Case 1:04-cv-01639-RJL Document 1036 Filed 08/03/12 Page 1 of 16

IN THE UNITED STATES DISTRICT COURT FOR THE DISTRICT OF COLUMBIA

MDL No. 1668 In re Fannie Mae Securities Litigation Civil Action No. 1:04-cv-01639 (RJL)

DEFENDANTS SUPPLEMENTAL MEMORANDUM OF POINTS AND AUTHORITIES IN SUPPORT OF THEIR JOINT MOTION FOR PARTIAL SUMMARY JUDGMENT BASED ON FAS 133 ACCOUNTING ISSUES

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TABLE OF CONTENTS Page A. B. The DAG Did Not Excise Fannie Maes Application of FAS 133. ................................ 1 Detailed Calculations on Tens of Thousands of Hedges Would Not Have Made Fannie Maes Results Significantly More Volatile. .................................................................... 5 Plaintiffs Cannot Avoid Their Experts Admission That the SEC Changed Their Interpretation of FAS 133. ................................................................................................ 7 It Is Plaintiffs, Not Defendants, Who Attempt to Isolate and Decontextualize the Substantial Record Evidence Concerning Fannie Maes FAS 133 Policy. ........................ 9

C.

D.

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TABLE OF AUTHORITIES Page(s) Cases AMSC Subsidiary Corp. v. FCC, 216 F.3d 1154 (D.C. Cir. 2000) .................................................................................................. 2 City of Nephi, Utah v. FERC, 147 F.3d 929 (D.C. Cir. 1998) .................................................................................................... 2 Cruz v. Am. Airlines, Inc., 356 F.3d 320 (D.C. Cir. 2004) .................................................................................................... 2 SEC v. Shanahan, 646 F.3d 536 (8th Cir. 2011) ....................................................................................................... 7 *SEC v. Steadman, 967 F.2d 636 (D.C. Cir. 1992) ................................................................................................ 1, 6

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Securities fraud based on FAS 133 is plaintiffs central allegation in this action. Defendants FAS 133 motion seeks summary judgment in favor of defendants on any claim that Fannie Maes FAS 133 policy was intended as a fraud on investors or was an extreme departure from the standards of ordinary care . . . which presents a danger of misleading buyers or sellers that is either known to the defendant or is so obvious that the actor must have been aware of it. SEC v. Steadman, 967 F.2d 636, 641-42 (D.C. Cir. 1992) (internal quotation omitted). At oral argument, plaintiffs made several assertions about the FAS 133 policy and its application that did not appear in their memorandum of law. Plaintiffs did not point to any evidence in the record supporting these assertions. Defendants, on the other hand, did develop a record on these issues, and that evidence squarely contradicts plaintiffs assertions. Defendants submit this supplemental brief to identify that record evidence. A. The DAG Did Not Excise Fannie Maes Application of FAS 133. At oral argument, plaintiffs did not dispute that Fannie Mae had distributed its Derivatives Accounting Guidelines (or DAG) widely, inside and outside the company, including to OFHEO and the GAO. Nor did they seriously contest that such transparency is at odds with any intent to mislead investors. Rather, they asserted that the DAG excised any reference to the interpretations and applications that plaintiffs challenge under FAS 133: 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 werent in there. So passing around a derivatives accounting guideline that excises the key stuff, thats not exactly transparency. June 5, 2012 Tr. at 99:20-25. It is a claim they made again and again. See id. at 96:20-97:1,

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111:21-112:6. Plaintiffs pointed to duration matching as their best evidence on this point.1 Plaintiffs called duration matching a new concept and novel transaction that didnt exist in FAS 133. June 5, 2012 Tr. at 107:24-109:2. Plaintiffs suggest this is an example of Fannie Mae deviating from the playbook it gave to OFHEO and the GAO. See id. at 122:9-13. They even go so far as to accuse Fannie Mae of intentionally flying under the radar on this issue in its communications with OFHEO. Id. at 109:13-15. Plaintiffs made no such argument in their memorandum of law. The sole reference to duration matching (at page 8) did not include the assertion that Fannie Maes actual duration matches deviated from its written policy.2 In fact, plaintiffs elsewhere agreed to just the opposite. Defendants stated at paragraph 61.b of their Statement of Undisputed Material Facts (SUMF): This DAG manual described how each type of business transaction worked; it provided a diagram illustrating the description; and it set out the parameters that needed to be satisfied before Fannie Mae would forego detailed, quarterly calculations of ineffectiveness. Plaintiffs responded: Lead Plaintiffs do not dispute this statement. They made no exception for duration matching.

