Abacus Redux

Remember Abacus? Maybe you don’t. It all happened around the time of the Great Recession, more than a decade ago.

Goldman Sachs offered certain of its clients several collateralized debt obligations, among them Abacus 2007 AC-1 (“Abacus”). Goldman marketed Abacus as an ordinary asset-based security, which permitted investors to buy shares in a bundle of mortgages.

At the same time, Goldman allowed Paulson & Co., a hedge fund, to play an active role in selecting the constituent mortgages of the CDO. Paulson then bet against the success of the Abacus investment through short sales. As a result, Paulson made approximately $1 billion at the expense of the Goldman clients who purchased the shares.

Goldman later admitted its failure to disclose Paulson’s role to the investors was mistaken. It was in actuality a conflict of interest of epic proportions. As the result of a civil suit instituted by the SEC, Goldman settled in July 2010 by making a payment of $550 million, at the time the largest penalty paid by a Wall Street firm. That was by no means the end of the Abacus saga.

In 2011, three pension funds (who were not investors in Abacus) filed suit in a New York federal court. They represented a class of individuals and entities that acquired Goldman shares between February 5, 2007 and June 10, 2010, alleging that Goldman violated Section 10(b) of the Securities Exchange Act of 1934 and Rule 10(b)(5).[i] In essence, they claimed that certain fraudulent representations by Goldman that it was conflict free, made between 2007 and 2010, artificially maintained an inflated price of the Goldman shares and that revelations of Goldman’s conflicts, brought to light as a result of the Abacus litigation, caused the share price to fall.

In the view of the pension funds, Goldman had created, and concealed, conflicts of interest with its own shareholders when it intentionally packaged and sold them securities designed to fail. Goldman and Paulson, a favored client, they maintained, had massively profited from the scheme. The funds estimated the losses of Goldman’s shareholders to be in excess of $13 billion as a result of Goldman’s fraudulent concealment of its conflicts.

During the period in question, from 2007 to 2010, Goldman made a number of statements about its business practices in general and its ability to avoid conflicts of interest in particular, among them: that Goldman client “interests always come first,” that the firm had extensive procedures and controls designed to identify and address conflicts of interests, and that “integrity and honesty are at the heart of our business.”

The trial court in the case granted the application by the pension funds to allow them to represent the class of Goldman investors they claim had suffered losses as a result of its concealment of the conflict of interests. In a decision on April 7, 2020[ii], the United States Court of Appeals for the Second Circuit ruled on Goldman’s appeal of the decision to permit the matter to proceed as a class action.

There are a number of things litigants must demonstrate to justify authorization, or “certification,” of a class of plaintiffs. One is that there is at least one question of law or fact common to the members of the class. A class of the owners of stock in a public company does not easily fit into this model.

Shareholders each have different reasons for buying, selling or holding their stock. In recognition of the conceptual difficulties facing courts on an application to certify such a class, the Supreme Court developed the so-called Basic test[iii] to determine whether claims of securities fraud, such as whether Goldman’s assertions about its integrity had a price impact, justify class action treatment. Under the test, a court may presume that members of the class relied to their detriment on the purported conduct if: (1) the company’s misstatements were publicly known; (2) its shares are traded in an efficient market—in other words, a market which presumably incorporates all public information into the share price; and (3) the class members purchased their shares after the misstatements were made, but before the truth was disclosed. The pension funds passed the test. So the case was presumably appropriate for class action treatment.

Goldman had the chance, however, to rebut the presumption. To do so, it posed a number of theories, the chief one being that its misstatements were too general to demonstrate that they could have had an impact on the share price. What Goldman was getting at was that, where there are allegations that misconduct caused a stock’s price to drop, to attain class certification, a plaintiff would have to do nothing more than cite a company’s general statement about its business conduct or risk controls and then claim that the statement served to artificially inflate or maintain the price of the security.

Goldman had a point about the vulnerability of a public company to class actions based on general statements that might have no real- world impact on the stock price. Second Circuit conceded as much, saying it was mindful that class certification can pressure such a company into settling large claims—the pension funds, after all, were seeking damages in excess of $13 billion—whether of not the underlying suit had merit, on account of the financial risk of a trial.

However, the court ultimately rejected Goldman’s theories, and certified the class, because it was satisfied that Goldman had protection enough. Existing mechanisms in the law, the court decided, “already beat back this parade of horribles in … meaningful ways.” The balance would not be altered for Goldman’s sake.

In the end, Goldman may decide it is wise to settle for the large sum it will undoubtedly require to resolve the suit prior to trial. The alternative would be to bear the financial risk of explaining to a jury that, in the face of a stunning conflict of interest, its repeated and admittedly hollow claims about its integrity and ability to root out conflicts did not impact the price of its stock.

[1] Arkansas Teacher Retirement Syst. v. Goldman Sachs Group, Inc., Docket No. 18-3667 (2d Cir. decided April 7, 2020).

[2] 15 U.S.C. sec. 78j(b); 17 C.F.R. sec. 240.10b-5.

[3] Basic, Inc. v. Levinson, 485 U.S. 224 (1988).