SUPREME COURT TO CONSIDER SECURITIES FRAUD PLEADING QUESTION

The Supreme Court granted certiorari on Monday in a securities fraud class action, agreeing to hear a question regarding pleading standards. The question presented is: “Whether a plaintiff can state a claim under Section 10(b) of the Securities Exchange Act and SEC Rule 10b-5 based on a pharmaceutical company’s nondisclosure of adverse event reports even though the reports are not alleged to be statistically significant?” Matrixx Initiatives v. Siracusano, No. 09-1158 (S.Ct. Cert. granted June 14, 2010).

The case is based on a decision by of the Ninth Circuit Court of Appeals in Siracusano v. Matrixx Initiatives, Inc., 585 F.3d 1167 (9th Cir. 2009), discussed here. The complaint claimed that Matrixx made false statements about its key product Zicam, a nasal spray. In 2003, the company issued statements regarding the success of the product and at one point revised guidance upward due to its success. The company had, however, received some information from researches and individuals that the nasal spray caused a loss of smell. Products liability suits had also been filed against the company asserting this claim.

Matrixx, however, maintained in press releases that none of the clinical trials supported any claim that the drug caused a loss of smell. The company denied press reports discussing complaints about a loss of smell. A report that the FDA was investigating this claim was followed by a drop in the share price despite statements by the company that it was not aware of any such investigation.

A shareholder suit alleging securities fraud based on claims that the denials of the company were false and misleading was dismissed by the district court. In its ruling, the court held that adverse product reports regarding a loss of smell need not be disclosed because they were not material. Specifically, the court held that a pharmaceutical company need not disclose every adverse report that it receives. Rather, those reports need only be disclosed when they are statistically significant. This conclusion was based on In re Carter-Wallace, Inc. Sec. Litig. , 220 F.3d 36 (2nd Cir. 2000). The First and Third Circuits follow a similar rule.

The Ninth Circuit reversed. Citing Basic v. Levinson, 485 U.S. 224 (1988) the court rejected the statistically significant test employed by the district court and the Second Circuit. Materiality, the court held, is a question generally reserved for the fact finder. Here, the question is whether the allegations are properly pleaded under the PSLRA and state a plausible cause of action under Bell Atlantic Corp. v. Twombly, 550 U.S. 554 (2007). After reviewing the claims in the complaint regarding the adverse product reports about Zicam, the circuit court concluded that the complaint met the pleading requirements. Accordingly, the decision of the district court was reversed. The Supreme Court will hear this case next term.

DO MORE CRIMINAL PROSEUCTIONS AND BIGGER FINES EQUAL DETERRANCE?

SEC Enforcement has been revamping and reorganizing in an effort to become more effective and efficient. Part of that process focuses on joint investigations with criminal prosecutors and other regulators. The recently recast Financial Fraud Task Force and the newly created Virginia Financial Fraud Task Force are two examples of SEC Enforcement teaming up with the Department of Justice and the U.S. Attorneys Office. Another part of the rejuvenation appears to be an increased reliance on civil fines. Together, more criminal prosecutions and bigger fines are supposed to caution the market place, resulting in deterrence.

As the rejuvenation moves forward, SEC Enforcement would do well to pause and review the recently released FSA Annual Report: 2009/10. The Financial Services Authority is the top market regulator in the U.K. In the report, available on its website, the FSA states that one of the ways in which it seeks to develop confidence in the U.K.’s markets is “to mitigate and deter market abuse. . .” by detecting and prosecuting insider trading. In the past the regulator has suffered from the perception that it was not aggressive at investigating and eliminating this type of market abuse, particularly by major market participants.

Beginning in 2006/07 the FSA “decided to make more extensive use of the full range of investigation and prosecution powers available . . .” This resulted in a series of insider trading investigations, the FSA’s first criminal prosecutions for insider dealing and an increased use of fines. The report goes on to cite a number of examples to illustrate the new more aggressive stance adopted by the regulator. This includes two criminal trials in which the FSA secured convictions and the execution of a number of searches followed by arrests which lead to more criminal prosecutions. In addition, the FSA published findings of market abuse and imposed large fines on a number of major market participants.

According to the report, the new policy of increased criminal prosecutions and large fines is working, sending a credible deterrence to the market. The policy is going to continue.

The statistics cited by the FSA, however, raise questions about the impact of its new policy. The FSA says it is the only regulator that publishes metrics by which possible insider trading and market abuse can be measured. Those metrics focus on incidents of suspicious trading activity in advance of a corporate announcement. Specifically, the FSA analyzes the scale of share price movement in the two days prior to regulatory announcements to assess trading and price movements which may be abnormal for that security. While this data does not establish or prove insider trading, it is some indication of possible market abuse, according to the FSA.

For the 2009/10 time period, the incidents of abnormal trading activity discovered by the FSA is about the same as in prior years. Stated differently, the incidents of suspicious trading activity and abnormal price movements have remained essentially constant. Accordingly, the metrics reported by the FSA do not support the claim that its new program is deterring market abuse. If in fact increased criminal prosecutions and large fines translate to deterrence in the marketplace then the data should show a decrease in suspicious trading and price movements.

Some might argue that the FSA’s program is new and that any assessment of its success should be deferred. At the same time, however, it would seem that the immediate impact of initiating a string of criminal prosecutions and imposing a series of large fines would have some impact in the marketplace if this type of activity translates to deterrence. That point, however, is not supported by FSA’s Annual Report.

As SEC Enforcement moves forward with its rejuvenation efforts it would do well to carefully assess the experience of the FSA. More criminal prosecutions and bigger fines may yield headlines as it has done for the FSA but not necessarily deterrence and more effective enforcement.