January 28, 2021
The U.S. Supreme Court has agreed to address the circumstances under which defendants in a securities class action can rebut the “fraud on the market” presumption of class-wide reliance necessary for plaintiffs to form a certified class. On December 11, 2020, the Supreme Court granted defendants’ petition to consider whether the Second U.S. Circuit Court of Appeals erred when it certified a plaintiff class in Goldman Sachs Group, Inc., et al., Petitioners v. Arkansas Teacher Retirement System, et al. A decision in the case, the first shareholder class action before the Supreme Court since the appointment of Associate Justice Amy Coney Barrett, could offer insight into how far the current court is willing to deviate from longstanding precedent in this area.
The case itself stems from allegations Goldman Sachs misled investors when marketing a subprime mortgage product in 2007 just as the U.S. housing market was starting to collapse. The investment bank created a collateralized debt obligation (CDO) known as ABACUS 2007- AC1 at the request of hedge fund manager John Paulson so he could bet against the risky underlying subprime mortgages it held. Goldman received $15 million in fees and Paulson pocketed $1 billion by shorting the CDO.
In 2010, Goldman agreed to pay $550 million to settle Securities and Exchange Commission charges for failing to disclose Paulson’s involvement in selecting the CDO’s underlying securities. Goldman Sachs stock fell on news of the enforcement action, the largest-ever SEC penalty against a Wall Street firm. Goldman Sachs shareholders sued the company and three former executives, claiming their false and misleading statements kept its stock price artificially high until the SEC announced its complaint.
In 2012, the district court judge denied defendants’ motion to dismiss and the case proceeded to the class certification stage. Since then, the Second Circuit weighed in twice, the second time in April 2020 when it upheld certification of the plaintiff class, ruling that defendants had failed to rebut the presumption of classwide reliance first established in the Supreme Court’s 1988 Basic Inc. v. Levinson decision. Basic held that “in an open and developed securities market,” a company’s stock price is determined by all material information available to the public. Therefore, under Basic, investors need not show that they individually relied on defendants’ misrepresentations to pursue a claim under Rule 10b-5 of the Securities Exchange Act of 1934. Their reliance is “presumed.”
Basic, however, also held that defendants could rebut this “fraud on the market” presumption by, among other things, showing that the misstatements had no impact on the company’s stock price, a right that was clarified by the Supreme Court in a 2014 decision, Halliburton v. Erica P. John Fund, Inc., known as Halliburton II.
In Goldman, the Second Circuit refused to let defendants rebut the presumption of class-wide reliance by arguing that the bank’s statements about identifying conflicts of interest and acting in clients’ best interests were so “generic” and “aspirational” that they had no impact on the stock price. Accepting that argument, the Second Circuit said in a split decision, would allow defendants to “smuggle materiality” into the class-certification stage. Arguments over materiality— whether a reasonable shareholder would consider the information important to investment decisions—are “merits” issues reserved for trial, which follows class certification.
In its petition, Goldman Sachs asked the Supreme Court to decide whether “a defendant in a securities class action may rebut the presumption of classwide reliance … by pointing to the generic nature of the alleged misstatements in showing that the statements had no impact on the price of the security, even though that evidence is also relevant to the substantive element of materiality.” It also sought to clarify whether a defendant rebutting the Basic presumption must persuade a court or simply present evidence on the issue of price impact.
Calling Goldman “the most important securities case to come before the [Supreme] Court” since Halliburton II, the petitioners argued that, left undisturbed, the Second Circuit’s decision would have “devastating practical consequences for public companies” by making it impossible to rebut the Basic presumption. In opposing the petition, lawyers for Arkansas Teacher Retirement System called such “breathless” claims exaggerated, mentioned the lack of a conflict between appeals courts in different circuits, and said neither question posed by the petitioners “presents an issue of recurring importance.” Observers have also pointed out that issues like materiality and price impact, explicitly or not, are usually factors in whether judges grant defendants’ motion to dismiss—something that occurs prior to both the class certification and merits stages.
In its forays into securities class actions in the three decades since Basic, the Supreme Court has nipped and tucked at the rights and obligations of both plaintiffs and defendants without excising shareholders’ fundamental ability to sue as a class under the Exchange Act. Indeed, judicial restraint and respect for prior decisions has been a hallmark of the court led by Chief Justice John Roberts. The addition of Justice Barrett has expanded the court’s conservative majority but is unlikely to cause wholesale overnight abandonment of precedent in this case. It seems far more likely that a pro-petitioner ruling would force plaintiffs to address the issue of price impact earlier in the case than eliminate securities class actions altogether