KMPG's Statement of Facts Re: Fannie

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 1 of 36
IN THE UNITED STATES DISTRICT COURT FOR THE DISTRICT OF COLUMBIA
MDL No. 1668 In re Fannie Mae Securities Litigation
REDACTED
Civil Action No.:1:04-cv-01639 (RJL)
KPMG LLPS STATEMENT OF UNDISPUTED MATERIAL FACTS IN SUPPORT OF ITS MOTION FOR SUMMARY JUDGMENT Pursuant to Local Rule 7(h), Defendant KPMG LLP respectfully submits the following statement of material facts as to which there is no genuine issue to be tried: I. SCIENTER A. Fannie Mae and Its Financial Reporting 1. During the class period, Fannie Mae was the nations largest source of funds for mortgage lenders, providing resources to lenders to make mortgage loans. E.g., Ex. 35,1 Fannie Mae Form 10-K for the year ending December 31, 2003 (2003 Form 10-K) (Mar. 15, 2004) at 1. Fannie Mae was a large, complex and financially sophisticated organization with a number of personnel who were highly qualified in accounting and financial matters. E.g., Ex. 2, Berliner Tr. at 107:17-108:6; Ex. 3, Fierstein Tr. at 268:8269:5. Fannie Mae published annual audited financial statements, initially disseminating them itself and later filing them with the SEC.2 Ex. 33, Fannie Mae Information Statement dated April 1, 2002 (2001 Information Statement); Ex. 34, Fannie Mae Form 10-K for the year ending December 31, 2002 (2002 Form 10-K) (Mar. 31, 2003); Ex. 35, 2003 Form 10-K. KPMG served as Fannie Maes
2.
3.
All citations are to exhibits in KPMG LLPs Motion for Summary Judgment Evidentiary Appendix, identified by Ex.__. All of the exhibits in the Evidentiary Appendix are supported by the declaration of Monica K. Loseman. Fannie Mae was not registered with the SEC until early 2003, when its 2002 financial statements were filed. Prior to year-end 2002, Fannie Mae published annual Information Statements and quarterly Supplements to Information Statements, which in some ways resembled form 10-Ks and 10-Qs. 1
2
independent auditor throughout the relevant period. Ex. 33, 2001 Infromation Statement at 55; Ex. 34, 2002 Form 10-K at 146; Ex. 35, 2003 Form 10-K at 170. 4. Fannie Maes management was responsible for preparing the companys financial statements and ensuring that the financial statements were fairly presented in accordance with Generally Accepted Accounting Principles, or GAAP. Ex. 24, Fierstein Rebuttal Rep. at 10; Ex. 2, Berliner Tr. at 89:14-17. GAAP is a term of art that encompasses a wide range of acceptable principles. Ex. 2, Berliner Tr. at 89:21-90:10. Applying these accounting principles to particular transactions can require a significant degree of professional judgment. Ex. 2, Berliner Tr. at 92:19-22. Management must make reasonable estimates based on information that may or may not be complete. Ex. 2, Berliner Tr. at 92:14-94:10. In exercising such judgment, a primary objective of GAAP is to present information from the point of view of the underlying economics of the reporting entity. Ex. 2, Berliner Tr. at 91:19-92:1. Asked if he had any reason to doubt whether the intent of Fannie Maes FAS 91 and FAS 133 policies was to preserve the accuracy and utility of Fannie Maes financial statements by reporting what [management] honestly believed were the true economics of Fannie Mae's business, Mr. Berliner replied, I have no reason to doubt that [they] believed that. Ex. 2, Berliner Tr. at 108:20-21. The accounting standards in dispute in this case were complex and difficult to interpret. Ex. 2, Berliner Tr. at 107:19-21; Ex. 23, Fierstein Rep. 1-1 to 1-4. For instance, Mr. Berliner premised one of his criticisms on the complexities involved in Fannie Maes operations and accounting policies. Ex. 22, Berliner Rep. at 2-6. KPMGs role as the independent auditor was limited to expressing an opinion on managements financial statements based on professional standards. Ex. 2, Berliner Tr. at 102:16-103:14. KPMG did not report on the effectiveness of a companys internal controls because Section 404 of the Sarbanes Oxley Act, which introduced that requirement, was not effective until after the class period. Id. at 121:13-122:2. Auditors do not express an opinion or provide any assurance about the future earnings of the company, the quality of its management or the quality of its corporate governance. Ex. 2, Berliner Tr. at 102:22-103:14. KPMGs audit reports, included in and filed with Fannie Maes annual Information Statements or forms 10-K for the relevant years, set forth the scope of its opinion as follows:
5. 6. 7. 8.
