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.

Insider Twitting

Bruce Carton’s Enforcement Action blog on Compliance Week is always interesting and informative. This week, he questioned whether someone who traded in securities based on information leaked through Twitter would be engaging in insider trading. He had three scenarios and analysed each (although he confessed it was “way tougher than I thought it would be”).

I thought it would be interesting to look at this from a Canadian perspective, given that our insider trading prohibition is more black and white, and got Mr. Carton’s consent to use his examples. But as the existing rules and guidelines were written well before the advent of social networking sites like Facebook and Twitter, I realized it was, well, way tougher than I thought it would be. As I thought it through, it occurred to me: this would make an excellent exam problem. And, as I have been watching the old Paper Chase TV series recently, I imagined a Socratic inquiry into the issue. You have to assume that Professor Charles Kingsfield teaches securities law in addition to contracts and that he teaches at the University of Toronto (where the movie version of The Paper Chase was filmed) and not Harvard (where it was set).

The biggest difference between Canadian and American law is that Canadian law is a blanket prohibition on trading on undisclosed material information, while American law requires a breach of a fiduciary duty, such that the person is misusing a confidence. In the recent SEC v. Cuban case,(1) six law professors filed an amici curiae brief (surprisingly short, given law professors wrote it!) arguing that the charges against Cuban should be dismissed. The SEC action alleged that Cuban breached Rule 10b-5 of the Securities Exchange Act of 1934 by selling shares of a company after he learned it was planning to issue shares at a discount to market, despite an agreement with the company that he would keep the information confidential. The professors argued (persuasively it seems, as the case was dismissed with leave for the SEC to refile) that breach of confidentiality alone is not sufficient. There must be some sort of family or other relationship that is betrayed when the confidential information is misused by the person receiving it. For example, someone giving confidential information to their spouse normally does so on the basis that the spouse will maintain the confidentiality and not trade on or otherwise unfairly profit from the information. In the Cuban case, there was no such relationship and no duty to refrain from trading absent an explicit agreement not to do so.

So are the Canadian rules clearer? Yes and no. Let’s see.

KINGSFIELD: Mr. Baikie, will you please give us the facts of Ontario Securities Commission v. Twaddle?

BAIKIE: Mr. Twaddle was a senior vice-president at ABC Corp. He knew that the company was in negotiations to be taken-over by XYZ Inc. at a premium to the current market price, and that they expected to come to final terms shortly. He made a posting on Twitter that said “I’m about to become a rich man. My company, ABC Corp., will be acquired next week at a 50% premium to the current stock price. Shhh!!!!” Several of his followers bought ABC stock on the Toronto Stock Exchange prior to the announcement of the merger, and the stock price jumped from $20 to $30 when the merger was announced. The OSC brought an enforcement action against Twaddle for violation of section 76 of the Ontario Securities Act.

KINGSFIELD: So, do you think Twaddle’s Twitter tweet was a violation?

BAIKIE: Clearly, sir. Subsection 76(2) of the Act prohibits any person or company in a special relationship with a reporting issuer from informing, or “tipping” any other person about a material fact or material change concerning the reporting issuer that has not been generally disclosed, or, in common parlance, “inside information.” As an insider, Mr. Twaddle was in a special relationship by virtue of the definition of “person in a special relationship” in subsection 76(5).

KINGSFIELD: Does it matter that Mr. Twaddle didn’t himself trade?

BAIKIE: No. Tipping is a violation in and of itself.

KINGSFIELD: Could Mr. Twaddle have argued that by tweeting the information he was “generally disclosing” it?

BAIKIE: I don’t think so. Both the Canadian Securities Administrators’ National Policy 51-201 Disclosure Standards and the TSX’s Timely Disclosure Policy (2) require broader dissemination than a tweet. The TSX policy requires the company to issue a news release with the broadest dissemination possible. NP 51-201 states that a conference call or press conference may be adequate if interested members of the public can attend or listen in and are given sufficient advance notice so they can decide whether to attend. NP 51-201 and the TSX’s Electronic Communications Disclosure Guidelines both state that posting information on a company’s website does not constitute general disclosure. If posting the information on ABC’s website would not be sufficient, it’s hard to see how posting it to a limited number of followers on Twitter would be.

KINGSFIELD: And what about Twaddle’s followers who bought the stock. Did they violate the Act?

BAIKIE: The OSC charged them separately, so this case doesn’t say what happened to them.

KINGSFIELD: I know, but I expect you to be able to analyse every aspect of the case. Come now, Mr. Baikie, we’re waiting. Fill this room with your intelligence!

BAIKIE: Any tippee, that is a person who receives inside information, violates subsection 76(1) of the Act if they trade in the subject security. The OSC does not have to prove that they used the information in their trading decision. Given that Mr. Twaddle’s tweet states “my company” and “Shhh,” I think it’s clear he was giving them inside information they could improperly use to their benefit. Furthermore, subsection 76(2), which I mentioned earlier, prohibits them from passing the inside information along to others.

