The Sixth Circuit has joined a majority of the other circuit courts in recognizing that loss causation can be shown through a “materialization of the risk” theory,” reversing the dismissal of a case against Freddie Mac stemming from the 2007 mortgage crisis.
In Ohio Public Employees Retirement Sys. v. Federal Home Loan Mortgage Corp. (“Freddie Mac”), — F.3d. —, 2016 WL 3916011 (6th Cir. 2016), the Sixth Circuit found that under “the clear weight of persuasive authority,” plaintiffs could adequately plead loss causation by alleging that a risk that had been fraudulently concealed caused harm to a company and a resultant stock drop — even if there was no corrective disclosure that revealed that the company’s statements had been false or misleading. Id. at *7.
Plaintiffs brought the action against Freddie Mac in January 2008, alleging that starting on August 1, 2006, the mortgage-holding giant had made false or misleading statements that concealed from purchasers of its stock its growing investment in loan portfolios comprised of risky mortgages, as well as the fact that it circumvented its traditional underwriting standards to purchase these portfolios.
Although Freddie Mac had given the market warnings about potential credit risk, plaintiffs alleged that it had made misleading statements highlighting its rigorous underwriting requirements and declaring that it had “basically no subprime exposure.” Id. at *7-8.
Plaintiffs allege that the market began to learn the truth behind these misrepresentations on November 20, 2007, when Freddie Mac released an earnings statement that revealed that more than a fourth of its loan portfolio was at high risk of substantial losses, and disclosed that it had incurred a record $2 billion in losses during the previous quarter. The company’s stock price dropped 29% on this news. However, it was not until 2008 that news articles and analyst reports suggested that Freddie Mac’s prior statements regarding its portfolio may have been false.
The complaint had previously withstood three motions to dismiss, but in 2013 the district judge in the Northern District of Ohio recused himself from the case and it was reassigned. The new district judge gave defendants leave to file a fourth motion to dismiss, which the court granted in 2014.
In finding the materialization of the risk theory sufficient to plead a Section 10(b) claim, the Sixth Circuit noted that it was an issue of first impression in the circuit, and referred to decisions from nine other circuit courts that recognize the theory. It cited to the Second Circuit in holding that alternate theories of loss causation that do not include a corrective disclosure are sufficient if they allege that the stock drop was caused by events that were “within the zone of risk concealed by the misrepresentations and omissions.” Id. at *6 (citing Lentell v. Merrill Lynch & Co., 396 F.3d 161, 172 (2d Cir. 2005)).
The court noted: “We are mindful of the dangerous incentive that is created when the success of any loss causation argument is made contingent upon a defendant’s acknowledgment that it misled investors. Our sister circuits are too and have recognized that defendants accused of securities fraud should not escape liability by simply avoiding a corrective disclosure.” Id. at *7.
Emphasizing that allegations of loss causation do not need to meet heightened pleading under the Reform Act, the court found that plaintiffs had sufficiently alleged that their investment losses were caused when the allegedly concealed risky mortgages and compromised underwriting standards resulted in substantial defaults and record losses for the company. The court found that the disclosure of these losses on November 20, 2007 “well within the ‘zone of risk’ that Freddie Mac allegedly concealed,” and therefore were sufficient to support a “plausible claim” of loss causation under the standard of Bell Atl. Corp. v. Twombly, 550 U.S. 544, 570 (2007)). Id. at *8-9.