United States: Challenges To The Scope Of Class Certification

Most securities fraud cases involve allegations that false statements were made to inflate the price of a company’s stock. A case pending in the U.S. District Court for the Northern District of Illinois presents the flip side of this situation, where allegedly misleading statements were made to keep the price low in anticipation of a merger.

On July 17, 2007, U.S. District Judge Robert W. Gettleman certified a shareholder class in Levie v. Sears Roebuck & Co.¹ Judge Gettleman’s decision raises interesting issues about the length of a certified class period, as well as the persons included in any class certified.

As alleged by the Sears plaintiff, in early September 2004, the beginning of the class period, Sears presented a "strategy update" to investors and analysts concerning a prior agreement with Kmart to purchase or lease stores, but failed to disclose that it was engaged in merger talks with Kmart. In the following weeks, Sears made other statements to the effect that it intended to follow its previously announced business plan to continue operating independently. Sears also announced a net loss of $61 million for the third quarter of 2004 and told investors that they should lower their expectations for the fourth quarter. The stock price dropped. The complaint alleges that, during this same time period, Sears was in the middle of negotiating a deal by which Kmart would acquire a controlling interest in Sears. If this news reached investors, it was expected that Sears’ stock price would rise and threaten to make Sears too expensive to acquire. During the third quarter of 2004, Sears also re-purchased millions of its own shares for what the plaintiff called a "rock bottom" average price of about $36. When the deal with Kmart was announced in mid-November 2004, the end of the class period, Sears stock price rose to about $53 per share. After Judge Gettleman denied Sears’ motion to dismiss, the plaintiff moved for certification of a "seller class" consisting of all investors who sold their shares during the period Sears allegedly had failed to disclose the merger talks.

Among other challenges to certification, Sears challenged the proposed class period, submitting documentary evidence and sworn statements demonstrating that merger talks only began in late October and arguing that plaintiff’s allegation that discussions began in early September was factually unsupported in the complaint. Arguing that the class period could only begin with the first purportedly misleading statement after merger talks commenced, Sears contended that the class period was at most seven trading days beginning with the complaint’s first factually supported allegation concerning merger discussions. The court declined to consider Sears’ evidence on class-period duration, holding that factual inquiries on a motion for class certification were limited to those required to determine if certification was appropriate under Rule 23, i.e., numerosity, commonality, typicality and class representation, and that the court could not look beyond the pleadings to evaluate the contested class period.²

Sears is a reminder that, even where outright dismissal is not possible on a motion to dismiss, defendants must challenge each alleged false statement, requiring plaintiffs to demonstrate, and pressing the court to review, the factual basis for the alleged falsity of each statement as well as each defendant’s knowledge of the falsity of each statement as demanded by the heightened pleading requirements of the PSLRA. (15 USC §78u-4(b))³ In this manner, a defendant can sometimes narrow the class period which a plaintiff may later seek to certify.

In Sears, the court did not undertake such an analysis in deciding the motion to dismiss. Judge Gettleman found that the claim arose from a duty to disclose merger negotiations, if they were occurring and were material, in order to make the statements issued not false or misleading, and did not arise from any independent duty to disclose those negotiations. Despite that finding, the court held only that whether merger negotiations were material was a fact issue for the jury. The court appears not to have addressed whether an adequate factual basis existed for plaintiff’s allegations of early merger discussions, even though those allegations formed the sole basis for the court’s decision that plaintiff’s complaint sufficiently pleaded that Sears public statements may have been misleading or false, including those made early in the class period. 2007 WL 2039534* n.3. Then, on the class certification motion, the court found any such inquiry off limits, as a factual inquiry unrelated to Rule 23.

Particularly where a court finds that some of the alleged false statements in a complaint do meet the particularity and scienter requirements of the PSLRA, judges may need to be reminded that the PSLRA nonetheless requires that each and every alleged false statement be analyzed separately as well as that faithful compliance with that exercise could be important for a possible later certification motion.

In instances where courts do not review each alleged false or misleading statement on a dismissal motion, and this failure has a later impact on the scope of the class certified, it might be useful to point out the policy considerations at issue in an effort to have the court address the matter on the certification motion. Although it is certainly correct that Rule 23 does not permit a merits review at the class certification stage absent a relevance to one of the four Rule 23 factors, the same policy reasons that support the Rule 23 merits inquiry also support a careful analysis of any time period certified. In the real world of securities litigation, class certification drastically raises the stakes and creates the likelihood of in terrorem settlements.