See June 5, 2012 Tr. at 105:22-109:16,116:25-117:25. For example, plaintiffs repeatedly pointed to an email in which Mr. Argires of KPMG recounted a discussion with Ms. Spencer where he noted that not all of the policy was in strict compliance with GAAP, but added that there is a mechanism in place that measures how material the departure from GAAP is. June 7, 2012 Tr. at 30:8-19; June 13, 2012 Tr. at 153:2-154:4. Mr. Argires testified that the matter not in strict compliance with GAAP was duration matching. Argires Tr. at 272:9-273:8 (Leanne G. Spencers Mot. for Summ. J. Ex. 173) (Deposition Exhibit 24 marked); id. at 277:14-284:13; see also June 13, 2012 Tr. at 158:2-18.

This is reason enough to disregard plaintiffs argument. Cf. AMSC Subsidiary Corp. v. FCC, 216 F.3d 1154, 1161 n.** (D.C. Cir. 2000) (Although AMSC alluded to the factual basis for this claim in the statement of facts in its opening brief, it did not actually make the argument until its reply brief. The argument is therefore waived.); cf. also Cruz v. Am. Airlines, Inc., 356 F.3d 320, 329 (D.C. Cir. 2004) (The issue is whether, in light of the policy of this rule to encourage[ ] parties to communicate with each other and the trial judge, plaintiffs apprised the district court with sufficient clarity of this challenge . . . . (alteration in original) (internal quotation omitted)); City of Nephi, Utah v. FERC, 147 F.3d 929, 933 n.9 (D.C. Cir. 1998) (petitioner failed properly to raise the argument because it merely inform[ed] the court in the statement of facts in its opening brief of the facts underlying the argument).

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Not only is plaintiffs argument new, it is wrong. The DAG describes duration matching in some detail. The section titled Derivatives Accounting Policies states: DIG Issue G-9 . . . clarifies some situations where a company can presume no ineffectiveness if the critical terms of the hedging instrument and the hedged item match. This guidance can be applied to certain hedging strategies used by the Hedge Desk. For example, the Hedge Desk can assume no ineffectiveness when it is hedging with derivatives that are Treasury-based (risk-free rate), LIBORbased, or Agency-based and are also within a certain duration range of the debt being hedged. 2001 Derivatives Accounting Guidelines, IV.12, KPMG-CIV-00108327 at 00108404 (Defs. Ex. 59). The section of the DAG titled Derivatives Accounting Procedures provides the details: Fannie Mae has defined procedures (using DIG Implementation Issue G-9 as guidance) that allow for no hedge ineffectiveness to be assumed when the critical terms of the hedging instrument and the hedged item match. Fannie Mae refers to this as the shortcut method for the Hedge Desk. The procedures for applying the shortcut method are outlined below. Id. at V.8., KPMG-CIV-00108327 at 00108427 (Defs. Ex. 59). Such hedges must meet certain criteria, including a duration parameter. Id. The hedging instruments: must be within a certain duration range of the anticipated debt issuance. The duration ranges for applying the shortcut method are: [Listing duration match ranges.] If the anticipated debt issuance and the derivatives used are within the range above, the notional amounts on the debt and the derivatives do not need to match. Id. at V.9, KPMG-CIV-00108327 at 00108428 (Defs. Ex. 59) (emphasis in original).3

Plaintiffs also are wrong in claiming that duration matching was a new concept that didnt exist in FAS 133. June 5, 2012 Tr. at 107:23-24, 108:22. Professor Dwight Grant explained that what Fannie Mae was doing is common in finance and economics. Grant Report at 47 (Defs. Ex. 50). In response to questions from plaintiffs about Fannie Maes duration matching, Mr. Timothy Lucas testified that it appeared in a FASB-authored 133 training program, a program that Mr. Lucas himself taught back at the time. Lucas Tr. at 330:12-331:1 (Defs. Ex. 110). (At that time, Mr. Lucas was the Director of Research and Technical Activities for the FASB and was significantly involved in the development of

