Transcript Fannie Mae Hearings

Case 1:04-cv-01639-RJL Document 1048 Filed 09/04/12 Page 1 of 131
UNITED STATES DISTRICT COURT FOR THE DISTRICT OF COLUMBIA
IN RE: FANNIE MAE SECURITIES LITIGATION . . . . . . . . . . . . . . . .
: Docket No. CV04-1639 (RJL) : : June 5, 2012 : 11:00 a.m.
TRANSCRIPT OF MOTIONS HEARING BEFORE THE HONORABLE RICHARD J. LEON UNITED STATES DISTRICT JUDGE APPEARANCES: For the Class Plaintiffs: WILLIAM MARKOVITS JOSEPH DETERS MELANIE CORWIN CHRISTOPHER STOCK PAUL DEMARCO Waite Schneider Bayless & Chesley 1513 Fourth & Vine Tower One West Fourth Street Cincinnati, Ohio 45202 DANIEL S. SOMMERS Cohen Milstein Sellers & Toll, PLLC 1000 New York Avenue, NW Washington, DC 20005
For Fannie Mae:
JEFFREY KILDUFF ROBERT STERN O'Melveny & Myers, LLP 1625 I Street, N.W. Washington, D.C. 20006
For Franklin Raines:
KEVIN DOWNEY, ESQ. ALEX ROMAIN Williams & Connolly, LLP 725 12th Street, N.W. Washington, D.C. 20005
For Leanne Spencer:
DAVID KRAKOFF CHRISTOPHER F. REGAN ESQ. ADAM MILLER Buckley Sandler, LLP 1250 24th Street, N.W. Washington, D.C. 20037 ERIC DELINSKY Zuckerman, Spaeder, LLP 1800 M Street, N.W. Suite 1000 Washington, D.C. 20006
For J. Timothy Howard:
For KPMG:
JOSEPH WARIN SCOTT FINK Gibson, Dunn & Crutcher, LLP 1050 Connecticut Avenue, N.W. Washington, D.C. 20036 JOSEPH ARONICA, ESQ. Duane Morris, LLP 505 9th Street, NW Washington, DC 20004 Kevin Lewis Carl Reed Jessica Thorn Adam Goldstein Evan Stolov Steve Georgian James Goldsmith Steve Carlin PATTY ARTRIP GELS, RMR Official Court Reporter Room 4700-A, U.S. Courthouse Washington, D.C. 20001 (202) 962-0200
For FHFA:
Also Present:
Court Reporter:
Proceedings reported by machine shorthand, transcript produced by computer-aided transcription
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
P R O C E E D I N G S COURTROOM DEPUTY: Calling civil case 04-1639, In Re:
Fannie Mae Securities Litigation. Counsel, please approach the podium and identify yourself for the record. MR. MARKOVITS: Good morning, your Honor, Bill With me
Markovits on behalf of Lead Plaintiffs OPERS and STRS.
at counsel stable are Chris Stock also of the Waite Schneider firm; Kevin Lewis, our technical consultant; Paul DeMarco from Waite Schneider; Joe Deters from Waite Schneider; Melanie Corwin from Waite Schneider and Dan Sommers Cohen Milstein. THE COURT: Welcome, everyone. Thank you.
MR. MARKOVITS: MR. KILDUFF:
Good morning, your Honor, Jeff Kilduff With me here
with O'Melveny & Myers for Defendant Fannie Mae.
today is my partner Rob Stern who will be handling the first argument opposing Plaintiffs' Motion for Summary Judgment and sitting with us at counsel table here today is Vice President Deputy Counsel Evan Stolov. THE COURT: Welcome back. Thank you.
MR. KILDUFF: MR. WARIN:
Good morning, your Honor, Joseph Warin for I am with my partner Scott
the Gibson, Dunn & Crutcher firm.
Fink who will be handling the 133 Motion; our clients James Goldsmith, Steve Carlin and Steve Georgian all in the law department of KPMG are here present as well. Thank you.
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
THE COURT: MR. DOWNEY:
Welcome. Good morning, your Honor, Kevin Downey Alex
from Williams & Connolly for Defendant Frank Raines. Romain also of Williams & Connolly is here as well. THE COURT: MR. DOWNEY: MR. DELINSKY: Welcome. Thank you, your Honor.
Good morning, your Honor, Eric Delinsky
on behalf of Defendant J. Timothy Howard. THE COURT: Good morning. Welcome back.
MR. DELINSKY: MR. KRAKOFF: THE COURT:
Good morning. Good morning, your Honor.
Mr. Krakoff. David Krakoff of Buckley Sandler with my
MR. KRAKOFF: partner -THE COURT:
Like old times, Krakoff. Like old sometimes, yes. We got the video
MR. KRAKOFF: and we got the Elmo. THE COURT:
Not quite as many lawyers over here. Yes, well, we need to fill in that table I am with Chris Regan and Adam Miller
MR. KRAKOFF: over there, your Honor.
from Buckley Sandler on behalf of Leanne G. Spencer. THE COURT: Welcome back. MR. KRAKOFF: THE COURT: Thank you.
I knew you were out there somewhere, Joe. My usual perch. Good morning, Judge, Joe
MR. ARONICA:
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Aronica from Duane Morris on behalf of FHFA as conservative of Fannie Mae. THE COURT: here, Mr. Markovits. Welcome back. Well, I guess everyone is
Are you ready to get rolling? Yes, sir.
MR. MARKOVITS: THE COURT:
As you know, the parties agreed to do
45 minutes a side, but the moving party gets to put aside a certain portion of that 45 minutes for rebuttal. So that's up Usually
to you as to how much you want to use for that purpose. it is split 30/15 or something like that but there is flexibility in the process so you go ahead. chess clock here. MR. MARKOVITS: any unused time? THE COURT: Yes, you can reserve it. Thank you.
I don't have a
If I may your Honor, may I just reserve
You can begin whenever you are ready. Thank you, your Honor. Good morning. May
MR. MARKOVITS:
Bill Markovits on behalf of Lead Plaintiffs OPERS and STRS.
it please the Court, over the next few days, you will be hearing eight Motions for Summary Judgment. THE COURT: That's a record for me. I think it is a record for me as well.
MR. MARKOVITS:
All but one of them, the Motion this morning relate to the voluminous record developed in this case. Now, the Motion this
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
morning, for the purposes of the Motion this morning, we haven't ignored that record. We have acknowledged as Defendants in some
of their Motions do not that the voluminous record, all the depositions, the millions of documents, the battling experts generally create genuine issues of material fact that would preclude Summary Judgment. That's why Plaintiffs in this Motion have concentrated and focused on a subset of the record which is the admissions of Fannie Mae because in its restatement, in its malpractice complaint against KPMG, in its Rudman Report, in the admissions of its experts, and in the facts it cannot and does not dispute, it has admitted all of the elements of liability for a securities violation. We have tried to avoid the he-said, she-said of the record and concentrate on what Fannie Mae has admitted. Now, Fannie Mae in its opposition has attempted to avoid that particular battle ground. It wants to fight over the
entire record and ignore the admissions it has made, and let me start off with a quick example. Slide three, Please.
This is from Fannie Mae's opposition at page 15. Fannie Mae makes this argument. They say: But neither
Plaintiffs nor their expert have ever articulated with any specificity what they contend was wrong about Fannie Mae's application of FAS 133. Fannie Mae has instead been forced to
decipher Plaintiffs' theories from a series of cryptic
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
allegations. Well, first that's untrue. Both Plaintiffs and their
experts as well as the SEC and OFHEO and many others have articulated exactly what they did wrong with respect to FAS 133; and my colleague Mr. Stock will address that a little later this afternoon. THE COURT: Sure. But for the purposes of the Motion and The question here
MR. MARKOVITS:
more importantly that's totally irrelevant. isn't what Plaintiffs say.
The question is what Fannie Mae
says, what Fannie Mae admitted; and it has admitted that it violated FAS 133. It admitted it in its restatement, in its
Rudman Report, in its malpractice complaints against KPMG. Here is what they said in the malpractice Slide four, please. complaint.
This is Plaintiffs' Exhibit 4, the
malpractice complaint they filed against KPMG at paragraph 123 they say: KPMG materially breached its contractual duties by
approving of policies and practices relating to FAS 133 that departed materially from the GAAP. That's a binding admission. They are judicially
estopped from asserting otherwise at this point in time. THE COURT: Now, let's go over this just quickly. The
various admissions that you are referring to, the restatement -MR. MARKOVITS: THE COURT: Yes.
-- right, Rudman Report.
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Yes.
The malpractice complaint. Correct. What was the fourth one?
That's three.
MR. MARKOVITS:
Their own experts' admissions and the
statements of material fact. THE COURT: Okay. Now, virtually all of these occurred
after this lawsuit was filed, right? MR. MARKOVITS: THE COURT: Yes.
Rudman Report certainly did. Yes.
MR. MARKOVITS:
THE COURT: The malpractice complaint, their own experts' statements. All of those -- the restatement, the
restatement postdated the filing of the suit as well did it not? MR. MARKOVITS: THE COURT: Yes, it did.
So if I understand you correctly, you are
saying that notwithstanding this suit having been filed and knowing the consequences potentially of engaging in or putting out, I should say, statements that could be interpreted as admissions, they did it nevertheless? MR. MARKOVITS: That is correct, your Honor. And,
again, with respect to the malpractice complaint in particular, that's a binding admission. They are judicially estopped from
contradicting. That's under the case we cited New Hampshire versus Maine, the Supreme Court case.
10
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 that:
THE COURT:
Um-hmm. Again, Fannie Mae however tries to
MR. MARKOVITS:
avoid that battleground and they try to ignore the admissions. They want to change venue as it were and drag the Plaintiffs and the Court into a dispute about facts they have already admitted. Let me give a few other quick examples. Slide five, please. In their opposition at page 14,
they raise three issues or they note three issues that were raised in Plaintiffs' Motion with regard to FAS 133. One, the
documentation of hedging relationships; two, classification of derivatives; three, assessment of effectiveness.
And then on slide six, please, they argue right after However, Plaintiffs fail to present any meaningful
discussion of any these three requirements much less how Fannie Mae allegedly violated them. Again, the point isn't that Plaintiffs allege that Fannie Mae violated them. The point is that Fannie Mae admitted Let's take a look at
it violated these three requirements. their restatement. Slide seven.
With respect to documentation of hedging relationships, they said in their restatement, which is Exhibit 7 at pages 74 to 75: In other instances hedging relationships were not
properly documented at the inception of the hedge. Let's look at the classification of derivatives. say in their restatement: They
We incorrectly classified derivatives
11
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
as cash flow or fair value hedges for accounting and reporting purposes even though they did not qualify for hedge accounting treatment pursuant to statement of financial accounting standards number 133. Again, that's an admission on their part. The third, assessment of effectiveness. restatement they say: In the
The primary reasons for the loss of hedge
accounting treatment were the improper use of the short-cut method as defined by FAS 133 and inadequate assessments of hedge effectiveness and ineffectiveness measurement both at hedge inception at each recording period thereafter. Those are all admissions they make in their restatement and they made admissions in their malpractice claim. Whatever
positions other Defendants may take, Fannie Mae can't be heard at this point in time in this Motion or any other Motion to take the Motion position that they did not violate FAS 133. The admissions as we talk about come from a number of sources. The source Fannie Mae focuses on in its opposition is They say that that's inadmissible hearsay, It is in
the Rudman Report.
can't be used for the purposes of Summary Judgment. fact admissible. It is not hearsay.
It comes in as an adoptive
admission under Federal Rule of Evidence 801(d)(2)(b). THE COURT: That's the question. MR. MARKOVITS: Well, that's the rub but if you look -Was it adopted? That's the rub part.
12
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
we believe there can be no genuine dispute as to that issue. the fall of 2004 when disclosures of Fannie Mae's fraud were occurring, they engaged
In
special review committee which in turn
hired former Senator Rudman of the Paul Weiss law firm who used the Huron Consulting Group for accounting, and they looked at these accounting issues that had taken place during the class period and they issued a report. On February 23, 2006, Fannie Mae made the Rudman Report publicly available and issued a statement which they then attached to an 8K they filed the next day. Exhibit 8, please. It was on Fannie And in
This statement was a Fannie Mae news release. Mae letterhead.
It was put on the Fannie Mae website.
this release, slide ten, please, this is Plaintiffs' Exhibit 22, in this release Fannie Mae's board chairman at the time Stephen Ashley publicly announces that the board is releasing the Rudman Report. Slide 11, please. He then touts the comprehensiveness of the report saying the board gave Paul Weiss unrestricted authority to take this investigation wherever it led and leave no stone unturned. THE COURT: Now, the investigation was not designed, as
I understand it, to determine whether or not there had been any security fraud conduct on the part of the company or the people running the company; isn't that right? MR. MARKOVITS: That is correct, your Honor. We are not
alleging that the report makes a finding of any securities
13
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
violation. THE COURT: Right. It does make a finding, however of --
In fact, I think Senator Rudman stays clear
of that and clearly said that. MR. MARKOVITS: finding. can. He states clearly these are the
Whatever the authorities wants to do with them, they
It is up to the authorities to decide what to do with them That's what he said.
and lawsuits that are sure to come.
Exhibit 1 to our reply is his testimony before Congress, but you are right. He was clear that we are not looking into whether
there was securities violations and, to clarify because Fannie Mae raises this in its opposition, they suggest, well, the Rudman Report doesn't show securities violations. We are not alleging it alone shows securities violations. It shows elements of a security violation. It is
an admission that there were violations. THE COURT: perspective anyway? What's the practical consequence, from your I mean this is a securities fraud case that This is a
you have brought on behalf of your clients. securities fraud case.
You are claiming on the issue of whether
or not there were violations of FAS 133 you are entitled to Summary Judgment based on this record. What's the practical consequence from your perspective of getting a ruling from this Court consistent with your wishes?
14
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Where does that take you with regard to the remainder of the case? MR. MARKOVITS: Where that takes us is liability will
be established as to Fannie Mae with the exception of the amount of damages, but liability will be established because we believe that through their THE COURT: admissions they have -What, liability for securities fraud? Yes.
Well, now, isn't securities fraud, isn't
an element securities fraud the scienter requirement? MR. MARKOVITS: scienter. THE COURT: Your argument is that a one or more -Yes, an element of securities fraud is
let's put it this way -- one or more violations of FAS 133 equals proof of some kind of securities fraud with all those requirements including scienter? MR. MARKOVITS: No, your Honor. What we are arguing is
that they have admitted the violations in multiple, in multiple respects -THE COURT: Right. -- through their Rudman Report, through
MR. MARKOVITS:
the restatement and most importantly through their malpractice complaint against KPMG. With respect to scienter, we look
primarily to the Rudman Report which is an admission and it is like now scienter is generally --
15
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
THE COURT:
But not an admission of scienter.
By what
you just said a minute ago, you acknowledge and I think accurately I might add, that Senator Rudman was not given the mission and he didn't assume the mission, in fact he specifically said that that wasn't what he was doing, to determine whether or not there had been a violation of the securities regulations. MR. MARKOVITS: Because the Rudman Report doesn't determine whether there is an efficient market, doesn't determine where there is reliance or loss causation or economic loss. THE COURT: Or scienter? It does determine scienter, your Honor.
MR. MARKOVITS: If I may be permitted -THE COURT:
Just start, you know, I want to give you a
chance to develop that argument in a second, but I want to start with before you develop it point me, remind me where in his report Senator Rudman says that he has determined that the company and the people acting on behalf of the company had the kind of scienter necessary for securities fraud. MR. MARKOVITS: All right. I will point you to a
number of those points in the report. THE COURT: Okay. If you go to slide 31, please, Kevin.
MR. MARKOVITS:
This is the Rudman Report Exhibit 21, the executive summary.
16
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 subject.
THE COURT:
Okay. Here is one of their findings and if
MR. MARKOVITS:
you recall the findings were embraced and accepted by Fannie Mae. One of the findings is management accounting practices in
virtually all of the areas we reviewed were not consistent with GAAP and in many instances management was aware of the departures from GAAP. THE COURT: Let me ask you to stop there a second. Yes.
You know, these phrases get thrown around
these briefs a lot and I want to make sure it is clear in my own mind here. Can something be a violation, from your perspective,
can something be a violation of FAS 133, perhaps a minor one, and still be consistent with GAAP or is it per se inconsistent with GAAP to have any violation of FAS 133? MR. MARKOVITS: Well, I will leave that to my
colleagues this afternoon to go into details of that. THE COURT: Oh, but just give me your thinking on the
MR. MARKOVITS:
I believe that in this case there were
clear and specific requirements as Senator Rudman and his group found that were violated and so regardless of whether there may have been other -THE COURT: Violations of GAAP or 133? Violations of 133 and subsequently
MR. MARKOVITS:
17
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
violations of GAAP. THE COURT:
Okay.
And --
But you are not saying under any and all
circumstances any violation of 133 is per se a violation of GAAP? MR. MARKOVITS: No, I am not making a claim that any I am making a claim that these
violation of 133 is per se.
violations were found to be violations of GAAP. THE COURT: Okay. And slide 32, please, Kevin. Again
MR. MARKOVITS:
from the Rudman Report Exhibit 21, this is talking about FAS 133 and it concludes -- it makes a finding: Fannie Mae did not
engage in innocuous practical interpretations or modest deviations from a strict reading of the standard. If you go to slide 33, please. says: A little further on, it
The company's approach deviated from FAS 133 requirements Indeed, the record of our
in numerous and important respects.
review shows that the company's method of hedge accounting conflicted with clear and specific provisions of FAS 133. That's at page 102 to 103 of Exhibit 21. Then if you would go to slide 34, please. Senator
Rudman's report makes conclusions of this nature throughout, but I have just chosen this one. THE COURT: Okay. In this excerpt which is at page 199,
MR. MARKOVITS:
it talks about what was the objective of these violations of FAS
18
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
133 which is getting into scienter.
What was the objective? And
they make a finding that the objective was to avoid both volatility and to avoid the need to change their -- to make complex changes to the company's business model. So avoid
volatility and avoid having to make changes to the company's business model and it goes on to say, it makes a finding: In
order to achieve this result, the company adopted policies that deviated from the requirements of FAS 133. These policies were
established with the knowledge and in some cases active involvement of Howard, Leanne Spencer, Jonathan Boyles and others. THE COURT: So let me ask you to pause there a second.
From your reading of this report, is Senator Rudman saying that that's what happened with the benefit of hindsight 20/20 or is he saying or do you find that the company knew that before it did it, i.e., violated FAS 133, they knew it before they did it but they did it anyway? Does he get into that distinction in his analysis of the facts as he uncovered them? MR. MARKOVITS: He does, your Honor. In fact, it is
clearly the latter that they knew it before they did it and they did it anyway. He a number times, as I say and I believe this
excerpt to some extent shows, he is saying this is why they did it. They wanted to avoid volatility. They wanted to void the
expensive changes to their accounting system so they knowingly
19
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
implemented policies that violated clear and specific provisions of FAS 133. Now, you can't say -- Fannie Mae can't admit, and again we say they adopted and therefore admitted the Rudman Report, they can't admit that we didn't make practical interpretations or innocuous practical interpretations. We violated clear and
specific provisions and this was done with the knowledge of the senior management including Howard and Spencer but we don't have scienter. If they admit that they violated, clearly violated clear and specific provisions of GAAP, that is scienter. establishes scienter. point. THE COURT: question? MR. MARKOVITS: THE COURT: Is what a legal question? I am sorry. Is that a legal question or a factual That
And they can't walk away from it at this
Well, has any Court held anywhere, this
Circuit or any other Circuit for that matter, let alone the Supreme Court, that a conscious violation of FAS 133, an admitted violation of FAS 133 per se constitutes scienter? Has any Court anywhere ever said that? Second Circuit? MR. MARKOVITS: THE COURT: Yes.
Any -Southern District of New York BISYS
MR. MARKOVITS:
case are 397 F. Supp. Second at 448 basically talks about if you
20
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
have a knowing or reckless violation of GAAP, it creates the strong inference of scienter. And there are courts that we
cited in our brief where Summary Judgment has been granted on scienter. SEC versus Platform Wireless 617 F.3d 1072; Fraxil So it has been
versus Johnson 541 F. Supp. 2nd 1127, 1138. done. Courts have found that -THE COURT:
That sounds like if the Court is saying
that it creates a strong inference of scienter, it sounds like the Court is a saying in essence it is a factual issue that the jury has to determine whether or not it in fact constitutes scienter. It is not for a Court as a matter of law to say, Therefore, we have scienter If we
okay, that equals an admission.
established and that issue is now off the table for jury.
go to trial, that issue will not be on the table for the jury. Scienter is established. causation. Now we got to look and see about loss
We have got to look at all these other issues. Actually the Courts we cited in our
MR. MARKOVITS: brief have done that.
There are Courts that will say, look, you He
admitted, the Defendant here essentially admitted scienter.
admitted that he knew what he was doing was wrong and based on that admission scienter is off the table. It is generally, you are right, it is absolutely scienter is almost always a jury issue. It is a question of
fact for the jury, but there are cases and we believe this is one where you have this admission that scienter is a given.
21
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
And when you look at whether -- again, this is an admission. I know there is the Rudman Report, there has been a
dispute about it, but for one, you can look at just the language and -THE COURT: In the Rudman Report? The language in the Rudman -- no, the
MR. MARKOVITS:
language in the statement of the chairman -THE COURT: Okay. -- which was issued on February 23, And the important language is
MR. MARKOVITS:
2006, slide 14, please, Kevin.
where after saying that this is a comprehensive report and here are some of the findings and the findings are disturbing, but the board accepts and embraces the report, its findings and recommendations. THE COURT: Markovits. Now, you have to be candid here, now, Mr.
You know that when he made this statement with this
lawsuit already pending and had been pending for awhile that he is walking a fine line. You know, he didn't use the word
"adopt" obviously, obviously; and I am sure without knowing that he had been counseled not to use the word "adopt." I think
that's probably a fair likelihood that that was the counsel he got along the way. Whether as a matter of law that quote you are just pointing me to constitutes an adoption so that the whole report comes in as an adoptive admission, well, again, that's a --
