Federal courts have been struggling with deciding motions for class certification as there have been a number of recent rulings by the U.S. Supreme Court and certain of the courts of appeals that answer certain questions while creating others. In Halliburton II, the Supreme Court held that a defendant in a securities class action may rebut the Basic presumption of reliance at the class certification stage by producing direct evidence that a misrepresentation did not affect stock prices. After all, the Supreme Court reasoned, “in the absence of price impact, Basic’s fraud-on-the-market theory and presumption of reliance collapse.” See Halliburton v. Erica P. John Fund, 573 U.S. 258, 278 (2014). Standing alone, the Halliburton II decision offers a deceivingly simple rule for lower courts to apply when deciding whether to certify a class where the plaintiffs invoke, and the defendants attempt to rebut, the fraud-on-the-market theory.
But simple it is not, the U.S. Court of Appeals for the Seventh Circuit recently opined in In re Allstate Securities Litigation, No. 19-1830, 2020 U.S. App. LEXIS 22121 (7th Cir. July 16, 2020). The challenge lies in applying the teachings of Halliburton II without violating the teachings of Halliburton I and Amgen. Both Halliburton I and Amgen provided guidance to lower courts on the appropriate evidence that can be considered at the class certification stage. In Halliburton I, the Supreme Court held that securities fraud plaintiffs do not need to prove loss causation to obtain class certification. In Amgen, the Supreme Court clarified that proof of materiality is not a prerequisite to class certification. See Amgen v. Connecticut Retirement Plans & Trust Funds, 568 U.S. 455 (2013).
In light of this precedent, the Seventh Circuit framed the issue as follows: “how can a district court deciding class certification decide whether reliance can be proven by common evidence without delving too far into the merits of the materiality or falsity of the representations at issue, while still reserving loss causation entirely for the merits phase.” After tackling these heady issues, the Seventh Circuit went on to provide guidance on how to manage the burden-shifting framework created by Basic in a price maintenance case—siding with the Second Circuit that defendants bear both the burden of production and persuasion to rebut the Basic presumption. The Allstate decision offers important guidance for courts when applying the Basic framework.
To Delve or Not To Delve Into the Merits
Under the Halliburton/Amgen trilogy a district court may not consider evidence to decide the issues of materiality or loss causation at the class certification stage but it must consider the same evidence if it is offered by the defendants to show the absence of price impact to rebut the Basic presumption.
The overlap between class and merits evidence is not new. In Newton v. Merrill Lynch, Pierce, Fenner & Smith, 259 F.3d 154, 168 (3rd Cir. 2001), the Third Circuit embraced the notion that it may be necessary for district courts to engage in “a preliminary inquiry into the merits” to determine whether the requirements for class certification are satisfied. In Reyes v. Netdeposit, 802 F.3d 469, 484 (3rd Cir. 2015), the Third Circuit elaborated that district courts “cannot be bashful” at the class certification stage in resolving the factual and legal issues relevant to class certification, even if they happen to overlap with the merits.
However, the Supreme Court precedent puts district courts in a difficult situation by requiring them “to split some very fine hairs” in determining the issues relevant to class certification, as opposed to those issues reserved for the merits. As the Seventh Circuit recognized, materiality, loss causation, and price impact are all connected. All three concepts attempt to address the same fundamental question: Did a statement matter?
The role of a court—the Seventh Circuit clarified—is to decide only the issue of price impact at the class certification stage without drawing “what may be obvious inferences for the closely related issues” that are reserved for the merits.
Price impact, or transaction causation, relates to whether alleged misrepresentations affected the market price in the first place. The temporal focus is on the time of purchase. By contrast, loss causation relates to whether a misrepresentation caused a subsequent loss. It focuses on the time of sale. A drop in price at the end of the class period may serve as direct evidence for or against loss causation but it is also indirect evidence of price impact. Thus, such evidence may be considered for this purpose at the class certification stage.
The ‘Basic’ Allocation of Burdens
The Seventh Circuit’s decision also addresses an important question left open by the Supreme Court. That is, what standard applies when determining the sufficiency of the evidence presented by a defendant to rebut the Basic presumption? The Seventh Circuit joined the Second Circuit in concluding that a defendant must prove the absence of price impact by a preponderance of the evidence.
In reaching this decision, the Seventh Circuit rejected the defendants’ argument that defendants need only produce evidence of a lack of price impact to rebut the Basic presumption. Such an argument relies on Federal Rule of Evidence 301, which governs presumptions in civil cases generally, and provides that a party rebutting a presumption only bears the burden of production unless a federal statute or another rule of evidence provides otherwise. Adopting the reasoning of the Second Circuit in Waggoner v. Barclays, 875 F.3d 79 (2d Cir. 2017), the Seventh Circuit concluded that the Rule 301 framework did not apply because the Basic presumption is a substantive doctrine of federal law that derives from federal securities laws.
Notably, the Supreme Court has not expressly addressed burden allocation under the rebuttable Basic presumption. However, courts examining the issue have found that certain dicta indicate that the Supreme Court intended to shift the burden of persuasion to defendants. Specifically, in Basic, the Supreme Court held that the defendant must produce evidence to “sever the link” because in doing so “the basis for finding that the fraud had been transmitted through market price would be gone.” See Basic v. Levinson, 485 U.S. 224, 248 (1988). In Halliburton II, the Supreme Court described defendants’ price impact evidence as “direct, more salient evidence that the alleged misrepresentation did not actually affect the stock’s market price.” Further in their concurrence, Justices Ruth Bader Ginsburg, Stephen Breyer and Sonia Sotomayor stated that “it is incumbent upon the defendant to show the absence of price impact.”