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Plaintiffs identified nothing that was excised from this description. To the contrary, in their response to paragraph 60.a of defendants Statement of Undisputed Material Facts, plaintiffs pointed to this very DAG language as the supposed FAS 133 violation: Rather than requiring matching notional amounts in connection with the hedging of anticipatory (forecasted) debt issuances, Section V.9 of Fannie Maes DAG provided that if the duration range between anticipated debt issuances and the derivatives used were within specified ranges, the notional amounts on the debt and the derivatives do not need to match to assume no ineffectiveness. (citation and footnote omitted). Plaintiffs FAS 133 expert pointed to the same statements in his report, and never claimed that anything had been omitted from that description. See Barron Report at 44 (Defs. Ex. 3).4 Likewise, while plaintiffs argued that the actual hedging transactions deviated from the DAG, they failed to cite even one example. See, e.g., June 7, 2012 Tr. at 32:24-33:9 (The book was saying one thing and they were doing another thing.). Defendants put into the record numerous actual duration matching transactions (which were included in the testing that showed minimal ineffectiveness). Defs. SUMF 48, 51 (Defs. Ex. 53 [Nov. 2004 Letter to the SEC, Tab C]). Plaintiffs do not point to any that departed from the parameters laid out in the DAG. With more than 30,000 hedging transactions entered into during the Class Period, Defs. SUMF 42, plaintiffs do not identify even one instance where the DAG said one thing and Fannie Mae did another.

FAS 133. Defs. SUMF 14, 93.) Defendants did not cite these materials in their motion papers because plaintiffs had never claimed that duration matching was new.
4

The same is true of the seven-day policy, which was the focus of much discovery but little attention at the arguments. It is set forth in the Derivatives Accounting Policies section of the DAG (2001 Derivatives Accounting Guidelines, IV.20, KPMG-CIV-00108327 at 00108412 (Defs. Ex. 59)) and repeated in the Derivatives Accounting Procedures section, including three different examples applying the policy (id. at V.53-55, 58, 71, KPMG-CIV-00108327 at 00108472 to 474, 00108477, 00108490 (Defs. Ex. 59)).

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B. Detailed Calculations on Tens of Thousands of Hedges Would Not Have Made Fannie Maes Results Significantly More Volatile. At oral argument, plaintiffs also asserted that had Fannie Mae been measuring and assessing ineffectiveness, and then recording that ineffectiveness as income or expense on the financial statements, their earnings would have been significantly more volatile. June 5, 2012 Tr. at 101:21-24. Plaintiffs pointed to no evidence that the amount of ineffectiveness produced by the hedging transactions would have had a significant effect on earnings volatility, instead simply stating: There would have been much more volatility, and Defendants would concede that. Id. at 102:2-3. Defendants made no such concession, because there is substantial record evidence on this very point, and all of it shows the ineffectiveness created by these hedges was inconsequential. For instance, Fannie Maes testing of the seven-day policy that underlay its hedges of discount notes (and plaintiffs claims) showed worst case ineffectiveness of only $5.4 million in 2004, and likely ineffectiveness of a mere $0.4 million. It showed even less on an annual basis from 2001 to 2003. See Nov. 2004 Letter to the SEC, Tab B (Defs. Ex. 53). Testing of the duration matches showed ineffectiveness of only $1.5 million in 2001 and $2.8 million in 2002. Id. at Tab C. In 2003, the ineffectiveness was approximately $12 million, and that amount was recorded and included in Fannie Maes financial statements. Id.; Mar. 13, 2004 Memo. from J. Boyles (Defs. Ex. 55) (also proffered as Pls. Ex. 30). Net income in 2001-2003 was $5.9 billion, $4.6 billion, and $7.9 billion, respectively (KPMG LLPs Statement of Additional Undisputed Material Facts Submitted in Supp. of Its Oppn to Pls. Mot. for Partial Summ. J. on Count III Against Def. KPMG LLP 47, 60, 61), amounts that dwarf the ineffectiveness at issue here.

