The Seventh Circuit Court of Appeals has just issued a decision of special interest to defendants in securities class actions under Section 10(b) of the Exchange Act. The Court vacated the district court’s certification of a class in a lawsuit against Allstate, holding that the district court failed to consider defendants’ evidence that the misrepresentations alleged by plaintiffs had no impact on Allstate’s stock price. Such evidence, the Court explained, could rebut the presumption of reliance on the market price, as the Supreme Court made clear in Halliburton II.
This new ruling has multiple implications for the defense of securities class actions. First, district courts cannot fail to consider defendants’ evidence at class certification stage, merely because the same evidence may also be relevant to merits issues. Second, where applicable, defendants should consider offering expert analysis at the class certification stage severing the “transaction causation” link between the alleged misrepresentation and the market price. Third, defendants must be careful about the probative value of the evidence they offer: as discussed below, the Court expressed skepticism that “no price movement” is the same thing as “no price impact.” We discuss below why we believe plaintiffs—not defendants—should bear the burden of distinguishing between these two concepts.
Background and the District Court’s decision
In early 2013, Allstate announced that it would relax the underwriting standards in its auto insurance business in an effort to increase growth. At the time, Allstate acknowledged the real possibility that new customers obtained as result of this policy might be riskier and file more claims. Allstate indicated that it would monitor the risk and adjust business practices if needed.
Claim frequency allegedly began increasing shortly after the new policy was adopted. In August 2015, Allstate announced that it was tightening its underwriting standards again, after three quarters of higher claim rates, fueled at least in part by the company’s relaxed underwriting policy. Allstate’s stock price declined by 10% after the announcement; plaintiffs filed their securities class action shortly thereafter.
Plaintiffs alleged that, between 2013 and 2015, Allstate had affirmatively misled the market by falsely attributing the rising claims to other factors such as bad weather and miles driven. Plaintiffs claimed the misrepresentations were made with scienter because Allstate analyzed factors impacting claims rates so closely that its executives must have been aware of the trend. The allegations survived past the pleadings stage.
Allstate opposed class certification on multiple grounds. Allstate offered into evidence the expert report of Lucy Allen (NERA), showing that Allstate’s stock price had not changed after the alleged misrepresentations. The expert report also cited market analyst reports expecting Allstate’s relaxed underwriting standards to lead to more claims. Allstate argued that the report “sever[ed] the link between the alleged misrepresentation and . . . the price . . . paid by the plaintiff,” thus rebutting the presumption of reliance on market price enshrined in Basic, Inc. v. Levinson, 485 U.S. 224, 248 (1988). Separately, Allstate opposed the addition of a new class representative, more than two years into the lawsuit, as prohibited by China Agritech, Inc. v. Resh, 138 S. Ct. 1800 (2018).
The district court declined to engage the expert report, postponing its consideration until a later “merits” stage. The district court also allowed the addition of the new class representative. On interlocutory appeal, the Seventh Circuit vacated class certification on the former ground. It affirmed, however, the district court on the addition of the class representative.
The Seventh Circuit’s ruling
Rebutting the Basic presumption
At the onset, the Court explained that the same substantive evidence may be relevant to multiple related issues, such as materiality, loss causation, and reliance (also referred to as “transaction causation”). The Court noted that materiality and loss causation are merits issues, reserved for later stages under Erica P. John Fund, Inc. v. Halliburton Co., 563 U.S. 804 (2011) (Halliburton I), and Amgen Inc. v. Connecticut Retirement Plans and Trust Funds, 568 U.S. 455 (2013). Reliance, however, may be squarely addressed at the class certification stage: the Basic presumption that plaintiffs relied on the price set by an efficient market may be rebutted by defendants’ evidence. See Halliburton Co. v. Erica P. John Fund, Inc., 573 U.S. 258 (2014) (Halliburton II). The Court clarified that district courts “must consider the same evidence if the defense offers it to show the absence of transaction causation” even if it is also probative of materiality and loss causation. Factual disputes on transaction causation, the Court emphasized, must be resolved at the class certification stage.
The Court explained there are multiple ways for defendants to rebut the basic presumption of reliance. One is to show that plaintiffs did not rely on the market’s integrity when making their purchase. Another is to attack the efficiency of the market itself. A third is lack of price impact: if the market learned of the purportedly concealed or misrepresented truth, then market efficiency dictates that the price at which the plaintiff purchased its stock had already incorporated the corrective information. Without inflation, the presumption that the misrepresentation impacted the stock price is negated.