The Eighth Circuit has cited Rule 301 for the proposition that defendants have the “burden to come forward with evidence showing a lack of price impact.” See IBEW Local 98 Pension Fund v. Best Buy, 818 F.3d 775, 782 (8th Cir. 2016). However, the decision did not directly state that defendants bear only the burden of production, and courts have disagreed about the precise meaning of the language in this decision.
This issue has not been decided in the Third Circuit, and lower courts appear to have come out on both sides of the issue. See Compare Li v. Aeterna Zentaris, 324 F.R.D. 331, 344 (D.N.J. 2018) (citing Rule 301 when explaining that to rebut the presumption of reliance, “defendant need only produce enough evidence ‘to withstand a motion for summary judgment or judgment as a matter of law on the issue’”), with City of Sterling Heights General Employees’ Retirement System v. Prudential Financial, No. 12-5275, 2015 U.S. Dist. LEXIS 115287, at *31 (D.N.J. Aug. 31, 2015) (rejecting argument that a defendant may rebut the Basic presumption by “introducing evidence raising a triable issue of fact as to whether there was a price impact”).
Rebutting the ‘Basic’ Presumption in a Price Maintenance Case
The Seventh Circuit’s decision also offers guidance on the type of evidence needed to rebut the Basic presumption when the plaintiff is proceeding on an inflation maintenance theory.
The theory of “inflation maintenance,” also referred to as “price maintenance,” holds that misstatements can serve to maintain stock price at an artificially inflated level without causing the stock price to increase further. Once the truth is revealed to the market, the inflation within the stock price dissipates, thereby eliminating whatever artificial value the misrepresentation caused. The theory is frequently invoked in securities fraud cases. Although the Third Circuit has not decided the issue, the Second, Seventh and Eleventh circuits have all endorsed the inflation maintenance theory.
In the Allstate decision, the Seventh Circuit reaffirmed the validity of the inflation maintenance theory but acknowledged the difficulties a defendant faces in attempting to prove the absence of price impact in cases involving allegations of inflation maintenance. Simply showing that there was no movement in the stock price in response to the false statement is not enough to satisfy a defendant’s burden. But what if a defendant could establish that information had already entered the market that revealed the supposed falsity of the misrepresentation without any discernible impact on stock price? Would this be sufficient to prove the absence of price impact?
The Seventh Circuit suggested that district courts should work backwards to determine the impact of a false statement by looking at the effect on share price when the truth was revealed. The court reasoned that this type of inquiry is permissible at the class certification stage “only as backward-looking, indirect evidence” relevant to transaction causation. The court conceded that “separating this argument from the kind of truth-on-the-market defense proscribed by Amgen’s holding on materiality cuts extraordinarily fine.” But the question at the class certification stage is whether common evidence could show that the market price at the time of the alleged misrepresentation already reflected the truth.
To aid in this inquiry, the Seventh Circuit suggested that district courts look to the scope and specificity of the information available in the market. While Allstate argued that the risks related to its new growth strategy had been generally disclosed, the plaintiffs responded that general statements made by Allstate advising investors of a possible risk are not the same thing as knowing that a risk has been realized. The court remanded the case for further proceedings on whether defendants rebutted the Basic presumption.
The court’s instruction to consider the scope and specificity may prove determinative at the class certification stage. Consider the recent decision of the Second Circuit in Arkansas Teacher Retirement System v. Goldman Sachs Group, 955 F.3d 254 (2d Cir. 2020). There, the Second Circuit affirmed the district court’s holding that even though the falsity of Goldman Sachs’ representations about being conflict free had been revealed in 36 news reports without causing any change in stock price, the defendants had not proven the absence of price impact because the subsequent disclosure in an SEC complaint provided hard evidence of conflicts and cited damning emails and memoranda that had not been previously disclosed. In other words, the court’s decision effectively turned on the generality of the earlier news reports and specificity of the subsequent corrective disclosure.
Judge Richard Sullivan, in a dissenting opinion, criticized the district court’s holding for effectively ignoring expert evidence that proved no price impact based on the assumption that some of the new disclosures in the SEC complaint must have at least contributed to the stock price declines. Sullivan’s concerns are well-founded. Carried to its extreme, any difference between the scope and specificity of the disclosures could allow a court to conclude that defendants have not shown the complete absence of price impact, which would validate Judge Sullivan’s concern that the Basic presumption is “truly irrebuttable and class certification is all but a certainty in every case.”
For now, these questions remain open in the Third Circuit, which has not yet endorsed the inflation maintenance theory. And any question relating to the rebuttability or irrebuttability of the Basic presumption clearly will be informed by whether the defendant bears the burden of persuasion, which is another issue the Third Circuit has not yet decided. In the meantime, the Seventh Circuit’s decision offers some helpful guidance to courts, including those in the Third Circuit, left perplexed by the question of what evidence may be considered at the class certification stage and what must be reserved for the merits.
Robert L. Hickok is a partner in business litigation department of Troutman Pepper Hamilton Sanders, resident in the Philadelphia office. He is a former co-chair of the litigation department and past member of Pepper Hamilton’s executive committee. He can be reached at 215-981-4583 or [email protected]
Whitney R. Redding is an associate with the firm, resident in the Pittsburgh office. She concentrates her practice in business litigation, with a particular emphasis on domestic and international arbitration, appellate work, and complex breach of contract litigation. She has provided successful representation to Fortune 500 companies, midsize companies and national and international clients.
Jay A. Dubow is a partner with the firm, resident in the Philadelphia office. He is a member of the firm’s business litigation department. He can be reached at 215-981-4713 or [email protected]