In Which the Second Circuit Overrules Blue Chip Stamps v. Manor Drug Stores, and also Basic v. Levinson

Back when the Supreme Court decided Goldman Sachs Grp., Inc. v. Ark. Tchr. Ret. Sys., 141 S. Ct. 1951 (2021), I blogged that the confused ruling would eventually be interpreted by lower courts to restore the Fifth Circuit’s decision in Archdiocese of Milwaulkee Supporting Fund v. Halliburton, 597 F.3d 330 (2010), which rejected Basic v. Levinson’s presumption of price impact in fraud on the market cases, and instead replaced it with its own burden on plaintiffs to show price impact. 

Thursday’s ruling in the same case – now before the Second Circuit – pretty much bore that out.  Despite the occasional lip service to the defendants’ burden to disprove the existence of price impact, in fact, most of the opinion is concerned with the kind of showing plaintiffs must make to – in the Second Circuit’s words – “do the work of proving front-end price impact.” Op. at 56.  See also op. at 54 n.11 (framing the question presented as “whether there is a basis to infer that the back-end price equals front-end inflation”).

But before we get there, the Second Circuit seems to have sub rosa rejected Blue Chip Stamps v. Manor Drug Stores, 421 U.S. 723 (1975), in this throwaway paragraph on page 57:

Consider, for example, an investor who reads certain statements in a company’s Form 10-K, and then thinks “Things seem to be going well; I think I’ll hold onto my shares.” Although the statements did not cause that investor to buy more stock, they informed or influenced her decision. And if the company’s statements are later revealed as false, liability might follow not because the statement caused new or more inflation—that is, caused investors to purchase more stock (thereby increasing demand and, ultimately, raising the share price)—but instead because the statement maintained inflation, or influenced the investor’s decision to hold tight.

Let that serve as a preview for what follows.

[More under the cut]

The only person who has written more commentary on this long-running case than me is Judge Crotty of the SDNY.  You can find my prior blog posts, in chronological order, here, and here, and here, and here, and here, and here, but the most important of these are this one about the Supreme Court’s decision, and this one about Judge Crotty’s third grant of class certification – the one that the Second Circuit just reversed.

The scenario is, Goldman made some relatively anodyne statements about its ability to manage conflicts of interest among its many lines of business, and these were proved to be false via financial-crisis era scandals.  Goldman’s stock price dropped as a result, and Goldman has been arguing ever since that the statements did not inflate its stock price, precluding a fraud on the market claim.  The latest set of arguments was the following: to show price impact, there must be some market movement, either when the lie is first told, or in response to revelation of the truth; here, there was no market movement when the lie was told (because the plaintiffs alleged that the lie simply maintained the status quo); the price drop in the end was not due to revelation of fraud, but to the real world effects of enforcement actions that followed.  Reasoned Goldman, if the price drop was attributable solely to enforcement actions – rather than revelation of the “truth” underlying its allegedly false statements – and if there was no price reaction when the lie was told initially, then, naturally, there was no inference that the false statements impacted stock prices in the first place.

As I explained in my post on the Supreme Court ruling, back in 2010, the Fifth Circuit replaced Basic’s presumption of price impact with a requirement that plaintiffs prove price impact to win class certification, either by showing that stock prices went up in response to a fraudulent statement, or that they dropped in response to disclosure of the truth.  I.e., the Fifth Circuit’s proposed rule was indistinguishable from the rule Goldman sought.  But that rule was, purportedly, rejected by the Supreme Court in Erica P. John Fund, Inc. v. Halliburton Co., 563 U.S. 804 (2011).  It used the terminology “loss causation,” rather than “price impact,” but the logic was, the fact that a subsequent drop was unrelated to an earlier lie does not shed much light on whether the earlier lie did in fact impact prices.  Suppose a company commits accounting fraud.  Its stock price is inflated.  Before the truth is disclosed, however, there’s an intervening event – the company’s manufacturing plants are destroyed by lightning.  Stock price plummets and firm is sent into bankruptcy.  In that scenario, the back end disclosure that caused a price drop was entirely unrelated to the initial lie, but it hardly suggests that the initial lie had no impact.  It doesn’t tell us anything at all about the effect of the initial lie. 

In that scenario, plaintiffs may be unable to prove loss causation, meaning they will lose their case on the merits, but there is no reason to disturb the Basic presumption that the lie impacted stock prices in the first place.  Since class certification is about whether there is price impact – demonstrating commonality, namely, whether the plaintiffs’ claims stand or fall together – the class would be certified, and the case would go to trial. 

By the time Goldman hit the Supreme Court though, that history was entirely forgotten.  The entire theory on Goldman’s side was that since there was no price movement upwards upon the initial lie, a class could only be certified if price impact was established via a drop when the truth was revealed.  And, ignoring Halliburton, the Supreme Court relied on loss causation cases to say:

Plaintiffs typically try to prove the amount of inflation indirectly: They point to a negative disclosure about a company and an associated drop in its stock price; allege that the disclosure corrected an earlier misrepresentation; and then claim that the price drop is equal to the amount of inflation maintained by the earlier misrepresentation….

