(Article changed on January 23, 2013 at 15:22)
After eight years of litigation, the plaintiffs came away with nothing. No damages awarded, no trial, nothing other than a summary verdict against them because, the judge ruled, no evidence of any substance had been uncovered and presented.
It was not as if plaintiffs' attorneys had left any stone unturned in their quest for any kind of evidence to prove that three former Fannie Mae executives had committed securities fraud. "The volume of information exchanged in discovery was enormous," wrote Judge Richard Leon. "The parties produced nearly 67 million pages of documents, deposed 123 fact witnesses, and engaged 35 expert witnesses." And then, in a gentle swipe at Fannie Mae's regulator, he noted how, "The discovery process was unnecessarily prolonged by OFHEO's repeated and stubborn assertion of privileges that had to be litigated up to the Court of Appeals."
It was kind of pathetic really, hundreds of millions of dollars in legal fees wasted in a fruitless search for something as elusive as the Treasure of Sierra Madre, or Saddam's nuclear weapons lab. But it was also obvious that the plaintiffs' lawyers, representing pension funds that held Fannie Mae stock in the early 2000s, were deluding themselves. Any competent lawyer could have seen, from the onset, that the case would go nowhere. I figured out in about an hour, after casually perusing some public documents two years ago.
Fannie's "Accounting Fraud" = Saddam's WMD
"The narrative of plaintiffs' securities fraud claims against [the former Fannie executives] not surprisingly, flows directly from an OFHEO investigation of Fannie Mae," wrote Judge Leon. Apparently the plaintiffs had a hard time believing that the Chairman of the S.E.C., and the Director of the Office of Federal Housing Enterprise Oversight would deceive the Courts, Congress and the public with their patently bogus allegations of securities fraud. After all, Fannie Mae settled with the government for $400 million! Former Fannie executives agreed to millions in clawbacks of their bonuses! Where there's smoke there's fire! There must be something there!
Except the government's deception was really, really obvious. Remember how, 10 years ago, U.N. inspectors eviscerated U.S. "intelligence," on WMD in Iraq, and the Bush Administration, which refused to consider the substance of the inspectors' findings, kept saying there was WMD and invaded anyway? The Bush Administration pulled the same kind of stunt when it accused Fannie Mae of committing securities fraud, even after the written record showed that such a fraud was virtually impossible.
Judge Richard Leon's rulings provide full exoneration of former CEO Franklin Raines, former CFO Timothy Howard and former Controller Leanne Spencer. The Judge was not asked to rule on the original charges brought by SEC Chairman Christopher Cox, and OFHEO Director James Lockhart, but it's impossible to read his decisions without making the obvious inference, that the charges brought by the government were a sham, which is why the government stonewalled for years thereafter. It's a felony to lie to or deceive Congress, and the statute of limitations for indicting Cox and Lockhart has probably passed.
What You Need To Prove
Remember, it's not easy to make a case for securities fraud. You need to show that the defendant knew that the financial condition of his company was being misrepresented in a material way. The S.E.C. and the OFHEO both accused Fannie of committing a massive accounting fraud of a magnitude of that comparable to the WorldCom case. Everyone understood what WorldCom's CEO did, he pulled revenues out of his ass and posted them on the income statement without telling outside auditors or the public.
With Fannie, the allegation was tough to explain. Purportedly, the company did not properly implement a newly-issued accounting standard, FAS 133, and thereby concealed $11 billion in losses. Accounting standards, which are very dense and very technical, are subject to interpretation. And FAS 133 gave companies some latitude as how to present certain information. If accounting experts disagree about the application of FAS 133, neither interpretation can be deemed to be fraud. The violation needs to be really clear-cut. Misinterpreting an accounting standard is not fraud. To commit fraud, you need to have actual knowledge that you are violating accounting standards, or show a reckless disregard of your obligation to know the truth.
Why The Case For Fraud Would Never Hold Up
Which is why it's all but impossible to make a case for fraud if the defendant relies on the company's outside auditor, KPMG, which had reviewed the relevant accounting and knowingly signed off on it. And then the regulator, the OFHEO, reviewed the relevant accounting and knowingly signed off on it, before assuring Fannie's Board that Fannie's accounting is proper. Also, if the matter is fully disclosed in contemporaneous S.E.C. filings, then the defendant is pretty much inoculated from charges of fraud. The coup de grace was the release of Fannie Mae's restated financials, which showed that the alleged "$11 billion loss" had disappeared.
