Back To Basic(s): SCOTUS Takes Case to Clarify Presumption of Classwide Reliance in Securities Litigation

The Supreme Court recently granted certiorari in Goldman Sachs Group, Inc. v. Arkansas Teach Retirement System, a case that petitioner described as "the most important securities case to come before the Court since Halliburton Co. v. Erica P. John Fund, Inc. (Halliburton II), 573 U.S. 258 (2014)."¹ The case concerns the "Basic presumption," a rule born out of a 1988 Supreme Court decision that allows a court to presume classwide "reliance" on a defendant's alleged misrepresentations if the plaintiff establishes certain prerequisites.² The Supreme Court granted certiorari with respect to two questions: (1) whether defendants may defeat the Basic presumption by showing that the "generic nature of the alleged misstatements" meant those statements had no impact on the price of defendants' securities; and (2) whether defendants seeking to rebut the Basic presumption bear the burden of production or also the ultimate burden of persuasion. The answers to these questions may provide guidance on how two elements of a securities fraud claim—materiality and reliance—intersect, and the extent to which defendants can challenge those elements at the class certification stage.

Factual Background

Between 2006 and 2010, petitioner made a series of statements about its efforts "to address potential conflicts of interest," including that the company had "extensive procedures and controls that are designed to identify and address conflicts," and that it was "dedicated to complying fully with the letter and spirit of the laws, rules and ethical principles that govern us."³ During the same time period, petitioner allegedly failed to disclose investor conflicts related to collateralized debt obligation (CDO) transactions involving subprime mortgages.⁴ When the Securities and Exchange Commission (SEC) learned of the conflicts, it launched an investigation, and petitioner eventually settled with the SEC for $550 million dollars.⁵

In 2011, a group of investors sued petitioner in the US District Court for the Southern District of New York, alleging that petitioner's conflicts-related representations "artificially maintained an inflated stock price" and that "the revelations of [petitioner's] conflicts" constituted "corrective disclosures" that caused the market to devalue their shares by as much as 13%.⁶ Spanning nearly a decade of litigation, the case has resulted in two separate appeals to the US Court of Appeals for the Second Circuit.

After the district court denied petitioner's motion to dismiss challenging the materiality of the alleged misstatements, the district court certified a class of investors. Petitioner appealed, and the Second Circuit reversed and remanded, holding that the district court did not properly apply a "preponderance of the evidence" standard to decide whether petitioner had rebutted the Basic presumption.⁷

On remand, the district court again found that plaintiffs had successfully invoked the Basic presumption under a theory of "price maintenance," which provides that "if a court finds a disclosure caused a reduction in a defendant's share price, it can infer that the price was inflated by the amount of the reduction."⁸ In this case, the "disclosure" was the SEC's complaint against the company, which caused its stock price to drop by 13%.⁹

Petitioner challenged the Basic presumption with the testimony of two experts who explained that 36 separate news articles had disclosed petitioner's alleged conflicts of interest without any "price impact" prior to the SEC's announcement.¹⁰ Relying on that fact, as well as an event study, the defense experts opined that the later price decline was tied to the SEC's enforcement action rather than the disclosure of the conflicts of interest themselves.¹¹

The district court, however, found the petitioner had not satisfied its burden of showing, by a preponderance of the evidence, that its representations had no price impact. Relying on the Basic presumption, it therefore certified the class a second time. Petitioner appealed again. This time, in a 2-1 decision, the Second Circuit affirmed the certification order.

Issues Presented

The Second Circuit's split decision illuminates a tension between the element of materiality in a securities fraud claim brought under Section 10(b), which does not need to be proven at the class certification stage, and the concept of "price impact," which defendants can raise at the class certification stage to defeat the Basic presumption and challenge the element of reliance.¹²

In Amgen, the Supreme Court held that plaintiffs need only allege materiality sufficiently to obtain class certification; they need not submit evidence to prove it.¹³ The Supreme Court explained that materiality—unlike reliance—is an objective inquiry "involving the significance of an omitted or misrepresented fact to a reasonable investor."¹⁴ And as an objective standard, materiality is a question common to all class members under Rule 23. If plaintiffs survive a motion to dismiss challenging materiality, they have carried their legal burden under Rule 23, and defendants may not introduce evidence to rebut materiality allegations at the class certification stage.

On the other hand, Basic held that investor plaintiffs can establish a classwide presumption of reliance if they show (1) that the defendant's misstatements were publicly known, (2) their shares were traded in an efficient market, and (3) the plaintiffs purchased the shares at market price during the relevant time period.¹⁵ Basic's presumption thus relies on a "fraud on the market" theory that is now commonplace in securities litigation.

