Monday, January 10, 2011

Supreme Court Oral Argument in Materiality Case Discusses Deference Due to SEC

As the US Supreme Court considered at oral argument the materiality element of Rule 10b-5 for the first time in decades, the Assistant US Solicitor General contended that the SEC is due a significant deference based on its long-standing historical practice in applying the materiality standard, which is part of its own Rule 10b-5, and its special expertise in knowing what a reasonable investor would want to know based upon its experience in this area. In a case 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, and in which the SEC filed an amicus brief, Justice Kagan asked what deference the SEC's understanding of materiality it's entitled to and why. Assistant Solicitor General Prakit Shah said that the Court in both its earlier materiality rulings in TSC and Basic that an omitted fact is material when there is a substantial likelihood that a reasonable investor would have considered it important, accorded what it called due deference to the SEC's views on the application of the materiality standard.

In those earlier cases, he noted, the Court was deferring to the views of the SEC as expressed in amicus briefs to the Court just like in this case. Thus, Mr. Shah believes that to the extent there is any ambiguity remaining in this case, the Court should defer to the SEC's views. In Basic, he continued, the Court not only articulated the general standard, but it laid out some factors. And in laying out those factors, that is where the Court deferred to the SEC's brief, which laid out factors that a reasonable investor might find relevant in the merger context. Similarly, noted , the SEC amicus brief lays out several factors that the Commission thinks should bear on the materiality question in this particular context; that is, involving adverse drug information.

In this case, the SEC urged the Court to hold that information that a drug causes adverse effects may be material to investors even absent statistical significance. Information suggesting a causal link between use of a drug and a serious adverse effect may significantly alter the behavior of consumers and regulators, contended the SEC, even when there is no allegation of a statistically significant association. In turn, because those reactions can affect a company’s share price reasonable investors would consider such information to be highly relevant to their investment decisions. Matrixx Initiatives Inc. v. Siracusano, Dkt. No. 09-1156.

The Assistant Solicitor General said that for 35 years the Court's precedents have instructed that information is material for securities fraud purposes if a reasonable investor would have viewed it as having meaningfully altered the total mix of information. Under the terms of their question presented, he argued, the petitioners propose to depart from that contextual inquiry in favor of a categorical rule that deems information about an adverse drug effect immaterial absent statistical significance.

Some of the Justices seemed skeptical of importing the statistical significance standard into Rule 10b-5 materiality.

Justice Kagan noted that the FDA takes action all the time as to drugs, they force the withdrawal of a drug from the market, they force relabeling of a drug, on the basis of findings that are not statistically significant. Clearly in those cases the market has a right to know the very things that are going to make the FDA take action against a product and that are going to severely affect the product's value to the company. Not statistical significance there, said the Justice, adding that statistically significant is not a test that the FDA itself uses when it thinks about what it should regulate.

Justice Alito asked counsel for the company if there can there be some situations in which statistically significant evidence would not be necessary, for example, suppose some very distinguished physicians concluded based on clinical trials that there was a connection between a drug and a very serious side effect. Could that establish materiality? Counsel responded that a distinguished physician would not conclude that there is a connection unless the clinical trials reveal a statistically significant difference between what they've seen and what they would expect to see were there no association.

Justice Scalia posed the situation if Good Morning America categorically said that this drug caused this condition, but did so simply on the basis of adverse incidents, without physician reports, and thousands of unreasonable investors relied upon it. Counsel said that the law doesn't respond to irrational, unpredictable, or unreasonable investors. It responds to a reasonable investor who wants accurate information. But the Chief Justice noted that a reasonable investor is going to worry about the fact that thousands of unreasonable investors are going to dump their company stock and there' is nothing unreasonable about that. Counsel said that the answer is statistical significance, just like the Second Circuit said in the Carter-Wallace opinion.

Justice Breyer said that it can't be, noting that Albert Einstein had the theory of relativity without any empirical evidence. We could get the greatest doctor in the world and he has dozens of theories, said the Justice, and the theories are very sound and all that fits in here is an allegation he now has learned that it's the free zinc ion that counts. And that could be devastating to a drug even though there isn't one person yet who has been hurt. So the Justice could not see how we can say this statistical evidence always works or always doesn't work.

Justice Sotomayor observed that cert was granted on a limited question of whether in a complaint that alleges only adverse reports can you prove materiality and scienter without proving statistical importance. She noted that Justice Kagan started with the point that the FDA doesn't require that. It requires just reasonable evidence of a connection, not statistical. Justice Sotomayor added that many of the amici have done a wonderful job of explaining why statistical importance can't be a measure because it depends on the nature of the study at issue.