9.
10.
11.
12.
13.
We have audited the accompanying balance sheets of Fannie Mae . . . and the related statements of income, changes in stockholders equity, and cash flows . . . . These financial statements are the responsibility of Fannie Maes management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, the financial statements . . . present fairly, in all material respects, the financial position of Fannie Mae . . . and the results of its operations and its cash flows . . ., in conformity with accounting principles generally accepted in the United States of America. Ex. 35, 2003 Form 10-K at 170 (emphasis added). KPMG offered no opinion on, and made no representation to investors about, the effectiveness of Fannie Maes internal controls. Id. 14. 15. The auditing standards to which KPMG referred are known as Generally Accepted Auditing Standards ("GAAS). Ex. 22, Berliner Rep. at 3. Auditors do not and cannot guarantee the accuracy of a companys financial statements. Rather, GAAS requires only that an auditor obtain reasonable assurance that the financial statements are fairly presented in accordance with GAAP. Ex. 28, AICPA Professional Standards (2005) (hereinafter AU) 230. The performance of an audit is a complex process, and no matter how professionally it may be performed the auditor cannot offer a guarantee or insurance (absolute assurance) that the financial statements are not materially misstated. Fundamentally, the audit process is based on professional judgment in planning the engagement and determining the nature, timing and extent of audit procedures. For example, an audit generally involves the selective testing of data, rather than a 100% examination. There is no guarantee that material misstatements due to errors or fraud are absent in the
items not tested. Even for those items tested, the auditor must use judgment in assessing the implications for the audit and, as in all professional services, the assessment might not always be correct. Besides, the accounting process is based on numerous estimates and judgments, which may or may not be confirmed by future events. In the audit environment, the best an auditor can do is to collect competent and sufficient evidence that is persuasive rather than convincing. For this reason, the auditors opinion on the financial statements is based on reasonable assurance but not absolute assurance. Ex. 29, Mark S. Beasley & Joseph V. Carcello, Miller GAAS Guide at 26 (2006) (emphasis added); Ex. 28, AU 230 (The nature of most evidence derives, in part, from the concept of selective testing of the data being audited, which involves judgment regarding both the areas to be tested and the nature, timing, and extent of the tests to be performed.); Ex. 2, Berliner Tr. at 96:4-9, 96:10-16, 99:5-9 (agreeing that an auditor is obligated only to obtain reasonable assurance that the financial statements are free of material misstatements); Ex. 26, Lhotka Rep. at 1; see also Ex. 117, Lhotka Tr. at 12:6-11 (authenticating report). 16. An independent auditor exercises professional judgment in planning the audit; deciding which areas to test and the scope of such testing. See Ex. 28, AU 311.14; Ex. 2, Berliner Tr. at 97:11-98:2. To inform that judgment, an auditor develops an understanding of the companys business processes and internal controls. The auditor then executes the audit plan; the auditor obtains evidential matter through testwork and determines whether that evidential matter, under relevant circumstances, provides reasonable assurance that the financial statements are fairly presented in accordance with GAAP. See Ex. 28, AU 150.02, 230.10. Auditors must exercise judgment in determining which procedures are necessary to provide reasonable assurance, and reasonable auditors may disagree as to which procedures provide reasonable assurance. Ex. 2, Berliner Tr. at 97:11-20. The amount and kinds of evidential matter required to support an audit opinion are also matters of professional judgment about which reasonable auditors may disagree. Ex. 2, Berliner Tr. at 98:3-10. If the auditor obtains reasonable assurance that the financial statements are free of material misstatements, the auditor provides an unqualified opinion on the financial statements. Ex. 28, AU 312.03-312.05. The auditor may disagree with a companys accounting judgment, or even find a deviation from GAAP, but if the auditor believes the possible misstatement or deviation is not material, the opinion is still unqualified. Id.