As the Supreme Court explained in Haliburton II, defendants may "defeat the [Basic] presumption at the class certification stage through evidence that the misrepresentation did not in fact affect the stock price."¹⁶ Halliburton II thus allows defendants to refute a plaintiff's arguments of general market efficiency by showing no "price impact" for a specific security.¹⁷

In the Second Circuit, the majority (Judge Richard Wesley, joined by Judge Denny Chin) held that petitioner had not satisfied its burden of proving the lack of a price impact by a preponderance of the evidence. In the majority's view, petitioner sought to relitigate "the precise question posed by materiality," an inquiry that Amgen foreclosed at the class certification stage.¹⁸ In dissent, by contrast, Judge Richard Sullivan observed that the materiality and "price impact" inquiries overlapped and that "[t]he mere fact that such an inquiry 'resembles' an assessment of materiality does not make it improper."¹⁹ Relying on Halliburton II, the dissent asserted that the majority's decision was unnecessarily "tiptoeing" the line between materiality and price impact.²⁰ In closing, the majority responded that "[c]areful footwork is often required in intricate judicial tasks."²¹ The Supreme Court's grant of certiorari may address the tension between Amgen and Halliburton II the Second Circuit confronted.

Analysis

The Supreme Court's grant of certiorari is a significant development, and there are at least four things to watch for as the case is briefed, argued and ultimately decided:

Materiality by Any Other Name: Petitioner argues that its alleged misstatements are simply too general to cause a price impact, and that it should be allowed to make that argument at the class certification stage. If the alleged misstatements are too general to cause a "price impact," (as contemplated by Halliburton II), however, it also suggests that they may be too general to influence the purchasing decision of a reasonable consumer (the materiality inquiry). The Second Circuit found that petitioner's argument would allow defendants to indirectly litigate materiality at the class certification stage, thereby undermining Amgen's holding that materiality may not be proven (or disproven) before class certification. The Supreme Court's review may resolve this tension between Amgen's "materiality" holding and Halliburton II's recognition that defendants may challenge reliance in class certification proceedings.

The Basic Framework: The second question presented asks whether defendants bear the burden of production or persuasion when they seek to rebut the Basic presumption. If defendants bear the lesser burden of production, once they present expert testimony or other evidence suggesting there is no price impact from an allegedly misleading disclosure, the burden would shift to plaintiffs to prove by a preponderance of the evidence that the price impact was indeed caused by the disclosure. At that point, the court would need to weigh the evidence presented by both parties, certifying the class only if plaintiffs tipped the evidentiary scale in their favor.

The Price/Inflation Maintenance Theory: Lurking beneath the burden-shifting framework is the "price maintenance" (also referred to as the "inflation maintenance") theory of securities fraud. That theory allows plaintiffs who identify a drop in stock price to claim that the defendant's prior misstatements kept the stock price at an inflated level.

Petitioner argues that the Basic presumption, when combined with the price inflation theory, becomes effectively unrebuttable: rather than needing to prove a defendant's statements caused a change in stock price, under the price maintenance theory, a plaintiff can invoke the Basic presumption by showing the statements caused no change at all. The Supreme Court could weigh in on whether, as petitioner argues, disproving price impact becomes an impossible task in a price maintenance case because the initial inflation is not tied to the defendant's statements.

Reading Tea Leaves: Three of the nine current justices (Justices Gorsuch, Kavanaugh and Barrett) were appointed after the Supreme Court decided Basic, Amgen and Halliburton II. For the remaining six justices, the Court's more recent opinions may provide a few hints about their leanings:

• Chief Justice Roberts wrote the majority opinion in Halliburton II, with all nine justices agreeing with the decision to narrow—but not overrule—the Basic presumption.
• In both Amgen and Halliburton II, Justices Thomas and Alito wrote separate opinions expressing skepticism about the continuing viability of the Basic presumption, and it seems unlikely they will vote to strengthen the doctrine.
• The majority opinion in Amgen was written by the late Justice Ginsburg for a six-justice majority, but that opinion was joined by the now-retired Justice Kennedy and included a skeptical concurrence from Justice Alito. Accordingly, the Amgen majority will not decide this case.
• The petition cites a recent Seventh Circuit decision, In re Allstate Corp. Securities Litigation, 966 F.3d 595 (2020), which held that a district court ran afoul of Halliburton II by failing to engage with the defendants' evidence on price impact, disagreeing with the district court's view that defendants' evidence was "tied" too "closely to the merits."²² In an opinion joined by then Circuit Judge Amy Coney Barrett, the Seventh Circuit interpreted Halliburton II to stand for the proposition that a court may not "refuse to consider the evidence" simply because of the overlap between the price-impact inquiry and those merits inquiries. Id.

© Arnold & Porter Kaye Scholer LLP 2020 All Rights Reserved. This Advisory is intended to be a general summary of the law and does not constitute legal advice. You should consult with counsel to determine applicable legal requirements in a specific fact situation.