But that 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. …Under those circumstances, it is less likely that the specific disclosure actually corrected the generic misrepresentation, which means that there is less reason to infer front-end price inflation—that is, price impact—from the back-end price drop.

See what they did there?  The Court both accepted what Halliburton rejected – i.e., the inference that there was no price impact initially without proof of a drop related to the fraud – and put the burden on plaintiffs to come forward with evidence of price impact in the first place.

And that’s how the case has played out since remand.

When the case went back down to the district court for a redo of the class certification, I discussed how Judge Crotty, in certifying the class, bought into that framing.  Now, in its opinion reversing Judge Crotty, the Second Circuit has done the same, except, it rejected Crotty’s reasoning and substituted its own.  The opinion is so meandering that I honestly am finding it difficult to summarize, but here is the bottom line:

a searching price impact analysis must be conducted where (1) there is a considerable gap in front-end–back-end genericness, as the district  court found here, (2) the corrective disclosure does not directly refer, as it did in Waggoner [v. Barclays PLC, 875 F.3d 79 (2d Cir. 2017)], to the alleged misstatement, and (3) the plaintiff claims, as plaintiffs claim here, that a company’s generic risk-disclosure was misleading by omission….

Where a gap exists, courts should ask, under [In re] Vivendi [, S.A. Sec. Litig., 838 F.3d 223 (2d Cir. 2016)], whether a truthful—but equally generic—substitute for the alleged misrepresentation would have impacted the stock price.  Importantly, unlike the classic inflation-maintenance case—where the back-end price drop is itself the evidence (albeit indirect) of the front-end price impact—the value of the back-end proxy, given the gap in specificity, will be diminished.

As such, courts should consider other indirect evidence of price impact, directed at either the inflation-maintaining nature of the generic misstatement, or the price-dropping capacity of an equally generic corrective disclosure.

The Second Circuit faulted the district court here because Judge Crotty did not conduct a hypothetical inquiry into what an “equally generic” disclosure of the truth would have looked like, but instead inferred price impact from the price drop in response to what was in fact disclosed, which operated at a more specific level than the original lie. 

Which is to say, Goldman’s original lie was “We have extensive procedures and controls that are designed to identify and address conflicts of interest, including those designed to prevent the improper sharing of information among our businesses,” so therefore, according to the Second Circuit, since this is a generic statement, and since the corrective disclosure – of extensive specific unmanaged conflicts – did not explicitly reference the earlier lie, the appropriate course is to … imagine how the price would have reacted if Goldman had said something like “We have extensive procedures and controls that are designed to identify and address conflicts of interest, but these do not in fact work because we exploit our conflicts to take advantage of our customers.”  If one imagines there would have been a price drop in response to that statement, then one can infer the actual statement impacted stock prices.  If one imagines there would have been no price drop in response to that statement, then one can infer the actual statement did not impact stock prices.

Except apparently that’s not what you do? 

Because if that’s the thought experiment – and it’s exactly what the Second Circuit says a court should do – it’s fairly obvious what would have happened; Goldman’s stock price would have plummeted.

Instead, the Second Circuit said, even though Judge Crotty did not conduct a hypothetical inquiry into what would have happened upon generic disclosure of the truth, there was enough evidence submitted by the parties that the Second Circuit could conduct that inquiry itself.  Per the court:

Although, of course, the district court did not have the benefit of our analysis, the parties submitted a mountain of evidence that bears directly on whether an equally generic substitute for the conflicts disclosure would have dissipated the inflation allegedly maintained by that statement, making remand for further factfinding unnecessary

And what evidence was that?  It was evidence that before the revelation of the truth, everyone thought that Goldman’s conflicts-management was important, and after revelation of the truth, everyone thought that Goldman’s conflicts-management was important, but no one specifically said they were relying on what Goldman had said.  Therefore, concluded the Second Circuit, there was no evidence that the false statement specifically impacted stock prices. Op. at 66-68.

In other words, having said that the court should consider “whether a truthful—but equally generic—substitute for the alleged misrepresentation would have impacted the stock price,” the Second Circuit at no time actually conducted the inquiry that it just said was necessary.  Instead, it looked to the fact that no one specifically mentioned the statements made by Goldman to conclude that “although market commentary can provide insight into the kind of information investors would rely upon in making investment decisions—and therefore can serve as indirect evidence of price impact—commentary touching upon only the same subject matter, given the contours of this case as discussed above, cannot be enough.” Op. at 68.

So.  Plaintiffs – having been tasked with proving a connection between the price drop and the initial fraud to establish price impact – failed because the statements were generic, and the commentary surrounding the fraud emphasized the importance of the subject of the generic statements but did not cite the statements themselves.  The absence of evidence of reliance on these specific statements (rather than their subject matter) is treated as evidence of absence.  That is the opposite of a presumption of price impact, and is a de facto rejection of Basic v. Levinson.

But wait, there’s more!!

