D I S P U T E S & I N V E S T I G A T I O N S • E C O N O M I C S • F I N A N C I A L A D V I S O R Y • M A N A G E M E N T C O N S U L T I N G

American Bar AssociationAnnual Meeting – ChicagoAugust 3, 2012Unsecure Footing: A Critical Look into the Matrixx Opinion and Other Changes to the Securities Law Landscape

Introductions – Moderator/Session Leader

Anthony B. Creamer III, CPA

» Navigant Consulting, Inc.

Page 2

Introductions - Panelists

Jay A. Dubow

» Pepper Hamilton, LLP

Page 3

Amy A. Ripepi, CPA

» Financial Reporting Advisors, LLC

Introductions – Panelists, cont’d

Zesara C. Chan

» Shartsis Friese, LLP

Page 4

Lynda J. Grant

» The Grant Law Firm, PLLC

Program Objectives

» Overview of Matrixx

» Subsequent Reliance on Matrixx

» Accounting and Auditing Standards

» Plaintiff Lawyer Prospective Views

» Synthesis of Framework for Evaluating Materiality

Page 5

Polling Question #1 – Audience Demographics

In securities cases, do you primarily work for:

a) Plaintiff Side

b) Defense Side

Page 6

Polling Question #2 – Audience Demographics

In what geographic region of the United States do you primarily practice?

a) East

b) Central

c) West

Page 7

Case #1 – ABC Manufacturing CompanyTermination of Sales Personnel in Medical Manufacturing Business

» ABC Manufacturing Company makes cardiac related medical devices

» Devices account for 90% of total revenue

» Company receives anonymous tip regarding unethical actions of sales personnel

» Company launches internal investigation based on tip

» Company terminates 10 sales personnel

Page 8

Polling Question #3 – ABC Manufacturing Company

Should ABC Manufacturing Company disclose the commencement of the internal investigation or the termination of the 10 sales personnel?

a) Disclose both commencement of investigation and termination of personnel

b) Disclose only commencement of investigation

c) Disclose only termination of personnel

d) Disclose neither the commencement of investigation nor termination of personnel

Page 9

Case #1 – ABC Manufacturing CompanyTermination of Sales Personnel in Medical Manufacturing Business

» Sales decline 10% in the quarter after sales personnel are terminated

» Sales personnel were among Company’s top performers

» Sales personnel took customers with them to new employers

» Company unable to mitigate lost sales

Page 10

Polling Question #4 – ABC Manufacturing Company

Looking back, should ABC Manufacturing Company have disclosed the termination of the 10 sales personnel at the time of their termination considering that they knew that their customers develop strong relationships with the sales personnel and typically follow them if they move to a new employer?

a) Yes

b) No

Page 11

Overview of Matrixx Decision

» Plaintiffs securities fraud class action under Section 10(b) of the 34 Act and Rule 10b-5.

» Claim that Matrixx’s Zicam nasal spray caused a loss of sense of smell that was not disclosed.

» After public disclosure of the possible link, Matrixx’s stock price dropped.

Page 12

Overview of Matrixx Decision, cont’d

» Defendants moved to dismiss:› Complaint failed to allege a statistically significant correlation

between Zicam and loss of smell ‒ None of the alleged misstatements or omissions were material

» U.S. Supreme Court granted cert. due to split among Circuit courts.

Page 13

Overview of Matrixx Decision, cont’d

» Court reiterated Basic Inc. v. Levinson, 485 U.S. 224 (1988).› Basic rejected a bright-line test for determining materiality and

refused to adopt such a test here.

» Court rejected defendants’ position that adverse event reports cannot be material unless they are statistically significant.

» Court held based on the “total mix” of information here that complaint satisfied pleading requirement for materiality.

Page 14

Overview of Matrixx Decision, cont’d

» These cases are fact specific.

» Decision does not mean the pharmaceutical companies must disclose all adverse event reports.

» Disclosure is required only when necessary to make statements made, in light of the circumstances under which they were made, not misleading.

» Court also rejected defendants’ arguments that statistical significance is required to establish a strong inference of scienter.

Page 15

Subsequent Reliance on Matrixx

» Matrixx reaffirms rule that materiality is fact intensive based on the “total mix of information”.

» From defense perspective, element of materiality is difficult to win on motion to dismiss or summary judgment.

» Post-Matrixx, courts have continued approach of fact driven analysis on motion to dismiss or summary judgment.

» Some cases have read Matrixx as affirming well-settled principles rather than ground-breaking.

