Ohio Public Employees Retirement System v. Federal Home Loan Mortgage Corp.

RECOMMENDED FOR FULL-TEXT PUBLICATION
Pursuant to Sixth Circuit I.O.P. 32.1(b)
File Name: 16a0167p.06
UNITED STATES COURT OF APPEALS
FOR THE SIXTH CIRCUIT
_________________
OHIO PUBLIC EMPLOYEES RETIREMENT SYSTEM, on ┐
behalf of itself and all others similarly situated, │
Plaintiff-Appellant, │
│
> No. 14-4189
v. │
│
│
FEDERAL HOME LOAN MORTGAGE CORPORATION; │
RICHARD F. SYRON; PATRICIA L. COOK; ANTHONY │
S. PISZEL; EUGENE M. MCQUADE, │
Defendants-Appellees. │
┘
Appeal from the United States District Court
for the Northern District of Ohio at Youngstown.
No. 4:08-cv-00160—Benita Y. Pearson, District Judge.
Argued: October 14, 2015
Decided and Filed: July 20, 2016
Before: GUY, KETHLEDGE, and STRANCH, Circuit Judges.
_________________
COUNSEL
ARGUED: W.B. Markovits, MARKOVITS, STOCK & DEMARCO, LLC, Cincinnati, Ohio,
for Appellant. Jordan D. Hershman, MORGAN, LEWIS & BOCKIUS LLP, Boston,
Massachusetts, for Appellees. ON BRIEF: W.B. Markovits, Christopher D. Stock,
MARKOVITS, STOCK & DEMARCO, LLC, Cincinnati, Ohio, Richard S. Wayne, STRAUSS
TROY CO., LPA, Cincinnati, Ohio, for Appellant. Jordan D. Hershman, Jason D. Frank,
MORGAN, LEWIS & BOCKIUS LLP, Boston, Massachusetts, Hugh E. McKay, PORTER
WRIGHT MORRIS & ARTHUR LLP, Cleveland, Ohio, for Appellee FHLMC. Mark D.
Hopson, Frank R. Volpe, Judith C. Gallagher, SIDLEY AUSTIN LLP, Washington, D.C., for
Appellee Syron. Carl S. Kravitz, Caroline E. Reynolds, ZUCKERMAN SPAEDER LLP,
Washington, D.C., for Appellee Cook. James K. Goldfarb, Michael V. Rella, Jonathan Bashi,
MURPHY & MCGONIGLE, P.C., New York, New York, Joseph C. Weinstein, William E.
Donnelly, MURPHY & MCGONIGLE, P.C., Washington, D.C., Steven A. Delchin, SQUIRE
1
No. 14-4189 Ohio Public Employees Retirement Sys. v. FHLMC, et al. Page 2
PATTON BOGGS (US) LLP, Cleveland, Ohio, for Appellee Piszel. Michael S. Doluisio,
Joseph S. McFarlane, DECHERT LLP, Philadelphia, Pennsylvania, Joseph C. Weinstein,
Stephen A. Delchin, SQUIRE PATTON BOGGS (US) LLP, Cleveland, Ohio, for Appellee
McQuade.
_________________
OPINION
_________________
JANE B. STRANCH, Circuit Judge. Lead Plaintiff Ohio Public Employees Retirement
System (OPERS) filed a class action suit alleging securities fraud against Federal Home Loan
Mortgage Corporation and four senior officers (collectively Freddie Mac). The district court
granted Defendants’ motions to dismiss, concluding that OPERS failed to show loss causation.
For the reasons stated below, we REVERSE the district court’s dismissal of the third amended
complaint and REMAND for further proceedings consistent with this opinion.
I. BACKGROUND
This lawsuit was brought by a state pension fund serving Ohio public employees that lost
significant value in the wake of the sharp decline in the price of Freddie Mac’s stock in late
2007. OPERS alleges that Freddie Mac concealed its overextension in the nontraditional
mortgage market—generally composed of instruments known as subprime mortgages or low
credit and high risk instruments—and its materially deficient underwriting, risk management and
fraud detection practices through misstatements and omissions to investors. It alleges that the
fund suffered foreseeable losses triggered when the risk that had been concealed materialized.
OPERS is a state pension fund that provides retirement, disability, survivor and health
care benefits, and services for Ohio public employees. R. 166, ¶18. It is the fourteenth-largest
retirement system in the United States and its assets fund the benefits for more than 920,000
members. Id. OPERS alleges that it purchased shares of Freddie Mac common stock between
August 1, 2006, and November 20, 2007 (the class period), id., and that the value of those shares
plummeted when the risks in Freddie Mac’s investments, risk management system, financial
condition and results were revealed, id. at ¶¶270, 271.
