Corporate Governance

Matrixx v. Siracusana: Revisiting the Materiality Standard (Part 4)

By J Robert Brown Jr.

Is there a circuit split?  Defendants rely on three cases: In re Carter-Wallace, Inc. Securities Litigation, 150 F.3d 153 (2d Cir. 1998), Oran v. Stafford, 226 F.3d 275, 284 (3d Cir. 2000), and New Jersey Carpenters Pension & Annuity Funds v. Biogen IDEC Inc., 537 F.3d 35, 48 (1st Cir. 2008).

Carter-Wallace is the lead case in this area.  The Company allegedly failed to disclose drug related deaths reported in connection with Felbatol.   In alleging a duty to disclose, the plaintiffs pointed to statements in the Company's Form 10-K that there had been "an increase in sales attributable to Felbatol, significant royalties from licensing the drug, and [there was] the expectation of increased Felbatol sales in the future."  In other words, the duty arose not from a direct statement about the safety of the drug but from statements about the earnings generated by the drug.  Carter-Wallace is, therefore, really a duty to disclose case, not a materiality case. 

In analyzing the issue, Judge Winter included only one paragraph of analysis.  As he stated (in its entirety although with citations): 

• We disagree that Carter-Wallace had a duty under Section 10(b) to disclose the Felbatol-related deaths prior to August 1, 1994. The statements in Carter-Wallace's Form 10-K and its "Report to Shareholders" did not become materially misleading until Carter-Wallace had information that Felbatol had caused a statistically significant number of aplastic-anemia deaths and therefore had reason to believe that the commercial viability of Felbatol was threatened.  Drug companies need not disclose isolated reports of illnesses suffered by users of their drugs until those reports provide statistically significant evidence that the ill effects may be caused by -- rather than randomly associated with -- use of the drugs and are sufficiently serious and frequent to affect future earnings. In the present case, four of the ten reported deaths occurred in July -- the disclosure was on August 1 -- and the earlier reports are not by themselves sufficient to support inferences of either actual knowledge or recklessness. We therefore affirm the district court's dismissal of the appellants' claims based on these statements.

There are a number of observations to make about this case. 

First, the statement does not cite any technical definition of statistical significance ("The likelihood that a result or relationship is caused by something other than mere random chance.").  Instead, Judge Winter uses the term to anecdotally mean that the Company did not have enough evidence to know that its drug could cause the adverse health effects.  In other words, the use of the term "statistical significance" adds nothing to the analysis.  The issue is whether the Company was aware of the connection between the drug and the adverse health effects.  The court concluded that it was not based upon a small number of reports.

Second, the case really turns on the duty to disclose.  The Court essentially held that statements about the anticipated earnings did not trigger a duty to reveal concerns over the safety of the drug.  The allegedly false statements went to the revenues generated by the drug.  Thus, the 10-K noted that  "sales have exceeded expectations" and that "this rate of growth is expected to continue."  To have been materially misleading, the Company would have had to be aware of a link between the drug and the adverse health effects and be aware that this link would be sufficient to impair the income stream.  The court essentially concluded that the company lacked this type of evidence.

Had the Company on the other hand made affirmative misstatements, the adverse event reports could have made the statement materially inaccurate.  This can be seen from the treatment of the other issue in the case, the advertisemens for the drug.  As Judge Winter described: 

• To promote Felbatol, Carter-Wallace ran a sixteen-page advertisement in the January 1994 issue of Neurology. The advertisement recited Felbatol's safety record and stated that "no life-threatening liver toxicities or blood dyscrasias have been attributed to Felbatol monotherapy." An identical advertisement appeared in the January 1994 issue of Archives of Neurology. Five-page advertisements containing the same statement appeared in the February, March, April, May, June, and July 1994 issues of Neurology and Archives of Neurology.

The court concluded that the advertisements could be actionable (they could be in connection with the purchase or sale of a security) and remanded the matter to the district court to determine whether the plaintiffs alleged all of the elements of a claim under Rule 10b-5 with respect to the advertisements. 

Had the court found that the adverse health reports were immaterial as a matter of law, there would have been no reason to remand.  Instead, the court left open the possibility that an affirmative statement about the safety of the drug (that no life-threatening liver toxicities or blood dyscrasias have been attributed to the drug) may have been materially misleading due to the adverse reports received by the company.  

Finally, as we will discuss in a later post, the reports in Carter-Wallace were the only evidence of a connection between the drug and the adverse health effects (at least as discussed by the court).  Moreover, they came in over a short period of time.  There was death in January, one in February and two in April and May.  (There were four additional deaths in July but the statements in the 10-K alleged to be false were issued in June).   The Company also acted relatively quickly.  It essentially went public with the problem on August 1. 

In other words, the case did not involve other factors in addition to the reports that suggested there was a problem with the drug nor did it involve a company receiving the reports yet delaying for substantial periods of time over disclosure of the potential health consequences. 

The most that can be said in Carter-Wallace, therefore, is that a company has no duty to disclose a possible health concern with a drug where it had not made affirmative representations about the drug's safety and where it had no other information about possible health effects other than a small number of isolated reports.

For the cert petition and the reply, we have posted them on the DU Corporate Governance web site.

Full post as published by The Race to the Bottom on June 23, 2010 (boomark / email).