Second Circuit Again Considers “Price Maintenance Theory” In Securities Class Actions
ATTORNEY: BRIAN CALANDRA
POMERANTZ MONITOR SEPTEMBER/OCTOBER 2019
On June 26, 2019, the Second Circuit heard oral argument on the defendants’ appeal of the district court’s class certification order in Arkansas Teacher Retirement System v. Goldman Sachs Group, Inc. (“ATRS”). The panel’s decision could provide guidance on how district courts should apply the Supreme Court’s decision concerning the “fraud on the market” presumption of reliance in securities fraud class actions involving the so-called price maintenance theory. This theory asserts that defendants’ fraud did not inflate the price of the company’s stock but, rather, prevented it from falling by misrepresenting or concealing bad news.
Demonstrating that the critical issue of investor reliance can be established on a class wide basis has always been a crucial issue in securities litigation. In Basic v. Levinson, the Supreme Court held that in securities class actions involving stock traded on “efficient markets”, courts may presume that investors all relied on “the integrity of the price set by the market,” and that fraudulent statements would have distorted the market price. In Halliburton Co. v. Erica P. John Fund, Inc. (“Halliburton II”), the Supreme Court held that defendants can rebut the presumption by showing “that the asserted misrepresentation (or its correction) “did not affect the market price of the defendant’s stock” because it was not “reflected in the market price at the time of [the investor’s] transaction.”
The simplest and most straightforward evidence of price impact is a misstatement quickly followed by an increase in the market price. Sometimes, however, plaintiffs try to demonstrate price impact by showing that the statement in question “maintain[ed] the inflation that is already present in a security’s price.” In other words, under this “price maintenance” theory, price impact is shown where a misstatement maintains that security’s artificially inflated price.
The Supreme Court’s decision in Halliburton II did not address several issues concerning the fraud-on-the-market presumption, including how defendants can rebut plaintiffs’ showing of price impact in cases alleging price maintenance. The Second Circuit panel in ATRS, however, squarely raises these issues.
ATRS arose out of losses incurred by investors in four collateralized debt obligations issued by Goldman Sachs (the “Goldman CDOs”). The Goldman CDOs in 2006 and 2007, shortly before the 2008 financial crisis, without disclosing that the CDOs were designed so that a Goldman hedge fund client, or Goldman itself, could reap billions in profits when the assets underlying the CDOs failed.
Plaintiffs, purchasers of Goldman common stock, filed a class action against Goldman and certain of its officers and directors alleging that they had made material misstatements and omissions regarding the conflicts of interest attendant to the Goldman CDOs, which harmed investors in Goldman’s stock when the stock price declined after the conflicts of interest were disclosed. According to plaintiffs, while Goldman was marketing the CDOs to its clients, it was filing 10-Ks with the SEC and releasing annual reports assuring investors that the firm had “extensive procedures and controls that are designed to identify and address conflicts of interest.” Plaintiffs alleged that these and other statements were revealed to be false when the press reported that (i) the SEC had filed a civil lawsuit charging Goldman with securities fraud in connection with one CDO, (ii) the United States Department of Justice had opened a criminal investigation into whether Goldman had committed securities fraud in connection with its mortgage trading and (iii) the SEC had opened an investigation into a second CDO.
After the court rejected defendants’ motion to dismiss the complaint, the ATRS plaintiffs then moved to certify a class of all purchasers of Goldman common stock during the relevant period. Defendants opposed class certification on the grounds that plaintiffs had failed to demonstrate “price impact.” Specifically, defendants submitted declarations and affidavits saying that Goldman’s stock did not increase on the dates that the 10-Ks and annual reports containing the alleged misrepresentations were disseminated, nor had the price of Goldman’s stock decreased on 34 days before 2010 when the press had previously reported the conflicts of interest concerning the Goldman CDOs. Goldman’s stock did, however, decline significantly after the disclosures that the government was investigating and suing Goldman over its role in issuing and underwriting these CDOs.
The district court rejected defendants’ arguments and certified the class, holding that defendants had not provided “conclusive evidence that no link exists between the price decline [of Goldman stock] and the misrepresentation[s]” (emphasis added). Among other things, the Court held that it could not consider defendants’ arguments that Goldman’s stock price had not increased on the dates of the alleged misstatements or decreased on dates of press reports regarding Goldman’s alleged conflicts of interest in connection with the Goldman CDOs because, the court said, “truth on the market” and materiality defenses were not appropriate to consider at the class certification stage.