If you looked at the substance of the government's case, or rather, the absence of substance, it was obvious that the allegations of securities fraud had been fabricated out of thin air, that all of the characterizations about financial manipulation were flimsy at best.
Let's go through what a plaintiff needs to prove, and then go through the documents that showed that the allegations by the S.E.C. and OFHEO were bogus. To prevail in a case of securities fraud (what the lawyers call a 10(b)(5) violation) you need to prove six elements:
(1) a material misrepresentation or omission by the defendant;
(2) "scienter" [or in plain English, that a person knew of, or showed reckless disregard for, the material misrepresentation] ;
(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.
Smoking Guns That Demolish The Government's Case
Here's a list summarizing the key documents or events, with further explanation below:
1) Rudman Investigation: In February 2006, a year-long independent investigation, led by former Senator Warren Rudman, then a partner at Paul Weiss Rifkind, virtually inoculated top Fannie executives from any allegation of scienter;
2) OFHEO Report: A May 2006 OFHEO report, which excoriated Fannie's accounting, also conceded that KPMG had signed off on what was being done. The OFHEO based its claims on its own interpretation of accounting rules, not that of an outside accountant.
3) S.E.C. Complaint: The June 2006 S.E.C. complaint complaint against Fannie Mae alleged securities fraud, but failed to lay out facts establishing all six necessary elements.
4) Cox/Lockhart Testimony: On June 15, 2006 Cox and Lockhart appeared before Congress and alleged that Fannie had "concealed" an "$11 billion loss," and offered testimony that was, to put it charitably, highly misleading, or more bluntly, dishonest.
5) Fannie's Restated Financials: When Fannie Mae released its restated financials in December 2006, it became obvious how the OFHEO and the S.E.C. had divined the so-called "$11 billion reduction in capital," which had always been hiding in plain sight. In order to show the "loss," on the books, accountants had to increase equity by $10.4 billion, so net equity increased by $4 billion. When restated, the financial reports showed that every financial metric--earnings, cash flow, equity--improved.
In an nutshell, any financial analyst of reasonable competence could have figured out what was going on, based on the original financial statements filed under Raines' watch. The FAS 133 adjustments were fully disclosed as adjustments to equity. (See fuller discussion here.)
6) OFHEO Administrative Charges: Afterwards, on December 18, 2006, the OFHEO sued the three former Fannie executives for committing accounting fraud. Since the lawsuits constituted "administrative charges," the adjudication of the matter was, to my knowledge, something unique in Anglo Saxon law. The complaint was signed by OFHEO Director James Lockhart, who was also designated to make the final ruling on the matter. (The Administrative judge heard evidence, but he merely made a recommendation; Lockhart was the final decider.) From the start, the OFHEO stonewalled about disclosure of any of its relevant records.
7) Frivolous Motions: The private lawsuit, initially filed in 2004, was relentlessly besieged by frivolous motions filed by a non-party, the OFHEO, which insulted everyone's intelligence by its refusal to hand over key documents and its demands to keep everything under seal. These tactics should have been a tipoff of what the OFHEO was trying to hide. See also here, here, and here.
If you read Judge Richard Leon's decisions--here, here, and here--it becomes obvious that nothing drawn from the OFHEO and S.E.C. investigations could withstand scrutiny. What are the chances that the Inspector General of OFHEO's successor agency, the Federal Housing Finance Agency, would ever investigate the waste, fraud and abuse that resulted from the government's attempts to conceal Lockhart's dirty laundry? I wouldn't bet on it.
One other little detail that may not have much to do with anything. James Lockhart was George W. Bush's buddy at prep school and college.
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Addendum:
Details on the the Seven Key Document/Events Above
I assumed some readers would not want to get bogged down in the details of the seven foregoing "smoking guns," but I thought it should be laid out for the record, and for readers who find this matter of interest.
Snippits From Leon's Decisions: If you like, you can skip over these excerpts from Leon's decisions to get a flavor of how emphatically he rejected the same theories put forth by the government. See how many times you can find the phrase "no evidence":
There is not only no direct evidence that [former CEO Franklin] Raines intended to deceive Fannie Mae's investors, there is no evidence that he even knew his statements were false.
... Moreover, plaintiffs fail to show that certain financial transactions were improper at all, or that Raines was even involved or knowledgeable about them.