No. 14-4189 Ohio Public Employees Retirement Sys. v. FHLMC, et al. Page 3
Freddie Mac is a government sponsored entity chartered by Congress that operates in the
secondary mortgage market. Id. at ¶19. Individual Defendants are former Chairman of the
Board and Chief Executive Officer Richard F. Syron, id. at ¶20, former Chief Business Officer
and Executive Vice President for Investments and Capital Markets Patricia L. Cook, id. at ¶21,
former Executive Vice President and Chief Financial Officer Anthony S. Piszel, id. at ¶22, and
former President and Chief Operating Officer Eugene M. McQuade, id. at ¶23.
As this appeal arises from dismissal of OPERS’s third amended complaint (the
Complaint), we draw the facts from the allegations therein. We recount the facts relevant to an
examination of the loss causation element of securities fraud, which formed the basis of the
district court’s dismissal. They are stated here only as needed for our examination.
A. Risk in the Nontraditional Mortgage Market
Congress chartered Freddie Mac in 1970 to maintain liquidity in the secondary market for
residential mortgage lending. Id. at ¶1. As a government sponsored entity, Freddie Mac’s
business is limited by statute to the purchase of home mortgages and mortgage-related securities.
See 12 U.S.C. § 1454(a)(1). It has become one of the largest purchasers of mortgages in the
nation. R. 166, ¶25.
Freddie Mac operates its extensive mortgage securitization business in three segments.
The primary business segment is the “single family” or “guarantee” portfolio, which guarantees
the payment of principal and interest on residential mortgages that it purchases in the secondary
market. Id. The mortgages are then securitized as Freddie Mac mortgage-backed securities for
sale on the capital markets. Id. Freddie Mac also operates a multifamily segment, id., and an
investment segment with a retained portfolio, id. at ¶86.
Freddie Mac funds its purchases by issuing short and long-term debt and preferred stock
offerings. Id. at ¶26. It monitors loan quality through its proprietary automated underwriting
system Loan Prospector. Id. at ¶28. Based on credit risk scores, the system divides loans into
six grades, available to Freddie Mac but not the public, that estimate the risk of default. Id. at
¶¶29-31. The four highest grades (A+, AI, A2, and A3, or collectively “Accept Loans”), permit
automated underwriting without special representations or warranties from the loan originator.
No. 14-4189 Ohio Public Employees Retirement Sys. v. FHLMC, et al. Page 4
Id. at ¶¶31-32. Loan Prospector’s two lower grades (CI and C2, or collectively “Caution
Loans”) carry multiple higher risk characteristics and are manually underwritten with additional
documentation, representations, and warranties. Id. at ¶¶31, 33.
As loan activity declined in the mid-2000s, large mortgage producers began to market
nontraditional mortgages aggressively to counteract the slowdown. Id. at ¶40. While these
products carried a higher likelihood of default, they also earned higher fees than prime
mortgages. R. 298-2, PageID 12479. Freddie Mac participated actively in this new arena to
maintain its position as a market leader. OPERS alleges that when Freddie Mac’s internal
quality control systems hindered its ability to transact in nontraditional mortgages, these systems
were disregarded or adjusted to allow for riskier purchases, as set forth in detail below.
First, Freddie Mac pursued increasingly permissive purchasing strategies that focused on
low credit, high risk mortgages, R. 166, ¶¶51, 53-54, and targeted low-to-moderate income
borrowers, to acquire loans that were internally considered “subprime-like,” id. at ¶61. To
increase its purchase of whole loan portfolios and compete more effectively with private issuers,
Freddie Mac entered auctions for the sale of loans in bulk. Id. at ¶¶54-55. It also guaranteed an
increasing number of low quality Expanded Approval (EA) loans from Fannie Mae, id. at ¶61, as
well as from banks known for poor loan quality, id. at ¶¶70-72. As Freddie Mac’s purchase pace
outgrew its own underwriting capabilities, it increasingly relied on the underwriting systems of
third parties, which routinely assigned artificially high quality designations to loans that would
have been considered subprime if internally underwritten. Id. at ¶¶73, 75, 130. OPERS alleges
that the more loans Freddie Mac accumulated, the larger the bonuses of Individual Defendants.
Id. at ¶53.
