United States: Second Circuit Holds That Price Impact Can Be Established For Class Certification Based On "Inflation Maintenance" Theory Even Where Inflation Is Not "Fraud-Induced," And Affirms, In A Split Panel, District Court's Determination That Defendants Failed To Rebut The Basic Presumption Of Reliance

On April 7, 2020, the United States Court of Appeals for the Second Circuit upheld certification of a shareholder class asserting claims under the Securities Exchange Act of 1934 against a financial institution and certain of its executives. Arkansas Teacher Ret. Sys. v. Goldman Sachs Group, Inc., ––F.3d––, 2020 WL 1682772 (2d Cir. 2020). Plaintiffs alleged that the company made misrepresentations about its practices with respect to collateralized debt obligations ("CDOs") and failed to disclose alleged conflicts of interest involving the selection of the subprime mortgages underlying the CDOs. As discussed in our prior post, in 2018 the Second Circuit vacated the district court's prior class certification order and remanded with instructions to apply a "preponderance of the evidence" standard in determining whether the company had rebutted the presumption of reliance under Basic Inc. v. Levinson, 485 U.S. 224 (1988), and to consider certain of defendants' evidence of lack of price impact from the alleged misrepresentations in assessing whether the presumption had been rebutted. Arkansas Teacher Ret. Sys. v. Goldman Sachs Group, Inc., 879 F.3d 474, 484–85 (2d Cir. 2018). On remand, the district court again certified a class. On an interlocutory appeal pursuant to Rule 23(f), the Second Circuit affirmed. The Court unanimously held that the "inflation-maintenance" theory was properly applied, rejecting defendants' argument that the theory should not apply where the inflation resulted from "general statements" about the company's business practices. The panel divided, however, on the question whether the district court correctly determined that defendants failed to rebut the Basic presumption of reliance. The majority held that the district court did not abuse its discretion; Judge Sullivan disagreed.

In certifying the class a second time, the district court held that plaintiffs could invoke the Basic presumption under an "inflation-maintenance" theory—i.e., although the alleged misstatements themselves did not inflate the company's stock price, they nevertheless allegedly "maintained" an already inflated stock price, as revealed when corrective disclosures allegedly caused the stock's price to decline. 2020 WL 1682772 at *4. The district court credited plaintiffs' expert's testimony as establishing a link between news of the company's alleged conflicts—including an SEC complaint—and subsequent price declines, and concluded that the company failed to demonstrate, by a preponderance of the evidence, that the alleged misstatements had no price impact. Id. In particular, although one of the company's experts purported to show that 36 prior news reports had not affected the company's stock price, the district court found this did not sever the link between the SEC complaint and the stock price drop because the SEC complaint disclosed previously unreported emails and internal memoranda and, further, was "more reliable and credible" than the earlier news reports. Id. at *5, 13. For similar reasons, the district court also declined to accept the conclusion of another expert for the company whose event study purported to show that the stock price decline following the SEC complaint was attributable to the announcement of an enforcement action, rather than to any new information about alleged conflicts of interest in the creation of the CDOs. Id. at *5.

The first issue addressed by the Court was application of the inflation-maintenance theory. The Court unanimously rejected what it described as defendants' invitation to "narrow" the theory. Specifically, the company argued, consistent with the fact that the claims at issue asserted fraud, that the inflation-maintenance theory should only apply if the inflation was "fraud-induced," and further that "general statements" regarding business practices should be insufficient as evidence of price impact (meaning that such statements could not provide a basis for invocation of the Basic presumption of reliance in an inflation-maintenance case). Id. at *7–8. The Court disagreed, holding that the inflation-maintenance theory as articulated in the Second Circuit and other Courts of Appeal does not require that the price was inflated due to the company's alleged fraud, and that all that is required is that the price be "inflated." Id. (citing In re Vivendi, S.A. Sec. Litig., 838 F.3d 223, 257 (2d Cir. 2016)). The Court further held that evidence of inflation can be inferred from a price decline upon a corrective disclosure and that the district court did not err in finding inflation on that basis.

