a claim.

Implications for Canadian companies

The test of materiality in Quebec is more or less the same as in the United States. In other provinces, the test is whether disclosure of the information would reasonably be foreseen to have a significant effect on the market price or value of securities. In most cases, including this one, the result would be the same. There is no bright line. Materiality must be assessed on a case-by-case basis. As is the case in the US, the mere existence of adverse reaction reports will not give rise to an obligation to disclose. But the number and context of such reports may give rise to an obligation to disclose well before they reach a statistically significant number.

Securities Class Actions and Discovery

As I was reading the Globe and Mail this morning, I saw an article about an Ontario Superior Court decision in Silver v.Imax Corp., upheld on appeal, that the test for questions on cross-examination on affidavits prior to class certification is that the question have a "semblance of relevance." The defendants had argued that "there is no pre-action right of discovery and as a general rule a plaintiff cannot compel production and disclosure from a prospective defendant" but in the view of Madame Justice Van Rensburg were not able to come up with a workable alternative.

I hadn't been aware of this one, but it raises interesting issues. This is the first case to deal with Part XXIII.1 of the Securities Act (Ontario), which imposes civil liability for secondary market disclosure. The defence bar is up in arms, saying that this will tie corporate executives up dealing with plaintiffs' fishing expeditions, effectively forcing them to discuss a settlement. The plaintiffs' bar feels that they are dead in the water if they can only have access to materials that are already in the public domain as they have to obtain leave from a judge to commence the action and in so doing, must prove they have a reasonable chance of success. In fact, both sides may rue this decision.

The Toronto Stock Exchange Committee on Corporate Disclosure (more commonly known as the Allen Committee after its chair, Tom Allen), for which I was TSX staff co-ordinator, considered whether there should be constraints on the abilities of plaintiffs to commence class actions. The context was the situation in the United States, where entrepreneurial plaintiff's lawyers would launch a class action immediately following a significant drop in a company's stock price. The demands on executives’ time (particularly in open-ended discovery) and uncertainty of litigation were so great that companies would settle cases that had little or no merit.

While the Committee was deliberating its final report, the U.S. Congress adopted the Private Securities Litigation Reform Act, which attempted to address some of the most egregious abuses. One of the major provisions of that Act (now § 27(b) of the Securities Act of 1933) deals with discovery, stating that ‘[i]n any private action arising under this title, all discovery and other proceedings shall be stayed during the pendency of any motion to dismiss, unless the court finds, upon the motion of any party, that particularized discovery is necessary to preserve evidence or to prevent undue prejudice to that party.”

I had thought that the requirement that leave be obtained for class actions originated with the Allen Committee, but on rereading their report I realized that I had, to quote the outgoing U.S. President, “misremembered.” The Committee considered a requirement that the securities commissions act as a gatekeeper, but felt that the existing disincentives to litigate in Canada would act as a sufficient deterrent to meritless actions. In fact, some on the Committee were concerned that the chance of a lawsuit was still so low that the threat of litigation would not be a sufficient incentive for companies to improve their disclosure practices (and, it was hoped, avoid ever making the misrepresentations that would land them in hot water).


With the courts grappling with the parameters for class actions (and whether to grant leave to proceed) for the first time, I think it is important to remember basic principles. The requirement for leave was not, I think, to balance the fact that plaintiffs do not have to prove reliance on a defendant's misrepresentation, as argued by the defendants. Having a requirement that a plaintiff prove reliance would make the liability provisions self-defeating. Class actions would not be possible as the individual issues (whether a given plaintiff was aware of a misrepresentation and relied on it to his or her detriment) would overwhelm the common ones. The amount an individual shareholder lost in any given instance would generally be too small to justify litigation.


The requirement for leave addresses the abusive litigation seen in the United States. It would make sense to leave the threshold for leave fairly low so that extensive discovery is not needed. Otherwise, the court could end up engaging in a mini-trial simply to decide whether there should even be a trial. That would serve neither plaintiffs nor defendants. The test should be whether the plaintiff has pled with such particularity that it is clear the lawsuit has merit and should proceed, with discovery falling after certification. If, on the other hand, the plaintiff's position is "we're pretty sure there's been a misrepresentation but won't know for sure until we've looked at everything the defendant has," leave shouldn't be given as the suit is clearly speculative.

It is unfortunate if courts hold the plaintiff to such a high standard that all of the litigation tactics normally seen at trial were used for leave applications. This will ultimately cost both plaintiffs and defendants and is not the outcome I believe the legislature had in mind when it adopted the civil liability provisions.