As the U.S. Court of Appeals for the Seventh Circuit observed in Szabo v. Bridgeport Machines, Inc., a case relied upon by Judge Gettleman, "[T]he class certification turns a $200,000 dispute…into a $200 million dispute." Judicial scrutiny is called for "not only because of the pressure that class certification places on the defendant [to "induce a substantial settlement"] but also because the ensuing settlement prevents resolution of the underlying issues." Szabo, 249 F3d at 675. As Sears demonstrates, not only the decision regarding whether to certify a class but also the duration of the class period can have a dramatic risk-multiplying effect. In Sears, the parties differed regarding the length of the class period by a factor of nearly 10 and, depending on trading patterns, the dollar amount of the losses incurred may have been greater. In many cases, the class period certified has even more pronounced consequences on the settlement value of a case. Proper judicial scrutiny of a plaintiff’s allegations should not be reserved solely for instances where complete dismissal is appropriate, but must also apply to narrow appropriately any class certified.

Sears also made novel application of the loss causation principles set forth in Dura Pharmaceuticals, Inc. v. Broudo, 544 US 336 (2005), to proposed class members who both bought and sold stock during the class period. In Dura, the Supreme Court held that to allege loss causation a plaintiff must assert not only that shares were purchased at an inflated price but also that the "share price fell significantly after the truth became known." Id. at 347. In doing so, the Court noted that in-and-out shareholders, that is, shareholders who buy after the false statement inflates the share price, then sell "quickly before the relevant truth begins to leak out," cannot "as a matter of pure logic" suffer a loss resulting from the false statement. Id. at 343.

Although Dura involved the classic securities fraud where the stock price is allegedly inflated, Sears confronted the question of whether in-andout shareholders who bought and sold Sears stock during the class period at a deflated price could show loss causation. Sears argued that these inand- out shareholders could not have suffered any loss caused by the alleged fraud, and that Dura compelled their exclusion from the class. Judge Gettleman disagreed, holding that in a seller class (plaintiffs claiming to be aggrieved sellers of artificially deflated stock) and not a purchaser class (plaintiffs claiming to be aggrieved buyers of artificially inflated stock), the rationale underlying the Supreme Court’s decision in Dura did not apply. Accordingly, the Court held these shareholders would be included in the class.

Judge Gettleman acknowledged that, in Dura and other traditional securities fraud cases, a purchaser who buys for an inflated price, then sells while the price is still inflated, actually suffers no economic loss caused by the alleged misrepresentation. However, the Court found that "the rationale behind excluding ‘in-and-out’ traders from a traditional purchaser class, where revelation of the truth results in a decrease in stock price, is not applicable to the instant seller class." The Court observed that "in the instant case, any investor who sold (during the class period) before the fraud was revealed incurred injuries because that investor sold at a price that was artificially lower than the investor should have received. Regardless of the price such an investor paid for the stock, the price would have been higher at any point after the (secret) merger negotiations became material and before the merger plans were disclosed. Consequently, that investor would have profited from the disclosure by the difference between the share price actually realized and the higher price that would have been driven by the disclosure." Sears, 2007 WL 2039534, *2. (emphasis added)

Judge Gettleman’s analysis stressed that in-andout sellers "should have received" more for the shares they sold during the class period, but does not account for the fact that they also would have paid more for those shares. Dura clearly states that a shareholder who buys and sells stock at an inflated price cannot show loss causation because, without an intervening corrective disclosure, movement in price must have been caused by market factors, not fraud. It is difficult to see why the analysis would be different simply because the fraud depresses, rather than inflates, the share price. Moreover, the effect of Judge Gettleman’s ruling, granting in-andout shareholders with a long position a recovery windfall, is especially perplexing in light of the court’s care to avoid giving a similar windfall to traders who had shorted Sears stock (and covered during the class period). As the Court correctly observed, short sellers who sold during the class period could not show loss causation because they benefited from the alleged fraud by purchasing shares to cover their position at the lower price. The Court properly excluded such in-and-out short sellers from the plaintiff class.

Sears also considered the proper application of the fraud-on-the-market theory to certain proposed class members. See Basic Inc. v. Levinson, 485 US 224, 226, 249 (1988). Sears argued that short sellers and options traders should be excluded from the plaintiff class because their trading strategy implicitly revealed that they were not relying on the integrity of the market, but rather their own analysis of the intrinsic value of Sears stock, and therefore the fraud-on-themarket theory was not available to them to show transaction causation.

The Court broadly rejected the notion that a particular trading strategy renders the fraud-on-themarket theory unavailable, noting, "[t]he fact that short sellers and put and call option traders may believe that there will be fluctuation in the price of a stock does not mean that they do not rely on the integrity of the information disseminated." 2007 WL 2039534, *3. Although there are cases holding that short-sellers are not entitled to the fraudon- the-market presumption because they ignore the market in favor of "gambling on a predicted loss," Judge Gettleman’s decision on this point seems the better reasoned.⁴ There is no logical reason the fraud-on-the-market theory should apply any less to those with short positions than long positions. Those who take long or short positions each expect the stock to move, disagreeing only as to the direction of that movement.

Despite many recent court decisions and legislative pronouncements requiring careful judicial scrutiny of securities class action complaints, there are still battles to be fought and the scope of class certification, including its time period and membership, is one such battle.

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