... At bottom, plaintiffs make much ado about earnings management, but plaintiffs present no evidence that Raines was ever aware that these transactions may have violated GAAP or, more importantly, were being used for an improper purpose.
... Plaintiffs fail to point to any evidence from which a reasonable jury could infer that [former CFO Timothy] Howard believed any of these transactions were improper or sought to conceal them from the public. Indeed, plaintiffs' own expert recognized that earnings management does not necessarily show an improper purpose.
... In sum, plaintiffs offer no evidence from which a reasonable juror could conclude that any of Howard's statements concerning Fannie Mae's accounting practices or internal controls were made with an intent to deceive, or were otherwise made without any reasonable basis.
... As such, plaintiffs do not put forth any evidence that [former Controller Leanne] Spencer was told during the class period that Fannie Mae committed fraud or material violations of GAAP. In sum, plaintiffs offer no evidence from which a reasonable juror could conclude that any of Spencer's statements concerning Fannie Mae's accounting practices or internal controls were made with an intent to deceive or were otherwise made without any reasonable basis.
... The heart of plaintiffs' case against Spencer is that she engaged in improper earnings management to increase executive bonuses, in violation of various accounting standards. At most, plaintiffs' evidence indicates that Spencer was involved with certain transactions that affected earnings. Plaintiffs fail to point to any evidence from which a reasonable jury could infer that Spencer believed any of these transactions were improper or sought to conceal them from the public. Indeed, plaintiffs' own expert recognized that earnings management does not necessarily show an improper purpose. But plaintiffs cite to no evidence that these debt repurchases violated GAAP or that Spencer believed that the debt repurchases violated GAAP. In fact, plaintiffs' expert used Fannie Mae's debt repurchases as an example of an earnings management strategy that did not violate GAAP.
... Plaintiffs' theories on Spencer's [state of mind] are insufficient to withstand her summary judgment motion, particularly in light of the overwhelming evidence of Spencer's good faith .
1) Rudman Investigation: The Rudman investigation outsourced the accounting analysis to a financial consulting firm, not an accounting firm called Huron Consulting. Huran found many violations of GAAP, but never stated whether any or all of those violations amounted to something material. (Think of it this way, a parking ticket and hit-and-run homicide are both traffic violations, but 25 tickets will never be as important as one hit-and-run.) Some of Huron's assessments make me question their sophistication, as when they disapprove of booking credit loss provisions in excess of actual writeoffs during the real estate bubble.
In addition, Huron found that Fannie had violated certain accounting standards, whereas Judge Leon, after hearing expert witnesses on the matter, ruled that such was not the case.
The investigation began in September 2004, after the S.E.C. said that Fannie's accounting was unacceptable, and Raines, Howard and Spenser resigned. And Rudman was not shy about slamming the management of people who were long gone, specifically Raines, Howard and Spencer:
Finally, we conclude that Howard, the former CFO, and Leanne Spencer, the former Controller, were primarily responsible for adopting or implementing accounting practices that departed from GAAP, and that they put undue emphasis on avoiding earnings volatility and meeting EPS targets and growth expectations. As for former Chairman and CEO Franklin D. Raines, we did not find that he knew that the Company's accounting practices departed from GAAP in significant ways. We did find however, that Raines contributed to a culture that improperly stressed stable earnings growth and that, as the Chairman and CEO of the Company from 1999 through 2004, he was ultimately responsible for the failures that occurred on his watch.
Of course, the extent to which a corporate culture improperly stresses stable earnings growth is very much in the eye of the beholder. But it was clear that Howard and Spenser kept everyone informed about the most important accounting issue, pertaining to the new FAS 133, which dealt with hedge accounting. It's virtually impossible to make a case for fraudulent intent if your outside auditor and regulator, who are fully aware of what you're doing, voice their assent to your accounting practices:
It appears that senior accountants in the Controller's Office were of the view that any deviations from a "strict application" of FAS 133 were immaterial. However, management did not conduct a systematic or comprehensive test to support that proposition, and the tests that it did conduct provided inadequate support for that view.