KINGSFIELD: And that’s the end of the analysis?

BAIKIE: Yes, sir.

KINGSFIELD: I think not. Mr. Gagarian, could you enlighten us, please?

GAGARIAN: Sir, the answer to whether they violated the Act has to be “it depends.”

KINGSFIELD: And it depends on what?

GAGARIAN: Subsection 76(4) provides a defence if the person trading reasonably believed that the information had been generally disclosed. The key word is reasonable, and that depends on the circumstances.

Suppose Twaddle’s postings were extremely boring and his only followers were 5 family members and close friends. It is unlikely that the followers would believe that he was doing anything other than giving them inside information.

Now suppose he has 2,000 followers. An argument could be made that a follower could assume that the information had been generally disclosed. Although tweeting clearly doesn’t satisfy the requirements of NP 51-201, the inquiry doesn’t end there. First off, NP 51-201 is a policy, which by definition isn’t a binding rule. It notes that the Act doesn’t define what constitutes “generally disseminated,” but cites some insider trading cases as precedent. It was written when the Internet was in its infancy and social networking sites like Twitter and Facebook weren’t even contemplated. The precedents are even older.

One of Twaddle’s many followers might have a reasonable belief it wasn’t confidential because he had never posted confidential information before and because it would be read by so many other people. This is negated somewhat by the fact that he did say “Shhh,” and by the fact that if the information had been disclosed it should have already been reflected in the stock price, but I think there’s an argument there. If there was nothing in the tweet suggesting the information was confidential, they would have a much stronger argument.

Now what if he had only 5 followers, all of whom were strangers? They could construct an argument that they didn’t believe he was giving them confidential information because he had absolutely no motive to tip off people he didn’t know, but I think they are in a weaker position than the 2,000 followers.

KINGSFIELD: Are you suggesting that Mr. Baikie was incorrect when he stated that the tweet did not constitute general disclosure?

GAGARIAN: No, sir. Although “generally disseminated” isn’t defined, the Act clearly contemplates widespread awareness of the information before someone can trade. That would be thwarted if someone could “disclose” the information by posting it on the internet such that only a few people will become aware of it. And it would be unworkable if the test were a certain minimum number of people being aware, as the person posting would have no way of knowing how many people actually read it.

I’m suggesting that even though tweeting would not constitute “generally disclosing” the information, in certain circumstances, someone reading the tweet would reasonably conclude that it had been generally disclosed. Maybe 2,000 followers isn’t enough, but what if Ashton Kutcher told his 2.9 million followers (3)about the take-over?

KINGSFIELD: But aren’t you ignoring the fact that a tweet isn’t considered “general disclosure”?

GAGARIAN: This is a defence to an insider trading charge. The test isn’t whether the information was in fact generally disclosed. If the information had been, there wouldn’t have been a violation in the first place. The test is whether the tippee reasonably believed it had been. I think the standard should be the reasonable Twitter follower, not the reasonable securities lawyer who should be expected to know it hadn’t.

KINGSFIELD: Excellent, Mr. Gagarian. Now, did ABC breach the Act? Ms . . . . Logan?

LOGAN: Although subsection 75(1) of the Act requires prompt disclosure of a material change in a reporting issuer, which a take-over bid certainly is, subsection 75(3) allows a company to delay disclosure if premature disclosure would be unduly detrimental. If so, the company can make a confidential filing with the OSC. In this case, ABC could reasonably argue that disclosing details of the pending merger before all the terms were finalized could cause XYZ to walk away, which would be to the detriment of ABC’s shareholders.

However, subsection 75(5)requires ABC to make immediate disclosure of the information if it becomes aware that people are trading on the information. So if ABC knew about the tweet, or if there were unusual buying interest in the stock suggesting that the information had leaked, they would have to issue a news release.

KINGSFIELD: Thank you, Ms. Logan. I see we are out of time. Class dismissed.

KINGSFIELD gathers up his books and seating chart and leaves quickly by the back of the room.

_____________
(1) I was directed to this by Jim Hamilton’s World of Securities Regulation, another excellent blog.
(2) The timely disclosure policies of the other Canadian exchanges are virtually identical.
(3) Actually, it’s 2,895,067 followers as of July 23.

The Financial Crisis II: Everything Old is New Again

The Pennsylvania family I mentioned in my last post can add to their accomplishments causing a constitutional crisis in Canada, nearly wiping out the North American auto industry and prompting a purportedly conservative U.S. government to effectively nationalize many companies. On the bright side, it seems they also caused Bernie Madoff's alleged record-breaking fraud to be exposed.

The crisis has also triggered regulatory responses. Some of these were taken from playbooks of yesteryear, such as imposing restrictions on short sales. Some were the opposite of actions taken in the past; the Glass-Steagall Act was passed in 1933 mandating the separation of banking functions so that customer deposits could not be put at risk by investment banking activities. This year, the remaining independent investment banks were allowed to become bank holding companies, shoring up their capital base in return for greater government prudential oversight.