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Defendants expert, Professor Dwight Grant, focused on precisely this issue and reached the same conclusion: any ineffectiveness on the hedges was inconsequential. Defs. SUMF 48.a (Defs. Ex. 50 [Grant Rep.]). Those conclusions are unrebutted. Plaintiffs experts did not speak to the subject, and they disclaimed any basis to challenge those conclusions. See Defs. SUMF 105, 106; Defs. SUMF Reply 48.c. Nor did plaintiffs claim a basis for challenging this conclusion, prior to oral argument. In their responses to defendants Statement of Undisputed Material Facts, plaintiffs stated: Lead Plaintiffs do not dispute that Fannie Maes FAS 133 team determined that if the difference in reset dates for the two sides of the hedging relationships was never more than seven days, any ineffectiveness would be insignificant. . . . .... Lead Plaintiffs do not dispute that Fannie Mae determined in a limited number of other areas that so long as certain terms of the hedged item and hedging instrument fit within highly constrained parameters, any ineffectiveness would always be inconsequential. Pls. SUMF Resp. 48, 49. During oral argument, this Court asked whether it was speculative to assert, as plaintiffs did, that investors would have said on the basis of this additional earnings volatility, we are not going to invest in that stock. June 5, 2012 Tr. at 102:7-12. Since all the record evidence demonstrates this ineffectiveness was tiny, such an inference is not only speculative but unsupported. Plaintiffs have not given a jury (or this Court) any basis to conclude that $1 million or $3 million or $5 million would have been even remotely significant to an investor in deciding to purchase or sell Fannie Mae stock. Even more to the point, plaintiffs have offered no evidence that the defendants acted with scienter: the small amount of ineffectiveness from these hedging transactions created no risk of misleading investors, much less one so obvious that defendants must have been aware of it. Steadman, 967 F.2d at 641-42 (internal quotation

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omitted); see also SEC v. Shanahan, 646 F.3d 536, 545 (8th Cir. 2011) (weak proof of materiality is fatal to a claim of scienter). C. Plaintiffs Cannot Avoid Their Experts Admission That the SEC Changed Their Interpretation of FAS 133. Plaintiffs spent the better part of their argument time on KPMGs summary judgment motion re-arguing the FAS 133 motion. They no longer seemed to contest thatin the words of their own expertthe SEC changed their interpretation about whether hedge terms had to match exactly. See Defs. SUMF 92. Instead, they argued that this change and the White Paper that preceded it applied to one provision of FAS 133 (paragraph 65). June 7, 2012 Tr. at 37:12-38:14. Fannie Maes DAG, they argued, relied exclusively on another provision of FAS 133 (paragraph 68), and that paragraph did not allow for immaterial departures or anything less than an exact match. See, e.g., id. at 33:23-35:23. Plaintiffs claimed that Fannie Maes citation of paragraph 65 in its 2003 revisions to the DAG was just a post hoc rationalization created because the heat was coming down on Fannie Maes FAS 133 policy. Id. at 41:9-13. This, according to plaintiffs, is the pie in the face that Mr. Warin was talking about. Your Honor, you got to show me pie. Well, here is the pie in the face. Id. at 42:25-43:7. Plaintiffs did not make this pie in the face argument in their memorandum of law on the FAS 133 motion, or in their memorandum of law on KPMGs summary judgment motion. See, e.g., Pls. Mem. of P. & A. in Oppn to Defs. Joint Mot. for Partial Summ. J. Based on FAS 133 Accounting Issues (Pls. FAS 133 Oppn) at 4 & n.8, 7; Pls. Mem. of P. & A. in Oppn to KPMG, LLPs Mot. for Summ. J. (Pls. KPMG Oppn) at 11 n.52 (only reference to paragraph 65).5 The reason may be that this pie in the face argument is a far cry from an intent to

Regarding the White Paper and the SECs changed interpretation, plaintiffs did not draw distinctions between paragraphs, but claimed only that these later events were irrelevant. Pls. FAS 133 Oppn at 40-