Securities litigators might wonder: how is this different from the truth on the market defense? They are not alone; the Seventh Circuit did too. The Court observed that, in Amgen, the Supreme Court held that truth on the market is reserved for merits adjudication. In fact, in Allstate, plaintiffs unsurprisingly characterized defendants’ position as a prohibited assertion of “truth on the market.” The Court distinguished between the prohibited use (truth on the market) and the permitted one (price impact), as “a question of scope and specificity.” The Court wrote that “the question at class certification is . . . the level of specificity of the information the market would have understood the price of Allstate’s common stock to transmit at the time of the purchase transaction.” While the same evidence could be used to establish the “truth on the market” defense, district courts are still bound to consider it if it shows that the market price was not impacted by the purported misrepresentation. The question is whether the price impact inquiry is conducted on the day of the purchase—relevant to the permitted inquiry into transaction causation—or on the day of the sale—which would venture into the prohibited realm of loss causation.
The Court also offered guidance on how, on remand, the district court should manage the inquiry related to the reliance presumption at class certification. Once plaintiffs have established an efficient market, the burden of persuasion shifts to defendants. The inquiry involves weighing the available evidence, and determining whether defendants have rebutted the presumption by a preponderance of evidence.
Adding a new class representative
The Seventh Circuit’s ruling also came with an unexpected bonus feature for students of China Agritech. The Court affirmed the addition of a class representative that had not filed a complaint and had not sought to be lead plaintiff, more than two years after the stock drop. The Court rationalized its decision by noting that such an addition does not pose the dangers enumerated in China Agritech and expressly distinguished the situation in which a court denies class certification or dismisses a complaint only to have another plaintiff try their hand again. By contrast, in Allstate, the Seventh Circuit noted that plaintiffs “sought only to rearrange the seating chart within a single, ongoing action.” The Court did not examine whether such rearrangements of the seating chart are consistent with the PSLRA.
Allstate presents some important considerations for securities litigation.
First, it clarifies, yet again, that district court must engage in weighing of evidence and fact-finding at the class certification stage. Defendants’ evidence may not be brushed aside as too complicated, or too enmeshed with merits issues.
Second, defendants should carefully examine the price reactions at the time of the alleged misstatements. Where applicable, they might consider offering expert evidence severing the connection between the alleged misstatements and market price. On this score, however, the Seventh Circuit’s analysis sounded some cautionary notes. For example, Allstate’s expert report showed that Allstate’s price remained unchanged on the days of the alleged misrepresentations. The Court observed, however, that lack of price movement need not be synonymous with lack of price impact. As the Court explained, by itself, evidence of an unchanged price does not establish lack of a price impact, since a plaintiff could well plead an “inflation maintenance” theory, i.e., claim that absent the misrepresentation the stock would have declined. The Court further wondered, if the market already knew of the consequences of relaxing Allstate’s underwriting standards, why did Allstate’s stock price decline when the alleged corrective disclosure was made two years later? The Court explained that the subsequent decline may be considered as indirect evidence of price inflation at the time of purchase. In other words, defendants’ expert should be prepared to address these issues head-on in their report.
Finally, the Court’s ruling raised an interesting practical consideration when evaluating “inflation maintenance” theories. Agreeing with Waggoner v. Barclays PLC, 875 F.3d 79 (2d Cir. 2017), the Seventh Circuit held that the burden of persuasion on the lack of price impact, given the totality of evidence, rests on defendants. But if defendants offer evidence that the price remained unchanged, who has the burden to bring additional evidence showing there would (or would not) have been a price impact absent the alleged misrepresentation? We believe that burden should rest with the plaintiffs. By showing that the price remained unchanged, defendants have provided direct evidence supporting a finding of no price impact. It is then plaintiffs’ responsibility to plead in their complaint and, at class certification, to adduce evidence showing that the price would have declined but for the alleged misrepresentations. Plaintiffs cannot simply assert an “inflation maintenance” theory and then expect defendants to adduce evidence to disprove it. Such an approach is inconsistent with Halliburton II. The Seventh Circuit’s ruling in Allstate supports our view, noting that “although plaintiffs need not initially introduce direct evidence of price impact, they may choose to do so as a means of responding to (or anticipating) a defendant’s direct rebuttal evidence.”