Second, the boom in Freddie Mac’s acquisition of nontraditional mortgages led to less
stringent institutional review and circumvention of its own underwriting standards. The
Complaint cites a confidential source, a Senior Director of IT for Freddie Mac’s Analytics and
Risk Management groups, who recounted that the practice of granting exceptions to otherwise
noncompliant loans became so common that a Director of Credit Risk Policy inquired, “Why do
we even have a credit risk policy if we allow more exceptions than we have compliance?” Id. at
No. 14-4189 Ohio Public Employees Retirement Sys. v. FHLMC, et al. Page 5
¶59. Ratings agencies were unaware of this practice and awarded mortgage pools artificially
high ratings as a result. Id. at ¶60.
Third, Freddie Mac’s exposure was aggravated by its reliance on antiquated evaluative
software and fraud detection measures, which could not keep up with the changes to Freddie
Mac’s portfolio. Id. at ¶96. These deficiencies compromised data quality controls and reporting
capability both within Freddie Mac and publicly. Id. at ¶¶96-97. Though identified internally in
late 2005, id. at ¶96, the shortcomings of Freddie Mac’s legacy software were not remedied
during the class period, id. at ¶98.
In combination, OPERS claims, Freddie Mac’s permissive purchasing strategies,
relaxation of underwriting standards, and deficient evaluation and fraud detection software
hastened the deterioration of its single family portfolio. Investment in low quality CI loans grew
from approximately $40 billion during the first quarter of 2005 to almost $120 billion at the end
of 2007. Id. at ¶37. Investment in even lower quality C2 loans grew from around $35 billion to
nearly $100 billion in the same period. Id. OPERS alleges that by the end of the class period,
Freddie Mac had exposed almost $227 billion of its loan portfolio to risk from subprime and
other low credit quality products. Id. All the while, according to OPERS, the Individual
Defendants procured advantageous personal compensation plans and bonuses, exercised stock
options, and implemented insider trading incentives. Id. at ¶¶7, 52-53, 211, 238-50.
B. Increasing Risk Exposure
OPERS contends that Freddie Mac was internally aware of the risks associated with its
accumulation of nontraditional mortgage products from the beginning, id. at ¶46, and used the
lack of uniformity among definitions of “subprime” and “Alt-A” to mislead investors. Freddie
Mac’s external statements differed from its internal reports, id. at ¶256(a)-(b), and it used a
“deceptive[ly]” narrow definition of subprime in public disclosures that made it “difficult for
even sophisticated investors to understand the negative implications of the financial
information,” id. at ¶256(c). Investors’ misconceptions were further reinforced by a steady
stream of false assurances and mischaracterizations from Freddie Mac’s senior officials,
including the Individual Defendants. Id. According to Freddie Mac’s 2007 Second Quarter
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Report, “approximately $2 billion, or 0.1 percent . . . of loans underlying our single-family
mortgage portfolio, at June 30, 2007 . . . were classified as subprime mortgage loans.” Id. at
¶182. OPERS alleges that at the time, the single family portfolio “consisted of approximately
$182 billion of C1, C2 and EA loans, which equated to approximately 12% of Freddie Mac’s
single-family credit guarantee portfolio.” Id. Freddie Mac first publicly reported its Alt-A loan
exposure in June 2007, when it estimated that Alt-A loans (loans identified as such by the
originator or with reduced documentation, id. at ¶88), made up less than 10% of Freddie Mac’s
portfolio, id. at ¶87. According to OPERS, reduced documentation loans actually constituted
29% of the single family portfolio. Id. at ¶90. As further support for its allegations concerning
concealed risk, OPERS offers additional evidence of risk materialization that became available
after the close of the class period, including Freddie Mac’s subsequent disclosure “that the
percentage of loans to borrowers with FICO scores below 620, the percentage of loans with
[loan-to-value] ratios above 90%, and the percentage of loans used to refinance a mortgage other
than a cash-out refinance, had all increased 50% over the comparable period in 2006.” Id. at
¶102.
As the skies above the subprime market began to darken, Freddie Mac dismissed news
reports forecasting trouble. However, on November 20, 2007, the last day of the class period,
OPERS contends that the truth of Freddie Mac’s exposure was finally revealed in the Third
Quarter Financial Results and accompanying press statement. R. 298-42. OPERS alleges that
this marks the first public disclosure of accurate information previously obscured through
misstatements and omissions, namely:
(a) that [Freddie Mac] in fact had heretofore unrevealed substantial involvement
in the nontraditional low credit mortgage industry;
(b) that at least $200 billion of its $700 billion mortgage portfolio was at high risk
of substantial losses; and
(c) that for just the 3 months ending September 20, 2007, Freddie Mac had
incurred a record $2 billion loss on its mortgage investments, with more
significant losses expected.
