The Supreme Courtís Smell Test: Buffett, Sokol, Becker and Zicam?

April 4, 2011

If you turn on the television these days, everyone seems to have an opinion as to what constitutes securities fraud.  In and of themselves, opinions are fine - the problem is that there is often a difference between those opinions and reality.  Debate is nice. Facts and the truth are even better.

On the heels of today's to-do about the burgeoning Sokol-Lubrizol-Buffett-Berkshire mess, I've heard lots of opinions about whether certain conduct violated the federal anti-fraud provisions. Unfortunately, while many of the commentaries were colorful and interesting, few folks seemed to understand the applicable statutes or how the courts have been applying them. 

To bring just a tad of accuracy to all these talking heads, this column will discuss a just-published case by the United States Supreme Court.  Yeah, I know, the Court itself  is voicing an opinion; however, the Court's opinions are usually cited with a capital "O" and are referred to as the "law of the land." 

For the Plaintiffs

In Matrixx Initiatives, Inc., Et Al. V. Siracusano Et Al. (563 U. S. ____ (2011)   the Respondents on appeal to the US Supreme Court were the plaintiffs in a securities fraud class action on behalf of individuals who purchased securities in Matrixx Initiatives, Inc. between October 22, 2003, and February 6, 2004 .

The lower-court Complaint alleged that defendants  Matrixx Initiatives, Inc., and three of its executives ("Matrixx"),violated §10(b) of the Securities Exchange Act of 1934 and Securities and Exchange Commission Rule 10b-5 when they failed to disclose reports of a possible link between Zicam Cold Remedy, the company's leading product (70% of sales), and the loss of smell (anosmia) - thus, rendering statements made by Matrixx misleading.

The Complaint charged that when telling the market that revenues were going to rise 50 and then 80 percent, Matrixx failed to disclose that it had information indicating a significant risk to Zicam Cold Remedy. It was further alleged that Matrixx also publicly dismissed reports linking Zicam's key ingredient (zinc gluconate) and anosmia, and stated that zinc gluconate's safety was well established. The Complaint alleged that there was evidence of a biological link between Zicam's key ingredient and anosmia, and that Matrixx had conducted no studies to disprove that link.

SIDE BAR: And now for a word from our sponsor: the Law.

Section 10(b) of the Securities Exchange Act makes it unlawful for any person to "use or employ, in connection with the purchase or sale of any security . . . any manipulative or deceptive device or contrivance in contravention of such rules and regulations as the Commission may prescribe as necessary or appropriate in the public interest or for the protection of investors."

SEC Rule 10b-5 makes it unlawful to, among other things, "make any untrue statement of a material fact or to omit to state a material fact necessary in order to make the statements made, inthe light of the circumstances under which they were made, not misleading."

To prevail on material misrepresentations/omissions claims under §10(b) and Rule 10b-5, respondents must prove

  • a material misrepresentation or omission by the defendant;
  • scienter;
  • a connection between the misrepresentation or omission and the purchase or sale of a security;
  • reliance upon the misrepresentation or omission;
  • economic loss; and
  • loss causation.

What They Knew Or Should Have Known?

The Supreme Court Opinion sets forth a number of examples of reports made to Matrixx raising concerns about Zicam.

In 1999, Dr. Alan Hirsch, neurological director of the Smell & Taste Treatment and Research Foundation, Ltd., called Matrixx's customer service line after discovering a possible link between Zicam nasal gel and a loss of smell in a cluster of his patients. Dr. Hirsch told a Matrixx employee that "previous studies had demonstrated that intranasal application of zinc could be problematic." He also told the employee about at least one of his patients who did not have a cold and who developed anosmia after using Zicam.

In September 2002, Timothy Clarot, Matrixx's vice president for research and development, called Miriam Linschoten, Ph.D., at the University of Colorado Health Sciences Center after receiving a complaint from a person Linschoten was treating who had lost her sense of smell after using Zicam. Clarot informed Linschoten that Matrixx had received similar complaints from other customers. Linschoten drew Clarot's attention to previous studies linking zinc sulfate to loss of smell. Clarot gave her the impression that he had not heard of the studies and indicated that Matrixx had not done any studies of its own but had hired a consultant to review the product.

By September 2003, one of Linschoten's colleagues,, Dr. Bruce Jafek, had observed10 patients suffering from anosmia after Zicam use. Matrixx learned of the doctors' planned presentation about the findings and Clarot sent a letter to Dr. Jafek warning him that he did not have permission to use Matrixx's name or the names of its products. Dr. Jafek deleted the references to Zicam before making a presentation to the American Rhinologic Society.

For the Defense

Matrixx contends that the Complaint does not adequately allege that Matrixx satisfied the first two enumerated prongs under the federal securities anti-fraud provisions; namely, 1) a material representation or omission, or 2) that it acted with scienter.

In support of its position, Matrixx argued that the Complaint does not allege that Matrixx knew of a statistically significant number of adverse events requiring disclosure. Matrixx moved to dismiss the Complaint, arguing that respondents had not satisfactorily pleaded the element of a material misstatement or omission and the element of scienter.