The Court also rejected the argument that inflation-maintenance only applied to certain types of alleged misrepresentations. In this regard, the Court opined that whether the company's statements about business principles and conflicts controls were too general to support a finding of price impact was really a question of materiality, but that question was not appropriate for consideration at the class certification stage because the issue was common to all class members and thus did not affect whether individual issues predominated. Id. at *8–10. In so holding, the Court emphasized that materiality challenges could be made at the motion to dismiss and summary judgment stages, and that defendants have the opportunity to disprove price impact at the class certification stage. Id. at *11.

The second issue on appeal concerned the district court's conclusion that defendants had not rebutted the presumption of reliance. Here, the panel divided. The majority, in an opinion by Judge Richard Wesley, rejected the company's arguments that the district court "erroneously construed" the company's rebuttal evidence and misapplied the preponderance standard. The company argued that the district court failed to account for (i) the substance of prior news reports that disclosed the company's alleged conflicts of interests but did not result in any stock price declines and (ii) evidence that the price decline on which plaintiffs relied was due to fears of government sanction arising out of its investigation. Id. at *13–14. The majority concluded, however, that the district court had not committed clear error in weighing the evidence and concluding that the alleged corrective disclosures revealed new and material information. Id. at *13. Moreover, the majority observed that even if the stock price decline was caused in part by the potentiality of an SEC fine, this was insufficient to rebut the Basic presumption. Id. In addition, and unlike the dissent, the majority found no clear error in how the district court weighed the competing expert evidence regarding price impact, holding that "the question is not which side has better evidence, but whether the defendant has rebutted the presumption," id. at *14, and that there was no clear error in the district court's conclusion that defendants had not done so.

Judge Richard Sullivan dissented, stating that "[o]nce the Basic presumption has been invoked . . . a defendant may then rebut it through any showing that severs the link between the alleged misrepresentation and either the price received (or paid) by the plaintiff, or his decision to trade at a fair market price." Id. at *17 (quoting Waggoner v. Barclays PLC, 875 F.3d 79, 95 (2d Cir. 2017)) (quotation marks omitted). In Judge Sullivan's view, the company had "severed the link that undergirds the Basic presumption" by offering "persuasive and uncontradicted" expert evidence that the company's share price was unaffected by prior news reports regarding alleged conflicts of interest. Id. In particular, Judge Sullivan noted that plaintiffs' reliance on evidence of market efficiency could not counter the company's rebuttal evidence, which assumed that the market was efficient and established that it had not reacted to relevant prior disclosures. And, although the majority concluded that consideration of whether the alleged misstatements were too general to be actionable was an attempt to inject a materiality inquiry into the class certification standard, Judge Sullivan viewed this as an unduly "rigid compartmentalization." Compare id. at *16 (majority opinion), with id. at *19 (Sullivan, J., dissenting). In his view, "a reviewing court is free to consider the alleged misrepresentations in order to assess their impact on price." Id. at *19 (Sullivan, J., dissenting). The "obvious explanation" for why the company's stock price did not move in response to the 36 news stories about its conflicts was because a reasonable investor would not have attached any significance to the "generic statements" upon which plaintiffs' claims were based. See id. at *19–20. The fact that an examination of the nature of the alleged misrepresentations "resemble[d]" a materiality inquiry did not, in Judge Sullivan's view, render it improper. Id. at *19. Indeed, he felt that the failure to undertake such an inquiry turned the Basic presumption "on its head." Id. at *17.

The decision confirms the Second Circuit's endorsement of the inflation-maintenance theory. However, the majority and dissenting opinions reveal that the extent to which a reviewing court must rigorously consider the parties' evidence on the question of price impact in determining whether the presumption of reliance has been rebutted remains unresolved. Given the importance of these issues, particularly given the partially split panel, it is possible the Second Circuit will consider this matter further on en banc review, even though grants of en banc review are less common in the Second Circuit than in most circuits.

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Arkansas Teacher Ret. Sys. v. Goldman Sachs Group, Inc.

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