17.
18.
19.
20.
21.
Given this degree of professional judgment, it is well recognized that even an audit conducted in accordance with GAAS may not detect a material misstatement. Ex. 2, Berliner Tr. at 97:6-15. Subsequent discovery of new information or a material misstatement does not indicate that the auditor failed to perform the audit in accordance with GAAS. Ex. 2, Berliner Tr. at 547:5-14.
22.
B.
KPMGs Audits 23. KPMG concluded that Fannie Maes financial statements for 2001, 2002 and 2003 presented fairly, in all material respects, the financial position of Fannie Mae and the results of its operations and its cash flows in conformity with GAAP. Ex. 33, 2001 Information Statement at 55; Ex. 34, 2002 Form 10-K at 146; Ex. 35, 2003 Form 10-K at 170. KPMGs audit team was highly qualified and had extensive experience in the financial services industry; it included internal subject-matter experts on issues relevant to the Fannie Mae audits. Ex. 26, Lhotka Rep. at 15. Plaintiffs audit expert did not find fault with the qualifications of KPMGs audit team. Ex. 2, Berliner Tr. at 119:19-22. Kenneth Russell was KPMGs engagement partner on the Fannie Mae audits when the companys FAS 91 and FAS 133 policies were developed. Mr. Russell spent the vast majority of his career auditing companies in the financial services industry. Ex. 16, Russell Mar. 1, 2005 SEC Tr. at 23:12-18. Mr. Russell was also a member of KPMGs Department of Professional Practice, KPMGs firm wide technical resource group. Ex. 2, Berliner Tr. at 290:15-291:5; Ex. 17, Russell Tr. at 42:14-17. While assigned to the Department of Professional Practice, Mr. Russell served on or led the financial instruments and derivatives topic group. Id. at 43:7-44:1. Mr. Russell was a designated KPMG Derivatives, Hedging and Financial Instruments Specialist. Ex. 2, Berliner Tr. at 290:15-291:5; Ex. 17, Russell Tr. at 45:4-46:1. Mark Serock became the lead engagement partner in 2001. Ex. 19, Serock Tr. at 28:10-14. Mr. Serock remained the lead audit partner during the 2002 and 2003 audit engagements. Ex. 1, Serock Decl. 3. Mr. Serock was a designated KPMG Derivatives, Hedging and Financial Instruments Specialist. Ex. 20, Serock Mar. 21, 2005 SEC Tr. at 13:20-16:3. Mr. Argires spent significant time during 2000 reviewing Fannie Maes planned adoption of FAS 133. Ex. 8, Argires Tr. at 193:4-12. Mr. Argires had extensive experience working in the financial services industry. Mr. Argires was a designated KPMG Derivatives and Financial Instruments specialist. Ex. 2, Berliner Tr. at 293:15-294:9; Ex. 8, Argires Tr. at 91:22-92:10. 5
24.
25. 26.
27.
28. 29. 30.
31. 32.