No. 14-4189 Ohio Public Employees Retirement Sys. v. FHLMC, et al. Page 7
R. 166, ¶134. OPERS concludes that “the business of Freddie Mac was far riskier than
Defendants had disclosed, and investors were incapable of measuring accurately the true
financial performance and risk of Freddie Mac’s business.” Id. at ¶138(h).
Freddie Mac alleges that when the unanticipated revelations materialized, common stock
plunged 29% or $3.29 per share—from $37.50 to $26.74. Id. at ¶191. The market capitalization
loss to shareholders totaled $6.6 billion. Id. Freddie Mac continued to suffer dramatic losses in
the coming year. Subsequent reports placed its actual net loss for the fourth quarter of 2007 at
$3.7 billion. Id. at ¶228. OPERS alleges that this loss was primarily related to subprime, Alt-A,
and other nontraditional credit losses from loans purchased between 2005 and 2007. Id. In
September 2008, the Secretary of the United States Treasury placed Freddie Mac in government
conservatorship. Id. at ¶232.
C. Procedural History
OPERS filed a securities fraud class action on behalf of purchasers of Freddie Mac
common stock in January 2008, alleging that Freddie Mac violated §§ 10(b) and 20(a) of the
Securities Exchange Act of 1934 and Securities and Exchange Commission (SEC) Rule 10b-5.
R. 1. It filed a first amended complaint in May 2008, R. 22, which Freddie Mac unsuccessfully
moved to dismiss the following September, R. 42. OPERS’s second amended complaint, R. 56,
likewise withstood Freddie Mac’s second motion to dismiss, R. 63, 126. The district court also
denied Freddie Mac’s motion to dismiss OPERS’s (third) Complaint. R. 184. However, in April
2013, the presiding judge recused himself and the case was reassigned.
At this juncture, the district court granted Freddie Mac leave to file a renewed motion to
dismiss, R. 281, and granted the subsequent motion with prejudice, concluding that OPERS
failed to adequately plead loss causation, R. 330, PageID 15908. The district court’s order also
denied OPERS’s fourth motion to amend its complaint. Id. at 15909. OPERS argues on appeal
that the district court erred by granting the motion to dismiss, rejecting the materialization of the
risk theory of loss causation, and misapplying the corrective disclosure theory. (Appellant Br. at
3-4.)
No. 14-4189 Ohio Public Employees Retirement Sys. v. FHLMC, et al. Page 8
II. ANALYSIS
A. Standard of Review
The district court’s order granting a Rule 12(b)(6) motion to dismiss is reviewed de novo.
Winget v. JP Morgan Chase Bank, N.A., 537 F.3d 565, 572 (6th Cir. 2008). We construe the
complaint in the light most favorable to the plaintiff, accept all well-pleaded factual allegations
as true, and examine whether the complaint contains “sufficient factual matter, accepted as true,
to ‘state a claim to relief that is plausible on its face.’” Ashcroft v. Iqbal, 556 U.S. 662, 678
(2009) (quoting Bell Atl. Corp. v. Twombly, 550 U.S. 544, 570 (2007)). “A claim has facial
plausibility when the plaintiff pleads factual content that allows the court to draw the reasonable
inference that the defendant is liable for the misconduct alleged.” Id. (citing Twombly, 550 U.S.
at 556). This standard “does not impose a probability requirement at the pleading stage; it
simply calls for enough fact to raise a reasonable expectation that discovery will reveal evidence
of illegal [conduct].” Twombly, 550 U.S. at 556.
The court “consider[s] the complaint in its entirety, as well as . . . documents
incorporated into the complaint by reference, and matters of which a court may take judicial
notice.” Tellabs, Inc. v. Makor Issues & Rights, Ltd., 551 U.S. 308, 322 (2007); see also Weiner
v. Klais & Co. Inc., 108 F.3d 86, 89 (6th Cir. 1997) (noting documents that a defendant attaches
to a motion to dismiss are also considered part of the pleadings if referred to in the complaint and
central to the claim). Denial of leave to amend is generally reviewed for abuse of discretion.
Sec. Ins. Co. of Hartford v. Kevin Tucker & Assocs., Inc., 64 F.3d 1001, 1008 (6th Cir. 1995).
