Tuesday, December 21, 2010

Law Professors Join SEC in Urging Supreme Court to Reject Bright Line Test for Rule 10b-5 Materiality

A group of law and business professors have filed an amicus brief urging the US Supreme Court to reject a bright line test for Rule 10b-5 materiality and retain the current fact specific test that federal courts and the SEC have used for years to determine materiality. The traditional fact intensive approach set out in the Supreme Court’s Northway ruling and reiterated in its Basic opinion provides an appropriate framework for resolving the materiality issue, argued amici, and the imposition of a bright line test would be fundamentally inconsistent with the reasoning in of those opinions. Similarly, the SEC has filed an amicus brief urging the Court to reject a bright-line rule both because it is too under inclusive and because the materiality inquiry requires delicate assessments better suited to the trier of fact.

The amicus briefs were filed in a private securities fraud action posing the question of whether an investor can state a claim under Rule 10b-5 based on a pharmaceutical company’s nondisclosure of adverse event reports about a drug even though the reports are not alleged to be statistically significant. The Court will hear oral argument in the case on Jan. 10, 2011. Matrixx Initiatives Inc. v. Siracusano, Dkt. No. 09-1156.

It cannot be established that investors will only find reports important upon a showing of a statistical significance, said the brief, and such an approach is inconsistent with assumptions underlying the Court’s use of a total mix analysis. Moreover, statistical significance assumes away, at least in the first instance, any contextual examination of the available information and presupposes that the market singularly relies on the presence or absence of a mathematically validated association between the drug and the adverse events at issue. This approach treats investors as nitwits, remarked the professors, who are unable to appreciate the importance of any other information that could affect their investment decisions.

Even if investors can be said to require evidence of an association between a drug and adverse health effect, reasoned the professors, statistical significance is not the only method of establishing the requisite relationship. For example, there are scientifically valid studies that, while not statistically significant, nonetheless provide evidence of biological significance.

Northway created the analytical template for addressing the materiality of factual misstatements or omissions under the antifraud provisions of the federal securities laws. Information is material if there is a substantial likelihood it would be important to a reasonable investor in making an investment decision or if there is a substantial likelihood that the information would, if disclosed, significantly impact the total mix of available information. The test is fact specific and eschews reliance on bright-line tests.

In the view of the professors, the materiality standard first set forth in Northway has proved sufficiently robust to allow courts to resolve the materiality of quantitative thresholds such as misstatements in earnings or the number of adverse event reports. The SEC has likewise rejected numerical cut offs and bright-line tests and instructed that the analysis take into consideration all the relevant circumstances. See SEC Staff Accounting Bulletin No. 99. While SAB 99 represents the views of the staff, said the brief, the Commission has recognized the need to consider qualitative factors when determining the materiality of quantitative elements. See In re AIG, Exchange Act Release No. 48477 (admin. proc. Sept. 11, 2003), where the SEC said that materiality judgments involve both quantitative and qualitative considerations. Amicus also noted remarks by former SEC Chair Arthur Levitt that materiality is not a bright line cutoff of three or five percent, but rather requires consideration of all relevant factors that could impact an investor’s decision. See Speech by Arthur Levitt, SEC Chairman, The Numbers Game (Sept. 28, 1998).

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