22
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
MR. MARKOVITS:
Well, your Honor, Fannie Mae admits
itself that under the case law particularly the Quesenbery case -THE COURT: Yes. -- you can have an adoptive admission Here
MR. MARKOVITS:
by either words, conduct or silence or so combination.
these words you couldn't have a stronger manifestation of adoption. They didn't use the magic word adopt, but they They didn't say, well, you know, we are They didn't say we
embraced and accepted.
accepting the report; we don't dispute it.
are just not disputing the report or we embrace and accept it, but we dispute it. They just said we embrace and accept it. stronger language than that. at the conduct. conduct. You can't get
Then what do they do? Let's look
Under the case law, it says you look at the
Did they accept the report? They put the report on They gave it to the SEC. They gave it to the
their website. DOJ.
They gave it to OFHEO.
They had Senator Rudman testify
about the report before Congress. THE COURT: I understand. And --
What year was that again? That was in 2006. So for some strange reason you all
MR. MARKOVITS: THE COURT: '06.
didn't bring this Summary Judgment Motion on this issue six
23
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
years ago which would have taken a lot of discovery if you had won it, would have saved a lot of time, money, effort and energy on the discovery front. If scienter was established by virtue of this adoption, we could have short-cut the discovery proces by a heck of a lot if you had won it back in '06 but you all for whatever reason chose not to do that. MR. MARKOVITS: That's correct, your Honor, and it
wasn't until the actual, the expert depositions which just took place recently that we felt we had all of the elements of the liability, even though you are correct that we could have sought a partial Summary Judgment just on scienter at that point in time. But we believe that we have all of the elements here and If you -- slide 23, Section 10b-5,
that we have them through admissions. please, Kevin.
If you look at the elements of
Rule 10b-5 violation material misrepresentations or omissions, they have admitted to the misrepresentations or omissions. in our statement of material facts from 43 to 64 set out a We
number of their public representations they made during the class period about we GAAP and FAS 133 and 91, and they admit they made those public representations. were false. THE COURT: By the way, did Senator Rudman, remind if They admit that they
you will, did Senator Rudman find in his investigation that these violations, these numerous violations that occurred of FAS
24
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
133, these were done over the objection of the outside accounting firm that was providing advice to Fannie Mae? MR. MARKOVITS: In some cases, yes. In some cases no.
It varied actually by the violation. THE COURT: So they contravened the expressed advice of
their outside accounting firm in some instances? MR. MARKOVITS: In some instances, yes, particularly
with some adjustments that were made where the accounting firm recommended that they not be taken, they went ahead and took them, but there was also the finding in the report that in many cases the outside accounting firm KPMG were aware of the violations as they were occurring so it is not sort of a black or white answer to that. THE COURT: It is more of a gray area. It varies.
Are these characterizable drawing all
inferences favorable to the nonmoving party as differences of opinion as to how to interpret and apply FAS 133 or were they in Senator Rudman's, from Senator Rudman's perspective not even capable of being characterized as differences of opinion between themselves and their outside accounting firm on how to apply FAS 133? Rather, it was, to put it in the vernacular, surreptitious
actions that were being taken without the knowledge of their accounting firm? MR. MARKOVITS: Let me answer that by pointing back to This is from the Rudman Report.
slide 32, Kevin, if I could.
Again, this is talking about FAS 133 and he starts off here:
25
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Fannie Mae did not engage in innocuous practical interpretations or modest deviations from a strict reading of the standard. And then it goes on to explain why. slide 33, he says: And then again on
The approach conflicted with clear and
specific provisions of FAS 133. So if you look at -- those are just a couple examples but throughout the report it is clear that what he is saying and what others have said, OFHEO and the SEC, again these were not subject to interpretation type violations. violations of clear and specific provisions. These were knowing Those were
findings that were made in the Rudman Report which we believe was adopted by words conduct and silence by Fannie Mae. With regard to whether or not the admissions were material or the misrepresentations were material here, there really can be no issue as to that because there was a restatement. We cited in our brief some case law and accounting These are two of the cases we
guidance, slide 27 please, Kevin. cited.
One is SEC versus Kelly of Southern District of New York
from 2009 that in that case said where the fact there was a statement quote, "belies any suggestion that any misstatement or omission was not material." End quote.
And that actually -- case actually quoted an earlier Southern District of Court, the BISYS case, which said pursuant to generally accepted accounting principles previously issued financial statements should be restated only to correct material
26
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
accounting errors.
So the case law is clear that where you have
a restatement, there is materiality. Now, the response of Fannie Mae to that was to just flat out ignore that line of cases. that at all. They did not respond to
The only argument they made was as to materiality,
quantitative materiality as to catchup adjustments under FAS 91; and that argument of quantitative materiality fails in that all the cases they cite if you look for the word "restatement" in them, you won't find them. They have cited no case where there has been a restatement and yet a Court has found that a misrepresentation or omission relating to that restatement was not material. have cited not one case. And it is also ironic that they are bringing up that They
quantitative materiality because in their malpractice complaint against KPMG, one of the factors they faulted KPMG on was a failure to consider qualitative materiality which again will be I am sure delved into in further detail in later Motions, but they simply ignore qualitative materiality. They talk about
quantitative materiality and they ignore that line of cases that says if you have a restatement, you have materiality. They admit the in connection with requirement. believe they admit the scienter requirement. We
On the fraud on
the market reliance or the reliance element, in order to have fraud on the market -- slide 39 please -- the Stoneridge case
27
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
beginning with the basic case and then the Stoneridge case in the Supreme Court -THE COURT: Let me ask you to hold on a second. Going
back to that admitting the scienter requirement -MR. MARKOVITS: THE COURT: Yes.
-- you would agree, would you not, that if
I were to disagree with you on that, then I couldn't grant Summary Judgment? MR. MARKOVITS: THE COURT: Your Honor, yes and no.
It is all or none? No. In fact, could you pull up slide
MR. MARKOVITS: 55, please?
They have recently changed Rule 56 to clarify
what's essentially always been the case but Rule 56 now reads that you can get partial Summary Judgment as basically as to any element. And so if you go down that list of elements for a
securities violation, if you were to find that we -- or that they have admitted all the elements but scienter, you could certainly grant Summary Judgment on all of the elements but scienter. With regard to reliance, there is a fraud on the market presumption of reliance. If you have an efficient market and
public misrepresentations, we have already established they have admitted there are public misrepresentations. As to an
efficient market, our expert Professor Jarrell, did an analysis which came to the conclusion there was an efficient market which
28
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
is fairly obvious actually in the case of Fannie Mae's common stock. None of the six experts including Fannie Mae's experts disputed that analysis there was an efficient market and if you look at the statement of material fact -- slide 40, please -our statement of material fact number 79 begins with: Fannie
Mae's common stock was traded in an efficient market with regard to publicly disclosed information. And they say it is undisputed that Plaintiffs' expert Professor Greg A. Jarrell determined Fannie Mae's common stock was traded in an efficient market. expert also calculated that. They dispute that their
They say he just assumed it and
then they dispute that its options were traded in an efficient market which we never even alleged, but they don't dispute that the common stock was traded in an efficient market. So we have admissions of an efficient market, public misrepresentations. That gives you the reliance. That also
gives you economic loss which we have alleged here and, finally, you have the issue of loss causation. And with regard to loss
causation, again they attempt to switch the battle here and talk about -- they talk at length in their brief about what our expert did with regard to loss causation. We recognize that
there are issues of fact in any expert testimony, but so what we are focusing on is -- what we are focusing on is what their expert did, what their expert admitted.
29
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
They had hired Dr. Alan Kleidon who is an expert and he performed an analysis which they say is an analysis of artificial inflation or an analysis of alternative inflation or alternative damages, but which in fact also establishes loss causation. Let me just go through that quickly and explain how
that is an admission their part. THE COURT: I just want to give you fair warning now,
you have used about, according to my calculation here, about 35 minutes of your 45 minutes. MR. MARKOVITS: THE COURT: I understand, your Honor.
So if you want to have a little time for
rebuttal, just be mindful of that. MR. MARKOVITS: Thank you, your Honor. I just want to
go through this last point which is Dr. Kleidon performed this analysis and he applied a fundamental impact approach what he called. He didn't look at the stock declines on corrective days
which is the typical approach for determining loss causation. He looked at what would the economic impact be to Fannie Mae of revelation of the fraud, and he concluded that that impact would be the additional cost of capital compliance. So slide 47, please, Kevin, this is Exhibit 31 from his deposition. He says: But what I am saying is that there is a
methodology to assess the change in the stock price from the capital compliance issue and that's what I am calculating. If you go to slide 48, please, Kevin, he assumes fraud
30
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
as did our loss causation expert and he says:
All right, I am
going to assume fraud and I am going to calculate what the artificial inflation due to fraud would be. And he calculates That's the
it at 77 cents per share as of September 21, 2004. additional cost of capital compliance.
So it is much less not
surprisingly than our expert calculated at that date, but I think that was part of the purpose of his analysis was to minimize damages and he did so. He said assume fraud. We have
artificial inflation of 77 cents. Then if you look at slide 49, this is also from his report, he says any inflation after October 6, 2004, must be less than 77 cents because it is implausible that the market believed after October 6, 2004 that there was no possibility that Fannie Mae would restate. So what he is saying is I am assuming fraud, I am calculating 77 cents of as September 21, but due to the disclosures that occurred after that, that fraud would dissipate, that inflation would dissipate and when you have -if you are assuming fraud when you have inflation that dissipates because of disclosures, that's loss causation. So he can't get around and Fannie Mae can't get around that their own expert admitted loss causation. It differed on the amount of damages, much smaller amount of damages, but admitted loss causation. And again we believe, your Honor, that
all of the elements -- this is an unusual case -- you have these
31
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
admissions in the Rudman Report, you have a malpractice complaint which usually isn't -- while the case is -- securities case is pending a malpractice complaint against one co-defendant against another auditing codefendant, but we have those here along with the admissions of the experts and we believe that we are entitled to Summary Judgment or partial Summary Judgment with respect to all of those elements. THE COURT: All right. Thank you.
We will take a five-minute
break so that Mr. Stern can get set up, and we will come back and hear his argument and any rebuttal. minutes left based on my clock. (Recess at 11:56 a.m.) (Resumed at 12:02 p.m.) THE COURT: MR. STERN: All right, Mr. Stern. Thank you, your Honor. If I may, your You have got five
See you in a few minutes.
Honor, I would like to hand up -- if I may approach? THE COURT: MR. STERN: Oh, sure. Ready, Patty? Your Honor, Mr. Markovits
argued for 40 minutes and he didn't cite a single piece of deposition testimony or a single document from this case. understand his theory about admissions, but Mr. Markovits doesn't contend that the Rudman Report is a judicial admission and it is not rebuttable. restatement is a judicial THE COURT: He doesn't contend that that the admission that's not rebuttable. I
Did this he depose Mr. Ashley?
32
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
MR. STERN:
Interestingly we are going to get to that,
your Honor, because the Lead Plaintiffs notwithstanding the fact that they took 150 depositions in this case never noticed Mr. Ashley's deposition. THE COURT: It is interesting. Did they depose anyone who was a Board
member at the time of that statement Ashley made to determine whether or not the board considered that statement to be an
adoption on their part of the findings for the purposes of this litigation which was extant? MR. STERN: There was one member of the board who was
deposed in the context of this litigation who was a Board member at the time of the OFHEO report. That was Tom Garrity. He was
not asked the question because I believe he was no longer a member of the board at the time of the Rudman Report. wrong about that. In any event, what I do know is he was not asked that question and he was not asked what Mr. Ashley meant. There were other members of the board deposed in the context of the ERISA litigation. There was a prior member of I may be
the board deposed in the shareholder derivative case, none of whom, noon of whom were asked about Mr. Ashley's statement but as your Honor is aware and we will get to it later we have a declaration, we submitted a declaration from Mr. Ashley. before I get to that -THE COURT: Hold on a second. Just to close the But
33
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
circle, it is your position as I understand it that if for that statement by Ashley to constitute an adoption, the adoption for the purposes of its admission in this litigation, the adoption had to be a decision of the board, not of Mr. Ashley unilaterally? MR. STERN: That's not my position. That's Mr.
Ashley's position and that's Fannie Mae's position and it is the position of the Board of Directors of Fannie Mae, your Honor. THE COURT: Right. So Fannie Mae's position in this
litigation is Ashley could not unilaterally adopt it for purposes of the Rules of Evidence and for its admission in this case, that would have to be a board decision? MR. STERN: THE COURT: board vote on it? MR. STERN: THE COURT: MR. STERN: THE COURT: MR. STERN: Absolutely. And there was no board vote? That's right. Okay. Go ahead. Before I get admissibility of the Paul Absolutely. And there would have have to have been a
Weiss report, and I understand Mr. Markovits spent a long time on that, I first want to focus on the record in this case. THE COURT: MR. STERN: Right. Because these things are not judicial
admissions and they can be rebutted and in fact they have been
34
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
rebutted by the 67 million pages of documents that were produced in this case, by the 150 witnesses who have been deposed over 180 days. The transcripts total tens of thousands of pages and three quarters of a million lines of testimony. bringing the transcripts here. We debated
There would be stacks my height
and in their opening brief the Lead Plaintiffs and their statement of undisputed facts in support of it cited one line, one line of testimony in their moving papers. In all fairness they do cite three lines of expert testimony from Fannie Mae's expert Alan Kleidon out of more than a quarter of a million lines of expert testimony in their opening brief but that's it. And one interesting thing about the Lead Plaintiffs' reliance on the Paul Weiss report as your Honor already noted they could have filed this Motion six years ago, right? The Paul Weiss report is dated February 23, 2006. it on February 24, 2006, but they didn't. They could have filed Instead, they chose
to notice or subpoena more than 150 witnesses presumably we know why. Because they thought when those people raised their right
hand and swore the oath, they would confirm the findings or the opinions in the Rudman Report. But an interesting thing happened. In the context of
this adversarial proceeding with the protections that are afforded to the Defendants under due process and the Federal
35
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Rules of Evidence, every single witness past, present, former employee of Fannie Mae who was involved in the development of these accounting policies every single on testified that they believed the accounting policies complied with GAAP. Every
single one and several of them testified they still believe they comply with GAAP notwithstanding what the chief accountant of the SEC testified or opined. THE COURT: I want to be clear on this. Mr. Markovits
pointed to what he characterized as admissions in the statement that Mr. Ashley made in connection with the Rudman Report accepting the Rudman Report, maybe not adopting although he says adopting it but that the Rudman Report noted numerous violations of FAS 133. That's what he said. Numerous.
And you are contending that a fair review of the depositions that have been taken place in this case indicate that notwithstanding that, the people who are engaged in these violations of FAS 133 all said that their actions were consistent with GAAP? MR. STERN: Your Honor, if I may. Mr. Markovits spent
a lot of time on whether there was a violation of GAAP or not. THE COURT: MR. STERN: Right. Right. That goes to this. That goes to
whether there was a material misrepresentation or omission made by the Defendant, but it is clear and the cases are plentiful that a violation of GAAP, an accounting error and accounting
36
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
restatement is not securities fraud.
In fact, in your Honor's
decision in the Evergreen case, your Honor noted that if an accounting error by itself even a large one were sufficient to qualify as fraud, it would eviscerate the entire scienter
requirement and let's be clear. This accounting error or the accounting errors that Mr. Markovits contends Fannie Mae made with respect to FAS 133 are just that. They are an accounting treatment that Fannie Mae
determined subsequently and in consultation with the chief accountant of the SEC to reverse. It doesn't speak anything to
what the people involved in making those judgments at the time knew, thought, intended and meant. And let's be clear. The factual record, and you are
going to hear from several of the witnesses in this case, shows they all believed it was GAAP at the time. You asked Mr. The
Markovits whether it was over the objection of KPMG. development of that policy was with the expertise in consultation with KPMG.
And as you will see later, the policy Fannie Mae turned
itself was shown to the Federal Government.
the policy over to its primary regulator OFHEO and it gave a copy of the policy to the Government Accounting Office. simply is not the stuff of fraud. But not surprisingly given that factual record Mr. Markovits and the Plaintiffs are running pretty far and pretty fast from the record in favor of rhetoric and hyperbole. What I This
37
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
want to do and what I would like to spend the balance of my doing is showing what the facts developed in case establish. Mr. Markovits said over and over FAS 133, large restatement equals fraud. In fact, he said I think it was But --
presumptively fraud or something like that. THE COURT: MR. STERN: THE COURT: You disagree on that? Vehemently, your Honor. To say the least.
Now, I asked him and I
will ask you the same question:
Were you able to find any cases
anywhere where a Court said just because you got a violation of FAS 133 doesn't necessarily mean that that constitutes some kind of scienter or some kind of securities fraud? MR. STERN: We are not aware of a case specifically
that dealt with 133 but the cases are plentiful that says an accounting error, a violation of GAAP without more is not securities fraud. THE COURT: Fine. So a violation of GAAP, maybe not FAS
133, but at least GAAP violations don't necessarily equal securities fraud? MR. STERN: Right. But the GAAP violation, just to
stay with the elements of the claim, the GAAP violation only goes to whether the financial statements of a company were materially misstated. It doesn't speak to whether the
accounting treatment, right, the accounting judgments made were made with scienter.
38
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Let's be clear.
The Supreme Court in Merck says
scienter is an important and essential element of the claim. THE COURT: MR. STERN: it is intent. Yes. The Supreme Court says scienter is intent, It is not recklessness.
It is not negligence.
You heard Mr. Markovits say -- spend an awful lot of time talking about the complaint against KPMG. based standard. It is a malpractice case. intentional standard. THE COURT: But for scienter you could have a situation That's a negligence It is not an
with extreme recklessness, could you not? MR. STERN: The D.C. Circuit in Steadman has held,
right, that the intent, the intent requirement could be satisfied by extreme recklessness, but let's be clear. It has
to be such a departure from the standards of ordinary care that were so obvious that the actor must have been aware of it. That's more than just recklessness. It is intent.
In this case, it would mean that the internal and external accounts at Fannie Mae would have had to do something to ensure that the accounting was -- would have had to do nothing to even try to comply with GAAP and it would it would mean that senior management with Mr. Raines and Mr. Howard who
weren't accountants would have had to know that the accountants were doing nothing to comply with GAAP and they do nothing about it. As you will see, those aren't the facts here.
39
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
THE COURT:
Well, did the facts uncover any situations
where a memo was written by KPMG to the senior management Mr. Raines, Howard and Spencer, whatever saying, you know, you can't do this and, if you do this, you will not only be in violation of GAAP but it could even be fraud? MR. STERN: THE COURT: uncovered? MR. STERN: THE COURT: MR. STERN: No, absolutely not. All right. So, your Honor, what do the Plaintiffs do No. There is nothing of that kind that was
when they are confronted with a voluminous factual record in this case that is the antithesis of scienter? They basically pull out the Rudman Report, right, they dust it off, they make some changes and they file it against Fannie Mae as their Summary Judgment Motion. That's what they have done here.
But more than six years of discovery and evidence has taken place, and I am about to show your Honor what that record shows. So let's talk about the actual evidence in this case. THE COURT: MR. STERN: All right. First, let's talk about this case really
is -- Mr. Markovits spent a lot all time on it -- this case really is all about FAS 133 because as your Honor will see this is a bar chart of Fannie Mae's restatement. Okay. These are What
aggregated up during the course of the restatement period.
40
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
