SECURITIES ALERT: Court of Appeals for the Second Circuit Says Pharmaceutical Advertisements May Violate Securities Law

August 10, 1998 Advisory

On July 13, 1998, the United States Court of Appeals for the Second Circuit ruled that technical drug advertisements in sophisticated medical journals could constitute statements made "in connection with the purchase or sale" of a security for purposes of securities fraud liability under Section 10(b) of the Securities Exchange Act of 1934 (15 U.S.C. §: 78j(b)). In In re CarterWallace, Inc. Securities Litigation (Brunjes v. Hoyt), the court reversed the lower court's dismissal of a Section 10(b) claim based on false advertising, reasoning that such advertising could affect stock market prices by misleading market professionals.

Chief Judge Winter prefaced the court's analysis and decision with a summary of the factual situation that led to the original complaint. In July 1993, Carter-Wallace, Inc. obtained approval from the Food and Drug Administration for the sale of the anti-epileptic drug Felbatol. For the first seven months of 1994, Carter-Wallace ran advertisements in issues of Neurology and Archives of Neurology declaring that "no life- threatening liver toxicities or blood dyscrasias have been attributed to Felbatol monotherapy." CarterWallace also filed a Form 10-K with the Securities Exchange Commission in which it attributed its higher sales to "greater than planned introductory sales of Felbatol" and stated that it expected this growth rate to continue. As early as January 1994, however, Carter-Wallace had received reports indicating that Felbatol caused a fatal disease called aplastic anemia in certain patients. On August 1, 1994, Carter-Wallace and the FDA released a statement urging most patients to withdraw from Felbatol treatment.

Investors who bought shares of Carter-Wallace in June and July 1994 sued the company under Section 10(b) of the Securities Exchange Act of 1934. The alleged in their complaint that the false medical journal advertisements and failure to mention the reports of death due to aplastic anemia in the Form 10-K misled the market and distorted the price of Carter-Wallace stock. The investors also claimed that the company violated Generally Accepted Accounting Principles ("GAAP") and Section 10(b) by overstating the value of Felbatol inventory when it knew Felbatol would not be viable. The lower court dismissed all of the allegations, and in its dismissal of the advertisement-based claim stated that drug advertisements in medical journals, even if false, are "not made in connection with the purchase or sale of securities, but [a]re directed at a technical audience intimately familiar with the potential adverse side effects of new drugs."

The Court of Appeals for the Second Circuit affirmed the lower court's dismissal of the appellant's claims based on statements contained in the Form 10-K, and the claims alleging a violation of GAAP, but reversed the dismissal of the advertisement-based securities fraud claim. Although a previous case, Ross v. A.H. Robbins Company, held that false product advertisements in medical journals were not actionable under Section 10(b), that case considered only the nexus between the advertisements and individual investments. Here, the investors sued on the fraud-on the-market theory, which the appeals court said provided a broader framework in which to analyze the "in connection with" requirements. A claim based on the fraud-on-the-market theory triggers a "straightforward cause and effect" test, under which a plaintiff must simply show that statements which manipulate the market are connected to resultant stock trading. That case also predated a Supreme Court case finding that market professionals consider most publicly announced material statements about companies, thereby affecting stock market prices. This finding, combined with the broad construal of "in connection with" dictated by the fraud-on-the-market theory, led Chief Judge Winter to state that the court could not find, as a matter of law, that detailed drug advertisements using technical jargon and published in sophisticated medical journals never constitute statements made in connection with a securities transaction. Judge Winter thought it quite plausible that financial analysts might use technical medical information contained in advertisements for a new drug in evaluating the stock of the company marketing the drug. The Second Circuit held that "false advertisements in technical journals may be 'in connection with' a securities transaction if the proof at trial establishes that the advertisements were used by market professionals in evaluating the stock of the company." This ruling puts pharmaceutical companies on notice that they now risk securities fraud liability by placing misleading advertisements in medical journals.