The finger-pointing has already begun, with an unseemly rush by regulators to blame other regulators for the fallout. The Federal Reserve argues it didn't have the authority to prevent the collapse of Lehman Brothers, while the SEC argues its mandate is investor protection, not prudential regulation. It is clear that at least two significant gaps are in the regulatory regime. There are significant transactions taking place in a completely opaque, unregulated environment. To make matters worse, no single regulator could see the potential impact of these transactions on regulated entities.

The Overall Regime

How these will be addressed is far from certain, but I will venture a few predictions. The first is that the regulatory regime in the United States will be overhauled (there is less need of a comprehensive overhaul in Canada). Regulation of derivative trading has traditionally had a light touch (except for a ban on trading onion futures) on the basis that everyone in the market was a sophisticated player. Clearly, they are not sophisticated enough. Therefore, I predict that the coming year will see more comprehensive regulation of option, futures and insurance contracts, possibly with a requirement to clear all over-the-counter trades through a new central clearing house that would establish maximum risk parameters. There may be a merger of the SEC and the CFTC, but more effective would be a single prudential regulator overseeing the financial health of banks, broker dealers and insurance companies. This will be coupled with greater financial disclosure requirements and stringent requirements to stress test various potential scenarios regardless of their likelihood.

This will create a tension as prudential and traditional securities regulation will sometimes be at cross-purposes. If a bank is experiencing difficulty, a prudential regulator may want it kept quiet to avoid a run on the bank while it attempts to shore up its capital. A securities regulator would insist on immediate disclosure.

In Canada, the banks and brokerages are in much better condition, perhaps because of greater conservatism. That being said, the crisis should bolster the call for a single national regulator that will have jurisdiction over the entire brokerage industry.

The crisis should also provide a stimulus for harmonization of international bankruptcy rules regarding things such as set-off rights.

Other Regulatory Responses

I will state for the record that I am unconvinced that the restrictions on short selling are necessary. I have seen nothing that convinces me that short sales have exacerbated the downward spiral of the markets, and removing exemptions for market makers will only hinder their ability to smooth-out price swings. That being said, the position of regulators world-wide appears to be entrenched and I doubt we will see any easing of restrictions on short sales any time soon.

We will probably also see a clamp-down on sales practices and not just in the brokerage industry. In Canada and the United States, selling asset-backed securities on the basis that they are as safe as houses has tied up a lot of people's savings indefinitely, and predatory mortgage lending in the U.S. has rendered houses considerably less safe. We can probably expect a tightening up of exempt transactions along with more detailed and focused risk disclosure requirements.

In Canada, sales of asset-backed securities were exempt if the securities had a credit rating. Credit rating practices have been called into question, and we can expect to see credit rating agencies subject to greater regulation and possibly self-regulation.

We may also see new financial certification coupled with stress testing requirements for public companies. This may be counterproductive; arguably one of the causes of the current mess is that the Sarbanes Oxley Act has forced management to focus on the wrong things.

NASAA Announces Core Principles for Co-Regulation

The North American Securities Administrators Association, which is the umbrella organization for American state and territorial securities regulators (and which includes Canadian and Mexican regulators), has issued five core principles for strengthening the United States' financial services regulatory structure:

• Preserve the system of state/federal collaboration while streamlining where possible;
• Close regulatory gaps by subjecting all financial products and markets to regulation;
• Strengthen standards of conduct, and use “principles” to complement rules, not replace them;
• Improve oversight through better risk assessment and interagency communication.
  Toughen enforcement and shore up private remedies.
  

This is the latest in NASAA'a efforts to prove its relevance. Despite the popular misconception here, the U.S. does not have just one securities regulator, but more than 50. The state regulators champion the fact that, for them, investor protection is paramount and in the past have viewed the SEC's emphasis on full, true and plain disclosure with suspicion. They have blocked SEC attempts to ease capital raising by refusing to adopt exemptions from their rules for financings done under SEC rules they considered inadequate.

Although the U.S. Congress has limited the states’ ability to regulate, they have not eliminated it completely. There have been a number of times recently where the states, not the SEC, took the enforcement lead, most notably in prosecuting analysts who were issuing “buy” ratings for stocks they personally believed were bad investments (and, less successfully, going after Richard Grasso of the NYSE for excessive compensation).

The core principles clearly see an important continuing role (albeit “streamlined”) for the state regulators by calling for greater collaboration and communication. The call to close regulatory gaps appears to herald a return to the old days where the states would block federal deregulation attempts.

One area of concern is that principles “complement” rather than replace rules. Normally a regulatory regime is comprised of principles supplemented by guidance or rules supplemented by interpretations. The idea the principles complement rules suggests that a principle could be used to expand enforcement jurisdiction to activities that are not specifically prohibited. This is similar to the ability of Canadian securities commission to take action against activities that are contrary to the public interest, which has been subject to much criticism for vagueness.