you see here is Fannie Mae's misapplication of FAS 133 reduced income over the restatement period by $9.8 billion. explain why that number is what it is. We will
All the other accounting
errors that he mentioned combined increased Fannie Mae's income by $3.6 billion resulting in a total net restatement the reduction of $6.2 billion that you have heard talked about over these eight years. So the case really is all about Fannie Mae's It is Fannie Mae's accounting for 133 that
accounting for 133.
drives the restatement. All you need to know about FAS 133 are two things. concerned accounting for financial instruments known as derivatives that Fannie Mae used to manage risks from changes in interest rates and, second, it is the one of if not the most complicated and misunderstood accounting pronouncements ever. THE COURT: It is kind of like the accounting against perpetuity. It
equivalent of the rule MR. STERN: THE COURT:
It is exactly like that, your Honor. You know, I remember when I was in law
school they used to say, well, you know, we are going to try to teach you about this, but the truth of the matter is no one really understands it. MR. STERN: The good news is you probably don't need to
know it for purposes of what you do today so it is all good. Let me elaborate briefly on this because it is important to
41
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
understand why it is not $9.8 billion and it is important to understand why it is not fraudulent. As the Court is aware, Fannie Mae is an enormous financial institution and it has a unique Government mission. It is basically in the business of buying mortgages from lenders and mortgage originators. In fact, during the class period
covering this litigation, Fannie Mae was the largest, the largest provider of liquidity in the residential mortgage market in the country with a balance sheet in excess of a trillion dollars, a trillion dollar balance sheet. But let's be clear. Fannie Mae doesn't originate or It buys it from a
lend the mortgage directly to the homeowner.
secondary market from the bank or financial institution that does and then Fannie Mae gives that banking financial some money and that financial institution can turn around and lend more mortgages. Fannie Mae funds all of this by issuing debt to Wall
Street or the capital markets and it makes money on the spread. If the income that it receives from mortgages is greater than its borrowing costs, it makes money; but as you can imagine, as
you can imagine, there is a significant risk if interest rates move because most of the mortgages Fannie Mae holds are 30-year fixed mortgages and if interest rates rise and then all of a sudden Fannie Mae's borrowing costs are higher than the income it is receiving on the mortgage it is holding. So it goes out in the market and it buys insurance, a
42
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
form of insurance, if you will. And the insurance it buys are financial instruments known as derivatives, and it is the accounting for these Derivatives. As I
derivatives that FAS 133 applies to.
mentioned, Fannie Mae's balance sheet is a trillion dollars so during the class period, Fannie Mae had to enter into 30,000 derivative transactions to protect against the risk of changes in interest rates. So as your Honor can imagine, if one applies an accounting standard or policy consistently 30,000 times and the policy is subsequently determined to be a mistake or did not comply with GAAP, the resulting number is big. And it is not
big because of it was fraud and it is not big because you intentionally got it wrong. the compounding effect. So the size of Fannie Mae's restatement speaks nothing of intent or fraud. It actually speaks of consistency. And It is big because of consistency in
while you are going to hear a lot more about the propriety of Fannie Mae's accounting under 133 later today from Mr. Fink, there are four undisputed facts that defeat Mr. Markovits' Motion and actually support Defendants' Motion for Summary Judgment on 133. The first of those is that Fannie Mae spent five years and millions of dollars developing its FAS 133 policy before The standard became
the standard ever became effective.
43
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
effective in 2001 and in 1996 Fannie Mae put together a team to do that. Second -THE COURT: When you say developing now, are you
talking about a group of internal accountants/economists who came up with the way to do this; or are we talking about also working with outside accounting firms like KPMG? MR. STERN: We will get to this. I am going to come
back, but we are talking about internally accountants, computer systems people, internal auditors, lawyers, executives, externally KPMG and the auditors, including KPMG's specialists in accounting for derivatives. OFHEO and the GAO. And also as I mentioned earlier,
Prior to the implementation of the policy as
you will see later Fannie Mae gave its 133 policy to the Federal Government. That's fact one.
Fact two, every fact witness testified that Fannie Mae made a good faith attempt to implement the standard and you are going to hear later from Mr. Fink that now the SEC thinks Fannie Mae's implementation of 133 is reasonable and right. THE COURT: MR. STERN: In hindsight? In hindsight. Third, as I mentioned,
Fannie Mae was transparent to everybody with its 133 accounting and the development of the policy internally its auditor its Government regulator. THE COURT: So there weren't in the discovery process, and
at least from your perspective, there weren't any memos that
44
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
were unturned or e-mails that were unturned in which it was demonstrated that accountants or officials within Fannie Mae were trying to surreptitiously avoid applying the FAS 133 policy that they had developed? MR. STERN: to -THE COURT: MR. STERN: none of it. No smoking gun, so to speak? No smoking gun, no smoke filled backroom, In fact, your No. And, in fact, your Honor, I am going
It was all out in the light of day.
Honor, I am going to go show you that the quote we saw from the Rudman Report about known departures from GAAP, I am going to show you the one memo that came from too so we can talk about that. THE COURT: MR. STERN: Okay. And finally, Plaintiffs own experts concede
that once Fannie Mae adopted and implemented 133, it followed its own policy during the entire class period. This is not a
situation where Fannie Mae wrote a policy and then went off script. You will see from Plaintiffs own experts they conceded
Fannie Mae followed the policy it wrote. And let's take each of these in turn now. First,
Plaintiffs' experts concede that Fannie Mae spent years implementing FAS 133. On the left, we have an excerpt from That's Plaintiffs' FAS 133 Fannie Mae's the
expert report of John Barron. expert.
As you can see, Mr. Barron says:
45
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
preparation for the implementation of FAS 133 began approximately five years prior to the effective date of the standard. And when Plaintiffs' audit expert Robert Berliner was Now you would agree that KPMG's
deposed, he was asked question:
pre-implementation work on Fannie Mae's FAS 133 implementation -THE COURT: MR. STERN: that Fannie Mae's Go slower. I am sorry, Patty. Now, you would agree
pre-implementation work on Fannie Mae's FAS
133 implementation span a number of years, correct? Answer: Yes. As your Honor asked how that implementation and policy was developed, I mentioned it was an interdisciplinary team of internal and external accountants, economists, computer systems people, lawyers, businessmen, KPMG. This is Fannie Mae's FAS 133 policy. THE COURT: MR. STERN: Um-hum. Now, I am not asking you to read it, your This is the product of it. May I approach?
Honor, and I am certainly -THE COURT: MR. STERN: I hope not. -- and I am certainly not asking you to
understand it because after 6 or 8 years, whatever we have been at it, I couldn't testify that I do, but I would like you to flip through it and what you are going to see is this policy documents the transactions, 65 transactions that Fannie Mae
46
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
regularly uses to run its business.
It provides diagrams about
how the cash flows are going to work and it provides the purported or proposed accounting for each of those transactions. This is called the Derivatives Accounting Guidelines and it is colloquially referred to sometimes as the DAG within and outside of Fannie Mae. THE COURT: So this is the policy that would be used as
it relates to each of those 30,000 derivative transactions? MR. STERN: Kinds, buckets, broad buckets. Right? So
not each individual transaction but the kind of business transactions in which Fannie Mae engages, this is the proposed accounting treatment for all of them. that this is the policy. And there is no dispute
Plaintiffs will concede it.
There is also no dispute to the second fact that everything KPMG witnessed who was involved in the development of this policy testified -- who was deposed in case has testified they believed at the time it complied with GAAP and many of them still believe it. But don't take my word for it. Watch and
listen to Jonathan Boyles.
He was a Senior Vice President for
financial standards and the head of Fannie Mae's accounting policy, developing the accounting policy. Your Honor would note he is not a Defendant in this case and at the time he was deposed he was not even employed by Fannie Mae any longer. In advance, I will tell your Honor that in the interest
47
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
of brevity we have made cuts to the video, but the transcripts are in the record. (Whereupon, the videotape was played.) MR. STERN: Your Honor, Mr. Boyles is such an expert in
accounting for derivatives that when the FASB, the Financial Accounting Standards Board, has a question with respect to how accounting for derivatives could have an impact on companies, they would call him and they would ask him questions; and that's -- Mr. Boyles was the internal expert at Fannie Mae on the development of this policy. He was chairman and head of the He believed
implementation group and you just heard from him. the accounting policy complied with GAAP. But it was not just Mr. Boyles.
Let's be clear.
You
will see here I have attached a memo dated January 31, 2001, where Fannie Mae, Mr. Boyles, circulates this internally to all those distributees at the bottom of the memo and you will see -I will pull them out for you. These are the ones who were Not a single one of them has
deposed in this case, 16 of them.
testified they believed this policy violated GAAP, not one. And then see the 17th entry there KPMG, that's not a single person, right. As you can imagine a couple people from
KPMG were deposed in this case. THE COURT: MR. STERN: complied with GAAP. I would think. And they all said they believed the policy In fact, after the OFHEO report was issued
48
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
in September 2004, you might recall that Fannie Mae took the issue to the chairman, the chief accountant of the SEC. KPMG
signed a letter with Fannie Mae explaining why after OFHEO's criticisms they believed the accounting complied with GAAP. THE COURT: Report? MR. STERN: THE COURT: MR. STERN: How does what square with the Rudman? The point you are going over here. It summarily defeats any inference of Now, how does this square with the Rudman
scienter that you could -- I mentioned, your Honor, before the Rudman Report and the restatement addressed whether there was a misrepresentation and whether there was a reliance upon that misrepresentation. As Mr. Markovits -- as you asked Mr.
Markovits whether the Rudman speaks to scienter, and he showed you a couple of conclusions that I think you noted were at best ambiguous with respect to whether there was scienter -THE COURT: I think he said, I am trying to do this
from memory now, I think Mr. Markovits said that Senator Rudman in his report pointed out and then, of course, the company accepted this when Ashley did his statement that the violations of FAS 133 were also violations of GAAP. MR. STERN: That's true, but there were not violations The scienter
that were made with the intent to deceive. requirement is with the intent to deceive. THE COURT: Right.
49
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
MR. STERN:
So an innocent mistake of GAAP, an innocent Your Honor noted that in
error of GAAP is not securities fraud. the Evergreen decision. THE COURT: MR. STERN: I know.
And the cases are plentiful.
So the key
issue here with respect to 133 is there is no evidence, no evidence of any intent to deceive. When you asked me about
smoking gun document, right, and I replied not only is there no smoking gun document, there is no smoke filled backroom, no -there is no evidence of any intent to deceive because to my next point you don't deceive in the light of day. And not only did Fannie Mae develop this policy, it shared the policy with its primary Federal regulator, OFHEO. Again, don't take my word for it. Listen to what Ms. Kvartunas,
OFHEO's market risk examination manager in charge of reviewing Fannie Mae's FAS 133 at the time testified to under oath. (Whereupon, the videotape was played.) MR. STERN: It wasn't just OFHEO. As Mr. Boyles
testified, Fannie Mae gave a copy of the DAG to the Government Accounting Office as well. (Whereupon, the videotape was played.) MR. STERN: Your Honor, given your accounting policy to
the Federal Government before you employ it or implement it is just not the stuff of fraud. Now, I will return as I mentioned, Mr. Markovits
50
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
directed you to an excerpt from the Rudman Report where the Rudman Report concluded there had been a known departure from GAAP and there was a colloquy whether that is scienter or not. After all the years of discovery, this is the reference to the known departure from GAAP. But look at the what memo says in While this has been a
context from Mr. Boyles, March 13, 2004.
known departure from strict compliance with GAAP, we allowed the treatment because, from an economic taken point, the analysis showed it produced an inconsequential difference. In approving
this policy we stated in our hedge guidelines that we would test the hypothesis that ineffectiveness was immaterial. of hedges in 2001 and 2002 confirmed our belief. So what Mr. Boyles is saying here at the time is while it might be a known departure, it is immaterial. And he was Our tests
asked, as you can imagine, he was asked about this document in discovery. Here is what he said.
(Whereupon, the videotape was played.) A. MR. STERN: That's the reference from behind tab 31.
That memo and that's the testimony that shows there is no scienter there. There is no attempt to hide anything.
Mr. Markovits also showed you behind tab 33 an excerpt from the Rudman Report that referenced Mr. Howard and Ms. Spencer; but if you look at the sentence carefully, all it says is that the policies were developed with their input, with their knowledge. No where in there are you going to find a reference
51
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
that they believed the policies weren't GAAP, knew the policies weren't GAAP, intended to violate GAAP. there because it is just not true. Finally, the last point I would like to make is that all the transparency in the development of the policy Lead Plaintiffs experts concede that Fannie Mae then followed it they didn't disregard it. During his deposition FAS -- Plaintiffs' I believe Fannie Mae Plaintiffs' auditing Paul Weiss doesn't go
FAS 133 expert John Barron Answer:
implemented and followed their policies. expert Robert Berliner. Question:
And you would agree with
Mr. Barron that Fannie Mae complied with its own interpretations? of 133. Answer: The question was had asked in the connection Yes. Fannie Mae spent It got the
So there was no dispute, your Honor.
years and millions of dollars implementing a policy.
best and brightest assembled they could, they served the policy with the Federal Government and they followed it. simply not the stuff of fraud. broad daylight. This is
One doesn't commit fraud in
One certainly doesn't go to the Federal I am going to commit fraud and then
Government and say here how do it. THE COURT:
So what's the relationship between that
reality as you see it and the fact that they had to do the restatement they had to do for $6 billion? None? MR. STERN: I will get -- let me say it this way, your
52
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Honor.
For a company like Fannie Mae, accounting isn't two plus It is much more akin to what we do as lawyers
two equals four.
applying Generally Accepted Accounting Principles, right, principles to concrete business transactions and determining how those principles should be applied. And so to use an analogy -- before I use the analogy, let me just -- there is no dispute that different accountants operating in good faith can look at the same transaction and reach different conclusions with respect to how those principles should be applied and, to draw an analogy, it wouldn't be that much different from how judges could look at an issue and reach different conclusions. So, for instance, if I came to your Honor in a criminal trial and filed a Motion in limine to excluded evidence under 404(b), that Motion might be granted. If I walked next door to
Judge Walton and I filed the same Motion in Judge Walton's courtroom, it might be denied. For it to be scienter, it would
have to be that one of you was right and the other was so insane that no reasonable Judge could make that ruling because that is what the extreme recklessness standard is. It is not two different judges disagreeing. It not negligence. It is one has to be
so beyond the pale that no reasonable Judge could reach this conclusion. And the answer how you reconcile these two realities with respect to the restatement of FAS 133 on the one hand and
53
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
the other absence of any evidence of scienter on the other is that Don Nicolaisen as Chief Head Accountant of the SEC when he was there said Fannie Mae's interpretation didn't comply with GAAP. So Fannie Mae changed the interpretation. Now, you are going to hear later today from Don Micolaisen and what he meant by that but let's be clear. just a difference of judgment. It is
It is just as you asked Mr.
Markovits, it is two accountants reaching a difference of opinion as to how you apply that standard. Mr. Markovits also noted that Fannie Mae used its 133 accounting to smooth earnings. was. That's what he said the purpose
This chart the red dotted line is Fannie Mae's GAAP You will notice that the
earnings during the class period.
spike up in the third quarter of '01 pretty dramatic, almost a dollar and it spikes back down; and then the second quarter of '03 it spikes and then it spikes back down. If Fannie Mae was
using its FAS 133 accounting to smooth its earnings, pretty unsuccessful at doing it. The blue line that we superimposed is an assumed three percent growth quarter of a quarter or 12 percent year over year which is what Plaintiffs allege Fannie Mae was smoothing too. THE COURT: Now, Plaintiffs' allegation though that it
was being used for smoothing purposes is based on whose testimony? MR. STERN: It is based on a document early on prior to
54
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
the implementation where Fannie Mae said in disclosing it to its accountants, Government, everybody else that its implementation was designed to achieve predictable earnings and to eliminate unnecessary volatility because let's be clear. There is no
debate about the economics of these derivative transactions. You are not going to hear Mr. Markovits tell you that they didn't in fact work economically the way insurance was supposed to and mitigate the risk of the economics. You are going to hear Mr. Fink tell you later today that the economics of those transactions were in fact reflected on the financial statements during the relevant period. going to hear all of that. You are
So this is not about whether these The only question is how they
derivatives economically worked.
get recorded on the financial statements at any point in time. THE COURT: So there was no one in their deposition, no
former senior official in the company or board member testified, if I understand you correctly, yes, we did this to smooth out earnings? MR. STERN: No. In fact, I am going to let you hear The only other, if I
from the senior executives at the and.
might, your Honor, the only other accounting error that we talked about and that could even cause Plaintiffs' loss because it was corrected during the class period is FAS 91 that you have heard a little bit about that early on. All of the other accounting errors that Mr. Markovits mentioned weren't corrected
55
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
until the restatement 6 years later after the class period and Plaintiffs don't even allege that somehow they could have caused any of the injury. So if I might just briefly a little bit of background on FAS 91. As I mentioned earlier, Fannie Mae is in the
business of buying mortgages and often when Fannie Mae buys a mortgage it does so at a price that's a little bit above or a little bit below the face of the mortgage so hypothetically if a mortgage were a $100,000 mortgage, 30-year fixed at five percent and interest rates moved down to four and half or up to five and a half, Fannie Mae may pay a little bit more or a little bit less depending upon whether that mortgage is more or less valuable today as a result of interest rates. And all you need to know about FAS 91 is it is the accounting policy that requires Fannie Mae to book the additional little premium or discount that it pays for that mortgage when it acquires it, and the accounting policy requires Fannie Mae to book that over the expected life of the mortgage, however it estimates that. And as you can imagine, estimating
the expected life of a mortgage is not an easy task because although the vast majority of mortgages Fannie Mae purchased were 30-year fixed mortgages, few mortgages go 30 years. So, for example, if you assume your Honor has a 30-year fixed mortgage, there is a chance that in a year or 2, 3, 4 interests rates my fall and you may choose to refinance.
56
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Alternatively you could decide to retire to Cape Cod, the Cayman Islands. THE COURT: MR. STERN: 30 years. Not on a Judge's salary.
Bermuda,
That's for sure.
Either way your mortgage isn't going As you can imagine, Fannie
It is going to pre-pay.
estimating the expected life of one mortgage is hard.
Mae has to estimate the expected life of all the mortgages it buys, tons and tons of them. And so the result understandably requires a lot of management judgment and is necessarily even imprecise, but Fannie Mae employed computer systems and a special model and a whole bunch of complicated rate paths to estimate that scenario to come up with the best estimate it could, but the estimate is still that, it is an estimate. And so Fannie Mae with the concurrence of KPMG decided that whatever number the computer system spit out within a reasonable small range plus or minus one percent, that estimate would be reasonable. precision threshold. It is referred to in the documents as the And as you can imagine, the precision
threshold was driven largely because of the imprecise nature of the accounting required and the nature of Fannie Mae's business. It is Fannie Mae's use of this precision threshold that the Plaintiffs claim violates GAAP and supports the securities fraud violation, but like 133 Plaintiffs can't base a securities fraud claim on our misapplication of 91 either because as with
57
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
FAS 133, the employees at Fannie Mae who are involved in the development of that policy have testified under oath they believe it complied with GAAP at the time. Plaintiffs' experts have conceded that the application of FAS 91 requires extensive judgment. are making estimates. As you can imagine, you
Third, Plaintiffs' experts agree that the
precision threshold, the outer boundaries of that precision threshold were immaterial to Fannie Mae's financial statements plus or minus one percent was immaterial; and you will see that. Finally, Fannie Mae's application of FAS 91 in the fourth quarter of 1998 to the extent relevant is obviously barred by the statute of repose. THE COURT: MR. STERN: THE COURT: I would ask you to back up to number three. Sure. When you say that the Plaintiffs' experts
say that it was immaterial to the financial statements, were they opining that, if I understand this correctly, were they opining that plus or minus one percent wouldn't be enough if known publicly to the stock purchasing public to make a difference as to whether to buy or sell Fannie Mae shares? MR. STERN: THE COURT: MR. STERN: Yes. That's basically what they were saying? The quantitative -- if you converted the
