Ohio Pub. Emps. Ret. Sys. v. Fed. Home Loan Mortg. Corp.

• Decision Date: 20 July 2016
• Docket Number: No. 14-4189,14-4189
• Parties: Ohio Public Employees Retirement System, on behalf of itself and all others similarly situated, Plaintiff–Appellant, v. Federal Home Loan Mortgage Corporation; Richard F. Syron; Patricia L. Cook ; Anthony S. Piszel; Eugene M. McQuade, Defendants–Appellees.
• Court: U.S. Court of Appeals — Sixth Circuit

830 F.3d 376

Ohio Public Employees Retirement System, on behalf of itself and all others similarly situated, Plaintiff–Appellant

v.Federal Home Loan Mortgage Corporation; Richard F. Syron; Patricia L. Cook ; Anthony S. Piszel; Eugene M. McQuade, Defendants–Appellees.

No. 14-4189

United States Court of Appeals, Sixth Circuit.

Argued: October 14, 2015

Decided and Filed: July 20, 2016

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 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.

Before: GUY, KETHLEDGE, and STRANCH, Circuit Judges.

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.

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. 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 ¶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...