However, when a district court denies a motion to amend based on the determination that the
amended pleading would not withstand a motion to dismiss, we review the decision de novo.
Demings v. Nationwide Life Ins. Co., 593 F.3d 486, 490 (6th Cir. 2010).
Issues not examined by the district court are ordinarily not considered on appeal. See
e.g., Singleton v. Wulff, 428 U.S. 106, 120 (1976) (“It is the general rule, of course, that a federal
appellate court does not consider an issue not passed upon below.”). In light of this rule, and the
fact-intensive questions that remain in this case, we limit our review to that considered by the
district court, namely, whether OPERS has sufficiently alleged loss causation at the pleading
No. 14-4189 Ohio Public Employees Retirement Sys. v. FHLMC, et al. Page 9
stage. R. 330, PageID 15908. In so doing, we express no opinion on the ultimate merits of the
securities fraud claims.
B. Legal Standards
Section 10(b) of the Securities Exchange Act provides a right of action to purchasers or
sellers of securities. 15 U.S.C. § 78j(b). It forbids the “use or employ, in connection with the
purchase or sale of any security . . . [of] any manipulative or deceptive device or contrivance in
contravention of such rules and regulations as the [SEC] may prescribe as necessary or
appropriate in the public interest or for the protection of investors.” Id. This section is
implemented through Rule 10b-5, which proscribes, among other things, “the making of any
‘untrue statement of material fact’ or the omission of any material fact ‘necessary in order to
make the statements made . . . not misleading.’” Dura Pharm., Inc. v. Broudo, 544 U.S. 336,
341 (2005) (quoting 17 C.F.R. § 240.10b-5) (alterations in original). The right of action
provided to the purchasers and sellers of securities through the Securities Exchange Act
resembles common law tort actions for deceit and misrepresentation, though it is not identical.
Id.A prima facie securities fraud action under § 10(b) and SEC Rule 10b–5 requires a
plaintiff to allege: “(1) a material misrepresentation or omission by the defendant; (2) scienter;
(3) a connection between the misrepresentation or omission and the purchase or sale of a
security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss
causation.” In re Omnicare, Inc. Sec. Litig., 769 F.3d 455, 469 (6th Cir. 2014) (quoting Matrixx
Initiatives, Inc. v. Siracusano, 563 U.S. 27, 37-38 (2011)). Federal Rule of Civil Procedure 9(b)
heightens the general “short and plain statement” pleading standard of Rule 8(a)(2) for a
complaint alleging fraud or mistake, which must be stated with particularity. The Private
Securities Litigation Reform Act of 1995 (PSLRA) further heightened the pleading standard by
requiring private securities complaints containing allegations of false or misleading statements to
both “specify each statement alleged to have been misleading [and] the reason or reasons why
the statement is misleading” and “state with particularity facts giving rise to a strong inference
that the defendant acted with the required state of mind.” 15 U.S.C. §78u-4(b)(1)(B), (b)(2)(A).
No. 14-4189 Ohio Public Employees Retirement Sys. v. FHLMC, et al. Page 10
C. Theories of Loss Causation
A party that brings a securities fraud claim bears the burden to prove “that the act or
omission of the defendant alleged to violate this chapter caused the loss for which the plaintiff
seeks to recover damages.” 15 U.S.C. § 78u-4(b)(4). This is “not meant to impose a great
burden upon a plaintiff,” but to “provide a defendant with some indication of the loss and the
causal connection that the plaintiff has in mind.” Dura Pharm., 544 U.S. at 347; see also id. at
346 (“[W]e assume, at least for argument’s sake, that neither the Rules nor the securities statutes
impose any special further requirement in respect to the pleading of proximate causation or
economic loss.”). At the dismissal stage, it is sufficient that OPERS’s allegations be plausible—
no final determination of amount of loss or its cause is required. See In re Fannie Mae 2008 Sec.
Litig., 891 F. Supp. 2d 458, 478 (S.D.N.Y. 2012) (denying defendant Fannie Mae’s motion to
dismiss stockholders’ § 10(b) and Rule 10b-5 claims because, in part, stockholders adequately
alleged their investment loss was caused by misstatements of risk management controls).
“Loss causation is the causal link between the alleged misconduct and the economic harm
ultimately suffered by the plaintiff.” Lentell v. Merrill Lynch & Co., 396 F.3d 161, 172 (2d Cir.