This whole notion – that somehow, to determine price impact, the court should evaluate what would have happened in the alternative world where the defendants told the truth – comes from Vivendi.  There, Vivendi argued that if its lies served to maintain the stock price at inflated levels, the court should conduct a hypothetical inquiry into what would have happened if it had remained silent.  If nothing would have happened – if the stock price would have remained the same – it necessarily follows that the lie had no effect.

The Second Circuit rejected that reasoning, because, having lied, Vivendi had no option to remain silent; it was required to tell the truth.  Therefore, the true hypothetical alternative state of the world was one where the truth was revealed.

But in Vivendi, the Second Circuit also said that there could be no assumption that silence would have maintained the stock price.  Without the false statements, the public might have discovered the truth.  Silence itself on the subject might have been suspicious.

And that was part of Judge Crotty’s reasoning when he certified the class.  He said:

in a marketplace where, according to Defendants, dozens of Goldman competitors and other blue-chip corporations routinely make statements “indistinguishable” from some of the alleged misstatements, it seems unlikely that Goldman's conspicuous failure to conform-…would be irrelevant to investors.

That was something I seized on in my earlier post on his decision.  As I said:

Goldman was making statements about its integrity and conflicts management long before the class period – at a time when, by hypothesis, the statements were true.  Can you even imagine how the market would have reacted if those statements suddenly disappeared?

But the Second Circuit has now jettisoned that aspect of Vivendi.  Now, in a price maintenance case – a case where a false statement allegedly maintained stock prices – the only hypothetical world one can imagine for the purpose of determining price impact or loss causation (which was the actual inquiry in Vivendi) is what would have happened if the defendants told the truth, with the exact level of specificity of the original false statement, except not even that because that’s not what the Second Circuit actually did.

As I put it before, “the inquiry into materiality/puffery/genericness what-have-you in securities cases is usually divorced from any honest attempt to assess the role these statements actually play in the market.”

Plus, the Second Circuit added this gem:

[P]laintiffs might still attempt to (a) identify a highly specific corrective disclosure, and (b) identify and extract a generic truth purportedly embodied therein, in order to (c) craft a link between a generic misrepresentation and specific corrective disclosure. For example, plaintiffs could point to news detailing a company’s commission of securities fraud, and then claim that nestled therein was the more generic revelation that the company’s earlier, general statement that it aims to act lawfully was a lie. From there, they might still contend that the back-end price drop is an appropriate proxy for front-end inflation.

Goldman dispels that notion....

Wait, what?  If a company lies about legal compliance, and then specific instances of illegal conduct are revealed, that’s not enough to bring a case?

Recall that ever since Dura Pharmaceuticals, Inc. v. Broudo, 544 U.S. 336 (2005), there have been fights about whether a subsequent disclosure is sufficiently connected to the earlier fraud to satisfy the element of loss causation.  (An issue I discuss in my essay, Fact or Fiction: Flawed Approaches to Evaluating Market Behavior in Securities Litigation). The Second Circuit has traditionally been on the more liberal (correct) side of this fight, allowing a disclosure to establish loss causation under the relaxed “materialization of the risk” standard.  But now, for the purposes of demonstrating reliance, it’s requiring a very tight connection between the original statement and revelation of the truth – even when, according to its own hypothetical, the original statement is entirely incompatible with the truth that is eventually revealed.  The Second Circuit acknowledged this disjunction explicitly.  See op. at 54 n.11 (“the question here—whether there is a basis to infer that the back-end price equals front-end inflation—is a different question than loss causation, and, in light of Goldman, requires a closer fit (even if not precise) between the front- and back-end statements…”).

In practical effect, that means there will be fights about sufficient genericness in every single case, and every single time, the plaintiffs will have to show either that the original statement wasn’t generic, or that the later disclosures were sufficiently connected.  And there will be no guide for the court's inquiry other than gut instinct, because – and I cannot stress this enough – a lack of a back end price drop does not tell us whether the initial lie inflated the stock price, particularly if one assumes there is little relationship between the lie and the subsequent disclosure.  Exactly as the Supreme Court originally recognized in Halliburton.

Think how this plays out.  Every case has a disclosure and price drop, because no one brings a securities fraud case without those elements.  Which means, every case will require plaintiffs to identify whether this is a case where defendants are alleged to have introduced new inflation into the stock price, or whether it’s a “price maintenance” case.  If the former, plaintiffs will have to prove as much by showing upward price movement in response to the lie (which, we can assume, defendants will vigorously fight), just to put themselves in the right category.  If it’s a “price maintenance” case, plaintiffs will have the initial burden of showing a sufficient link between the disclosure and the price drop in order to establish price impact, which inquiry will depend in part of the “genericness” of the fraud.  This is exactly the rule that the Fifth Circuit adopted back in 2010, and that the Supreme Court rejected over ten years ago.

And – and I said this before – genericness is a bad way to go about this, because lots of statements are “generic” and yet inarguably critical to investors.  “Generic” statements include representations that financial statements comply with GAAP, and that merger prices are “fair” to shareholders.  Will all of these be subject to the same stringent standards for establishing price impact?  And what exactly are those standards again?

So, yeah.  At least plaintiffs have some comfort in their apparent new ability to bring holder claims.