Publications

(Article from Securities Law Alert, July/August 2020)

For more information, please visit the Securities Law Alert Resource Center

On July 16, 2020, the Seventh Circuit vacated an order granting class certification in a securities fraud action where the district court admitted, but did not consider, “the evidence that defendants offered to defeat the Basic presumption, an expert opinion that the alleged misrepresentations had no impact on the stock price.” In re: Allstate Corp. Sec. Litig., 966 F.3d 595 (7th Cir. 2020) (Hamilton, J.).[1] The Seventh Circuit found the district court erred in “conclud[ing] that the issue was tied so closely to the merits that [the court] should not decide it on class certification.” The Seventh Circuit held that under the Supreme Court’s decision in Halliburton Co. v. Erica P. John Fund, 573 U.S. 258 (2014) (Halliburton II), “the district court must decide at the class [certification] stage the price impact issue posed by the defendants’ price impact evidence and plaintiffs’ rebuttal” and “may not defer that question for the merits.”[2]

Background

In 2013, an auto insurance company “announced a new growth strategy [of] . . . attracting more new customers by ‘softening’ its underwriting standards." The company “disclosed that this approach could cause ‘some pressure’ on its auto claims ‘frequency’” because “new and potentially riskier customers might file more auto claims.” Plaintiffs alleged that when claims frequency increased after the implementation of this strategy, the company “misled the market by falsely attributing the increases to other factors such as higher-than-usual precipitation and miles driven[.]” Approximately two years later, the company “announced that the higher claims rates it had experienced for three quarters had been fueled at least in part by the company’s recent growth strategy[.]” The company’s “stock price dropped by more than 10 percent” immediately after this announcement.

Defendants presented the report of an expert who “found no statistically significant increase in [the company’s] stock price following any of the alleged misrepresentations[.]” Defendants’ expert also stated that “the alleged misrepresentations could not [i.e., as a matter of logic] have had price impact because [the company’s] growth strategy, and the fact that the [c]ompany’s growth strategy was expected to cause higher claims frequencies, was publicly disclosed” and, therefore, “would have already been impounded into [the company’s] stock price.”

Plaintiffs contended that defendants’ expert report presented “a truth-on-the-market defense forbidden” for consideration at the class certification stage under the Supreme Court’s decision in Amgen v. Connecticut Ret. Plans and Trust Funds, 568 U.S. 455 (2013).[3] Plaintiffs argued that the company “had at best disclosed only potential risks, but . . . chose not to inform the market that these dangers were in fact being realized.” The district court agreed with plaintiffs and concluded that resolving the question of price impact in the case before it “essentially and improperly would require [it] to decide disputed material issues of fact underlying plaintiff’s case” at the class certification stage. In re Allstate Corp. Sec. Litig., 2019 WL 1512268 (N.D. Ill. Mar. 26, 2019). Defendants appealed.

District Court Erred in Declining to Resolve the Question of Price Impact

At the outset of its analysis, the Seventh Circuit acknowledged that recent Supreme Court decisions governing “[e]vidence supporting or refuting the Basic presumption of reliance . . . pose a difficult challenge at the class certification stage.” The Seventh Circuit explained that under Erica P. John Fund v. Halliburton Co., 563 U.S. 804 (2011) (Halliburton I), “[a] district court deciding whether to certify a plaintiff class may not use the evidence to decide loss causation[.]”[4] And under Amgen, a district court “may not use the same evidence to decide materiality[,]” or to credit a “truth-on-the-market defense.” Yet under Halliburton II, “a court must consider the same evidence if the defense offers it to show the absence of transaction causation, also known as price impact.” The Seventh Circuit observed that “[t]he crucial challenge for the district court is to decide only the issues the Supreme Court has said should be decided for class certification while resisting the temptation to draw what may be obvious inferences for the closely related issues that must be left for the merits, including materiality and loss causation, as required by Halliburton I and Amgen.”

The Seventh Circuit “agree[d] with the district court that the [company’s] price impact theory looks very much like the prohibited defenses of no materiality or ‘truth on the market.’” But the Seventh Circuit “conclude[d] that the close similarity does not allow a district court to avoid a price impact defense at the class certification stage.” The Seventh Circuit explained that in Halliburton II, the Supreme Court “made clear that the defense is entitled to offer evidence of a lack of price impact at the class certification stage[.]” The Seventh Circuit found “[t]he district court here made a legal error by embracing Amgen at the expense of Halliburton II— a tempting way of more cleanly managing price impact evidence—rather than engaging in the messier but required process of simultaneously complying with the instructions from the Supreme Court in both cases.” The Seventh Circuit “therefore vacate[d] the class certification and order and remand[ed] for further consideration of evidence relevant to price impact.”[5]

Seventh Circuit Provides Guidance for the District Court on the Consideration of Price Impact

The Seventh Circuit provided the district court with detailed guidance for remand. First, the court addressed “the scope of discovery available at class certification.” The Seventh Circuit stated that “[g]iven the significant and growing overlap between the evidence at stake at the certification and merits stages, district courts may well choose not to bifurcate discovery at all in putative fraud-on-the-market securities class actions.”

Second, the Seventh Circuit agreed with the Second Circuit’s decision in Waggoner v. Barclays, 875 F.3d 79 (2d Cir. 2017), that “once plaintiffs have made a prima facie showing [that the Basic presumption applies,] the burden of persuasion, not production, to rebut the Basic presumption shifts to defendants.”[6] The Seventh Circuit explained that “Basic said that ‘any showing that severs the link’ would be sufficient to rebut the presumption, . . . not that mere production of evidence would defeat the presumption.”

Third, the Seventh Circuit cautioned that “price reaction (the simple movement of the price in response to a given statement) is quite different from the legal concept of price impact” because “the price might have fallen even more if the full extent of the bad news were known.” The court explained that “the best way to determine the impact of a false statement is to observe what happens when the truth is finally disclosed and use that to work backward, on the assumption that the lie’s positive effect on the share price is equal to the additive inverse of the truth’s negative effect.” The Seventh Circuit instructed that “[o]n remand, the district court may take into account expert findings with regard to . . . whether the stock price responds when the alleged fraud is revealed to the market, only as backward-looking, indirect evidence of the core question here [of] . . . whether [the] stock price is distorted at the time that the plaintiff trades.”[7]

The Seventh Circuit acknowledged that “separating this argument from the kind of truth-on-the-market defense proscribed by Amgen’s holding on materiality cuts extraordinarily fine.” The court explained that it “see[s] this case as a question of scope and specificity[,]” given plaintiffs’ contention that “the more general representations that [the company] made do not encompass the more specific representations it should have made[.]” The Seventh Circuit instructed that “the question at class certification is . . .  the level of specificity of the information the market would have understood the price of [the company’s] common stock to transmit at the time of the purchase transaction.”