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A Case of Not Keeping One’s Word

Goldman Sachs said it would avoid conflicts of interest, but investors and the courts say they did the opposite.


The Second Circuit’s recent decision in Arkansas Teacher Retirement System v. Goldman Sachs Group, Inc., stands as an important class certification victory for securities fraud plaintiffs. The decision rebuffed Goldman’s attempts to relitigate merits issues – such as materiality – that were previously decided on a motion to dismiss, and reinforcing that it is the defendants’ clear burden to rebut the legal presumption of class-wide reliance.

Allegations against Goldman

Arkansas Teachers vs. Goldman concerns alleged misrepresentations concerning the bank’s commitment to avoiding conflicts of interest. Specifically, the plaintiffs allege that Goldman and certain executive officers at the firm represented (among other things) that Goldman maintains “extensive procedures and controls that are designed to identify and address conflicts of interest,” and that Goldman’s “clients’ interests always come first.” However, Goldman failed to disclose that it had substantial conflicts of interest with respect to at least four collateralized debt obligation (CDO) transactions involving subprime mortgages.

Most notably, in a transaction involving the Abacus 2007 AC-1 CDO, Goldman secretly allowed a hedge fund – Paulson & Co. – to dictate the composition of the mortgages within the Abacus CDO while also taking a short position against it. As a result, Paulson received a significant profit when Abacus collapsed in the midst of the 2008 financial crisis. Goldman later paid a record $550 million to settle claims brought by the U.S. Securities and Exchange Commission for its role in Abacus. In other instances, Goldman represented to investors that its interests were aligned with theirs, while Goldman was in fact short selling against its clients’ positions.

The plaintiffs in Arkansas Teachers vs. Goldman are Goldman shareholders alleging securities fraud claims under Sections 10(b) and 20(a) of the Securities Exchange Act of 1934. The Southern District of New York first certified a class of Goldman shareholders in 2015. Goldman appealed, and the Second Circuit remanded with instructions for the district court to reconsider Defendants’ evidence against class certification. On remand, the district court once again certified a class of Goldman shareholders, and once again Goldman appealed.

Inflation maintenance theory at issue

The first issue raised by Goldman on appeal was the district court’s application of the inflation maintenance theory. There are two types of false statements that can affect the market price of a security in a securities fraud – statements that introduce price inflation and statements that maintain existing price inflation. The plaintiffs relied on an inflation-maintenance theory, i.e. that Goldman’s misrepresentations and omissions regarding conflicts of interest impacted the price of Goldman’s stock by maintaining price inflation rather than introducing it. Goldman argued that plaintiffs must show that the initial price inflation being maintained must be “fraud-induced.” The Second Circuit disagreed, holding that the “actual issue is simply whether Goldman’s share price was inflated,” and that 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.”

Defendants next argued that the inflation-maintenance theory should apply only in special circumstances and specific statements – for example, optimistic statements to stop stock price declines or statements that falsely convey that market expectations have been met – not general statements. The court also rejected that argument, explaining that the standard proposed by Goldman was “really a means for smuggling materiality into Rule 23” and that such a 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.” The court noted materiality is properly considered in a motion to dismiss and later at summary judgment – not at class certification, where it is irrelevant because “win or lose, the issue [of materiality] is common to all class members.”

The Court further noted that Defendants’ attempt to narrow the inflation-maintenance theory is squarely at odds with the Second Circuit’s prior decision in Vivendi, which held that “inflation maintenance” and “inflation introduction” are not separate legal categories of price impact.

Burden of persuasion in rebutting the basic presumption

Goldman further argued that the district court abused its discretion when it found that the bank had failed to rebut the basic presumption essential to class certification in a securities class action. The courts can presume that an entire class of shareholders relied on the defendants’ misrepresentations in choosing to purchase the relevant securities if the plaintiffs establish that the defendants’ false statements were publicly known; that the relevant shares traded in an efficient market; and, the plaintiffs purchased their shares at the market price after the misrepresentations were made but before the truth was revealed. Once a plaintiff makes this showing, the reliance requirement is satisfied and the burden shifts to the defendant to rebut the presumption. The presumption may be rebutted “by showing, by a preponderance of the evidence, that the entire price decline on the corrective disclosure dates was due to something other than its alleged misstatements.”

After examining the evidence presented by Goldman – which included expert testimony concerning 36 media reports that discussed Goldman’s conflicts of interest prior to the corrective disclosures, as well as an event study that attributed no price movement to the corrective disclosures — the Second Circuit held that the district court had not erred in concluding that Goldman failed to rebut the basic presumption. On the contrary, the Second Circuit credited the district court’s finding that the corrective disclosures had revealed new information that was not included in the prior media reports and that the event study was flawed.

Further, in rejecting Goldman’s argument that the district court had improperly weighed the evidence, the Second Circuit noted that, under the inflation maintenance theory, “Goldman’s burden is to show that the market would not have reacted had Goldman told the truth about its alleged failure to manage its conflicts. And, because “it is difficult to imagine that Goldman’s shareholders would have been indifferent had Goldman disclosed its alleged failure to prevent employees from illegally advising clients to buy into CDOs that were built to fail by a hedge fund secretly shorting the investors’ positions,” the Second Circuit concluded that it is reasonable to assume that the resulting harm to Goldman’s reputation would have “caused the market to devalue [Goldman’s] share price accordingly.”

In its decision, the Second Circuit recognized the “heavy burden” the Basic presumption places on defendants: “For a defendant to erase the inference that the corrective disclosure had price impact – i.e., that it played some role in the price decline – it must demonstrate under the preponderance-of-the-evidence standard, using event studies or other means, that the other events explain the entire price drop.

The Second Circuit also rejected Goldman’s contention that the plaintiffs had failed to introduce sufficient evidence of price impact, concluding that the district court properly credited plaintiffs’ evidence and noting that “the question is not which side has better evidence, but whether the defendant has rebutted the presumption.” Accordingly, the Second Circuit affirmed the district court’s decision granting class certification.

Future impact

The Second Circuit’s decision in Goldman is a clear endorsement of the inflation maintenance theory and further precludes defendants from re-litigating the issue of materiality at the class certification stage. Moreover, the decision reaffirms prior precedent, explaining that it is defendants’ burden to set forth evidence rebutting the basic presumption – and not plaintiffs’ burden to undermine defendants’ evidence. As a result, this decision is likely to serve as helpful authority to support class certification in future securities fraud actions.

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