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From Securities Regulation Daily, July 7, 2017

Petrobras class certification required Morrison assessment

By John M. Jascob, J.D., LL.M.

The Second Circuit has vacated in part a district court order certifying two classes of claims by holders of securities issued by Brazilian oil giant Petrobras. The district court erred by finding that Rule 23(b)(3)’s predominance requirement was satisfied without considering the need for individual Morrison inquiries regarding domestic transactions. The Second Circuit panel affirmed, however, the district court’s ruling that the Exchange Act class was entitled to a presumption of reliance under Basic Inc. v. Levinson, finding no abuse of discretion in the lower court’s blended analysis of direct and indirect evidence of market efficiency (In re Petrobras Securities, July 7, 2017, Garaufis, N.).

Kickback cartel. The plaintiffs, holders of Petrobras American Depository Shares (ADS) and notes, alleged that the company knew about a multi-billion dollar kickback scheme involving contractors, suppliers, and corrupt Petrobras executives. The scheme's revelation caused the value of Petrobras to drop from $310 billion to $39 billion. According to the plaintiffs, Petrobras was complicit in concealing information about the kickback cartel from investors and the public.

On February 2, 2016, the Southern District of New York granted the plaintiffs’ motion to certify two classes under Rule 23(b)(3), one asserting claims under the Exchange Act and the other asserting claims under the Securities Act. The Petrobras defendants then appealed, arguing that both classes failed to satisfy ascertainability and predominance requirements under Rule 23 because putative class members must prove that they acquired their securities in "domestic transactions" in compliance with the Supreme Court’s decision in Morrison v. National Australia Bank Ltd. (U.S. 2010). The defendants also argued that the district court erred in finding that the plaintiffs successfully established a class-wide presumption of reliance under the "fraud on the market" theory.

Ascertainability. The Second Circuit panel first rejected the appellants’ argument that the district court should have applied a "heightened" ascertainability requirement, under which any proposed class must be "administratively feasible." The appellate court reasoned that adopting an implied administrative feasibility requirement would be inconsistent with the careful balance struck in Rule 23, which directs courts to weigh the competing interests inherent in any class certification decision. Rather, the Second Circuit clarified that a class is ascertainable if it is defined using objective criteria that establish a membership with definite boundaries. As the district court’s findings reflected an understanding that objective criteria would permit the identification of class members, the classes defined by the district court did not fail on ascertainability grounds.

Predominance. The Second Circuit vacated, however, the district court’s certification of the classes insofar as they included all otherwise eligible class members who acquired their securities in "domestic transactions." The appellate court held that the district court erred in conducting its predominance analysis without considering the need for individualized Morrison inquiries. Significantly, the Second Circuit noted, the classes included investors who purchased notes in the initial offerings, as well as investors who purchased their notes on the secondary market. The potential for variation across putative class members—who sold them the relevant securities, how those transactions were effectuated, and what forms of documentation might be offered in support of domesticity—appeared to generate a set of individualized inquiries that must be considered within the framework of Rule 23(b)(3)’s predominance requirement. The district court’s certification order, however, offered no indication that the district court considered the ways in which evidence of domesticity might vary in nature or availability across the many permutations of transactions in Petrobras securities.

"Fraud on the market" and presumption of reliance. Finally, the appellate panel affirmed the district court’s finding that the Exchange Act class was entitled to a presumption of reliance because the plaintiffs satisfied their burden of showing that the Petrobras securities traded in efficient markets, as required under the "fraud on the market" doctrine established in Basic Inc. v. Levinson, (U.S. 1988). Among other things, the appellants argued that that the district court gave undue weight to the plaintiffs’ empirical test, which measured the magnitude of responsive price changes in Petrobras securities without considering the direction of those changes.

In the appellants' view, the plaintiffs would only be entitled to the Basic presumption after making a substantial showing of market efficiency based on directional empirical evidence alone, irrespective of any other evidence they may have offered. The appellate panel rejected this argument, however, observing that methodological challenges, including limitations on statistical power by small sample size, counsel against imposing a blanket rule requiring district courts to rely on directional event studies and directional event studies alone at the class certification stage. Accordingly, the panel affirmed the district court’s finding that the plaintiffs were entitled to a presumption of reliance on the market price of the Petrobras securities.

The case is No. 16-1914-cv.

Attorneys: Jeremy Alan Lieberman (Pomerantz LLP) for Universities Superannuation Scheme Ltd., Employees Retirement System of the State of Hawaii and North Carolina Department of State Treasurer. Lewis J. Liman (Cleary Gottlieb Steen & Hamilton LLP) for Petroleo Brasileiro S.A. Petrobras. Jay B. Kasner (Skadden, Arps, Slate, Meagher & Flom LLP and Affiliates) for BB Securities Ltd., Merrill Lynch, Pierce, Fenner & Smith Inc. and Bank of China [Hong Kong] Ltd.

Companies: Universities Superannuation Scheme Ltd.; Employees Retirement System of the State of Hawaii; North Carolina Department of State Treasurer; Petroleo Brasileiro S.A. Petrobras; BB Securities Ltd.; Merrill Lynch, Pierce, Fenner & Smith Inc.; Bank of China [Hong Kong] Ltd.

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