Second Circuit Upholds Class Certification Order in Goldman Sachs

ATTORNEY: OMAR JAFRI | POMERANTZ MONITOR | JULY/AUGUST 2020

On April 7, 2020, the United States Court of Appeals for the Second Circuit affirmed the district court’s order to certify a class under Rule 23(b)(3) of the Federal Rules of Civil Procedure in In re Goldman Sachs Grp. Inc. Sec. Litig. This case arose out of four collateralized debt obligation (“CDO”) transactions that were marketed by Goldman as ordinary asset-backed securities. Behind the scenes, however, Goldman allowed the hedge fund, Paulson & Co. (“Paulson”), to select risky mortgages that it knew would perform poorly or would otherwise fail. Goldman ultimately admitted that it failed to disclose Paulson’s role in the CDOs, and paid a $550 million fine in connection with a settlement with the SEC.

Shareholders of Goldman alleged that it made false and misleading statements regarding (1) the procedures and controls utilized to identify or avoid conflicts of interest; (2) the effort made to comply with all applicable laws, rules and ethical principles; and (3) the alleged dedication to integrity and honesty in dealing with clients. In other words, the plaintiffs alleged that Goldman falsely represented that it was aligned with the interests of investors when, together with Paulson, it was profiting from short positions that conflicted with the interests of those very investors.

Numerous amicus briefs, including from parties routinely hostile to investors’ rights such as the U.S Chamber of Commerce and the Securities Industry and Financial Markets Association, urged the Second Circuit to let Goldman off the hook based on the assumption that the district court held Goldman to an “impossible standard,” and that allowing its decision to stand would open the floodgates for “abusive” securities lawsuits.

In upholding the district court’s order to certify the class under Rule 23(b)(3) of the Federal Rules of Civil Procedure, the Second Circuit rejected Goldman’s attempt to limit the scope of the inflation-maintenance theory in securities fraud actions. Under the inflation-maintenance theory, otherwise known as the price impact theory, material misrepresentations are presumed to artificially maintain an already inflated price of stock. Goldman requested the Second Circuit to limit the inflation-maintenance theory to either “fraud-induced” appreciation of the stock price or “unduly optimistic” misrepresentations about “specific, material financial or operational information” or those that “falsely convey that the company has met market expectations about a specific, material financial metric, product, or event.”

The full panel declined to narrow the scope of the inflation maintenance theory on these grounds. The majority relied on the Second Circuit’s decision in In re Vivendi, S.A. Sec. Litig. to observe that “[a]rtificial inflation is not necessarily fraud-induced, for a falsehood can exist in the market (and thereby cause artificial inflation) for reasons unrelated to fraudulent conduct.” The dissent agreed that Vivendi was the law of the Circuit, and that “the district court did not misapply the inflation-maintenance theory of price impact.” The majority further rejected Goldman’s attempt to limit the inflation maintenance theory to a specific set of narrow circumstances such as misrepresentations about financial or operational information or specific metrics, products or events. Observing that none of the authorities that Goldman relied on supported such a limited application of the inflation-maintenance theory, the majority also rejected Goldman’s argument that general statements cannot artificially maintain the price of a company’s shares.

The majority construed Goldman’s attempt to carve out “general statements” from the inflation-maintenance theory as a means to “smuggle” materiality into a certification inquiry even though long-standing precedent holds that materiality is not an appropriate consideration at the class certification stage and Goldman had, in fact, failed to convince the district court that the general statements at issue were immaterial as a matter of law at the pleading stage. Accordingly, the Second Circuit held that it is proper to infer that the company’s stock price was inflated by the amount of the reduction in price following a disclosure of the falsity of the statements. That is all the law requires to demonstrate price impact in the Second Circuit.

The majority also affirmed the district court’s ruling that Goldman had failed to rebut the Basic presumption. In a securities fraud action, a plaintiff is entitled to the Basic presumption if the defendants’ misstatements are publicly known, the shares trade in an efficient market, and the plaintiff purchases the shares after the misrepresentations are made but before the truth is revealed. Once a plaintiff properly invokes the Basic presumption, defendants face a “heavy burden” to show, by a preponderance of the evidence, that the decline in stock price was entirely due to factors other than the alleged misrepresentations. Goldman sought to rebut the Basic presumption by alleging that dozens of news articles published before the corrective disclosures revealed facts about its conflicts of interest but were not accompanied by a corresponding decline in its stock price. Goldman also presented expert testimony that the decline in its stock price was not due to the alleged misrepresentations, but was caused by the revelation of an SEC enforcement action, including a possible fine.

The majority affirmed the district court’s conclusion that the absence of price movement following the release of the news articles was not sufficient to break the link between the alleged corrective disclosures and the subsequent price decline. This was so because the purported corrective disclosures, including the SEC’s complaint against Goldman, contained newly revealed “hard evidence” in the form of damning emails and internal memoranda regarding Goldman’s pervasive conflicts of interest, which was not revealed in the earlier news reports. The majority thus found no “clear error” in the district court’s decision to weigh the evidence, upheld its conclusion that Goldman failed to rebut the Basic presumption, and affirmed the order to certify the class.

The majority’s decision is consistent with the Second Circuit’s decision in Waggoner v. Barclays PLC—a case where Pomerantz prevailed in convincing the Second Circuit to affirm the district court’s decision to certify the class. In Barclays, the Second Circuit had similarly emphasized that defendants must present “direct, more salient evidence” to rebut the Basic presumption, and rejected the defendants’ attempt to overcome the presumption via a more lenient standard.

One member of the panel dissented. While the dissent agreed with the basic contours of the price inflation theory, it disagreed with the majority’s decision to uphold the certification order. According to the dissent, Goldman rebutted the Basic presumption based on “persuasive and uncontradicted evidence” that Goldman’s share price did not decline after dozens of news reports allegedly revealed the nature of its conflicts of interest. The dissent further found that plaintiffs failed to refute Goldman’s expert’s conclusion that the decline in stock price was caused by the announcement of the SEC and DOJ enforcement actions rather than factual allegations contained in the complaint. However, the dissent did not explain why newly revealed “hard evidence,” in the form of damning emails and internal memoranda regarding Goldman’s pervasive conflicts of interest that was not revealed in the earlier news reports, was immaterial. The dissent would also have given courts the license to assess materiality at the class certification stage even though prior precedent holds that materiality is irrelevant at the class certification stage and defendants face an uphill battle to challenge materiality even at summary judgment.

In late June 2020, Goldman asked the Second Circuit to stay its mandate while it petitioned the Supreme Court to hear its appeal.