plus or minus one percent, and I will get to that in a second, into dollars during the class period, it would be roughly
58
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
$100 million.
I understand that sounds like a really large
number, okay, but as I mentioned earlier, Fannie Mae had a trillion dollar balance sheet and in the years during the class period was earning billions of dollars. So while $100 million may seem like a lot, that would be roughly the precision threshold. What you are going to hear So if
is Plaintiffs' experts say $135 million is immaterial.
$135 million is immaterial, then $100 million is immaterial. THE COURT: MR. STERN: Okay. Your Honor, I started with the notion that
the people involved in the development of Fannie Mae's approach to FAS 91 believed in good faith it complied with GAAP. Ms. Pennewell. This is
Janet Pennewell was the Senior Vice President of She was the senior executive
Financial Reporting and Planning.
at Fannie Mae charged with the development of Fannie Mae's FAS 91 approach and the implementation on the books. Here is what Ms. Pennewell said during her deposition. (Whereupon, the videotape was MR. STERN: played.)
Second, I mentioned to your Honor that it
is undisputed that the implementation requires extensive management judgment. Plaintiffs' FAS 91 expert Ms. Fierstein I am sorry. When
testified that $135 million was immaterial.
she was asked if there was a prescription for this, she testified there is not. As did Mr. Berliner. Extensive
management judgment they both said.
59
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
And, finally, as I mentioned to you when they were asked whether the precision threshold was material, they both testified that $135 million was immaterial. is immaterial, $100 million can't be. Lastly, your Honor, I would like to return to where I started, the Paul Weiss report. Mr. Markovits spent a lot of So if $135 million
time, you asked about it and, as I mentioned to you, they deposed 150 witnesses and they never deposed Mr. Ashley to ask him what he meant by the statement. That speaks volumes. But
his declaration speaks even louder because in his declaration he said I did not adopt for myself or the board the factual findings set forth in the report. He goes on to make the point that you made which is it would have required full board approval. And he also says that
the board specifically directed Fannie Mae to contest liability in this case when the lawsuits were first filed, after Paul Weiss was hired, throughout Paul Weiss's investigation and after the report was issued. It is simply not an adoptive admission. But even if it
is, as I mentioned before, it is more than rebutted by all the evidence I just showed you. And I would like to close by
letting your Honor hear from just a couple more of the senior executives at Fannie Mae because the Plaintiffs allege that this is a financial fraud, that Fannie Mae intentionally misrepresented its financials to the public. It knowingly
60
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
misapplied GAAP. I am going to let you hear from all the senior executives what they meant and what they believed at the time. You are going to hear from Mr. Boyles again who is in charge of the development of the accounting policy. You are going to
hear from Ms. Pennewell who is in charge of implementing the policies. You are going to hear from Ms. Spencer who was the controller. You are going to hear from Mr. Howard the CFO, and
you are going to hear from Ms. Kappler, the General Counsel who is head of the disclosure committee and who was in charge of ensuring that the processes used to develop the disclosures were robust. You are going to hear from Mr. Rajappa the head of
internal audit and lastly you are going to hear from Mr. Serock. Mr. -THE COURT: How long is all that going to take? I think it is three
MR. STERN: 2 minutes, 3 minutes. minutes and 6 seconds. THE COURT: MR. STERN: THE COURT: MR. STERN:
You had me worried there. No chance. No chance.
I will give Markovits two extra minutes. Mr. Serock, the engagement partner of KPMG,
he was guy when the financial statements got issued and KPMG issues a clean audit opinion saying they fairly present, he is the guy who has to sign that, who has to sign off on that. are going to hear from him as well. You
61
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 further.
THE COURT:
All right.
(Whereupon, the videotape was played.) MR. STERN: Thank you, your Honor. I have nothing
THE COURT: have seven minutes.
Thank you, sir.
Mr. Markovits, you can
MR. MARKOVITS:
Thank you, your Honor.
Your Honor, if
a securities case could be dismissed because the participants in the knowing violations claim they knew nothing of the violations, we would have no securities cases. It hardly is
shocking that all of these people testified that they knew nothing of -- or were not aware of any violations of GAAP. That
is directly contrary to what Fannie Mae admitted in its Rudman Report. Let's go back to its admissions. In Rudman, in the malpractice complaint, the restatement it is not just FAS 133. It is 30 critical
accounting policies, thousands of internal control violations. That's what they have admitted to, and now they are trying to walk away from that and claim that never happened, we never admitted to it. Mr. Ashley. an authority. This wasn't a frolicking detour on the part of
He didn't go off and issue this statement without This was a statement by Fannie Mae that was
published on their website that said that the board, not Mr. Ashley, embraced and adopted the Rudman Report. said not one negative word. Again, they
62
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 silence.
THE COURT:
Did they say adopt? They said accepted and embraced. They
MR. MARKOVITS:
did not say the magic word adopt, but that doesn't matter; and it doesn't matter whether as a corporation they would have had to have a formal resolution. The case law says we look at words, conduct and
THE COURT:
Hold on a second there.
Mr. Stern just put
up on the Elmo there, I don't know if it was a quote so I will just say he had something up there, you probably recall seeing it as well in which he pointed out that the board specifically directed management to contest the security fraud suit of this case. Okay. He represented that that that was a board decision
to contest it. Now, I think you would have to agree that a decision to contest the security frauds suit here would be inconsistent with an adoption of a report which you contend on its face would constitute evidence of scienter. MR. MARKOVITS: THE COURT: Would it not?
Not at all, your Honor.
Isn't that inconsistent? I don't see that inconsistency because
MR. MARKOVITS:
it is clear that if you look at Senator Rudman's before Congress that what they were saying, that what he was saying to Congress and what Fannie Mae was saying is we made all these mistakes, the bad people are gone including Mr. Boyles, by the way, who
63
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
testified.
He was let go because the Rudman Report found that
he had knowingly violated clear and specific GAAP provisions. Bad people are gone. they sent. They could contest the securities complaint because of loss causation, damages, reliance, whatever else; but the Rudman Report which they embraced and accepted and therefore adopted clearly said that they were both these misrepresentations and that they were made knowingly. Let me turn quickly to a few of them that dealt with FAS 91. Slide 36, please. Exhibit 21, management was well We are moving forward. That's the message
aware of the requirements of FAS 91 as it developed the policy. A little lower down: Management considered the prospective
treatment of catchup notwithstanding its awareness that it did not conform with GAAP. Slide 37. Finally we conclude -- this is a finding --
that Spencer and Howard concealed the true purpose of the amortization policy and the manner which it was implemented from the board. That shows both scienter, and it shows a lack of Let's look at this question of transparency for a
transparency. second.
Slide 51. Rudman who is hired -THE COURT: Let me have you back up there. What was
the amortization. MR. MARKOVITS: That's FAS 91.
64
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 touch --
THE COURT:
Okay. I am sorry, your Honor. Slide 51,
MR. MARKOVITS: Rudman Report Exhibit 21:
The information that management
provided to the board of directors with respect to accounting, financial reporting, and internal audit issues incomplete and at times misleading. generally was Based on our
And slide 52.
interviews and the documentary record it would be incorrect to assume that the FASB had a significant appreciation of the facts behind the company's accounting policies surrounding FAS 133. The evidence will show that there wasn't this transparency that they claimed. The evidence will show that
although FAS 133 may be complicated in some respects, there were clear violations of clear and specific provisions which OFHEO found, which the SEC found, and which Fannie Mae's own investigators found; and they found it with regard to FAS 133, FAS 91, and these dozens of other critical accounting policies. These were all material violations and let me just
THE COURT:
Well, now he is making that finding,
Senator Rudman, he is making that finding in hindsight, right? MR. MARKOVITS: THE COURT: Yes. Right.
He is not finding -- he did not unearth,
for example, documents or e-mails that showed Fannie Mae officials, if I understand you correctly, Fannie Mae officials consciously saying we are going to do this, this, this and this
65
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
even though it violates GAAP? MR. MARKOVITS: a very long report. In fact, he did, your Honor, and it is
If you look at the report, he cites to a We mainly cited his findings or conclusion The
number of instances.
based on those instances that are cited in the report.
report is attached as an exhibit to our Motion, but there are a number of cases in the report where he does specifically find that. THE COURT: So it is your understanding of the report,
your recollection of the report that there are specific documents that are referenced in the report in which it is indicated, whether they be e-mails or memos or whatever, an intentional conscious decision by Fannie Mae executives, accountants, whatever, to violate GAAP? MR. MARKOVITS: Yes, your Honor, absolutely. And
that's how he makes his findings -THE COURT: Knowing that it is a violation of GAAP? Knowing that it is a violation of GAAP,
MR. MARKOVITS: yes. THE COURT:
And were there any where they were
countermanding advice from KPMG not to do it and they just countermanded it in violation of GAAP? Did you find any of those? MR. MARKOVITS: Yes. There are a few, and I believe my
colleague Mr. Stock will be discussing them later at a later
66
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
point.
Let me point to slide 36 because this gets directly to
your issue you just raised. THE COURT: All right.
MR. MARKOVITS: Management considered the prospective treatment of catchup notwithstanding its awareness that it did not conform with GAAP. policy. All right. That's the amortization
They are saying they are well aware of the
requirements of FAS 91 and they intentionally violated the requirement in this case. And that's how he reaches his
conclusions as to the intent behind their violations. He looks at the evidence and he had findings, and they admitted and adopted those findings. findings. They did not contest those
Again, when this report came out, did you see
anywhere, have they produced any evidence that anywhere they contested any of the findings or conclusions of Senator Rudman in the report, the report that he spent two years that they paid $62 million for where he interviewed 240 fact witnesses more than double the number of fact witnesses who are interviewed or
who were deposed in this case and closer to the time period with the full cooperation of the company? All of those factors point to the Rudman Report being a reliable piece of evidence; but apart from that, it is an admission on the part of Fannie Mae. And they have to rebut --
it is rebuttable, unlike the malpractice complaint, it is a rebuttable admission but where it says Spencer and Howard
67
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
concealed the true purposes of the amortization policy and the manner in which it was implemented from the board, they produced no evidence rebutting that. THE COURT: Well, I mean it is your Motion. So I mean
you have got to convince the Court that this was adopted by the board and I mean obviously the burden is on you in that regard. MR. MARKOVITS: THE COURT: Absolutely. So you have got to convince
Not on them.
the Court that this was in fact adopted and that, of course, is a legal question -MR. MARKOVITS: That is a legal question. THE COURT: -- as to whether or not it was adopted and
would therefore usable in any future trial that may occur. MR. MARKOVITS: Correct. I would just point out a case There is the And
that sort of resonates in that regard.
Wright-Simmons case versus City of Oklahoma, 155 F.3d 1264. there is an investigative report and a city manager took the
investigative report and said this is the information I have, it seems to be substantiated; and on that basis a Court of Appeals affirmed that in fact that was an adoptive admission. the information I have. It seems to be substantiated. This is
Well, the words and conduct we have here are much stronger than in that case, and what we have here were clear violations as found by Rudman and as reflected in the record. We will get to the record evidence later. What we are pointing
68
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
out here was we have admissions by Fannie Mae.
They are
unrebutted that entitle us to Summary Judgement, partial Summary Judgement as to the elements. THE COURT: One last point --
You want Summary Judgment, ideally you want
Summary Judgement as to liability. MR. MARKOVITS: elements of liability. THE COURT: That's pretty -It is unusual but again this is an As to liability. So all of the
MR. MARKOVITS: unusual case. THE COURT:
To say the least. This is an unusual case where we do
MR. MARKOVITS:
have the Rudman Report, we have the malpractice complaint which is a binding judicial admission, and we have the admissions that they did both in their statements of material fact and their experts. As to our experts, supposedly agreeing that the precision threshold was immaterial, in fact they said the contrary. They said it was qualitatively material and that is
why it is was in fact in the restatement because there is this issue of qualitative materiality which again Fannie Mae wants to ignore here; but they sued KPMG on the basis of, KPMG, you forgot about qualitative materiality. about it here today as well. THE COURT: All right. They appear to forget
69
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 with us.
Thank you, your Honor. We will take a break and See you
All right.
reconvene the next round of arguments at 2:30 p.m. then. (Recess at 1:05 p.m.) (Resumed at 2.45 p.m.) THE COURT: MR. WARIN: Mr. Warin.
Good afternoon, your Honor. I would like to
reintroduce my partner Scott Fink who will be arguing the Motion this afternoon. At counsel table with him is Steve Georgian who
is a Certified Public Accountant, has been engaged as partner on many significant engagements for KPMG over the many years but who is attached to the law department, is actually assigned to the law department in assisting Mr. Fink in the FAS 133 argument, your Honor. Mr. Fink has been working on this matters for years He has been invisible to the Court, but I can assure
you that he has been deeply and intimately involved as we thought when we induced him to come over and work on it a short case, your Honor. Thank you. THE COURT: trying to say. So he got the short straw is what you are
All right. Good afternoon, your Honor. Welcome. May it please the Court, Scott Fink Gibson,
MR. FINK: THE COURT: MR. FINK:
70
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Dunn & Crutcher representing KPMG in this matter.
But I am
speaking now in support of Defendants' Joint Motion for Summary Judgment on the issue of scienter as to Fannie Mae's accounting for derivatives under FAS 133, the famous 133 that you have heard so much about. Your Honor, I think that the fraud claim here as to FAS 133 is unlike any you are likely ever to see. why I say that. Let me tell you No
There were no fake transactions here.
phoney revenues were recognized. allege that.
The Plaintiffs don't even The liabilities
There were no hidden liabilities.
were right there in the financial statements, and Fannie Mae was not speculating in derivatives unlike some of what you have read about in the newspapers. movements of markets. hedging. Another reason that the fraud claim is so unusual here we think is that the Plaintiffs agree that the hedge accounting policies of Fannie Mae accurately portrayed the economics of the business. That's very unusual, and they have to concede that Fannie Mae was not making bets on the They were
They were not doing that.
because everybody agrees that Fannie Mae was in fact hedging its risks as opposed to speculating. So it is not surprising, your Honor, that the Plaintiffs own experts have testified and agreed that Fannie Mae sought to disclose quote the "true economics" of Fannie Mae's business. That's not disputed.
71
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
In fact, this is how the Plaintiffs summarize what we think is truly an extraordinary claim if we could have the first slide. Fannie Mae with KPMG's guidance and approval designed
and implemented a hedge accounting policy that violated FAS 133. Why? In the service of the company's mission to portray the economics business realities underlying those transactions. So that's the fraud that Fannie Mae told everybody what was really happening in their business? We are not aware, your
Honor, of any case holding that financial statement is false and misleading and fraudulently so when it accurately reflects the economics of the business. not cited any such case. The fraud claim, your Honor, here is unlike any you will ever see we believe for at least two other reasons. First, And certainly the Plaintiffs have
as Mr. Stern explained to you and I won't spend too much time on this, the Defendants methodically wrote the plans that the Plaintiffs say were fraudulent into a playbook transaction by transaction with words and pictures. They then took that
playbook and they handed it over to their primary regulator and the GAO, arms of the Federal Government, to their outside auditor and they widely distributed it within the company. actually put it online within the company. They
So why distribution
of something that the Plaintiffs say the Defendants thought was a fraud? That is as far from the behavior of somebody attempting to commit a fraud as I can possibly imagine.
72
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 the
Secondly, your Honor, as you know all too well, that in 2004, the SEC chief accountant disagreed with Fannie Mae's accounting for 133. THE COURT: No issue. He disagreed.
Did he disagree with the policy or did he
disagree with the application of the policy? MR. FINK: He disagreed with Fannie Mae's This is all about interpretation and he That's what I am here to
interpretation of 133.
disagreed with the interpretation. talk mostly about. THE COURT: MR. FINK: interpretation.
Interpretation and application? Well, the application followed directly from Again, as Mr. Stern pointed out, there is
no real allegation here that they didn't do what they said they were going to do. They put it into a book, they programmed it
into their computers and they did it; and he showed you the concession from the expert that -- I think from two of the experts -- that they followed those policies. So it is really a
question of how did Fannie Mae interpret it and was that interpretation appropriate or not? So in 2004 the SEC chief accountant said he disagreed; but in 2007, the SEC examining this same issue reversed course and accepted the same approach under FAS 133 that had been used by Fannie Mae during the class period. Plaintiffs own expert
when asked about this said, well, the SEC changed its mind. They changed their mind. And it wasn't just the SEC that agreed
73
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
with this approach that Fannie Mae and others had been using historically. Lots of other professionals out in the field were They also had interpreted it the
doing this at the same time. same way Fannie Mae did.
Now, we think that this uncontroverted evidence entitles the Defendants to Summary Judgment on the issue of scienter. THE COURT: MR. FINK: significant. What's the consequence of that? The consequence, your Honor, is very
We believe it would effectively end the case.
There is no question that FAS 133 is the biggest issue in the case and we think the Plaintiffs would be completely and totally unable to show damages or loss causation were 133 to be removed from the case. Now, they might argue to the contrary and, if your Honor were to grant this Motion, presumably we would then have to have some discussion, perhaps some briefing about exactly what is the impact of your having dismissed the 133 claim; but make no mistake we think it would be effectively a case ender and I am not going to make any bones about that that's what we think. Now, we can fight all day and people have been fighting for all these years about who was right or wrong about the accounting. That's not the issue here. The issue here as I That's the
think was discussed in the first Motion is scienter.
74
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
issue, not who was right or who was wrong. They cannot fight with us that reasonable professionals agreed with Fannie Mae's interpretation. that. They cannot fight
We have put in the evidence, and I am going to go through Scienter is not the Latin word for That's not what it means. It
the evidence for you today.
you got the accounting wrong. means fraudulent intent.
That is actual intent to defraud
investors or -- let's put up Steadman, you are going to see Steadman a lot so let's put it up -- or something that is so extremely reckless that may also satisfy the intent requirement. So it has to be actual intent and extreme recklessness may also satisfy the intent requirement. departure, extreme. The danger of misleading buyers had to be either known to the Defendant or so obvious that effectively they were aware of it. Again, intent. So Fannie Mae's interpretation and that's what I said it I was, it is an interpretation -THE COURT: MR. FINK: THE COURT: Well, I am going to conflate the two. Okay. You are interpreting and applying it -What does it require? Extreme
MR. FINK: Interpreting and applying it. THE COURT: -- because you appreciate, I am sure, that there are situations where there may be an interpretation but the application never ever occurs.
75
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
MR. FINK: THE COURT: and applied. MR. FINK:
Right. Here it is both. It is being interpreted
The way they actually applied it according
to the way they interpreted it, I am fine with that. THE COURT: MR. FINK: All right. So for Fannie Mae's application and
interpretation to be fraudulent, they would have to prove one of two things; that they actually knew the policy was wrong and it would materially mislead investors and I think there is just no evidence of that whatsoever, or that the interpretation and application, I will put that in, was so clearly and obviously wrong, so utterly lacking in support that no respectable and intelligent accountant could have conceivably that way. interpreted it
If there was a clear rule that says you can't do this That's not this
and they just did it, maybe that would work. case. THE COURT:
Well, now, when you say -- well, you are
implying objectively wrong, right? FAS 133 and this policy that is an application of FAS 133, right, has certain objectively certain components to it, right? MR. FINK: fighting over It has language that people have been
what those words mean for the last decade. It is interpreting what do the
That's what this is about.
actual words mean in FAS 133, and that's why this saga has gone
76
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
on as long as it has including, as I mentioned, the SEC changing its view as to whether the words meant what Fannie Mae thought they meant or what the SEC originally thought they meant. going to go through that for you. THE COURT: MR. FINK: about -THE COURT: But I want to make sure it is clear at All right. But that's my goal here is to talk I am