Mr. Argires served as an audit partner on the 2001 through 2003 audit engagements. Ex. 8, Argires Tr. at 47:2-8. Mark Serock signed KPMGs audit opinions during the class period. Ex. 1, Serock Decl. 3. Mr. Serock concluded in his professional judgment that KPMG had obtained sufficient, competent evidential matter that provided reasonable assurance that the financial statements were presented fairly, in all material respects, in accordance with GAAP. Ex. 1, Serock Decl. 4. To this day, Mr. Serock believes that KPMGs audit conclusions were appropriate and that the audits were conducted in accordance with GAAS. Ex. 1, Serock Decl. 4. KPMG auditors, consisting of partners, managers, staff and subject-matter experts spent well over 10,000 hours on the audits of the December 31, 2001, 2002 and 2003 financial statements and the reviews of interim quarterly financial statements for those years. Ex. 1, Serock Decl. 5. KPMGs work is documented in approximately 40,000 pages of KPMG audit work papers. Ex. 1, Serock Decl. 5; Att. 1, KPMG-CIV-00028836-39258; Att. 2, KPMG-CIV-00015309-28835; Att. 3, KPMG-CIV-00000001-15308. Work papers are the principal record of auditing procedures applied, evidence obtained and conclusions reached by the auditor in the engagement. Ex. 1, Serock Decl. 5. KPMGs Planning Process Was Thorough KPMGs planning process was extensive. It included documenting KPMGs understanding of Fannie Maes business and its critical accounting policies, performing analytical reviews of the financial statements, developing a preliminary judgment of materiality for planning purposes and analyzing the strategic, business and audit risks of the engagement. Ex. 2, Berliner Tr. at 108:22-109:19. The audit team used this information to determine the nature, timing and extent of the audit procedures performed. Ex. 2, Berliner Tr.at 112:9-12. KPMGs consideration of the information gathered was documented in key working papers that explained its audit procedures. For example, KPMG used a Business Understanding Document to record its consideration of Fannie Maes objectives, strategies and business. Ex. 22, Berliner Rep. at 1-9; Ex. 2, Berliner Tr. at 109:21-110:8. KPMG had monthly meetings with Fannie Maes Financial Standards group, which was responsible for accounting policy, devoted solely to discussing accounting policies, which Mr. Berliner described as a good practice. Ex. 2, Berliner Tr. at 110:9-22; Ex. 22, Berliner Rep. at 3-4. 6
33.
34.
35.
36.
i. 37.
38. 39.
40.
41.
KPMG documented its findings in several key work papers. The Planning and Analytical Document set forth KPMGs analysis of Fannie Maes periodic financial statement and its overall planning considerations. Ex. 26, Lhotka Rep. at 21; e.g., Ex. 73, KPMG-CIV-00032539. The Risk Analysis Document set forth KPMGs understanding and critical analysis of risks in Fannie Maes business and accounting processes. Ex. 26, Lhotka Rep. at 21; Ex. 74, KPMG-CIV-00032545. The Process Analysis Document explained the processes and financial statement controls in relation to strategic business risks, assessed financial statement risks and controls in relation to the significant classes of transactions and determined how the processes related to the identified audit objectives. See Ex. 2, Berliner Tr. at 115:4-12. The Consideration of Fraud in a Financial Statement Document memorialized KPMGs consideration of fraud risks and steps taken to address those risks in the audit. Ex. 26, Lhotka Rep. at 22; Ex. 72, KPMG-CIV-00032509. The Significant Issues and Decisions Document set forth significant issues or business decisions affecting Fannie Maes financial statements. Ex. 26, Lhotka Rep. at 22; Ex. 70, KPMG-CIV-00031561. KPMG Expressly Considered the Accounting Policies at Issue The accounting policies that Mr. Berliner claims were erroneous were laid out clearly in KPMGs working papers. A KPMG memorandum walked through the entire FAS 91 estimation process. Ex. 91, KPMG-CIV-00046334. Mr. Berliner discusses this memorandum at length and notes it was included in the work papers for each audit. Ex. 22, Berliner Rep. at 3-5, 3-6. Mr. Berliner cites KPMGs working papers to identify the FAS 133 policies with which he disagrees. Ex. 22, Berliner Rep. at 3-14 to 3-15, 3-17 to 3-18. For FAS 115, Mr. Berliner quotes the work papers for the policy and affirms they make it clear what the supposedly erroneous policy was. Ex. 22, Berliner Rep. at 3-22. KPMG Assessed the Risks of Financial Statement Error The auditors engaged in a risk assessment process and documented their understanding of strategic business risks. Ex. 2, Berliner Tr. at 113:6-13. KPMG grouped the financial statement assertions for each strategic business risk and significant class of transactions with the associated key process and identified the related audit objectives and procedures. Ex. 2, Berliner Tr. at 115:4-116:5. The auditors engaged in an assessment of the risk of significant misstatement for each audit objective. Ex. 2, Berliner Tr. at 116:10-17. 7
42.
