The Sixth Circuit Recognizes The Materialization Of The Risk Theory Of Loss Causation

On July, 20, 2016, the United States Sixth Circuit Court of Appeals issued a decision in Ohio Pub. Emples. Ret. Sys. v. Fed. Home Loan Mortg. Corp., No. 14-4189, 2016 U.S. App. LEXIS 13229 (6th Cir. July 20, 2016) which reversed the district court’s order dismissing plaintiff’s lawsuit.  The Sixth Circuit joined “[a] decisive majority of circuits” which have recognized “the alternative theory of materialization of the risk[.]”  Fed. Home Loan Mortg. Corp., 2016 U.S. App. LEXIS 13229, at *18.

Materialization of the risk is an alternative theory of loss causation.  Loss causation is the proximate cause element of a securities fraud claim which is described as the “causal link between the alleged misconduct and the economic harm ultimately suffered by the plaintiff.”  Id. at *17.  In contrast to a corrective disclosure theory, in which a plaintiff alleges a negative market reaction to a corrective disclosure “which reveals the [company’s] fraud to the public” to establish loss causation, the materialization of the risk theory allows a plaintiff to allege loss causation “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. at *18 (emphasis added).

In Fed. Home Loan Mortg. Corp., plaintiff, Ohio Public Employees Retirement System (“OPERS”), alleged that defendant, Freddie Mac, failed to disclose and misled investors regarding the extent of its excessive purchasing of high risk subprime mortgage portfolios, and its deficient internal controls and underwriting standards which allowed defendant to load up on the subprime mortgage portfolios, ultimately increasing its risk.  Id. at *8.  OPERS alleged that Freddie Mac concealed the risk of its overextension in the subprime mortgage market and that risk eventually materialized in its 2007 Third Quarter Financial Results, when Freddie Mac disclosed losses of $2 billion which led to a 29% stock drop.  Id. at *10, *27.  Under a materialization of the risk theory, this was sufficient for the survival of plaintiff’s complaint.  Id. at *27.

In sustaining OPERS’ claims through the endorsement of the materialization of the risk theory, the Sixth Circuit noted “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.”  Id. at *19.  Stated another way, by only granting plaintiffs a corrective disclosure loss causation theory, defendants may attempt to avoid liability “by simply refusing to concede that a prior misstatement was false[.]”  Id. at *19.

After Fed. Home Loan Mortg. Corp., plaintiffs in the Sixth Circuit should have more clarity, and options, in pleading loss causation.

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About Sherief Morsy

Sherief Morsy is an Associate in Faruqi & Faruqi, LLP’s New York office and focuses his practice on securities litigation, representing plaintiffs in federal securities fraud class actions.  His achievements include successful appeals at the New York State Appellate level.  He is also extensively involved in ongoing securities class actions.  Please feel free to contact Sherief regarding any questions concerning this blog post or any questions related to F&F’s practice areas.

Posted by Sherief Morsy

Associate at Faruqi & Faruqi, LLP
New York Office
Tel: (212) 983-9330
Fax: (212) 983-9331
Email: smorsy@faruqilaw.com
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