Second Circuit Declines To Decertify Class And Rejects Invitation To Narrow Inflation-Maintenance Theory In Investors’ Suit Against Goldman Sachs

In a 2-1 decision on Tuesday, April 7, 2020, a Second Circuit panel upheld the district court’s certification of a class of shareholders who alleged that Goldman Sachs Group, Inc. (“Goldman” or the “Bank”) and certain of its executives violated, inter alia, Section 10(b) of the Securities Exchange Act of 1934 and U.S. Securities and Exchange Commission (“SEC”) Rule 10b-5 promulgated thereunder.  Ark. Teacher Ret. Sys. v. Goldman Sachs Group, Inc., No. 18-3667, 2020 WL 1682772, at *1-*2 (2d Cir. Apr. 7, 2020).  The shareholders’ suit was filed in 2011, shortly after the SEC sued Goldman for allegedly helping a hedge fund client short a collateralized debt obligation (“CDO”) that the Bank was selling to customers, which made the hedge fund $1 billion at the customers’ expense.  Id. at *2.  Goldman settled the SEC action for $550 million.  Id.  The shareholders’ suit claims that Goldman’s representations about its freedom from conflict artificially maintained an inflated stock price for the Bank’s shares and that the revelations of Goldman’s conflicts, such as those presented in the SEC’s complaint, caused the Bank’s share price to decline.  Id.  
 
Goldman was previously successful in overturning class certification in this case in 2018, when the Second Circuit held that the district court failed to apply the “preponderance of the evidence” standard to determine whether Goldman had rebutted a legal presumption of reliance, known as the Basic presumption, that the shareholders relied on the Bank’s allegedly material misstatements in choosing to purchase Goldman’s stock at the market price.  Id. at *1, *4.
 
On remand, the district court certified the class again under Federal Rule of Civil Procedure 23(b)(3), and Goldman appealed once more, seeking reversal on two grounds: (1) that the district court misapplied the inflation-maintenance theory, which the Bank asked the Second Circuit to narrow; and (2) that the district court abused its discretion by holding that Goldman failed to rebut the Basic presumption by a preponderance of the evidence.  Id. at *4, *6.  A majority of the Second Circuit panel disagreed with Goldman on both grounds and affirmed the district court’s decision.  Id. at *1, *17.
 
The District Court Properly Applied the Inflation-Maintenance Theory
 
All three members of the Second Circuit panel agreed that the district court properly applied the inflation-maintenance theory.  Id. at *8-*9, *17.  By way of background, “[i]n the classic § 10(b) case, a corporation’s shareholders allege that a corporation . . . made false statements that caused them to overvalue its stock[,]” and “the question of whether the statements actually affected the market price is called ‘price impact.’”  Id. at *6.  The Second Circuit has held that two types of false statements can have price impact: inflation-introducing statements and inflation-maintaining statements.  Id.  Under an inflation-introduction theory, a corporation’s false statement has price impact because the market believed the statement “to be true and reacted accordingly.”  Id.  Under an inflation-maintenance theory, a false statement has price impact because it maintains existing inflation in the corporation’s share price.  Id.  The shareholder plaintiffs in this case argued price impact under the latter theory, claiming that the statements about Goldman’s freedom from conflict artificially maintained an inflated stock price, and that the revelations of the Bank’s conflicts were “corrective disclosures” that caused the market to devalue their shares.  Id. at *2.
 
The majority disagreed with Goldman’s argument that the inflation-maintenance theory only applies when the alleged misstatements maintain “fraud-induced inflation[,]” explaining that the Second Circuit case on which the Bank based its argument, In re Vivendi, S.A. Sec. Litig., 838 F.3d 223, 256 (2d Cir. 2016), “said no such thing,” and actually contradicted its claim.  Goldman, 2020 WL 1682772, at *7.  Additionally, the majority disagreed with Goldman’s argument that the district court “made no finding” that Goldman’s share price was inflated.  Id.  Under the inflation-maintenance theory, “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.”  Id.  The majority found “no abuse of discretion in the [district] court’s finding that the inflation maintained by Goldman’s statements equaled the price drop caused by the corrective disclosures.”  Id. at *8.  As the majority explained, “these findings satisfy the inflation-maintenance doctrine.”  Id.
 
The Second Circuit Declines to Narrow the Inflation-Maintenance Theory
 
The majority also declined Goldman’s request to narrow the focus of the inflation-maintenance theory.  Id. at *8.  A key part of Goldman’s argument on appeal was that the district court had erred by applying the inflation-maintenance theory to “general statements,” such as those “about business principles and conflicts controls,” which Goldman maintains “are too general to cause a reasonable investor to rely upon them.”   Id. at *7, *9.  Under Goldman’s proposed revision of the theory, plaintiffs relying on “general statements” “would be unable to invoke the Basic presumption of classwide reliance and would therefore be unable to demonstrate under [Fed. R. Civ. P.] 23(b)(3) that classwide issues (i.e., reliance on the defendant’s misstatements) predominate over individual issues.”  Id. at *8.  According to Law360, “Goldman’s argument for narrowing the application of the theory caught the eye of many in the securities class action industry, given its implications for proving securities fraud writ large.”
 
The majority explained that none of the cases Goldman relies on “held that the inflation-maintenance theory applies so narrowly,” and Goldman’s proposed test “would commandeer the inflation-maintenance theory by essentially requiring courts to ask whether the alleged misstatements are, in Goldman’s words, ‘immaterial as a matter of law.”  Goldman, 2020 WL 1682772, at *8-*9.  Materiality, however, is not appropriate to consider at the class certification stage, because “[w]in or lose, the issue is common to all class members.”  Id. at *9-*10.  The majority concluded, “while securities class action defendants have numerous avenues for challenging materiality, Rule 23 is not one of them.  The inflation-maintenance theory does not discriminate between general and specific misstatements.”  Id. at *11. 
 
The District Court Did Not Abuse Its Discretion By Holding That Goldman Failed to Rebut the Basic Presumption 
 
The majority also disagreed with Goldman’s argument that the district court erred in finding that the Bank failed to rebut the Basic presumption of reliance.  Id. at *16.  To rebut the presumption, Goldman needed to “show by a preponderance of the evidence that the entire price decline on the corrective-disclosure dates was due to something other than the corrective disclosures.”  Id. at *13.  The Bank claimed, inter alia, that the district court erred by ignoring the substance of the 36 press reports that touched on its conflicts of interest before the corrective disclosures came out.  Id.  According to Goldman, “the market’s nonreaction to these reports proved that it was indifferent to the revelation that Goldman’s statements about being conflict free were untrue.”  Id.  The dissenting judge sided with Goldman on this issue, id. at *20, but the majority disagreed, explaining, inter alia, that “Goldman has no persuasive response” to the district court’s findings that the “hard evidence” of Goldman’s conflicts in the corrective disclosures “moved the market” in a way that the “more generic” press reports did not.  Id. at *13.