least in my mind that the challenged conduct that the Plaintiffs are criticizing and raising doubts about and relying upon actually, scienter, the impression I have is that it is conduct not of mere interpretation of what the words in FAS 133 mean, but disregarding of what FAS 133 requires a company to do so it is not really a question, if I understand their position, they are not saying it is a different interpretation of what 133 stands for. It is the utter disregard of what is 133 requires
and because it is an utter disregard, well, then they are not willing to comply with the agreed upon standard that the accounting profession would require under these circumstances for derivatives. trying. I think that's the distinction they are
MR. FINK: position --
Right.
You have correctly stated their
THE COURT: And you disagree --
77
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
MR. FINK: -- and my job is to explain to you why they are just completely wrong. THE COURT: MR. FINK: Judgement. THE COURT: Why is it is a matter of interpretation as Right. So wrong that we are entitled to Summary
opposed to matter of utter disregard. MR. FINK: That's right. THE COURT: Rudman, Senator Rudman, what's your read on what Senator Rudman concluded? Was he saying it was an utter disregard or what was -MR. FINK: I am sorry. THE COURT: -- or was he is saying it was a misinterpretation? MR. FINK: I think he says many things including
potentially that it was a disregard of clear rules, but what I am here to tell you and explain to you is as this has gone on for all these years, it is quite obvious to everybody in the profession now that the rules weren't clear or there would have been no reason for the SEC to go back and examine it again and come out with a different conclusion. The SEC literally came out with a different reading of the same words. 2007. FAS 133 did not change from 2001 to 2004 to
The SEC came in and the SEC changed its interpretation,
and their expert admitted that the SEC changed its
78
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
interpretation. If the same words are susceptible to different meanings, then it is an interpretation issue. It is not an
issue that's black and white and that is exactly our point. THE COURT: MR. FINK: Okay. That's what happened here and that's what I
am going to hopefully persuade you of as I go through my argument. THE COURT: MR. FINK: Okay. Go ahead.
Now, I am not going to spend a lot time on It is well briefed I think in our
the transparency issue.
briefs but the key point is, as I mentioned, Fannie Mae wrote the fraud, this supposed fraud into a playbook. playbook. regulator. Here is the
It is 475 pages long and they handed it to the They handed it to the GAO. They gave it to KPMG.
They widely distributed it within the company. We just don't think that's the kind of behavior that's consistent with fraud. We think that's as a matter of law The cases we cited in our brief are
essentially in this case.
instances in which perhaps they made a disclosure to regulator or the auditor or maybe within the company. There is no case
like this where it was so widely distributed and yet a Judge let the case go to trial on the issue of scienter. case like that. that. There is just no
The Plaintiffs have not cited any case like
79
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 cited.
THE COURT:
Were there cases that you found where the
Judge granted Summary Judgment on the scienter issue? MR. FINK: There were cases where based on this
transparency issue and based on the fact that the policy was a matter of interpretation as opposed to being clear the Court I will give you
either dismissed or granted Summary Judgment. one or two examples. THE COURT: MR. FINK: Yes.
There is a Tenth Circuit case that we have Dronsejko -I even
I always trip over the pronounce.
wrote it down here so I wouldn't say it wrong -- Dronsejko versus Grant Thornton, and there was an issue in that case as to whether an accounting rule was sufficiently clear that if the Defendant disregarded it, it was scienter. And the Court looked
at the rule, looked to see how clear it was, looked to see that people interpreted it differently and said even if the Defendant got it wrong, and it was a case where the SEC said you got it wrong, the Tenth Circuit said that's not good enough. be obviously wrong. It has to be clearly wrong. The It has to
interpretation just has to be ridiculous or you are not acting with scienter. THE COURT: MR. FINK: All right. So that's one case and I think there are a The Worlds of Wonder case talks about
couple of other cases.
the policy needing to be obviously wrong citing SEC versus
80
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
PriceWaterhouse. THE COURT: MR. FINK: recklessness issue. All right. So let me move on to this extreme We have covered some of it. It is
undisputed that other people in the profession were interpreting, were reading the words of FAS 133 the same way that Fannie Mae was. And the SEC -- and, as I said, the most
stark evidence of this, the most stark evidence the fact that there are people reading it differently is, of course, the SEC in 2007 reading the same language differently than it had previously read it. And as I mentioned, the SEC was We can take this down.
interpreting the exact same language.
If the SEC is interpreting the same language differently than it did four years earlier, it had to at least be a reasonable interpretation. We are not going to say that
the SEC in 2007 adopted a ridiculous interpretation so we are going to only look at the one that the SEC came out with in 2004. So it had to be at least a reasonable interpretation, and
it can't be fraudulent in this case for Fannie Mae to have come to that reading of FAS 133 before the SEC was willing to accept it. They were looking at the same words. They just disagreed
about what the words meant. THE COURT: Was it known in the markets, if you know,
or if the record develops this, I don't know if the record did develop it or not, does the record indicate or do you know if it
81
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
doesn't whether or not the people in the marketplace who are looked to for guidance on evaluating the health of Fannie Mae for the purposes of purchasing stock or selling stock, whether or not those kind of people, the analysts I think guess they are, were sufficiently knowledgeable back then of FAS 133 as it applied to derivative transactions and the complexity of applying and interpreting it? Were they witting of all that back then? MR. FINK: That's have very question, your Honor, and
it is part of presentation so I will just jump ahead and answer the question. When the restatement occurred and when Fannie Mae
had to change its accounting, of course it was a significant event. THE COURT: MR. FINK: Sure. The analysts commented on it. The analysts
said you know what? We know because of all the disclosures about derivatives and there are all kinds of disclosures, we know that the losses that Fannie Mae had to report were offset by gains on the hedged item. It doesn't really matter to us how they
account for them because we know that those losses are offset by hedged items. at all. We put that evidence in. It is undisputed. They did It doesn't change our evaluation of the business
not even try to dispute that the analysts understood the change was not an economic change. In other words, sometimes
82
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
restatements happen because of an incorrect assertion as to what the actual business is. THE COURT: MR. FINK: Exactly. That's not what happened here. Everybody
understood the business.
It is only what the accounting was.
And that's a key point because how can you say that the Defendants were intending to mislead people when they put out information that enabled the market to understand exactly what they were doing regardless of how they were accounting for it. It is a very significant question. Now, I have talked a fair amount about this change. How did this change come about? I mean just magically one day the SEC decided let's revisit that? No. There was confusion out
in the profession about this whole question that Fannie Mae faced and the SEC chief accountant, not Mr. Nicolaisen but the new SEC chief accountant three years later said I would like a white paper from the accounting profession to talk about this issue. I don't know if this was going through his head, but there had been several hundred restatements on 133 and he may have been thinking, gee, maybe we ought to go back and look at this, it has caused a big problem. So we asked the big four, of which KPMG is one, to write a white paper and they did. All the big four signed it --
PriceWaterhouseCoopers, Ernst & Young, KPMG and Deloitte &
83
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Touche which was Fannie Mae's auditor.
They signed it.
And
this white paper gave examples and it said here are different ways you could interpret this language and we are going to tell you, Mr. Chief Accountant, that this would be a reasonable interpretation the way Fannie Mae did it, or, you know, the way the SEC chief accountant originally did it, that would also be a reasonable interpretation. It is not that one is black and the It is just
other is white and one is right or one is wrong. that both of them are reasonable.
You just need to decide and
tell people basically so they know what to do. And they put in examples and some of the examples were very much like what Fannie Mae was doing. The Plaintiffs' FAS 133 expert, Mr. Barron, admitted that both approaches in the white paper were reasonable, they were rational, and they could be considered to be GAAP-compliant. That concession we think in and of itself dooms If both approaches were reasonable,
the Plaintiffs' claim.
rational and could be deemed to comply with GAAP, how could it possibly be said, how could it possibly be said that the interpretation was so absurd and ridiculous that it had to be fraud. That just cannot follow. THE COURT: Is it your position that a reasonable
interpretation of FAS 133 is per se GAAP-compliant? MR. FINK: I would say a reasonable interpretation is
per se GAAP-compliant, yes.
84
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 speak. here.
THE COURT:
So could you have a situation where an
interpretation of FAS 133 was not reasonable but it was still GAAP-compliant? MR. FINK: THE COURT: That's somewhat of a metaphysical question. We try to avoid those questions around
MR. FINK:
I think overall, overall one would have to When it is reasonable, it is
conclude that it was reasonable.
reasonable compared to what? It is reasonable compared to the requirements of GAAP so I think it is kind of a truism a little bit. THE COURT: Yes, because there was testimony that I a half either excerpts or
obviously saw in the first hour and
on the video of people who were saying that they believed everything that they were doing was GAAP-compliant. MR. FINK: THE COURT: Right. And I think what is implicit it that but I
don't want to read it into it unfairly something beyond because they thought it was GAAP-compliant, it was also a fair application and interpretation of FAS 133, that those kind of -MR. FINK: THE COURT: I think that's a fair inference. -- that those kind of go together, so to
MR. FINK:
I think that's an absolutely fair inference.
THE COURT: Okay.
85
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 in 2007.
MR. FINK: So the SEC came out with this interpretation They read the white paper and they said the
interpretation that Fannie Mae was using all along was acceptable. wrong. It was okay. They weren't saying the other one was If people
They were just saying this one was also okay.
are out there doing it, it is okay. And Plaintiffs' expert was not able to distinguish between what the SEC said and what Fannie Mae was doing so it was clearly applicable. How do I know it was clearly
applicable? Because we asked him so how do you explain what the SEC did in 2007? And he said they changed their mind. hear it. (Whereupon, the videotape was played.) MR. FINK: And he didn't just say it once. We asked Let's
him again slightly differently. (Whereupon, the videotape was played.) MR. FINK: So Plaintiffs' expert was clear. The words
of FAS 133 hadn't changed, but the SEC's interpretation of FAS 133 had evolved. There had been confusion. People had come in SEC said, you
and said are you sure this doesn't work? And the
know, on reflection those words are susceptible to that interpretation. That cannot have been fraud in 2001 for somebody to read those words and say, you know, I think this is what it means; and the SEC ultimately said, yeah, gee, I am a little bit
86
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
late, but, yeah, that's a reasonable interpretation. THE COURT: right? MR. FINK: THE COURT: I do. Did your client, were they asked to opine Did your client -- you represent KPMG,
on how to interpret and apply certain provisions within FAS 133 during this time frame? Were they being asked to give sort of their expert opinion, so to speak? MR. FINK: I am not sure exactly what your question is Fannie Mae came to KPMG and explained in
so let me try it way.
great detail what they were planning to do and what their interpretations were and KPMG agreed that those interpretations were appropriate under FAS 133 final book. You know, there was back and forth along the way, but when they got to the final book, KPMG had agreed that those interpretations were appropriate under 133. THE COURT: case? MR. FINK: THE COURT: MR. FINK: Absolutely. And they did that in writing I assume? Absolutely, yes. So the key question for Was there one and only So that's part of the evidence in this by the time they got to the
extreme recklessness, your Honor, is:
one conceivable interpretation of FAS 133 that was so clear and obvious that anybody who interpreted it differently must have
87
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
been committing fraud or was there another interpretation that experts in the area believed was appropriate and permitted in practice? We know the answer. The answer was the latter.
That's an objective fact.
That's not my spin on it.
And you can make an analogy to statutory interpretation. There is a new statute. District Judges all
over the country are reading it differently. It goes up to the Circuits. Circuit Judges are reading it differently. It
eventually goes to the Supreme Court. way, four read it the other way.
Five justices read it one think to say
Nobody would
that the judges who got it wrong, wrong whose interpretation was rejected were engaged in an extreme departure from the standards of statutory interpretation. We wouldn't ever say that. They are reading the words of So
This is just like that. this book.
It has all kinds of paragraphs and provisions.
we just wouldn't say that. Now, I want to talk just a bit about what hedging is and what hedge accounting is. all the nitty-gritty of it. I am not going to get into the
I don't think you need to, but I
think you do need to understand that a hedge is something, as I mentioned, of a risk. the value of which moves in the opposite direction The risk here was interest rates would go up and so It is like a see-saw. That's the way it
Fannie Mae hedged to try to offset that.
One side goes up, the other side goes down. works.
Gains and losses and they offset each other.
88
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
If you are hedging, and it is undisputed that Fannie Mae was hedging, one way to qualify for hedge accounting would be to match up the terms of the instruments. When I say terms,
I mean things like interest rate, maturity amount, things like when the two pay out cash. It is not the only way to do, but it
is the way that Fannie Mae was doing it. And there are actually a couple of different paragraphs of FAS 133 that allow this, and that's what created some of the confusion. Now, the Plaintiffs say if you want to use this
method, the terms literally have to exactly match in every respect. Fannie Mae disagreed. KPMG disagreed. Fannie Mae
knew that the terms of many of these hedges didn't exactly match but they were really, really close. And Fannie Mae believed that as long as those terms were so close that any difference in the pay-outs would be trivial. People here have used the word inconsequential, de Back to my
minimus, trivial that you could use this method. see-saw analogy. You have a see-saw.
If the length of each
side is literally exactly the same, that's great; but if one side is just a tiny bit shorter than the other, almost imperceptible, the see-saw is going to work just fine. If you are sitting on the see-saw, you are not going to notice that slight difference in the length on one side versus the other side. It is inconsequential. It is trivial. This is
what the dispute was about.
It was about whether or not the
89
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
terms had to exactly match, and there are different provisions that talk about it and the words in those provisions were the provisions that caused all the confusion, and the SEC settled the confusion after getting the white paper in 2007. Now, this brings me to what I will call Plaintiffs misuse of a comment by the former chief accountant in 2004. have heard it over and over. You
Plaintiffs stand up usually with
great drama and they talk about how Mr. Nicolaisen said the accounting was not even on the page. They want the Court to
believe that what Mr. Nicolaisen meant by that was that it was crazy, it was an extremely ridiculous interpretation. Now, even if he had that opinion in 2004, we still win because we have shown through objective evidence that reasonable people disagreed about this including that the SEC changed its mind, but that was not his opinion; and I don't want to leave you with the impression that it was his opinion. This is what
he said when the Plaintiffs asked him about it at his deposition. (Whereupon, the videotape was played.) MR. FINK: And he was asked also by the Plaintiffs what
he meant when he said in 2004 that Fannie Mae's interpretation was outside of professional standards. to say. (Whereupon, the videotape was played.) MR. FINK: It was his professional judgment, it was an Let's hear what he had
90
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
opinion, and, oh, by the way, a lot of other people concluded otherwise. He also admitted that at the time he didn't realize
just how many people didn't interpret FAS 133 the same way that he did. "Even I was surprised by the number of companies that
after the Fannie Mae restatement actually restated for 133." So rather than supporting the Plaintiffs' position Mr. Nicolaisen's testimony completely proves Defendants' point. acknowledged that other people in the profession didn't interpret 133 the way he did. He didn't label them fraudsters. The Nicolaisen remark helps Unless the Court has He
He didn't label them extremists.
the Plaintiffs prove scienter not one bit. questions, I will stop here. THE COURT: MR. STOCK: All right.
Thank you very much.
Your Honor, Chris Stock on behalf of the
Plaintiffs and I think I would like to note at the outset that I didn't get quite the rousing introduction from Mr. Markovits that Mr. Warin gave to Mr. Fink so I wanted to make that perfectly clear on the record. THE COURT: MR. STOCK: Don't let it bother you. You know, I took some notes while Mr. Fink
was making his presentation just now and essentially his arguments for why you should grant Defendants' Summary Judgment seemed to fall into two category. You heard him talk a lot
about how their approach was reasonable and so that negates an inference of scienter. And you also heard him talk a lot
91
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
about, a
little bit about how they were transparent in their
approach and that too negates an inference of scienter. Well, I will get into the evidence of why that's not true in a minute, but in nutshell, there is evidence in the record that Defendants' approach to FAS 133 was not only not
reasonable, but numerous third parties, the other third parties Defendants like to make a note of how there is other third parties concluding the same way they did. Well, there is also a number of third parties in this case that determined that this was clearly outside of professional accounting standards. fact, you heard part of Mr. Nicolaisen's In
testimony that it was
outside of professional accounting standards. Now, I know we just went through the sheet of paper and I will try not to stand up and be dramatic as Mr. Fink indicated, but the point is if I was talking to a jury and I
held up the piece of paper and explained what Mr. Nicolaisen said, the jury could fairly draw the inference that, wow, these guys were -- to quote Mr. Nicolaisen -- not even on the page, extremely reckless. Now, you hear Mr. Fink say, well, wait a minute, that's not what Mr. Nicolaisen meant. He meant that he was close
enough to the page and, you know, there were other people out there, but again that was Mr. Nicolaisen's, a chief accountant's view in 2004, the moment before they required them to eliminate the use of hedge accounting and, by the way, brought an
92
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
enforcement action against them for violating FAS 133 in such a material way. Certainly the jury could take an inference that, well, gosh, Mr. Nicolaisen who was the chief accountant seemed to be on to something about extreme recklessness here. Now, in
fairness the jury could take the position that Mr. Fink advances, but at bottom we are arguing over what the evidence says. I can ask the jury to make an inference. He can ask the That's what it is. It is
jury to make an inference. inferences.
I want to go back again and sort of talk to you -THE COURT: So you agree it is an issue for the jury as
opposed to an issue of law for the Judge? MR. STOCK: I absolutely agree that the issue of an issue for the jury, especially where
extreme recklessness is
given the substantial amount of evidence that I hope to go through with you shows that Fannie Mae was knowingly violating these clear requirements of GAAP. Now, remember you heard Mr. Stern talk earlier about how this was an extraordinarily complex standard. I know your
Honor talked about this being the accounting rule against perpetuities, but at the end of the day as Mr. Nicolaisen was testifying, in the sense of what these requirements were that they violated, he indicated that those rules are not overly complex. In fact, Kevin, could you pull up slide 91? This is
93
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Mr. Nicolaisen's deposition. In talking about the rules that the Defendants violated, he said those rules are not overly complex. those rules are clear, and I think they are laid out. I think They are
laid out because the FASB thought it was important to maintain the financial integrity of reporting when exceptions to basic rules are followed that you had to comply with. So clearly Mr.
Nicolaisen at this point has said, yeah, those rules are clear and you have got to follow them. And what the SEC found at that point in 2004 was that these guys are not following the clear requirements. bringing an enforcement action. So I want to go back and start with the basics, start Under the scienter You can Again,
with this extreme recklessness prong.
analysis, you can prove scienter two different ways.
prove it through actual knowledge of GAAP violations or, like we have talked about, you can prove it through an extremely reckless application of FAS 133. Well, let's start with the actual knowledge prong. There is clear evidence in this case that the Defendants were knowingly circumventing FAS 133's clear requirements because FAS 133 conflicted with Fannie Mae's business operations. In fact,
in 2004, this is during the class period now when Mr. Boyles was asked -- can you put up slide 78, please -- when Mr. Boyles was asked is Fannie Mae applying a little bit inartfully when it is
94
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
not consistent with the guidance in FAS 133? Mr. Boyles states quote: departures from GAAP." "We have several known
Now, a little context first before we To understand what
talk about what those known departures were.
the known departures were, you got to have some sense of what FAS 133's clear requirements were. In a nutshell, and you heard
Mr. Fink talking about this before, there is certain criteria that need to be met before you can comply with FAS 133. Some of
those criteria are found in the short-cut method paragraph 68. Some are found in what's called the critical terms match method. I don't want to get into it. place. Fannie Mae in its DAG that we have talked about indicated that, you know, we are using the short-cut method. are following the short-cut method. what we are doing. The short-cut method is We They essentially come to the same
But the problem was Defendants weren't
actually following the requirements in the short-cut method. They created a series of exceptions to the short-cut method and then followed those requirements, and that's what got the OFHEO and SEC and Rudman and everyone after them. THE COURT: What would you point to the record if you
