The Situation: The United States Court of Appeals for the Second Circuit recently decertified a class of stockholders who alleged that Goldman Sachs maintained an inflated share price by making misrepresentations about its business principles and conflict-of-interest policies.
The Development: The Second Circuit applied the United States Supreme Court's "mismatch" framework to find that the stockholders could not rely on specific corrective disclosures and the resulting drop in stock price to show that Goldman's generic "front-end" misstatements maintained an inflated stock price.
Looking Ahead: This ruling provides corporate defendants with a significant new defense against class certification in "inflation maintenance" securities suits, as it bolsters available options to challenge price impact at the class certification stage.
In June 2021, we reported on the Supreme Court's decision in Goldman Sachs Group, Inc. v. Arkansas Teacher Retirement System. There, the Supreme Court held that courts should consider the generic nature of a misrepresentation when evaluating whether to apply the Basic presumption of reliance in a securities fraud class action. Importantly, the Court explained that the "final inference—that the back-end price drop equals front-end inflation—starts to break down when there is a mismatch between the contents of the misrepresentation and the corrective disclosure," and that where the misrepresentation is generic and the disclosure specific, "it is less likely that the specific disclosure actually corrected the generic misrepresentation."
The Supreme Court remanded to the Second Circuit because it was unclear whether the Second Circuit considered evidence regarding the generic nature of the misrepresentation. The Second Circuit then found that the record was not sufficiently developed, and remanded to the district court to apply the Supreme Court's "mismatch" framework. On remand, the district court found a sufficient match between Goldman's generic misrepresentations and later-issued, specific corrective disclosures. The district court thus determined that Goldman failed to rebut the presumption of reliance and certified the class. The defendants then appealed to the Second Circuit once again.
The Second Circuit's Decision
On appeal, the Second Circuit addressed whether defendants sufficiently rebutted the presumption of reliance at the class stage by establishing that the challenged generic front-end misstatements failed to match the specific back-end corrective disclosures for purposes of establishing price impact under Supreme Court precedent.
In an inflation-maintenance case, a "front-end" misstatement props up, or maintains, an inflated stock price. A later "back-end" corrective disclosure exposes the falsity of the front-end misstatement and deflates the price of the stock accordingly. As the Second Circuit observed, however, the Supreme Court placed limits on the use of a back-end statement to establish front-end inflation-maintenance where the corrective disclosure is specific while the earlier misstatement is generic.
The Second Circuit explained that although the Supreme Court had previously held that courts could not address materiality at the class stage, its subsequent Goldman decision clarified that courts should consider the genericness of front-end misstatements, "'particularly in cases proceeding under the inflation-maintenance theory . . . regardless whether that evidence is also relevant to a merits question like materiality.'" Id. at *10 (italics added). The Second Circuit observed that "back-end price drop is, at most, 'backward-looking indirect evidence,'" id. at *13, and that such indirect evidence is less compelling when the front-end misstatement is so generic that it could not impact, let alone prop up, the price of the stock.
The court concluded that the district court's mismatch analysis, which focused on Goldman's conflicts risk disclosures, misapplied the inflation-maintenance theory in weighing whether the back-end corrective disclosures were indirect evidence of price impact caused by a front-end misstatement. Specifically, unlike other Second Circuit inflation-maintenance cases, the level of specificity of the back-end corrective disclosures did not match the genericness of the challenged front-end misstatement.
The court also rejected plaintiffs' contention that, had the generic risk disclosures contained a detailed admission of severe wrongdoing, a price drop would have followed. In rejecting that argument, the court relied upon "duty-to-disclose" case law and observed that if a risk disclosure is too generic for a shareholder to rely upon, then it is too generic to trigger a duty to disclose specific adverse information that a corporation is not otherwise obligated to disclose. Id. at *21.
In sum, for purposes of the mismatch price impact analysis, the court held that a plaintiff cannot rely upon a specific back-end, price-dropping event to show front-end price impact "unless the front-end disclosure is sufficiently detailed in the first place." Id. at *62. At least in the context of an inflation-maintenance argument, the court thereby permits district courts to consider evidence bearing on the materiality of the front-end misstatement to conduct a price impact analysis.
In closing, the court provided guidance for district courts and future litigants. It directed district courts to conduct a "searching price impact analysis" where: (i) a "considerable gap" between the genericness of the front-end and back-end statements exists; (ii) the back-end corrective disclosure does not specifically refer to the front-end misstatement; and (iii) a plaintiff claims that a generic risk-disclosure was misleading by omission. Id. at *63. The Second Circuit then remanded to the district court with instructions to decertify the class.
The Second Circuit's ruling provides corporate defendants with a significant new defense against class certification in securities suits. While it remains to be seen how this application of the Supreme Court's mismatch framework will impact class certification determinations in the Second Circuit and other jurisdictions, the decision offers several key takeaways for corporate defendants discussed below.
Five Key Takeaways
- There must be a strong match in specificity between front-end misstatements and back-end corrective statements to establish that the front-end misstatements impacted stock price.
- An unsuccessful challenge to materiality or loss causation at the dismissal stage will not foreclose a defendant from making a similar argument as to lack of price impact at the class certification stage.
- Defendants can introduce case law and indirect evidence relevant to materiality to rebut the presumption of reliance at class certification.
- Judge Richard J. Sullivan's concurrence offers courts a "straightforward" way to resolve disputes over reliance that considers the genericness of the alleged misstatements and the actual price impact of corrective disclosures related to the generic front-end misstatements.
- This decision may make it less attractive for plaintiffs to bring securities fraud cases arising from general corporate assurances.