2005) (internal quotation marks omitted). It partakes of the traditional elements of loss and
proximate causation. See Dura Pharm., 544 U.S. at 346. Any analogy to the common law tort
concept, however, would be imperfect because the alleged misstatements do not generally cause
a security to drop in value, but rather, the “underlying circumstance that is concealed or
misstated.” Lentell, 396 F.3d at 173. Thus, in the securities fraud context, “a misstatement or
omission is the ‘proximate cause’ of an investment loss if the risk that caused the loss was within
the zone of risk concealed by the misrepresentations and omissions alleged by a disappointed
investor.” Id. (emphasis in original).
This court has acknowledged in an unpublished decision that loss causation can be shown
through a corrective disclosure. See In re KBC Asset Mgmt. N.V., 572 F. App’x 356, 360 (6th
Cir. 2014). Under the corrective disclosure theory, a plaintiff alleges “cause-in-fact on the
ground that the market reacted negatively to a corrective disclosure of fraud.” In re Omnicom
Grp., Inc. Sec. Litig., 597 F.3d 501, 511 (2d Cir. 2010). A decisive majority of circuits have also
recognized the alternative theory of materialization of the risk, whereby a plaintiff may allege
No. 14-4189 Ohio Public Employees Retirement Sys. v. FHLMC, et al. Page 11
“proximate cause on the ground that negative investor inferences,” drawn from a particular event
or disclosure, “caused the loss and were a foreseeable materialization of the risk concealed by the
fraudulent statement.” Id.; see also In re Harman Int’l Indus., Inc. Sec. Litig., 791 F.3d 90, 110
(D.C. Cir. 2015); McCabe v. Ernst & Young, LLP, 494 F.3d 418, 428-29 (3d Cir. 2007);
Teachers’ Ret. Sys. of La. v. Hunter, 477 F.3d 162, 187-88 (4th Cir. 2007); Lormand v. US
Unwired, Inc., 565 F.3d 228, 258 (5th Cir. 2009); Ray v. Citigroup Glob. Mkts., Inc., 482 F.3d
991, 995 (7th Cir. 2007); Schaaf v. Residential Funding Corp., 517 F.3d 544, 550 (8th Cir.
2008); Nuveen Mun. High Income Opportunity Fund v. City of Alameda, 730 F.3d 1111, 1120
(9th Cir. 2013); Nakkhumpun v. Taylor, 782 F.3d 1142, 1156 (10th Cir. 2015), cert. denied,
136 S. Ct. 499 (2015).
When considering Freddie Mac’s motion to dismiss, the district court rejected OPERS’s
materialization of the risk argument, stating that it was a “theory not adopted by the Sixth Circuit
or persuasive to the Court.” R. 330, PageID 15907. While we have not yet considered this issue
directly, our prior decisions, both controlling and unpublished, recognize the viability of
alternative theories of loss causation. See In re KBC Asset Mgmt. N.V., 572 F. App’x at 360
(implicitly recognizing alternative theories as “loss causation is ‘easiest to show when a
corrective disclosure reveals the fraud to the public and the [company’s share] price
subsequently drops’”) (alteration in original); Ind. State Dist. Council of Laborers v. Omnicare,
Inc., 583 F.3d 935, 944 (6th Cir. 2009) (observing that a single sentence in an article reporting
defendants’ “struggles to overcome major glitches” was insufficient to satisfy plaintiff’s burden
to “show that an economic loss occurred after the truth behind the misrepresentation or omission
became known to the market”).
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 acknowledgement 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. See Mass. Ret. Sys.
v. CVS Caremark Corp., 716 F.3d 229, 240 (1st Cir. 2013) (reasoning by reference to a Fifth
Circuit case, that “a defendant’s failure to admit to making a misrepresentation, or his denial that
No. 14-4189 Ohio Public Employees Retirement Sys. v. FHLMC, et al. Page 12
a misrepresentation was made” should not shield him in the loss causation analysis, lest he avoid
liability by simply refusing to concede that a prior misstatement was false).
In light of our applicable precedent and the clear weight of persuasive authority, we join
our fellow circuits in recognizing the viability of alternative theories of loss causation and apply
materialization of the risk in this case.
D. Materialization of the Risk
Freddie Mac asserts that even if the court recognizes materialization of the risk as a
viable theory, OPERS has failed to sufficiently allege loss causation. First, as the district court
noted, Freddie Mac’s quarterly and annual disclosures did provide a description of its assumption
of risk. R. 330, PageID 15901. As explicitly stated in Freddie Mac’s 2006 Annual Report,
To improve our ability to better fulfill our mission, we have increased our
participation in nontraditional mortgage market products. . . .