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mislead investors. Plaintiffs do not contest that Fannie Mae could have properly cited paragraph 65 in the original DAG. Nor do they question that the White Paper and the SECs changed . . . interpretation of paragraph 65 are consistent with Fannie Maes FAS 133 policy. Even if it were true that the 2003 version of the DAG referenced paragraph 65 but the original version did not, that is no evidence of securities fraud. Being right for the wrong reason in an internal policy document is not deceiving the public. The claim also is not true. The original DAG did rely on paragraph 65, and for the very policies on which plaintiffs focus. The description of the shortcut for duration matching contained in the original DAG (quoted in section A above) never mentions paragraph 68; rather, it cites DIG Issue G-9, which is an interpretation of paragraph 65. See Compendium of DIG Issues (Defs. Ex. 119). Likewise, the description of the seven-day policy in the original DAG refers to the circumstances when dates will be considered the same, which is the term used in paragraph 65. (Paragraph 68, on the other hand, talks about a match.) See 2001 Derivatives Accounting Guidelines, V.51-53, KPMG-CIV-00108327 at 00108470 to 472 (Defs. Ex. 59); June 5, 2012 Tr. at 124:17-126:2. Not surprisingly, plaintiffs cite no record evidence to support their counsels statement that Fannie Mae decided to revise the DAG in 2003 because the heat was coming down. June 7, 2012 Tr. at 58:8-25. Even plaintiffs own FAS 133 expert agreed that it was appropriate for Fannie Mae to look to paragraph 65 as guidance for its accounting policy: Q. . . . . Is it your opinion that Paragraph 65 is not relevant guidance for [the hedging of Fannie Maes discount note] program? A. No. Thats not my opinion that its not relevant, no. ....
41. When arguing the FAS 133 motion, plaintiffs dismissed any difference between the paragraphs. June 5, 2012 Tr. at 94:8-12 (I dont want to get into it. They essentially come to the same place.).

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Q. [I]s it appropriate for Fannie Mae, among other things, to look at Paragraph 65 in determining how to account for this program? A. Yes. Well, 65 and 66. I hate to keep adding that, but you have to look at them together. Barron Tr. at 272:12-16, 273:16-22 (Defs. Ex. 33). He went further. As the DAG notes, the hedging programs on which plaintiffs have focusedthe rollover of discount notes and duration matchingare hedges of forecasted transactions. See 2001 Derivatives Accounting Guidelines, IV.10, IV.20, KPMG-CIV-00108327 at 00108402, 00108412 (Defs. Ex. 59). Plaintiffs FAS 133 expert opined that a forecasted issuance of debt is entirely out of the purview of Paragraph 68. Barron Tr. at 272:17-273:14 (Defs. Ex. 33). In other words, Fannie Mae could look only to paragraph 65the very opposite of what plaintiffs claimed at oral argument. In sum, plaintiffs used the better part of their time in response to KPMGs summary judgment motion in order to make yet another new argument about the FAS 133 policy, unsupported by record evidence, and contradicted by the undisputed evidence (including the testimony of their own expert), without any link to an intent to mislead investors. Such arguments cannot save plaintiffs FAS 133 claims from summary judgment. D. It Is Plaintiffs, Not Defendants, Who Attempt to Isolate and Decontextualize the Substantial Record Evidence Concerning Fannie Maes FAS 133 Policy. Asked by the Court whether the lack of evidence that Fannie Maes FAS 133 policy was intended as a fraud on investors would be the end of the case, plaintiffs argued that defendants attempt to isolate and decontextualize the evidence of scienter. June 5, 2012 Tr. at 120:18121:6. But the record on the development and implementation of the FAS 133 policy is comprehensive. No other accounting policy received as much attention during discovery in this matter. That discovery identified no other policy that was developed by a large, cross-

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disciplinary team, that took five years to implement, or that was as highly computerized as the FAS 133 policy. Plaintiffs point to no other policy that was discussed as often and in as much detail with OFHEO, or any other policy that was shared with the GAO. Plaintiffs own FAS 133 expert acknowledged that FAS 133 related adjustments made up approximately 90% of the net amount of the total restatement. Barron Report at 57 (Defs. Ex. 3); see also June 5, 2012 Tr. at 42:9-17. It is not defendants, but rather plaintiffs, who isolate and decontextualize. They quote snippets of documents. Time and again, the entire quote makes clear that there is no dispute over what any defendant was thinking about the FAS 133 policy: that it complied with GAAP; and that if it departed from GAAP in any respect, such departure was immaterial. See, e.g., June 7, 2012 Tr. at 29:7-21, 31:9-32:5. That is the only evidence as to any defendants intent, and it is utterly contrary to any inference that Fannie Maes FAS 133 policy presented a risk of misleading shareholdersmuch less a risk so obvious that defendants had to have known shareholders would be misled. When plaintiffs are forced to put their FAS 133 claims in context, it is clear just how far those claims are from any evidence of securities fraud. Explaining at oral argument how earnings management can amount to securities fraud, plaintiffs admitted that [i]t is not an evil in and of itself. June 13, 2012 Tr. at 13:4-9. Rather, if you are simply doing a transaction at the end of the year for no economic purpose other than to meet a target . . . thats abusive earnings management. That is a violation. Id. at 14:22-15:7. Nothing could be further from the hedging transactions at issue here. There is no question of economic purpose: these were hedging transactions, undertaken to manage interest rate risk. See June 5, 2012 Tr. at 87:17-25; Mem. of P. & A. in Supp. of Defs. Joint Mot. for Partial Summ. J. Based on FAS 133 Accounting Issues