have anything to indicate that they are doing it that way was done with the intent to defraud shareholders? Do you have like someone testify to that effect or do you have a document like an e-mail or some kind of memo or anything?
95
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 process.
MR. STOCK:
We have a number of memos, and I can point
to that in the record, where there are recognitions on the part of Fannie Mae and on the part of KPMG that these are known
departures from strict compliance with FAS 133. For instance -THE COURT: other words, I am I am trying to go to the next step. In
trying to see if the record that's been
developed over the last six years in the depositions and in the document review has yielded any statements under oath or any documents that have been uncovered that indicate that the reason why the people were doing what you just said they were doing, failing to comply with certain requirements of FAS 133, were being done in order to carry out an intent to deceive shareholders and the marketplace? MR. STOCK: Sure. I think it is a several step
Certainly what we don't have are Fannie Mae employees
who are deposed raising their hand and saying, you know what? We were trying to defraud investors. don't have that evidence. I mean, unfortunately we
But what we do is a ton of So let's start
circumstantial evidence that gets to that point. from the beginning and build it up. Kevin, if you could pull up slide 89.
This is a memo
from Mr. Boyles during 2003 when he was looking back at the implementation efforts of FAS 133. And he said essentially
there were three tenents that were guiding our implementation efforts. We wanted to -- earnings volatility was to minimized
96
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
and if there was earnings volatility it should be as predictable as possible. We were to leverage off existing systems as much to be simple and
as possible and operating earnings needed easily understood.
The driving principle behind these known departures from GAAP was the fact that they had these tenents in place that said we have got to minimize earnings volatility because earnings volatility is bad for the investor, and we have got to avoid costly systems upgrades because that's going to cost us money and it is going to slow us down. Now, the second part of the response to your question comes actually in the form of their transparency or lack of transparency. Now, remember, we have evidence of these known
departures from GAAP and then Mr. Fink at the end of his presentation talked about how those departures were inconsequential. Essentially what the Defendants were saying
is, look, we know we are violating FAS 133 here, but we believe we are violating FAS 133 because on such an inconsequential basis that we are allowed to do that. But if you look at their DAG, this DAG that they have been touting and saying we give the DAG to everybody, everybody signed off on it, the DAG doesn't include those meat and potatoes violations. It is silent as to them. It is silent as
to the known departures.
There is nothing in the DAG that says
we know we are departing from FAS 133 here and it is silent as
97
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
to this concept of inconsequential ineffectiveness. So whereas this DAG is suggesting that it is following paragraph 68 of 133, easy enough, right, I mean no controversy there, it is not talking about the known departures from GAAP. It is not talking about this concept of inconsequential ineffectiveness. And in fact, Kevin, if you could pull up slide 102. In
2004 Fannie Mae went to the SEC and sort of a last ditch attempt to qualify their hedge accounting policy. Again, we know that
that didn't work, but after seeing the letter where Fannie Mae was attempting to justify this policy, OFHEO said wait a minute. That's not what your policy says you were doing. So they wrote
a letter to the SEC attempting to clarify this lack of transparency. You see that in slide 102. To explain its actions on hedge
OFHEO notes:
accounting, Fannie Mae now introduces a novel term quote "inconsequential ineffectiveness." While this term does not
exist in accounting standards or literature, it is employed to overlay the concept of materiality into a matter where materiality does not apply. As OFHEO noted, Fannie always assumed perfect effectiveness and took no steps to determine if ineffectiveness existed. Finally, what is quote "inconsequential" is nowhere
defined in the current letter or in any earlier documentation reviewed by OFHEO.
98
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
That's OFHEO saying we
have never seen this before. And two
Where is this coming from? What are you talking about?
Deloitte auditors who were in there doing the restatement work came up with the same conclusion. 103, Kevin. I would like to pull up slide
This is an e-mail between two Deloitte auditors
after having reviewed that same letter to the SEC where in talking about the concept of inconsequential ineffectiveness quote: I don't believe you find that term, that is, It
"inconsequential ineffectiveness," in the literature."
appears to be yet another addition to the many examples of quote "Fannie speak." You skip down a sentence. What strikes me most
is that they appear to be rewriting history in this letter and then there is a little discussion about how this idea of inconsequential ineffectiveness never shows up in their policy. In fact, no where -- and suggesting that, well, if they would Quote: But
have done that, maybe that would be one thing. that's not what they did.
Nowhere in their hedging policies or The term I believe we saw
documentation is the term mentioned.
repeatedly throughout their documentation is perfectly effective and short-cut. This letter, that is, the letter to the SEC that they were attempting to justify their policy, this letter would lead a reader to believe that they had initially documented their hedges designated and
in a manner differently from what we These are two Deloitte auditors
know their documentation says.
99
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
saying where are these guys coming up with this stuff? THE COURT: Were they deposed, these auditors? I am sorry, your
MR. STOCK: Ms. DeLeo was deposed. Honor, I am not sure if Mr. Thompson was. THE COURT: MR. STOCK: Okay.
And, by the way, that's consistent with the Now, remember at the end
actions that Defendants took in 2004.
of 2004 OFHEO has already tagged them and said, look, these known departures are clear violations from GAAP. Your idea of
inconsequential ineffectiveness is a rouse and we have never seen it anywhere in your documentation before. Don't you think
that in this SEC letter, their last ditch effort to justify, they would have said, hey, wait a minute, we told everybody about this. We told everybody about this concept of We told you that we were There
inconsequential ineffectiveness.
knowingly departing from GAAP, but they never said that. is nothing in those SEC letters that talks about, hey, we
cleared known departures with OFHEO, we cleared this with the GAO. We cleared it with everyone. What you are hearing Mr. Fink say is we were transparent because we passed our DAG around to everybody, but the problem is the key provisions, the key problems, the key violations with the DAG weren't in there. So passing around a
derivatives accounting guideline that excises the key stuff, that's not exactly transparency.
100
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 page 99.
Let's talk about transparency in the context of Fannie Mae a little bit more. I think I heard Mr. Stern earlier this
morning and to a lesser extent Mr. Fink this afternoon argue that Defendants were consistently applying this policy. Remember, Defendants consistently applied this policy and that is evidence somehow a lack of scienter. Well, the problem is
there is evidence in the record that they weren't in fact consistently applying the policy. 105. This is Mr. Barron's testimony where he is asked to look at the derivative accounting policy and he says at the bottom in the middle there he says quote: "So within their And you see that at slide
policies they described critical matched terms perfectly" -excuse me. I misread that. Let me start over. Quote: So
within their policies, they described critical terms match perfectly. The problem is they don't follow and comply with the
provisions of 133 that are their policies. Now, the OFHEO interim report makes the same point at That's slide 106, Kevin. I will quote. Fannie Mae's
assumption of perfect effectiveness upon a hedge designation is not only inconsistent with FAS-133 guidance, it is inconsistent with Fannie Mae's own internal accounting guidance. So to suggest that Fannie Mae was consistently applying its policy, there is evidence in the record that it wasn't consistently applying its policy. Let's look at this concept of
101
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
distributing the DAG to everyone we have already talked about, but again the DAG failed to disclose those key violations and Mr. Barron makes that point as well in slide 107. THE COURT: But is the inconsistent application of
their policy an inconsistent application that's based upon varying or changing interpretations of it, or is it based upon an intent to defraud the marketplace? MR. STOCK: Well, we suggest that it is an intent to
defraud the marketplace in that what they are saying in their policy is, hey, we are following the clear -- we are following FAS 133 and here are the provisions of FAS 133 that we are following; but the problem was they weren't following those provisions of FAS 133. THE COURT: What would the differential have been if
they had followed it? How different would -- does the record develop what it would have looked like if they had followed it
in the way that you think they should have, how much different their public profile would have been in the marketplace? How big a difference it would have been? MR. STOCK: I think I understand your Honor's question. The problem is
Let me see if I can respond to it two parts.
they weren't measuring and assessing ineffectiveness, part of the concept of 133. Had they been doing that, their earnings Remember, I
would have been significantly more volatile.
showed that three tenents memo where they were worried about
102
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
earnings volatility. There would have been much more volatility, and Defendants would concede that. So investors would have seen a
profile that instead of showing a significantly diminished earnings volatility as you saw with the policy they implemented, there would have been more earnings volatility. So it is a fair
inference that investors would have said on the basis of this additional earnings volatility, we are not going to invest in that stock. The concept of earnings volatility being -That's speculative, right? That's an inference that the jury could
THE COURT: MR. STOCK:
draw, correct, your Honor. We haven't, with the possible exception of Mr. Barron, we don't have any of the fact witnesses from Fannie Mae suggesting that that could happen. The problem is put in front of a jury and a jury could certainly make that determination. I want to talk a little bit more about this concept of transparency with investors that your Honor has raised. Now, I
think I heard your Honor ask the question was it known in the market what happened? And Mr. Fink responded in sum and substance that, yes, it was known in the market what happened. This was just a movement of transactions from point A to point B and analysts recognized that.
If analysts recognized what it was wrong with FAS 133, if analysts recognized that there was these known departures
103
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
from GAAP, that there were these explicit violations of GAAP, then on the day that the SEC determined that they were going to require Fannie Mae the eliminate their use of hedge accounting, there would be no price drop in the stock due to the indication because the analyst and the market would have already priced this concept that, hey, if you are knowingly departing from GAAP, that's one thing and we recognize that, but that's not what happened. violating GAAP. The stock dropped on news that Fannie Mae was So clearly investors didn't know that this was
going on, analysts may or may not have known, but the stock dropped anyway. And in fact -THE COURT: You are talking about violations of GAAP
based on the Rudman Report? MR. STOCK: Excuse me, no. I am talking about the
violations of FAS 133 that were disclosed by the SEC chief accountant with the extraordinarily dramatic holding up of the piece of paper on December 17, 2004 or thereabouts. if you could, Kevin. Slide 120
Representative Royce sort of made that Quote:
same point in Lead Plaintiffs' Exhibit 14, page seven.
Fannie Mae's misapplication of FAS 133 prevents outsiders from getting a clean view of the true risk at the company. So that's representative Royce indicating that, look, we didn't know what was going to with respect to FAS 133. THE COURT: This is a Congressman?
104
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
MR. STOCK: hearing -THE COURT: MR. STOCK: THE COURT:
That's correct.
It is during the
He wasn't under oath, was he? No, your Honor. No.
Well, then what evidentiary value does this
have? This is just some Congressman's thinking on what's going on? That's not evidence in this case. relying on that as evidence, are you? MR. STOCK: THE COURT: MR. STOCK: I am not relying on that as evidence. I hope. What I am relying on as evidence is the I mean you are not
fact that the stock price dropped on the day of the disclosures that FAS 133 was not being complied with. THE COURT: Why the stock price or didn't drop is a
matter for experts under oath subject to Cross-Examination, not some comment by some Congressman who is sitting up on a deias giving his or her opinion on what's going on. That is not evidence. So stick to the evidence. MR. STOCK: I recognize that, your Honor. Thank you.
I think I would like to turn to the FASB, the evidence of the transparency or lack of transparency with respect to the FASB. THE COURT: MR. STOCK: All right. There is also no evidence that Defendants In fact,
went to FASB with respect to these violations of GAAP.
there is evidence from Mr. Barron's rebuttal report, slide 114
105
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
where Mr. Barron is discussing, you know, 35 communications from Fannie Mae to the FASB and none of those communications quote "describe or revealed to the FASB the numerous practical interpretation of the critical terms match provision." THE COURT: Hold on a second. The evidence that the
Defendants are pointing out on the record, and you can take a different position obviously, you are entitled to do that, they are saying that the evidence that's been developed in this record indicates that the people at Fannie Mae thought that what they were doing as it related to applying FAS 133 was consistent with GAAP. They cited numerous statements under oath, people
who were being deposed saying that what they were doing was consistent with GAAP. Now, obviously that's their interpretation. If they
think it is consistent with GAAP, they have no reason to go to FASB about it. That wouldn't make any sense. So I am looking
for what the counter evidence is to what they have, counter evidence on this record that the people at Fannie Mae knew or believed, I should say, at least believed if not knew, that what they were doing was not consistent with GAAP and kept that from the FASB. MR. STOCK: Kevin, could you call up in response to the This is Lead Plaintiffs' Exhibit 30. Okay.
Judge's question slide 85? THE COURT: MR. STOCK: 30.
This is a discussion of one of those known
106
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
departures from GAAP. THE COURT: MR. STOCK: Okay. And Mr. Boyles is suggesting in a memo from Included in our hedge guidelines is the
the class period that:
concept of duration matching, that subject to certain criteria allowed the hedge desk to assume no ineffectiveness in their hedge relationships. While this has been a known departure from
strict compliance with GAAP, we allowed that treatment because from an economics standpoint the correlation from matching and durations between the anticipated debt and the actual debt to
be issued is better than just matching notional and payment reset dates. Now, that's a lot of gobbledegook -I would like to see a D.C. jury unravel Try
THE COURT: that.
I would like to see you explain that to a D.C. jury.
explaining it to a Federal Judge in the first instance because I am trying to imagine a D.C. jury unraveling that one. What did he just say in plain old fashioned English? MR. STOCK: Plain English. Let's look at line 79 and Go ahead.
see if we can unravel it for Court. Essentially what the short short-cut method is saying is there are various terms that you need to match. The terms in connection with this known
departure from GAAP were the notional terms and the expiration date, and the maturity date. notional terms were. Now, it doesn't matter what
It doesn't matter what these other
expiration date and maturity date is.
107
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
What you need to know is in number six.
Number six is
a DIG issue E4 and that's a derivative implementation guideline. And essentially what it is saying is the verb match is used in this specified conditions to mean exactly the same or corresponding exactly. What Mr. Boyles is saying in this memo is, hey, forget about us matching number two. three. Forget about us matching number
Let's come up with our own matching concept, and we will
call it duration matching but there is nowhere in FAS -THE COURT: MR. STOCK: Who is that memo to? That was an internal memo to distribution. Raines, Howard,
THE COURT: Okay. It goes to like to
Spencer? Did it go to those kind of folks or the board? MR. STOCK: board, your Honor. THE COURT: I am trying to determine whether the record Kevin, could you -- it did not go to the
indicates, maybe you know off the top of your head, does the record indicate that this memo that Boyles wrote was actually reviewed, A, and if reviewed, B, relied upon in the implementation of policies that resulted stock fluctuation. MR. STOCK: Well, certainly KPMG reviewed it. You see
that in slide 86 which is an e-mail between two KPMG auditors talking about the same concept, talking about this duration matching concept that didn't exist in FAS 133. THE COURT: Okay.
108
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
MR. STOCK:
Saying: I do know that the SEC has taken a
view that applying FAS 133 needs to be in strict compliance with the letter of the standard. This is obviously a departure from
that, although as they demonstrated an immaterial departure. Then he recognizes later in the same e-mail: Should we go ahead
and insist that they employ the long hall at this juncture just to be by the book. this policy. This is KPMG suggesting we know that Fannie Mae's policy violates 133 at least with respect to this duration matching concept. They demonstrate -- it is an immaterial I not believe so. We have already agreed to
departure but the problem was they hadn't done the calculations required under FAS 133 the to make that determination. THE COURT: What kind of, if you know, what kind of
application -- he is referencing here an application of FAS 133. So what was the kind of application that he is referencing here that was not in quote "strict compliance" with the letter of the standard? MR. STOCK: This concept of duration matching. This
concept as we talked about earlier with ignoring numbers 2 and 3 determining that they don't need to match, but instead we will come up with this new concept of matching durations. That's the
concept that Mr. Boyles indicated in his previous e-mail that that was a known departure from GAAP. THE COURT: Was that some kind of novel interpretation
109
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
of FAS 133? MR. STOCK: THE COURT: It was indeed, your Honor. Okay. And is it your position or thinking
or your expert's position and thinking that before they could take a novel interpretation of that kind, they had to first go to the FASB to get a blessing on it? MR. STOCK: Well, what Mr. Barron is saying, our
expert, is, look, there have been 35 times -- you are running up to the FASB for every issue, on all kinds of issues but then when you came up with these known departures from GAAP, you didn't go to the FASB and Mr. Barron makes the conclusion that on the basis of that evidence, this was quote "intentionally flying under the radar" on this issue. They were intentionally
flying under the radar on this issue with respect to OFHEO as well. We sort of talked about how that's the case especially
with OFHEO in the letter to the SEC. THE COURT: Did your expert say that the failure to
comply, strictly comply under these circumstances had a material effect on the market or on the market's impression of the company's financial well-being at that time? MR. STOCK: of What Mr. Barron said is on the basis of all
these known departures, this is one of a group of known
departures, but what he said was on the basis of all of these known departures, the investors weren't in a position -investors, OFHEO, FASB, SEC all of these entities weren't in a
110
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
position to accurately assess Fannie Mae's accounting policies. And the case law suggests this that where is there is a knowing violation of GAAP, a recognized violation of GAAP, that's enough in and of itself to establish scienter. THE COURT: Well, that's the second point. I don't You have
know if you have shown me the evidence of that yet.
shown me a piece of evidence here that suggests that the interpretation and application of FAS 133 under these circumstances was not a strict compliance with FAS 133; but as we have had earlier discussions today, as you may recall, because it is not a strict compliance of FAS 133 doesn't necessarily mean it is a violation of GAAP. It is not a just
necessary connection between those two things. MR. STOCK: Well, I think Fannie Mae in its restatement
already admitted that these known departures from GAAP were material misstatements of previous -THE COURT: departures from GAAP? MR. STOCK: Known departures from FAS 133. Fannie Mae Known departures from FAS 133 or known
has already admitted in its restatement that they violated FAS 133 for exactly what we are talking about here, the fact that they didn't do the assessment and measurement required and knowingly departed from FAS 133 on these issues. THE COURT: Is it your position that any violation of Is that
FAS 133 is per se or necessarily a violation of GAAP?
111
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
the Plaintiffs' position? MR. STOCK: position. THE COURT: So you could have a violation of FAS 133 No. That wouldn't the Plaintiffs'
that's not in strict compliance that's of an interpretive nature that still -- well, I will put it in the negative. That isn't inconsistent with GAAP? MR. STOCK: No. No that's not what I am saying. I
understood your Honor's previous question to be could there be errors with respect to FAS 133 that were immaterial and thus not violations of GAAP, and we would concede that there could be a situation where that would be happen. THE COURT: MR. STOCK: Okay. But in this case as you remember the letter
from OFHEO, the idea of immateriality in this particular context with respect to these known violations, they are attempting, as OFHEO said, the Defendants were attempting to impute a materiality standard where no materiality standard exists. That's in the OFHEO letter. Deloitte says it too. There is no
evidence that they were actually following the standard here. THE COURT: Well, where is the evidence that this was
being done with an intent to defraud? That's what I am trying to get your help to help me to see where if any there is any evidence of that. MR. STOCK: Well, I think the evidence is pretty
112
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
apparent from the fact that they weren't out -disclose those.
they didn't and
They would go to these various entities
disclose the fact that, hey, we are out here doing all this stuff with respect to FAS 133; and then never disclose the known departures, the very issues that the SEC filed an enforcement action against them. Now, remember they trotted this concept of we were okay to knowingly depart from GAAP under this inconsequential and effectiveness idea to OFHEO and Deloitte, and OFHEO and Deloitte rejected it, the SEC rejected it, Rudman rejected it as well. Plaintiffs' experts reviewed it and rejected it. And I want to talk about what Mr. Barron says in concept -excuse me -- in this context. his
Look at slide 104. Senator Rudman
THE COURT:
You say Rudman rejected it.