Page 16

Subsequent Reliance on Matrixx, cont’d

» Hill v. Gozani

» Hutchinson v. Deutsche Bank

» Boston Scientific

» Motorola

» Smith and Wesson

Page 17

Case #2 – ABC Medical CompanyRevenue Recognition Error in Medical Device Company

» ABC Medical Company’s main product is a robotic catheter system

» Sales price is $1 million per unit

» Company policy and US GAAP require system to be delivered and installed and training to be provided before revenue recognition

» Total Company revenue = $1 billion, EPS = $1.42

» Company discovers error in revenue recognition on 5 units – revenue overstated by $5 million

» Error is attributed to inexperienced accounting staff

Page 18

Polling Question #5 – ABC Medical Company

Is the $5M revenue recognized in error material so that ABC Medical Company should adjust their financial statements and delay their Form 10-K? Reversing the $5 million in revenue would decrease EPS by $0.01.

a) Yes

b) No

Page 19

Polling Question #6 – ABC Medical Company

At what threshold would the revenue recognized in error be material so that ABC Medical Company should adjust their financial statements?

a) $5 million in revenue ($0.01 EPS)

b) $10 million in revenue ($0.03 EPS)

c) $25 million in revenue ($0.07 EPS)

d) None of these thresholds are material

Page 20

» Company discovers installation and training documents were forged in order to meet sales targets

» Error is due to fraud instead of honest mistake

Page 21

Case #2 – ABC Medical CompanyRevenue Recognition Error in Medical Device Company

Polling Question #7 – ABC Medical Company

Knowing that fraud was involved, at what threshold would the revenue recognized in error be material so that ABC Medical Company should adjust their financial statements?

a) $5 million in revenue ($0.01 EPS)

b) $10 million in revenue ($0.03 EPS)

c) $25 million in revenue ($0.07 EPS)

d) None of these thresholds are material

e) The error is material at any threshold since fraud was involvedPage 22

Accounting and Auditing Standards Salient Principles

» No bright lines in U.S. - use judgment

» Consider quantitative and qualitative factors

» Preparers consider materiality in:› Preparing financial statements› Setting accounting policies› Designing systems and controls

» Auditors consider materiality in:› Evaluating the results of the audit (uncorrected misstatements)› Planning the audit (what to test)› Performing the audit (sample size)

Page 23

Accounting and Auditing Standards Salient Principles, cont’d

» Most materiality questions deal with “numbers” (revenue, assets, net income, EPS, cash flow from operations)

» No added (or different) guidance on assessing materiality of narrative, qualitative information

› Audit opinion applies to footnote disclosures, but

‒ Auditors are not associated with earnings releases/calls

‒ Auditors have very limited association with MD&A

Page 24

Accounting and Auditing Standards Salient Principles, cont’d

» Upcoming FASB Disclosure Framework may establish a “decision process” for determining footnote disclosures

› Would apply to preparers (and, by extension, auditors)

› Would be based on “the difference the information would make in a user’s assessment of future cash flow prospects”

» ESMA (European Securities Regulators) also looking at materiality in financial reporting

› Consultation paper (2011) to be followed by final report (2012)

Page 25

Case #3 – ABC Technology CompanyExecutive Compensation in Technology Company

» ABC Technology Company on verge of bankruptcy

» Hires retired former CEO to turn around business

» CEO agrees to annual salary of $1

» Company discloses CEO’s annual salary

» CEO receives additional perquisites (private jet, luxury car, vacation

home) costing the Company $1 million per year

» Company’s annual revenue = $750 million, net loss = $200 million

Page 26

Polling Question #8 – ABC Technology Company

Does ABC Technology Company have a duty to disclose the perquisites that the CEO is receiving in additional to his $1 annual salary?

a) Yes

b) No

Page 27

Plaintiff Lawyer Prospective Views

» Matrixx represents departure from prior law

» Prior to Matrixx, Carter-Wallace:› 57 adverse medical reports were not statistically significant

› Plaintiffs had to allege connection by showing statistical significance

» Trend among courts was to reject claim of materiality unless statistically significant

» Matrixx could significantly change future disclosures of companies in life sciences field

Page 28

Case #4 – ABC Pharmaceutical CompanyDisclosure of Developmental Drug Approval in Pharmaceutical Company

» ABC Pharmaceutical Company is developing a new cancer drug

» Company believes new drug has potential to account for 5% of total sales

» Drug is rejected for human testing by European Medicines Agency (European equivalent of FDA)

» Company announces plans to apply to the FDA in the United States for human testing of their drug

Page 29

Polling Question #9 – ABC Pharmaceutical Company

Should ABC Pharmaceutical Company disclose the rejection of their application for human testing by the European Medicines Agency?

a) Yes

b) No

Page 30

Polling Question #10 – ABC Pharmaceutical Company

Now that ABC Pharmaceutical Company is applying for approval of their new drug in the US, should they disclose the prior rejection by the European Medicines Agency?

a) Yes

b) No

Page 31

» FDA denies Company’s application for human testing of their drug

» Company suspends further development and abandons drug

Page 32

Case #4 – ABC Pharmaceutical CompanyDisclosure of Developmental Drug Approval in Pharmaceutical Company

Polling Question #11 – ABC Pharmaceutical Company

Knowing that the FDA denied ABC Pharmaceutical Company’s application for human testing of their drug and that the Company abandoned any further development, when should the Company have disclosed the denial of the application by the European Medicines Agency?

a) As soon as the European Medicines Agency denied it

b) In conjunction with the announcement of application for FDA approval

c) The Company was correct in not disclosing the denial by the European Medicines Agency

Page 33

Synthesis of Framework for Evaluating Materiality

» “Total Mix” of information available to investors

» No quantitative threshold

» Qualitative factors must be considered

» Balance between necessary disclosure and over-disclosure of insignificant information

Page 34

Polling Question #12

Did you enjoy the presentation?

a) Yes

b) No

c) Need more information

d) It depends

Page 35

Questions/Concluding Remarks

Page 36

???