Product mix affects the credit risk profile of our Total mortgage
portfolio. . . .
. . . We expect each of these products to default more often than traditional
products and we consider this when determining our credit and guarantee fees. . . .
We will continue to monitor the growth of these products in our portfolio and, if
appropriate, may seek credit enhancements to further manage the incremental
risk.
R. 298-2, PageID 12478-79.
These statements, however, mean little if OPERS’s allegations of systemic
mismanagement within Freddie Mac are to be believed—as all well-pleaded allegations must be
at this stage. Freddie Mac’s financial reports highlighted rigorous underwriting requirements
and quality control standards as key focus areas for management of credit risk. Id. at 12476. All
the while, OPERS contends, and we accept as true, Freddie Mac disregarded its internal controls
through such practices as artificial inflation of property values to lower loan-to-value ratios,
R. 166, ¶¶62-63, excessive application of exceptions to otherwise non-qualifying loans, id. at
¶59, purchase of increasingly risky products, id. at ¶¶51-55, 72-73, and reliance on outdated
evaluative software and fraud detection measures, id. at ¶¶96-99, 108-12.
No. 14-4189 Ohio Public Employees Retirement Sys. v. FHLMC, et al. Page 13
OPERS alleges to be untrue Freddie Mac’s assertion that the quantitative data in its
financial reports gave investors an accurate picture of its risk exposure. As explained above,
Freddie Mac claimed that .01% of the loans in its single family portfolio were subprime, while
OPERS alleges this number is closer to 12% when low quality loans like CI, C2, and EA are
considered. Id. at ¶182. It also alleges that Freddie Mac made no public disclosure of its Alt-A
holdings until June 2007, well into the class period, reporting that they made up 8% or
$120 billion of the portfolio when such loans actually consisted of $462 billion or 29% of the
portfolio. Id. at ¶87-90. As the Supreme Court observed in the context of a separate section of
the Securities Exchange Act, “not every mixture with the true will neutralize the deceptive.”
Va. Bankshares, Inc. v. Sandberg, 501 U.S. 1083, 1097 (1991). “If it would take a financial
analyst to spot the tension between the one and the other, whatever is misleading will remain
materially so, and liability should follow.” Id.In a similar case, SEC v. Mudd, the court found that regular financial reports did not
sufficiently correct defendants’ alleged misstatements to investors regarding Fannie Mae’s level
of subprime exposure. 885 F. Supp. 2d 654, 666-67 (S.D.N.Y. 2012). Like Freddie Mac’s
financial reports, those considered in Mudd measured loans based on borrowers’ FICO scores
and loan-to-value ratios. Id. However, defendants’ reports “did not define subprime loans” by
these metrics, nor did they measure loans by adequacy of documentation to show Alt-A
exposure. Id. at 667. The court found it was “not clear that this data would have corrected,
clarified, or rendered immaterial [Fannie Mae’s] subprime exposure calculations.” Id. In
holding that defendants’ disclaimers and warnings did not preclude liability, the court quoted the
Second Circuit’s conclusion that “[c]autionary words about future risk cannot insulate from
liability the failure to disclose that the risk has transpired.” Id. (quoting Rombach v. Chang,
355 F.3d 164, 173 (2d Cir. 2004)).
In addition to inaccurate quantitative data, the Complaint also alleged instances of
Freddie Mac’s internal recognition that its public statements regarding exposure were
misleading. For example, in May 2007, the then-Head of External Reporting reviewed a draft
speech to be delivered by Syron at the UBS Global Financial Services Conference. He suggested
in an email that references to subprime loan exposure be refined:
No. 14-4189 Ohio Public Employees Retirement Sys. v. FHLMC, et al. Page 14
We need to be careful how we word this. Certainly our portfolio includes loans
that under some definitions would be considered subprime. Look back at the
subprime language in the annual report and use that as a guide as what to say.
Basically, we say we don’t have a definition of subprime and we don’t acquire
loans from subprime lenders. We should reconsider making as sweeping a
statement as we have “basically no subprime exposure.”
R.166, ¶83. This advice was rejected, however, and at the conference a few days later, Syron
included the original language in his speech: “As we discussed in the past, at the end of 2006,
Freddie had basically no subprime exposure in our guarantee business, and about $124 billion of
AAA rated subprime exposure in our retained portfolio.” Id. at ¶84 (emphasis added). Cook
repeated this statement a few days later when she delivered a speech at the Lehman Brothers
Tenth Annual Financial Services Conference. Id. at ¶85. The Complaint details many additional
communications to investors to the same effect. See e.g., id. at ¶¶140-43, 156, 164, 177.