While defendants’ appeal to the Second Circuit was pending, a different Second Circuit panel ruled in Waggoner v. Barclays plc (“Barclays”), where the investor class was represented by Pomerantz LLP. The Barclays panel held that when opposing a motion to certify a class in a securities fraud action, a defendant can rebut a purported showing of price impact by demonstrating by a preponderance of the evidence that an alleged misrepresentation had no effect on the price of the security at issue. While Barclays was a significant victory for investors, the “preponderance of the evidence” burden it seemed to be placing on defendants to rebut price impact was less onerous than the “conclusive evidence” required by the district court in the ATRS case.
Citing Barclays, the Second Circuit reversed the district court’s certification of the ATRS class because it was unclear whether the district court had applied Barclays’ “preponderance of the evidence” standard. On remand, the ATRS Plaintiffs relied on a declaration and testimony from an expert who concluded that the declines in Goldman’s share price after disclosure of the government’s actions against Goldman were at least in part attributable to the revelation that defendants had made misstatements concerning Goldman’s conflicts of interest, commitment to its clients and compliance with governing laws Defendants countered with expert reports and testimony that purported to show that the alleged misrepresentations had no effect on Goldman’s stock price because plaintiffs’ expert testimony was unreliable and incomplete, and Goldman’s stock price did not decline on 36 different days prior to 2010 when the press published articles concerning alleged conflicts of interest with regard to the Goldman CDOs.
The district court rejected defendants’ arguments and re-certified the class. The court first held that plaintiffs’ expert had established a link between the reports of Goldman’s conflicts and the subsequent declines in Goldman’s share price. It then held that defendants’ evidence that Goldman’s stock price had not declined on 36 days prior to 2010 did not rebut plaintiffs’ showing because “[t]he absence of price movement . . . in and of itself, is not sufficient to sever the link between the first corrective disclosure and the subsequent stock price drop.” Finally, the district court held that defendants’ arguments that the alleged misstatements could not have affected Goldman’s stock price because those statements were immaterial was not appropriate to consider at the class certification stage.
Defendants appealed again, arguing, among other things, that the district court had erred in applying price maintenance theory. They argued once again that there was no evidence that Goldman’s stock price was ever “inflated” by defendants’ alleged fraud, and that the district court had never addressed whether there was inflation “already extant” in Goldman’s stock price at the time the alleged misstatements were made. Defendants also argued that the alleged misstatements “were not the types of statements that courts have recognized as capable of maintaining inflation in a public company’s stock price.” Finally, Goldman argued that the alleged misstatements were “so general that a reasonable investor would not rely on” them and thus the statements could not “inflate or maintain a stock price.”
Plaintiffs responded that “[t]his Court and others have repeatedly rejected Goldman’s claim that price-maintenance is limited to cases involving ‘fraud-induced’ inflation” and “[the Second Circuit] rejected [Defendants’] attempt to defeat class certification on materiality grounds in the last appeal.”
The Second Circuit panel hearing this second appeal in ATRS has the opportunity to provide much-needed guidance on plaintiffs’ use of price maintenance theory. The most important issues on the table are whether a plaintiff has to establish that there was fraud-induced price inflation of the company’s stock before the misrepresentations were made. Suppose, for example, that a company’s previous financial disclosures had been accurate, but then profits had declined but the company falsely claimed that profits had not declined, preventing the stock price from falling. Does that pattern of behavior not satisfy the requirements of price maintenance theory? The case also raises the question of whether price declines following disclosures of the negative information are enough to support “price impact” claims even if the price had not declined in other instances following disclosure of similar information.
The appeal also raises the issue of whether, as defendants contend, the panel should limit price maintenance theory to circumstances “where specific statements . . . (i) offset investor concerns or (ii) confirm[] market expectations, in either case about a material financial metric, product, or event.” If the panel rejects this argument, it would clarify that price maintenance theory applies to misstate-ments that, when corrected, revealed no concrete financial or operational information that had been hidden from the market for the purpose of maintaining the stock price, as well as misstatements whose materiality is in question.
Finally, the panel’s decision could address a potential ambiguity in the Goldman I decision concerning whether the materiality of the alleged misrepresentations should be considered on a class certification motion.