The U.S. Court of Appeals for the Sixth Circuit yesterday recognized the “materialization of the risk” standard as a means of proving loss causation in securities-fraud cases. The court’s decision in Ohio Public Employees Retirement System v. Federal Home Loan Mortgage Corp. aligns the Sixth Circuit with the majority of other circuits, which have also allowed plaintiffs to plead loss causation by alleging damages arising from a materialization of a concealed risk, even in the absence of a corrective disclosure of the previously hidden or misstated “truth.”

Factual Background

Federal Home Loan Mortgage Corp. is a securities-fraud class action against Freddie Mac, which issued securities to fund its purchases and securitizations of mortgages.  The plaintiff alleged that Freddie Mac had “concealed its overextension in the nontraditional mortgage market” (subprime mortgages or low-credit and high-risk instruments) “and its materially deficient underwriting, risk management and fraud detection practices through misstatements to investors.”  The plaintiff further charged that it had suffered foreseeable injury when the risks arising from Freddie Mac’s allegedly misrepresented business practices materialized:  the company reported a large quarterly loss and told the market that a substantial portion of its portfolio was at risk of incurring losses.  Freddie Mac’s stock price fell after those disclosures.

The District Court dismissed the case, holding that the plaintiff had not met its burden of pleading loss causation – a causal link between the defendant’s alleged acts or omissions and the plaintiff’s loss. The plaintiff had not alleged a corrective disclosure revealing the previously hidden or misrepresented “truth” about Freddie Mac’s purported underwriting and business practices, and the District Court concluded that the Sixth Circuit had not recognized the alternative theory of loss causation based on materialization of an allegedly concealed risk.  The Sixth Circuit reversed.

Sixth Circuit’s Decision

The Sixth Circuit observed that a “decisive majority” of the federal circuit courts have held that plaintiffs can establish loss causation even without pleading a corrective disclosure. Instead, those courts have recognized an alternative theory of loss causation based on “materialization of the risk, whereby a plaintiff may allege 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.”

The Sixth Circuit noted that those other appellate courts “have recognized that defendants accused of securities fraud should not escape liability by simply avoiding a corrective disclosure.” Instead, those courts have held that a misstatement or omission can be “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.”

The Sixth Circuit therefore held that, in light of its prior 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.”

The court then ruled that the plaintiff’s allegations, as pled, sufficiently alleged a materialization of a concealed risk. Although Freddie Mac had publicly disclosed the risks of its portfolio, the court held that those warnings “mean little if [the plaintiff’s] allegations of systemic mismanagement within Freddie Mac are to be believed.”  Freddie Mac’s financial reports had “highlighted rigorous underwriting requirements and quality control standards as key focus areas for management of credit risk,” but the plaintiff alleged that Freddie Mac had “disregarded its internal controls through such practices as artificial inflation of property values to lower loan-to-value ratios, . . . excessive application of exceptions to otherwise non-qualifying loans, . . . purchase of increasingly risky products, . . . and reliance on outdated evaluative software and fraud detection measures.”  The Sixth Circuit therefore allowed the plaintiff to proceed on the theory that its losses arose when the risks created by those allegedly undisclosed practices materialized and caused Freddie Mac’s stock price to drop.

The Sixth Circuit’s acceptance of the materialization-of-the-risk theory of loss causation is perhaps not surprising, in that many other circuits have reached the same conclusion. We will continue to watch other hot loss-causation topics.