An Initial Win for the Defense, but Then a Loss

The District Court granted the Defendant's Motion to Dismiss, but the Ninth Circuit reversed, holding that

  • the District Court erred in requiring an allegation of statistical significance to establish materiality, concluding instead that the complaint adequately alleged information linking Zicam and anosmia that would have been significant to a reasonable investor; and
  • Matrixx's withholding of information about reports of adverse effects and about pending lawsuits by Zicam users gave rise to a strong inference of scienter.

The Final Appeal

On Appeal, the Supreme Court held in an Opinion delivered by Justice Sotomayor that Respondents had stated a claim under §10(b) and Rule 10b-5.  Preliminarily, the Court framed the issue as whether Respondents satisfied the threshold of  proving a

  1. material misrepresentation/omission by Matrrixx and
  2. scienter. 


The Court defined "materiality" as being satisfactorily pleaded by a showing that there is a substantial likelihood that the disclosure of the omitted fact would have been viewed by the reasonable investor as having significantly altered the total mix of information made available.

Pointedly, the Court rejected Matrixx's arguement that Respondents failed to satisfy the materiality standard when then could not show some statistical significance between the product and the cited adverse events. Absent statistical significance, Matrixx argued that adverse event reports provide only "anecdotal" evidence that the user of a drug experienced an adverse event at some point during or following the use of that drug. Accordingly, Matrixx contends that reasonable investors would not consider such reports relevant unless they are statistically significant because only then do they reflect a scientifically reliable basis for inferring a potential causal link between product use and the adverse event.

The Court rejected that proposed test of a bright-line of statistical significance because it held that materiality was a fact-specific inquiry, requiring consideration of source, content, and context.  The Court held that there was no so-called "bright-line rule" whereby a given, single fact or occurrence would always be deemed dispositive of the issue of materiality  - in this case, the mere absence of statistical cause and effect would not render the proof as falling short of establishing materiality.

As such, the issue is again focused as one asking whether a reasonable investor would have viewed the non-disclosed information concerning incidents of anosmia as having significantly altered the "total mix" of information made available.


As to the issue of scienter - the mental state embracing intent to deceive, manipulate, or defraud - the Court found that this component was adequately pleaded. Given the various facts and allegations, the Court found that a reasonable person may deem that Matrixx acted with scienter because such an inference was at least as compelling as any other plausible, opposing inference. Essentially, a reasonable person may go to the smorgasbord of inferences attendant to a named defendant's conduct, and as long as scienter is as compelling a plausible option as anything else on the table, that's sufficient for the issue of pleading that issue.  Of course, if there's this tantalizing bucket of shrimp on the table and there's also a piece of celery with some pink cream thing sprayed on it, then the shrimp is the more compelling choice and the hell with veggie.

No, you're not an idiot, and, yes, you should be scratching your head over this issue.  This scienter thing is as close to metaphysics as the law gets. After all, we're trying to figure out if some theoretical "reasonable investor" would be acting reasonably when concluding that Matrixx had formed some state of mind evidencing an intent to deceive. Amazingly, this test involves a theoretical being, the concept of reasonableness, and an attempt to discern human beings' state of mind involving "intent."  And you wonder why there's so much securities litigation?

Nonetheless, those alchemists on the Supreme Court divined the signs and affirmed the Ninth Circuit's finding that Respondents stated a claim under §10(b) and Rule 10b-5.

Bill Singer's Comment:  What's the takeaway from the Supreme Court's Matrixx Opinion?  For starters, anyone who is asserting for a fact that David Sokol violated the federal securities anti-fraud laws is, well, okay, you come up with a euphemism for "idiot."  These anti-fraud cases are fact-specific and frequently require a detailed inquiry as to who, what, when, where, and why. 

Based upon the sparse facts presently before us, there is no way for anyone to make an assertion, pro or con, as to whether the purchases of Lubrizol by Sokol were material events. Similarly, whether a reasonable investor would deem that Sokol acted with the scienter to defraud is also beyond any present credible legal analysis because we know  too few facts concerning the transaction.  As of today, we're only scratching the threshold surface of an anti-fraud analysis.

While I agree with the proposition many experts have voiced that the cited conduct would likely be a violation if the parties were stockbrokers or if Berkshire Hathaway was an SEC-registered brokerage firm, the fact is that this transaction did not occur between a stockbroker and his/her client.  Which reminds me of that wonderful line: If my aunt were a man, she'd be my uncle. 

For me, Sokol's conduct (and, frankly, that of Berkshire Hathaway) doesn't pass the stink test. It looks wrong. It feels wrong.  It's something that Berkshire's internal policies should have required be disclosed, in writing, and retained in the records attendant to making the decision to buy or not to buy a given pitched investment by a Berkshire insider.

However, as most veteran lawyers will tell you, there is ethics and there is illegal; and those two considerations are very different. Moreover, within the context of business where folks and companies are always trying to get an edge on the competition, the game isn't always played fairly. In the scrum, a lot of nasty stuff goes on. 

Alex Rodriguez may run across the opposing pitcher's mound in the middle of a game. It ain't nice according to some unwritten code. However, it ain't illegal.  Whether David Sokol merely ran across the mound remains to be seen.  I'll leave it to plaintiffs' lawyers and regulators to figure that one out. 

Hey, Securities and Exchange Commission Chair Mary Schapiro didn't think that David Becker had a conflict with the Madoff investigation. Maybe she and her SEC minions can wrestle with David Sokol's conduct?  Can't wait to see how the SEC resolves giving Becker the okay and then slamming Sokol.