Sixth Circuit Revived Class Action Against Freddie Mac For Misleading Investors About Exposure To Subprime Mortgages
07/25/2016On July 20, 2016, the U.S. Court of Appeals for the Sixth Circuit revived a putative class action against Federal Home Loan Mortgage Corporation (“Freddie Mac”). Ohio Public Employees Retirement Sys. v. Federal Home Loan Mortgage Corp., et al., No. 14-4189, 2016 WL 3916011 (6th Cir. Jul. 20, 2016). In reversing the U.S. District Court for the Northern District of Ohio, the Court found that plaintiff’s allegations regarding loss causation were sufficient to sustain a claim against Freddie Mac under Section 10(b) of the Securities Exchange Act of 1934 (“Exchange Act”) for making materially false and misleading statements and omissions concerning its financial health.
Lead Plaintiff is a state pension fund which lost significant value when Freddie Mac’s stock rapidly declined in late 2007. As a result, plaintiff brought a securities fraud class action on behalf of purchasers of Freddie Mac common stock, alleging violations of Section 10(b) of the Exchange Act against Freddie Mac and Section 20(a) of the Exchange Act against certain former officers of Freddie Mac. Plaintiff’s amended complaint alleged that Freddie Mac concealed from investors the extent of its exposure to the subprime mortgage market and its deficient underwriting, risk management, and fraud detection practices. The District Court granted defendants’ motion to dismiss finding that plaintiff failed to adequately allege loss causation.
The Sixth Circuit reversed, holding that plaintiff had sufficiently alleged loss causation in its complaint. The Court initially noted that plaintiff identified a 29% drop in stock price which occurred when Freddie Mac disclosed a $2 billion loss, and alleged that the drop was directly attributable to the market’s reaction to the activities at Freddie Mac. In support of its ruling, the Court held that the District Court had erred by not applying the corrective disclosure theory, whereby a plaintiff can allege cause-in-fact on the ground that the market reacted negatively to a corrective disclosure of fraud. As a basis for its holding concerning this theory of loss causation, the Court cited to the Second Circuit’s decision in In re Omnicom Grp., Inc. Sec. Litig., 597 F.3d 501, 511 (2d. Cir. 2010).
Further, the Court held that the District Court had erred by rejecting the materialization of the risk theory of causation, whereby a plaintiff may allege proximate cause on the ground that the negative investor inferences drawn to the particular event or disclosure caused the loss and were a foreseeable materialization of the risk concealed by the fraudulent statement or omission. Noting that the Sixth Circuit had not yet considered this issue directly, the Sixth Circuit observed that in its prior decisions, both controlling and unpublished, it has recognized the viability of alternative theories of loss causation. The Court also noted that the vast majority of circuits have also recognized the alternative theory of materialization of the risk.
The Court rejected Freddie Mac’s argument that its quarterly and annual disclosures contained assumption of risk disclosures related to nontraditional risk mortgage market products. The Court similarly was not persuaded by Freddie Mac’s argument that plaintiff failed to plead facts sufficient to exclude more likely explanations for the alleged losses. Here, the Court emphasized “the relationship between the risks allegedly concealed and the risks that subsequently materialized, as well as the close correlation between the alleged revelation or materialization of the risk and the immediate fall in stock price,” as clear evidence that plaintiff had sufficiently plead loss causation at the motion to dismiss stage under a materialization of the risk theory.