wasn't taking a position on whether or not the concept of inconsequential effectiveness was in some inconsistent with GAAP, was he? He is not an expert in accounting. MR. STOCK: THE COURT: MR. STOCK: The Rudman Report. Right. The Rudman Report took the position that Excuse me. I misspoke.
this was inconsistent with the strict requirements of FAS 133. Now, if you look at what Mr. Barron is saying, FAS 133 doesn't include any reference to inconsequential ineffectiveness, and skip to the bottom. The only options available under FAS 133
are either to, number one, qualify for the assumption of no
113
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
ineffectiveness or, number two, assess and measure effectiveness. What Fannie Mae was doing was coming up with work-arounds to say, hey, we now qualify for the assumption of no ineffectiveness and, therefore, we don't have to assess and measure under these two prongs. THE COURT: But --
What was the benefit that inured to Fannie
Mae for doing it this way? MR. STOCK: That's exactly it. The three tenents memo
that we looked at before, the first prong allowing them to qualify for the assumption of no ineffectiveness met their tenent of reducing earnings volatility. If they could qualify
for that assumption no ineffectiveness, there would be no earnings volatility in their statements. Secondly, the second tenent if you remember was to avoid those costly systems upgrades. If they could qualify for
the assumption of ineffectiveness under number one here, they wouldn't have to do those assessments and measurements which
could be costly for a company like Fannie Mae who had 30,000 hedging transactions. So it is clear that these work-arounds were in the service of those three tenents that we looked at earlier. We have to leverage off existing systems and we have to earnings volatility. minimize
That's the genesis of these known
departures from GAAP, and it fits consistently with the
114
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
motivation of, you know, following those three tenents we discussed. THE COURT: And the person who came up with this
concept, was he deposed? MR. STOCK: Boyles during 2003. THE COURT: Did he confirm under oath that he did it in This is Mr. Boyles. The memo was from Mr.
order to meet those tenents? MR. STOCK: He did not confirm under oath that -- I
guess I don't follow your Honor's question aside from -THE COURT: Well, are you suggesting that he did what
he did in order to comply with certain tenents that he had been given by management that were to be kind of the objectives that he was to be striving to achieve? Did he under oath confirm
that he came up with this approach, which is novel, as a means to enable him to comply with these tenents that he had been given by management? Did he say that under oath? MR. STOCK: What he said under oath -- I don't think he I think what he said under oath
said exactly that under oath.
was these -- and what the document itself says -- is these were the three tenents that were driving our implementation efforts. But I want to point to the evidence where other third parties have in fact determined that they were violating GAAP to serve these tenents. You look at OFHEO in its final report at page ten,
115
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
slide 93 said that by inappropriately assuming that the vast majority of its derivatives were quote perfectly effective hedges, the hedging system adopted by Fannie Mae management achieved the volatility dampening benefits of the hedge
accounting without the need to address the associated operational challenges. As a result of their preoccupation with
reducing earnings volatility and minimizing infrastructure investment, senior management caused the enterprise to adopt a FAS 133 policy that did not comply with GAAP, consistent with what I just said. Mr. Barron says the same thing. Slide 95.
Fannie Mae personnel were aware early in the implementation process that the company;s edging strategies did not fit within the strict requirements to qualify for the assumption of no ineffectiveness yet they chose to develop accounting policies that worked around the requirements in order the avoid the required quarterly assessments and measurements rather than develop adequate systems. Again, the same concept. There are these tenents out
there and they worked around the requirements to serve the three tenents and, in fact, in this scienter context, Mr. Barron makes a couple of other points that spoke directly to Defendants' actual knowledge of these work-arounds. If you look at slide Fannie Mae's
96, this is Mr. Barron's report at page 34.
management knew that the accounting policies it established with respect to the application of hedge accounting were not in
116
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
conformity with FAS 133. I mean what better way to discuss the fact that this was at least extremely reckless than a recognition on the part of Fannie Mae that we know what the requirements of FAS 133 are, yet we are deliberately going to come up with a policy that doesn't follow that. And Mr. Barron makes that point at slide 100. Mae's senior management recognized and documented the requirements of FAS 133. They understood what FAS 133 was Fannie
saying but then quote "designed, implemented and applied a policy for accounting for derivatives that violated FAS 133 in
several respects." This is all evidence of affirmative scienter. very least, it is evidence of extreme recklessness. THE COURT: Were the people who did this confronted in At the
depositions about this conduct? MR. STOCK: THE COURT: MR. STOCK: Were the people -Was Barron confronted? Mr. Barron was certainly confronted for
two days I think over this. THE COURT: And what did he say as to his explanation
for why he did what he did? MR. STOCK: THE COURT: MR. STOCK: Why Mr. Boyles did he what he did? Boyles. Not Barron. Boyles. I see. Mr. Boyles
Why did Mr. Boyles --
117
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
said that we believed we were complying with the spirit of the standard. In fact, if you look at slide 41 -- Kevin, I am Mr. Boyles in Exhibit 10 at page 65 says:
sorry, Kevin -- 125.
When we developed the duration short-cut, we felt like it was in the spirit of 133 while not exactly to the letter. Now, I want to speak to Mr. Boyles' spirit argument because -THE COURT: MR. STOCK: Hold on. Read the rest of that.
And so we built that into our adoption of
133 because we felt like that was within the tenents of 133 of a match, and then on an annual basis we would report back to our
auditors and the management what the effect of -- had we gone long haul on those transactions and not taken the duration short-cut -- what the effect would have been on earnings. Now, FAS 133 doesn't allow companies to make this sort of testing on an annual basis. If you are not following the
strict requirements of FAS 133, you have an obligation under FAS 133 to assess and measure the ineffectiveness on at least a quarterly basis. And this is Mr. Boyles saying we would go back
and look at this on an annual basis. So even under that, even under Mr. Boyles' explanation that violates FAS 133, but I want to -THE COURT: So you think this is evidence of an intent
to defraud on his part? MR. STOCK: I think it is.
118
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 sorry.
THE COURT:
Would you point to that to the jury as
evidence of his intent to defraud shareholders? MR. STOCK: I would point to this -- excuse me --
I would point to this as evidence of extreme In fact, one of
recklessness with respect to this position.
these other people that Defendants are fond of citing talked about this exact concept. rely upon. The PWC publication that Defendants
Kevin, if you could, pull up 126.
This is one of the other accountants that supposedly went the same way as Fannie Mae. Well, in a separate portion
that they didn't quote of the publication, you see about halfway down, they note that, in contrast to Mr. Boyles in the spirit of argument, in some instances registrants have assumed that they did not need to assess or measure ineffectiveness because they had met the quote "spirit" of the short-cut method. The SEC
staff does not believe that the short-cut criteria have a spirit or principle that can be met without strict compliance with the stated requirements. And, by the way, this PWC publication came out at the same time as this white paper and SEC exposure draft were working through what means critical terms match so clearly PriceWaterhouseCoopers, one of the big four that signed on to the white paper, was suggesting there is no spirit of the standard here. or you don't. There is -- you have to meet the requirements
And that's another example of at least an extreme
119
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
recklessness. And, by the way, your Honor, I mean if they believed that this was an approach that was coming up close to the line or there was clearly a recognition on their part that they had the opportunity to go to the FASB, they could go to their regulator OFHEO. They could go to the SEC as they did in 2004
and preclear it or clear it or even discuss it, but there is no evidence in the record that they ever went to any of these entities, GAO included, to say, look, we have got this policy, it is 1998, 2000, 2001. with this? Even though they were going to the FASB on almost every other application as we saw in the evidence. So I want to conclude with slide 127 which is a quote Mr. Barron The standard is new. What should we do
from Mr. Barron's report, rebuttal report at 25. pointed out that quote:
None of the restatements I reviewed Fannie
resulted in the total elimination of hedge accounting.
Mae truly stands out in this regard indicating the pervasiveness and severity of its violations FAS 133. Now, that pervasiveness
and severity led to 12.1 billion dollar restatement of earnings based on these material misrepresentations. And I recognize
that while scienter can't be established by publishing inaccurate figures alone, courts have held that quote "significant violations of GAAP standards can provide evidence of scienter," and one of those cases is the In Re: Daou Systems
120
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
D A O U Systems case, 411 F.3d 1006. As to the scienter issue, there is evidence in this case that Defendants knew they were violating FAS 133, that Defendants were at best extremely reckless in adopting a policy that they knew violated GAAP on multiple occasions, that they deliberately obscured these known departures from GAAP from their regulator, from the FASB, from the SEC, and from their investors and that there were numerous other entities that concluded that Fannie Mae's FAS 133 policy was entirely unreasonable. All of this evidence, not to mention the evidence in our papers, suggest a strong inference of scienter, certainly creates at least a general issue of material fact on the issue of FAS 133. So with so much evidence of scienter here, the So
Defendants cannot possibly be entitled to Summary Judgment. for those reasons, we respectfully request this Court to deny it. THE COURT: Let me ask you this question.
Do you agree
with Mr. Fink that if they were to win this Motion, that would be the end of the case? MR. STOCK: I think if FAS -- there is no question that
FAS 133 is a large portion of the restatement. THE COURT: MR. STOCK: What would be left? Well, there were 30 accounting violations
in this case so they have not sought Summary Judgment as to the
121
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
other 29 accounting policy violations so one out of 30.
I mean
recognizing again that 13 is a large part of this here and that's another problem with the approach the Defendants have taken. They attempt to isolate and decontectualize one of
these standards away from all the scienter evidence of the other standards. THE COURT: MR. STOCK: THE COURT: MR. STOCK: THE COURT: MR. STOCK: Decontecturalize? I am riffing here, your Honor. Is that a midwestern term? It must be. That's interesting. Under these facts, your Honor, not
including the representative Royce transcript -THE COURT: What would the ripple effect be as to the
individual Defendants? MR. STOCK: THE COURT: MR. STOCK: If you were to grant Summary Judgment? On this one. I think we would have the same issue. The
individuals would -- again there are still allegations here as to 29 other GAAP violations. We would have to still prove that
there were scienter and all the other Rule 10(b)5 elements with respect to all the other 29 GAAP violations, but we don't think the Court needs to reach that issue here. questions, thank you, your Honor. THE COURT: You are welcome. You have got ten minutes, If there are no other
122
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
Mr. Fink. MR. FINK: Thank you, your Honor. Before I respond to
some of the specific points made by Mr. Stock, I would like to first say is that nothing he said creates a genuine issue of fact for trial on the issue scienter as to FAS 133. Nothing
overcomes the showing that we made that Fannie Mae showed all kinds of outsiders its playbook. to the GAO, to KPMG. THE COURT: Now, this most recent one he just put up on It gave its playbook to OFHEO,
the screen here he contends that Mr. Boyles acknowledged that under that situation that was a kind of a modification of the playbook as it occurred in that situation. that characterization? MR. FINK: Absolutely 100 percent. What Fannie Mae did Do you disagree with
was to write down in writing in detail exactly what it was going to do. Did it label it known departures from GAAP? No, it did
not label it as known departures from GAAP because they didn't believe that those policies materially departed from GAAP. Now, you have asked a number of questions about what if you violated 133, would that automatically be a violation of GAAP? The answer is no. The reason the answer is no is because You could have
you have always embed the issue of materiality. a departure from
an accounting standard, but if it is not a
material departure, if the amount of the departure is immaterial, it doesn't violate GAAP.
123
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
They believed, and it is undisputed they believed, that the policies as written as detailed in the DAG materially
complied with GAAP and so they were not afraid to hand it over to people who could read it and say, well, maybe you don't think it materially violates GAAP, but I have some questions. They
were not afraid of that scrutiny, and that's why they wrote it down and handed it out. THE COURT: So this concept of inconsequential
effectiveness that Mr. Boyles talked about, testified about, wrote about in the documents, this was something that was known in advance of its execution and application? MR. FINK: THE COURT: MR. FINK: THE COURT: MR. FINK: Absolutely. It was known to the people at OFHEO? Absolutely. It was known to the people at the SEC? Well, they didn't go to the SEC to discuss
their policies in advance, but let me explain -THE COURT: But -MR. FINK: -- let me explain how they know that from getting the DAG. Any time you have a derivative in a hedged It is just
item, they will literally not offset to the penny. humanly impossible.
So the question is if the derivative goes
up in value, how much does the hedged item go down and vice versa? It is never going to be to the penny. What if it is a dollar? Who cares? What if it $10? Who
124
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
cares?
Well, in this situation when the change in value of the
derivatives was in the tens of billions of dollars and you asked him that question, how much was it, the part that wasn't completely offset, that's the ineffectiveness. The part that
was not completely offset was in the low millions of dollars on tens of billions of dollars of change in value. That is by
anybody's definition de minimus, inconsequential, trivial, whatever word you want to use. THE COURT: MR. FINK: How about immaterial? It is nothing and their experts said they
had no basis to disagree with the company's tests which they did and which we put into evidence that showed that the ineffectiveness was trivial, inconsequential, immaterial. That's what we are talking about, and anybody who understood this area when they read paragraphs 68, when they read paragraph 65 would know that's exactly what it means. So let's put up, if we can, paragraph 68 which is I think number seven. Oh, sorry. This is paragraph 68. What's
important here is that paragraph 68 which is one -- I remember I told you there were two paragraphs -- this is one of them. uses the word match. The terms have to match. Well, what does that It
People started asking questions.
mean? Let's put up number three which is the slide that Mr. Stock used I think on paragraph 68. Yes. It is the same slide, He said, well,
but I just highlighted what he talked about.
125
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
there was DIG, DIG was an arm of the FASB, Derivatives Implementation Group. People were so confused about FAS 133
they had to form a special group just to answer questions about 13. THE COURT: MR. FINK: No wonder. People are wondering what does match mean? So the DIG came out
Does that mean literally exactly match?
with E4 and said the verb match means exactly the same, exactly the same. Okay? Now let's look at paragraph 65. This is the other
paragraph that allows for this quote "assumption" of no ineffectiveness that's been discussed. eight I think. Okay. Let's put up, yes, slide
So this is paragraph 65. It uses It says the terms,
different language.
It doesn't say match.
the critical terms must be the same.
Well, why did they use
different words? There must have been some reason. This is the debate. This is what people were
debating -- wow, why did they do that? Does it mean maybe it is not exactly the same? exactly the same. The DIG came out and said match means
There is no DIG E4 or E5 or E6 or E7 that
tells you what the same means. So people started thinking and believing that the same had some wiggle room. If two people are both 62 years old but
one is born in August and the other born in April they would both say they are the same age. They are not exactly the same
126
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
age, but for all intents and purposes, for any reason that it would matter to anyone, they are the same age. And that's what Fannie Mae did. They said we think
that if we design the derivatives so that they are so close that they are essentially the same, that we can do this. This is the
issue that the SEC disagreed with them in 2004, and this is the same issue, the exact same issue, that in 2007 the SEC said you know what? Same doesn't have to be exactly the same. If the
terms are close enough so that that ineffectiveness, that differential so small that it doesn't matter to anyone, then we are going to let you do this. It is okay. And that
interpretation is the same words. So Fannie Mae interpreted those words in 2001 to mean what I just told and the SEC interpreted those exact same words in 2007 to mean what I just told you. It cannot have been a
fraudulent interpretation of the same words just because it happened six years earlier. They are the same exact words. So
that's why I say objectively it can't be the case that it was a fraudulent interpretation. Now Mr. Stock said, well, OFHEO and SEC originally although they changed their mind and Deloitte were over here and then there were other people over here. That's my point.
Different people interpreted the exact same words differently. It doesn't mean either one was committing fraud. they read these words differently. It just means
127
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
THE COURT:
He says they were doing it the way -- they
were doing it that way in order to deal with the volatility issues that was set forth in those tenents knowing full well will that if they were successful in minimizing the volatility, it would have a positive effect on the stock price, the value of the stock price on the marketplace. MR. FINK: What do you say to that?
Well, what I say to that is that hedge That's the
accounting in fact is designed to avoid volatility. whole purpose of hedge accounting. the hedges
Otherwise, you would have
and the derivatives going up and down like this.
What the FASB says if you meet certain tests, you get to -- you have earned the privilege of not having volatile financial statements. And, remember, the volatility is not reflecting what's actually happening in the business. If everybody knows the loss
is offset by the gain, what purpose would it serve to have earnings that are going like this instead of actually reflecting what was happening in the business? To say that somebody wants
to, I am motivated by this evil desire to portray the economics accurately, what kind of fraud is that? It doesn't make any sense. That is not an intent to materially mislead investors. It is an intent to the accurately portray the business. Let me
address the three tenents because this comes up all the time in this case and somebody is going to have to explain this so I
128
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
might as well be the person to do it. The three tenents. The first tenent was earnings
volatility should be minimized and, if there is earnings volatility, it should be as predictable as possible. THE COURT: MR. FINK: Who created these three tenents? Jonathan Boyles wrote them in a memo in 2003
talking about the implementation of 133 in-THE COURT: MR. FINK: Where? He was trying to explain to senior
management what motivated some of the decisions that had been previously made . He was actually talking more about
operational issues, but let's take them at face value. THE COURT: MR. FINK: So these were his tenents? Right. Exactly. Their experts said there
is nothing wrong with that.
Earnings volatility should be
minimized and if there is to be earnings volatility, it should be as predictable as possible. Nothing. What's wrong with that? If
And their experts agreed nothing wrong with it.
that's evil, if that's evil, then the inverse of it should be pure and good. What's the inverse? Earnings volatility should be maximized and earnings volatility should be as unpredictable as possible. That's ridiculous and -THE COURT: At a minimum that would outlaw hedge
accounting, wouldn't it?
129
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 same.
MR. FINK:
Yes.
And all the other tenents are the
Fannie Mae should leverage off existing systems as much What's the pure and good inverse? Fannie Mae
as possible.
should leverage off existing systems as little as possible. That's ridiculous. easily understood. Operating earnings need to be simple and Operating earnings need to be complicated
and difficult to understand. Now, if they had adopted those three tenents maybe we would be talking about some kind of fraud but -THE COURT: MR. FINK: motivation. OFHEO liked that idea. But I mean those tenents, they are not evil Your
They are nothing at all like evil motivation.
Honor, I know I am running out of time here so I am not going to try to respond to every point. that. It is in our briefs. It would be difficult to do
I would say as you observed yourself
much of what they showed you was inadmissible hearsay -- OFHEO reports, the Paul Weiss report, complaints that various people have filed, you know, internal e-mails and documents from people who didn't testify that aren't -- you know, don't show, you know, what the person meant or they weren't cross-examined. There is all kinds of documents in the record like this. They flashed a lot of them up. We stand on those objections. into consideration. Your Honor, if you are having trouble seeing clear and We objected to them.
We would like you to take those
130
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
obvious answers as to what the accounting should or should not have been, I say welcome to the club. This went on year and
year after year, the confusion about what these words meant. The SEC ultimately settled it. interpret it this way. So we respectfully request, your Honor, that the Court enter Summary Judgment on the issue of scienter in favor of the Defendants. THE COURT: All right. Counsel. We will back tomorrow They came in and said you can
for the three individual Defendants have Summary Judgment Motions. We will be covering Raines' and Howard's Motions in
the morning before lunch and in the afternoon the Spencer Motion. So we will start at ten with the Raines' Motion and
take a break at 11:30 and then we will do the Howard Motion from 12:00 to 1:30. There will be a late lunch tomorrow but we will
get back going with the Spencer Summary Judgment Motion at 3:30 tomorrow. tomorrow. It will be a long day. Thank you. (Whereupon, at 4:24 p.m., the proceedings were concluded.) Get your rest. See you
131
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25
CERTIFICATE OF REPORTER
I, Patty A. Gels, certify that the foregoing is a correct transcript from the record of proceedings in the above-entitled matter.
_________________________