The record also shows that management took steps throughout the FAS 133 implementation process to keep the Company's outside auditor informed of its decisions. Management engaged the auditor to review the Company's new hedge accounting policies (the "Derivatives Accounting Guidelines") prior to the effective date of FAS 133, to ensure that the principal features of the Company's implementation program complied with GAAP. The audit workpapers reveal that the auditor knew of, and accepted, Fannie Mae's major accounting policies concerning FAS 133 on the grounds that any deviations from GAAP reflected in Fannie Mae's policies were immaterial.
In April 2000, moreover, the auditor described to the Board's Audit Committee its planned involvement in the FAS 133 implementation effort and prior to Special Examination, the auditor did not raise any concerns to the Audit Committee or the full Board regarding the Company's approach to hedge accounting. In addition, the Company's Derivatives Accounting Guidelines were available to, and were reviewed by, OFHEO examination staff.
As late as June 2002, when OFHEO issued its report on Fannie Mae's operations in 2001, OFHEO reported that the Company's implementation of FAS 133 had a sound basis. Howard set the tone for the FAS 133 implementation effort and, from the outset and throughout the process, he focused the implementation team's efforts on avoiding the volatility associated with FAS 133 while not changing the Company's business to any significant degree. However, we did not find any evidence that Howard directed anyone to violate GAAP.
... Finally, the Board received assurances from management on several occasions (as well as from the Company's auditor and OFHEO) that the Company's implementation of FAS 133 was appropriate.
2) OFHEO Report: OFHEO's 348-page report is a piece of work, on may levels. What stands out is that OFHEO made its own interpretation of GAAP, without relying on any outside accounting experts. It found that there were many egregious violations of GAAP, which threatened the "safety and soundness" of Fannie. It found that KPMG's auditing work was a travesty, and faulted management and the Board for for failing to properly oversee KPMG. It's kind of a weird accusation to make, since the outside auditor is supposed to be independent, and, in the real world, efforts to "oversee" an outside auditor's accounting opinions would be deemed to be attempts at undue influence. The OFHEO says:
KPMG provided an unqualified opinion each year to the Enterprise [Fannie] and its Board of Directors that the financial statements did not contain material deviations from GAAP.
... The Enterprise also failed to oversee external audits performed by KPMG as required by OFHEO guidance and regulations. Those audits failed to include an adequate review of Fannie Mae's significant accounting policies for GAAP compliance. KPMG also improperly provided unqualified opinions on financial statements even though they contained significant departures from GAAP. Both the failure to review adequately significant accounting policies and procedures for GAAP compliance and representations regarding GAAP compliance indicate that Fannie Mae's external audits contravened requirements for external audits established by OFHEO. The failure of KPMG to detect and disclose the serious weaknesses in policies, procedures, systems, and controls in Fannie Mae's financial accounting and reporting, coupled with the failure of the board of Directors to oversee the external auditors properly, contributed to the unsafe and unsound conditions at the Enterprise.
It should be noted that the OFHEO's concerns about "safety and soundness" had absolutely nothing, zero, to do with the creditworthiness of Fannie's loans, or its credit or underwriting standards. These accounting "violations" had virtually nothing to do with the recognition of income, only the timing of such recognition.
Read KPMG's pretty devastating refutation of those allegations (set forth the the securities lawsuit) here.
3) S.E.C. Complaint: In a case alleging securities fraud, you need to lay out all six elements of of the violation in the initial complaint. You need to specify how someone had the requisite scienter, how someone made a material misrepresentation, and how that misrepresentation caused an economic loss.
The S.E.C. alleged all sorts of accounting violations, but almost none of them rose to the level of causing a misrepresentation that was material. If also failed to identify who had scienter.(No individuals were identified, or included as defendants.) The only infraction to have a material impact was the so-called FAS 133 violation. The complaint states:
By failing to comply with the requirements of FAS 133, the Company failed to qualify for hedge accounting. This failure led to the Company publicly issuing materially false and misleading financial statements for the periods covering the first quarter 2001 to the second quarter 2004. The vast majority of the anticipated restatement of at least an $11 billion reduction of previously reported net income is a result of Fannie Mae's improper hedge accounting.
Again, one of the elements is "loss causation." The S.E.C. needed to specify how this misapplication of FAS 133 caused an $11 billion loss, but it failed to do so. Saying that Fannie violated 10(b)(5) doesn't do it, and saying Fannie violated FAS 133 doesn't do it.
And why did Fannie's Board settle the case for $400 million? Because the blame was allocated to the prior management, and because it's bad business to get in a protracted fight with your regulator.
