Angela DiIenno contributed to this article.

On September 27, 2016, the Second Circuit ruled against an opt-out action brought in the continuing Vivendi litigation. The recently issued opinion, however, does have positive implications for institutional investor class participants. First, the opinion confirms the availability of the fraud-on-the-market theory of reliance for institutional investors. Second, the opinion restricts the situations in which defendants may successfully rebut the presumption of reliance. Notably, however, institutions that have significant after-class purchases should be aware that such purchases could undercut their ability to rely on the fraud-on-the-market theory of reliance.

In GAMCO Investors Inc. v. Vivendi, S.A., GAMCO brought an individual action asserting Section 10(b) and Rule 10b-5 claims against Vivendi, alleging Vivendi made material misrepresentations regarding its liquidity. First, the U.S. District Court for the Southern District of New York held that Vivendi was estopped from denying any elements of GAMCO’s Section 10(b) claim other than reliance. After a bench trial on the reliance issue, the Court entered judgment for Vivendi, holding that Vivendi had successfully rebutted the fraud-on-the-market presumption of reliance.

On appeal, GAMCO argued that the district court erred in finding that because GAMCO was a value investor, GAMCO necessarily did not rely on an efficient market when purchasing securities. As the Second Circuit explained in its opinion (“Op.”), value investors make their own estimation of the value of securities and attempt to buy such securities when the market price is lower than their own valuation. For support GAMCO cited the Supreme Court’s 2014 Halliburton decision, where the Court noted that “there is no reason to suppose that . . . [value investors are] indifferent to the integrity of market prices.” Indeed, GAMCO’s process involves its own calculations of the “Private Market Value” (“PMV”) of securities and comparison to the valuation of market prices – if the difference in valuation is substantial enough, GAMCO transacts in the security. In other words, although value investors rely on the inefficiencies of the market to profit, they still rely on the theory of market efficiency when making decisions about whether to transact in securities.

The Second Circuit declined to consider whether, under the “contours of Haliburton,” defendants could rebut Basic’s presumption of reliance by simply showing that a plaintiff was a value investor. Instead the Second Circuit focused on the narrower issue of whether “Vivendi proved that GAMCO would have purchased Vivendi securities even had it known of Vivendi’s alleged fraud,” thereby rebutting the fraud-on-the-market presumption of reliance. The Second Circuit held that the district court was not clearly erroneous in finding that “on this record, that in this case, and with regard to this particular fraud,” GAMCO would have purchased the Vivendi securities regardless of whether the liquidity issue at Vivendi was public knowledge. Op. at 15-16.

The Second Circuit noted that the District Court focused on three aspects of the evidence presented in concluding that GAMCO would have purchased Vivendi shares regardless of the liquidity problem.

First, the District Court pointed to the fact that “GAMCO continued to buy Vivendi securities as the full extent of Vivendi’s alleged fraud came to light,” which the Second Circuit found specifically relevant to the narrower question whether knowledge of the liquidity problems would have affected GAMCO’s [transactions].”

Second, the District Court heard testimony from the analyst responsible for calculating the PMV of the securities in question, who testified that “the knowledge of the liquidity problems had no ‘impact [on his] PMV calculation.’ As he believed those problems constituted a ‘short-term issue . . . . [s]omething that could be solved within a year or so.’” Op. at 12. This testimony “support[ed] the district court’s conclusion that, if GAMCO had known of the liquidity problems and their concealment, GAMCO would still have believed Vivendi’s PMV to be ‘materially higher’ than the public market price,” and thus GAMCO would have likely still purchased the securities. Op. at 13. Finally, the District Court relied on testimony establishing that “GAMCO had no ironclad policy against purchasing stock it believed might be inflated by fraud, provided that other circumstances made the deal one worth pursuing.” Op. at 11.

While the Second Circuit declined to explore all the demarcations of fraud-on-the-market theory as it applies to value investors, the GAMCO decision does confirm that the theory is applicable to institutional investors. Further, the decision suggests that the fraud-on-the-market presumption is rebuttable only in those narrow circumstances akin to the facts of GAMCO: when there is specific and sufficient evidence showing that an institutional investor, had it known of a particular misrepresentation, would have believed that misrepresentation was immaterial and thus transacted in the securities in question nonetheless. However, institutional investors should be aware of the facts that allowed Vivendi to successfully rebut the presumption of reliance. Specifically, institutions that have significant after-class purchases should be aware that such purchases could undercut their ability to rely on the fraud-on-the-market theory of reliance.