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(Defs. Mem.) at 3-4. There is no issue that these transactions were highly successful in achieving that purpose. See June 5, 2012 Tr. at 124:1-16; Defs. Mem. at 7-8. And there is no issue that the transactions and their effect were disclosed and that investors understood them. See June 5, 2012 Tr. at 81:15-82:10; Defs. Mem. at 13-14, 24. Plaintiffs are left trying to make a nonsensical claim that defendants designed and implemented a hedge accounting policy that violated FAS 133 in the service of the Companys mission to portray the economic business realities underlying those transactions. Pls. KPMG Oppn at 16 (emphasis added). Whatever such a claim means, it is not securities fraud. It is time the claim was dismissed. * * *

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For the reasons stated above and in defendants joint briefs in support of their Motion for Partial Summary Judgment Based on FAS 133 Accounting Issues, as well as defendants briefs on their separate motions for summary judgment, the Court should grant summary judgment in favor of defendants on the issue of scienter as it relates to Fannie Maes FAS 133 accounting. DATED: August 3, 2012 Respectfully submitted,

/s/ F. Joseph Warin______________ F. Joseph Warin (D.C. Bar No. 235978) Scott A. Fink (pro hac vice) John H. Sturc (D.C. Bar No. 914028) George H. Brown (pro hac vice) Andrew S. Tulumello (D.C. Bar No. 468351) David Debold (D.C. Bar No. 484791) GIBSON, DUNN & CRUTCHER LLP 1050 Connecticut Avenue, N.W. Washington, D.C. 20036 Telephone: (202) 955-8500 Facsimile: (202) 467-0539 Counsel for Defendant KPMG LLP /s/ David S. Krakoff_______________ David S. Krakoff (D.C. Bar No. 229641) Christopher F. Regan (D.C. Bar No. 433972) Adam B. Miller (D.C. Bar No. 496339) BUCKLEYSANDLER LLP 1250 24th Street, N.W. Washington, D.C. 20037 Telephone: (202) 349-8000 Facsimile: (202) 349-8080 Counsel for Defendant Leanne G. Spencer

/s/ Jeffrey W. Kilduff_______________ Jeffrey W. Kilduff (D.C. Bar No. 426632) Robert M. Stern (D.C. Bar No. 478742) Michael J. Walsh, Jr. (D.C. Bar No. 483296) OMELVENY & MYERS LLP 1625 Eye Street, N.W. Washington, D.C. 20006-4001 Telephone: (202) 383-5300 Facsimile: (202) 383-5414 Counsel for Defendant Fannie Mae

/s/ Eric R. Delinsky__________________ Steven M. Salky (D.C. Bar No. 360175) Eric R. Delinsky (D.C. Bar No. 460958) ZUCKERMAN SPAEDER LLP 1800 M Street, N.W. Washington, D.C. 20036 Telephone: (202) 778-1800 Facsimile: (202) 822-8106 Counsel for Defendant J. Timothy Howard

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CERTIFICATE OF SERVICE I certify that on August 3, 2012, I electronically filed the foregoing DEFENDANTS SUPPLEMENTAL MEMORANDUM OF POINTS AND AUTHORITIES IN SUPPORT OF THEIR JOINT MOTION FOR PARTIAL SUMMARY JUDGMENT BASED ON FAS 133 ACCOUNTING ISSUES with the Clerk of the Court using the CM/ECF system, which will send notification of such filing to counsel of record in this matter who are registered on CM/ECF. /s/ Christopher Meeks Christopher Meeks