Compared to Fannie Mae's financial statements, the disinformation campaign conducted by Cox and Lockhart was 100 times more misleading. Nowhere, in the press release, their testimony or the complaint would any non-accountant get any idea that a $10.6 billion "loss" represented timing differences, which had washed out over time. Nowhere would anyone get the idea that these mark-to-market adjustments under FAS 133 had already been fully disclosed in the original financial statements, albeit as adjustment to equity, or "comprehensive income," rather than as something shown on the income statement. (See a fuller discussion go here.)
Again, in the real world, in order to understand the annual report of a company like Fannie, you need to have the ability to deconstruct the presentation of numbers to evaluate what's going on.
In open hearings, Senator Robert Bennett got to the heart if the matter, and asked if the "loss" was actually a timing difference. Lockhart artfully threw sand in his face:
SEN. BENNETT: If all of the money was completely lost and would never, ever be seen again, that's one thing. But as some of it's going to be seen in future down --
MR. LOCKHART: Well, I -- you can ask that to Chairman -- I mean, CEO Mudd. But I think the issue is, when they correct the accounting, that those transactions will disappear, basically, because they were not GAAP-compliant. And when they make them GAAP-compliant, they'll put the earnings back where they're supposed to be. So maybe if I can correct that statement a little bit --
SEN. BENNETT: Yeah. But the thing I'm trying to find out is, were there earnings? If they were improperly allocated or improperly appointed -- apportioned, obviously that's not GAAP-compliant, and obviously that falls under --
MR. LOCKHART: Well, as I understand it, that $11 billion restatement is a net number.
SEN. BENNETT: It's a net number? Okay. That's what I'm trying to find out.
MR. LOCKHART: And there's -- the future earnings will be depending on what they do in the future, basically --
SEN. BENNETT: Yeah. Okay.
MR. LOCKHART: -- because they're going to be keeping their books by GAAP, and now that they've lost most of their hedge accounting, we'll see a relatively volatile set of earnings from these companies.
SEN. BENNETT: I see. But that's the point I had not had before. The $11 billion is a net number.
MR. LOCKHART: It's my understanding, Senator.
SEN. BENNETT: I see. Okay.
Do you think anyone in the room got the impression that this "loss" was comprised of timing differences that had already washed out by 2004?
5) Fannie's Restated Financials: So far as I can tell, I may be the only person in America who found it intriguing that, six months after Lockhart and the S.E.C. said that income and capital had been overstated by $10.6 billion, the final numbers showed that, shareholder equity, net income and cash flows had all improved. (See fuller discussion here.)
6) OFHEO Administrative Charges: Lockhart pulled a neat trick. Rather than subject his allegations to the scrutiny of a real court which adhered to procedural due process, he could allege that Raines, Howard and Spencer had committed securities fraud, and make sure that every aspect of the litigation, especially the final outcome, went his way. The D.C. Circuit Court of Appeals declined to consider Raines' request for Lockhart's recusal, and made sure that every court filing was kept under seal. We only know what happened because Judge Leon mentioned the matter in one of his rulings.
To add insult to injury, after Raines requested Lockhart's recusal, Lockhart accused Raines of making improper ex-parte communications with the judge. From the very beginning, the OFHEO made it apparent that it would not disclose any records pertaining to its accounting assessments.
7) Frivolous Motions: Perhaps one of the most suspicious attempts to withhold evidence came from the S.E.C.'s refusal to allow its former Chief Accountant Donald Nicolaisen, to testify about his former finding, presented to Congress on February 9, 2005, that Fannie's interpretation of FAS 133 was out of bounds. At the same time, Walter Schuetze, a former Chief Accountant for the S.E.C., disagreed.
Plaintiffs had hired Harvey Pitt, the former S.E.C. Chairman, who, like Lockhart, felt himself immune from conflicts of interest, as an expert witness to parrot Nicolaisen's assessment. But after he heard that Nicolaisen had been deposed, Pitt refused to continue his testimony and stated that he wished to amend what he said. He simply refused to continue to testify and defiantly walked out of the deposition room.
And as it turned out, plaintiff's attorney's had almost nothing to say about FAS 133 at the hearing to consider motions for summary judgement.
Ya think that maybe the S.E.C. accountant backtracked?
The defendants allege that OFHEO's internal records records show, pretty conclusively, that, in its public positions the agency had been lying all the time.