Transcript Fannie Mae Hearings

Uploaded by

Document Information

Original Description:

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Transcript Fannie Mae Hearings

Uploaded by

Copyright:

Available Formats

Case 1:04-cv-01639-RJL Document 1048 Filed 09/04/12 Page 1 of 131

UNITED STATES DISTRICT COURT FOR THE DISTRICT OF COLUMBIA

IN RE: FANNIE MAE SECURITIES LITIGATION . . . . . . . . . . . . . . . .

: Docket No. CV04-1639 (RJL) : : June 5, 2012 : 11:00 a.m.

For Fannie Mae:

Case 1:04-cv-01639-RJL Document 1048 Filed 09/04/12 Page 2 of 131

For Franklin Raines:

For Leanne Spencer:

For J. Timothy Howard:

Case 1:04-cv-01639-RJL Document 1048 Filed 09/04/12 Page 3 of 131

Proceedings reported by machine shorthand, transcript produced by computer-aided transcription

Case 1:04-cv-01639-RJL Document 1048 Filed 09/04/12 Page 4 of 131

P R O C E E D I N G S COURTROOM DEPUTY: Calling civil case 04-1639, In Re:

Markovits on behalf of Lead Plaintiffs OPERS and STRS.

MR. MARKOVITS: MR. KILDUFF:

Good morning, your Honor, Jeff Kilduff With me here

with O'Melveny & Myers for Defendant Fannie Mae.

MR. KILDUFF: MR. WARIN:

the Gibson, Dunn & Crutcher firm.

Case 1:04-cv-01639-RJL Document 1048 Filed 09/04/12 Page 5 of 131

THE COURT: MR. DOWNEY:

Welcome. Good morning, your Honor, Kevin Downey Alex

Good morning, your Honor, Eric Delinsky

MR. DELINSKY: MR. KRAKOFF: THE COURT:

Good morning. Good morning, your Honor.

Mr. Krakoff. David Krakoff of Buckley Sandler with my

MR. KRAKOFF: partner -THE COURT:

MR. KRAKOFF: and we got the Elmo. THE COURT:

MR. KRAKOFF: over there, your Honor.

Case 1:04-cv-01639-RJL Document 1048 Filed 09/04/12 Page 6 of 131

Are you ready to get rolling? Yes, sir.

MR. MARKOVITS: THE COURT:

As you know, the parties agreed to do

If I may your Honor, may I just reserve

MR. MARKOVITS: THE COURT:

Bill Markovits on behalf of Lead Plaintiffs OPERS and STRS.

Case 1:04-cv-01639-RJL Document 1048 Filed 09/04/12 Page 7 of 131

decipher Plaintiffs' theories from a series of cryptic

Case 1:04-cv-01639-RJL Document 1048 Filed 09/04/12 Page 8 of 131

allegations. Well, first that's untrue. Both Plaintiffs and their

more importantly that's totally irrelevant. isn't what Plaintiffs say.

The question is what Fannie Mae

This is Plaintiffs' Exhibit 4, the

-- right, Rudman Report.

Case 1:04-cv-01639-RJL Document 1048 Filed 09/04/12 Page 9 of 131

MR. MARKOVITS: THE COURT:

The malpractice complaint. Correct. What was the fourth one?

MR. MARKOVITS: THE COURT:

Their own experts' admissions and the

Rudman Report certainly did. Yes.

So if I understand you correctly, you are

Case 1:04-cv-01639-RJL Document 1048 Filed 09/04/12 Page 10 of 131

Um-hmm. Again, Fannie Mae however tries to

documentation of hedging relationships; two, classification of derivatives; three, assessment of effectiveness.

it violated these three requirements. their restatement. Slide seven.

We incorrectly classified derivatives

Case 1:04-cv-01639-RJL Document 1048 Filed 09/04/12 Page 11 of 131

The primary reasons for the loss of hedge

the Rudman Report.

Case 1:04-cv-01639-RJL Document 1048 Filed 09/04/12 Page 12 of 131

special review committee which in turn

This statement was a Fannie Mae news release. Mae letterhead.

It was put on the Fannie Mae website.