Freddie Mac draws our attention to Central States, Southeast and Southwest Areas
Pension Fund v. Federal Home Loan Mortgage Corp., 543 F. App’x 72 (2d Cir. 2013), which it
characterizes as “virtually identical” to the present case. In an unpublished opinion, the Second
Circuit affirmed the dismissal of investors’ claim against Freddie Mac for failure to meet the
pleading requirements for loss causation. Id. at 77. The Central States investors purchased
Freddie Mac stock during a class period that ran from November 20, 2007, to September 7, 2008,
the day it was announced that Freddie Mac would be placed into conservatorship. Id. at 73. The
court rejected investors’ loss causation argument that the stock price fell after news articles and
independent analyst reports in 2008 revealed that Freddie Mac’s prior statements claiming it was
“adequately capitalized and had sufficient internal controls” were false. Id. at 74.
That case, though not controlling in the Sixth Circuit and factually distinguishable, lends
support to our conclusions. November 20, 2007, is indeed a familiar date but it stands at the
beginning of the class period in Central States; here it stands as the end of the class period. That
makes all the difference. The court in Central States emphasized that on the first day of its class
period, Freddie Mac “reported a loss of more than $2 billion, causing its stock price to fall from
$37.50 at the close of trading on November 19 to $26.74 at the close of trading on November
20.” Id. On that day, Freddie Mac also disclosed “its increased involvement in nontraditional
mortgage markets and the ‘greater credit risks’ from ‘increased delinquencies and credit losses’
No. 14-4189 Ohio Public Employees Retirement Sys. v. FHLMC, et al. Page 15
involving nontraditional mortgage products.” Id. Given these disclosures, the court reasoned,
investors could not “plausibly allege that they were not on notice of the true gravity of Freddie’s
situation until corrective disclosures began to be published on July 3, 2008.” Id. at 74-75. Based
on the class period in the present case, OPERS could and did plausibly allege that it was not on
notice. OPERS’s position differed from that of Central States, as it had purchased stock before
November 20 under the misimpression (allegedly fostered by Freddie Mac) that Freddie Mac
adequately protected its higher-risk purchases, had virtually no subprime exposure, and enjoyed
more success than its competitors. The subsequent revelation of loss on the November 20 close
of this class is well within the “zone of risk” that Freddie Mac allegedly concealed here. Lentell,
396 F.3d at 173.
Based on the allegations detailed above, OPERS’s claims can be summarized as follows:
Freddie Mac made materially false statements and omissions regarding its extension into the
nontraditional mortgage market and its financial health. R. 166, ¶¶270-71. When these risks
were realized, the market price of Freddie Mac stock dropped dramatically. Had OPERS known
the truth, it would not have invested in Freddie Mac common stock, or would have done so at a
much lower purchase price. Id. at ¶270. OPERS concludes that the 29% loss in stock price that
occurred on November 20, 2007, when Freddie Mac disclosed a loss of $2 billion, is “directly
attributable to the market’s reaction to revelations of the nature, extent, and impact of the fraud at
Freddie Mac.” Id. at ¶271.
We are not persuaded by Freddie Mac’s argument that OPERS fails to “plead[] facts
sufficient to exclude more likely explanations for its alleged losses, such as the worst financial
crisis since the Great Depression.” (Appellee Federal Home Loan Mortgage Corporation Br. at
51.) OPERS need only allege sufficient facts to support a plausible claim—not the most likely—
at this stage. See Twombly, 550 U.S. at 570. Having considered “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, we conclude that it has done so. In re Am. Intern. Grp., Inc. 2008 Sec. Litig., 741 F.
Supp. 2d 511, 534 (S.D.N.Y. 2010).
No. 14-4189 Ohio Public Employees Retirement Sys. v. FHLMC, et al. Page 16
When considering a motion to dismiss, “we must tread lightly . . . engaging carefully
with the facts of a given case and considering them in their full context.” In re Omnicare, 769
F.3d at 473. Taking the allegations in the Complaint as true and drawing all reasonable
inferences in OPERS’s favor, we conclude that OPERS has sufficiently alleged loss causation to
survive a Rule 12(b)(6) motion to dismiss.
III. CONCLUSION
Based on the foregoing reasoning, we REVERSE the district court’s dismissal of
OPERS’s Complaint and REMAND for further proceedings consistent with this opinion.