We write today about a recent decision addressing the issue of pleading loss causation in private securities actions. On October 31, 2014, United States District Court Judge Benita Pearson dismissed putative class action claims against the Federal Home Loan Mortgage Corp. (FHLMC or “Freddie Mac”) arising out of alleged losses by investors on Freddie Mac stock because of insufficient disclosures of exposure to subprime mortgages in the FHLMC mortgage portfolio. Although numerous flaws in the complaint were cited in the motion to dismiss these claims, the court found it necessary to address only one of these: the failure to plead sufficient facts to support the “loss causation” element of a private securities claim. A copy of the opinion in Ohio Public Employees Retirement System v. Federal Home Loan Mortgage Corp., Case No. 4:08cv160 (N.D. Ohio Oct. 31, 2014) (“Freddie Mac”), is available here: Ohio Public Employees Retirement System v. FHLMC.
The case involved what are now common allegations in securities actions in the wake of the 2007-2008 housing and financial crisis. Freddie Mac buys mortgage loans from originators – in fact, under its charter that’s all it can do. It packages these mortgage loans into mortgage-backed securities (MBS) and sells those securities in the capital markets with certain guarantees. It also buys MBS issued by others and keeps them in its portfolio. On November 20, 2007, Freddie Mac issued a press release disclosing that it lost over $2 billion during the third quarter of 2007, that its increased purchases of subprime mortgages exposed it to “greater credit risks,” and that it was in danger of falling below its minimum capital requirements. FHLMC stock dropped 29%; the enterprise value of FHLMC dropped by $6.6 billion. The class action plaintiffs bar sprung into action.
This class action sought damages for losses incurred by a class of Freddie Mac shareholders who purchased shares between August 1, 2006 and November 20, 2007 (the alleged “class period”). Only two causes of action were asserted: for violations of section 10(b) of the Securities and Exchange Act of 1934, and for “control person” liability under section 20(a) of that statute. By the time of this decision, plaintiff was on its third amended complaint. In substance, the claims alleged that Freddie Mac violated section 10(b) by making misleading statements and omissions in its disclosures in the period before November 20, 2007 about its mortgage portfolio exposure.
The defendants argued there were several shortcomings in the complaint, but the critical one discussed in the opinion involves the pleading of loss causation. In Dura Pharmaceuticals Inc. v. Broudo, 544 U.S. 336, 346 (2005), the Supreme Court held that a plaintiff must plead loss causation as a required element for a securities claim alleging a violation of section 10(b). The Freddie Mac decision turned on what is required to plead and prove loss causation in these cases.
In the first of three decisions in the Omnicare class action case, the second of which is now pending before the Supreme Court (see here), the Sixth Circuit dismissed section 10(b) claims for failing sufficiently to allege the loss causation element, saying “a plaintiff must show that an economic loss occurred after the truth behind the misrepresentation or omission became known to the market.” Indiana State Dist. Council of Laborers & Hod Carriers Pension & Welfare Fund v. Omnicare, Inc., 583 F.3d 935, 944 (6th Cir. 2009) (citing Dura). Sitting in Ohio, Judge Pearson was following this Sixth Circuit guidance.
Plaintiff argued that this requirement could be satisfied either by (1) the disclosure of “a previously undisclosed truth” that caused a decline in stock price, or (2) the “materialization of a concealed risk” that caused a stock price drop. Freddie Mac, slip op. at 8. Judge Pearson took odds with the “materialization of a concealed risk” prong, which she found unsupported in the Sixth Circuit. Plaintiff’s cited only case law in the Second Circuit to support this contention (id. at 8 n.5), and the judge found “no binding authority supporting a theory of loss causation that does not require a corrective revelation.” Id. at 18-19. But in the end, the decision did not turn on this distinction because the court noted that a “disclosure or revelation of a misstatement or omission” was not pleaded, which even plaintiff acknowledged was required for its “materialization of a concealed risk” theory. Id. at 19.
The court reasoned that if the stock price dropped following the November 20, 2007 Freddie Mac release, the source of the stock drop would have to be found in that release. She then reviewed the contents of the release and found that none of them revealed a previous misstatement or omission. Plaintiff argued that the very fact of a stock price drop “confirms empirically that the market was previously unaware of the full extent of Freddie Mac’s exposure,” but the court rejected that approach (which plainly is circular). The judge noted that just because the market reacted to the disclosure of a $2 billion loss does not mean that Freddie Mac concealed facts about its mortgage portfolio that led to that loss. And she pointed to several prior disclosures in which Freddie Mac noted increased purchases of subprime mortgages with increased default risks.
In the end, Freddie Mac was able to point to multiple occasions on which it discussed increased subprime exposures with higher credit risk. Conclusory allegations that the company failed to “come clean” before the November release, or that the November release was part of a “newly emerging truth” fell before the court’s examination of specific disclosures in which the risks of Freddie Mac’s subprime disclosure were discussed. Because the plaintiff “does not allege how the disclosures made on November 20, 2007 were corrective or revealed a truth behind the alleged misrepresentations” the claims were dismissed for failure to plead loss causation. Id. at 17.
Interestingly, the same type of analysis could lead a court to conclude that no false or misleading statements or omissions were properly alleged, especially given the particularity requirements of the Private Securities Litigation Reform Act (PSLRA). Defendants certainly made this argument. But the court was more comfortable honing in on the loss causation element than taking on the issue of sufficiency of the fraud pleadings.
Following Dura, the courts have increased their emphasis on, and examination of, loss causation pleadings in section 10(b) actions. The Freddie Mac case provides a useful formula to defendants to follow in their motions to dismiss. Examine the disclosure allegedly causing the stock price decline closely. The mere fact of a stock price drop in and of itself is not sufficient to show the price drop was the result of new revelations about old conditions, or even the realization of undisclosed risks about old conditions. Things change, sometimes surprisingly, and those changes do not have to reflect a previous failure to disclose conditions that led to the change. As they say, life is a bell curve, and when things happen on the left or right edges of that curve it may just reflect life, not fraud. Or at least that appears to be what Judge Pearson concluded.
November 12, 2014
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