43.
44.
45.
ii. 46.
47. 48.
iii. 49. 50.
51.
KPMG documented the audit objectives and how those audit objectives related to the financial statement assertions, made an assessment of the risk of significant misstatement for each audit objective, developed the planned audit procedures that were used to gain the necessary audit evidence and considered the need for additional audit procedures. Ex. 2, Berliner Tr. at 116:6-21. KPMG planned and documented its approach in the audit program by key process. Ex. 2, Berliner Tr. at 116:2-3. For each audit, KPMG identified key control objectives and activities and developed a joint audit plan to test certain controls in collaboration with Fannie Mae's internal audit department . . . [and] tested key controls that were not tested by internal audit. Ex. 2, Berliner Tr. at 118:17-119:4; cf. Ex. 2, Berliner Tr. at 260:2-14. Members of the Office of Audit and members of KPMG's audit team met regularly with the Audit Committee without management present. Ex. 2, Berliner Tr. at 117:14-118:16. KPMG considered significant issues that it identified during the course of the engagement and critical accounting policies in determining the scope and results of its audit procedures. See Ex. 22, Berliner Rep. at 114:1-10. The items KPMG identified included the accounting issues central to this matter, such as Fannie Maes accounting under FAS 133 and FAS 91. Ex. 70, KPMGCIV-00031560 at 1562. KPMG performed a risk assessment process and gained an understanding of strategic business risks, related potential financial statement effects and the related processes. Ex. 74, KPMG-CIV-00032545; Ex. 61, KPMG-CIV00017086; Ex. 44, KPMG-CIV-00001038; Ex. 22, Berliner Rep. at 2-9; Ex. 2, Berliner Tr. at 113:6-9. Mr. Berliner described the companys goal of doubling EPS in five years as excessive, and opined that KPMG should have assessed the corresponding risk area as high. Ex. 2, Berliner Rep. at 1-16. KPMG assessed the risk of material misstatement due to fraud given the companys goal of doubling EPS in five years. Ex. 22, Berliner Rep. 1-17; Ex. 43, KPMG-CIV-00000929 at 930. KPMG identified the EPS goal, recognized the increased risks resulting from this focus on EPS and took steps to make sure the engagement team understood its impact. Ex. 22, Berliner Rep. at 1-17. Mr. Berliner stated: I dont think [KPMG] gave sufficient attention to it in the design of their procedures. Ex. 2, Berliner Tr. at 173:13-17. For several years prior to 2001, Fannie Mae had achieved double-digit growth. Ex. 26, Lhotka Rep. at 42-43; see also Ex. 2, Berliner Tr. at 175:4-177:6.
52. 53.
54.
55.
56.
57.
58.
59.
60.
61.
Fannie Mae still achieved double-digit EPS growth even after Fannie Mae restated its financial statements. Ex. 36, 2004 Annual Statement, (2004 Form 10-K) at F-4 (Dec. 6, 2006). Fannie Maes goal of doubling earnings in five years was consistent with past performance. Ex. 26, Lhotka Rep. at 43; see also Ex. 2, Berliner Tr. 647:8-15. Fannie Maes earnings were strongly correlated with the growth in the size of its portfolio. Ex. 2, Berliner Tr. at 171:5-11. Fannie Maes mortgage portfolio had been growing steadily for a number of years prior to 1999, and at the same time, there was a housing boom going on in the United States. Ex. 2, Berliner Tr. at 171:12-18. The Company was halfway to doubling the size of its portfolio before the Class Period even began. Ex. 2, Berliner Tr. at 175:16-177:2; Ex. 33, 2001 Information Statement at 5. Fannie Maes EPS goal was not excessively aggressive. Mr. Berliner testified: I dont know that I would say [the EPS goal was] excessively aggressive. Ex. 2, Berliner Tr. at 644:15-19. Fannie Maes EPS goal would be appropriate if realistic. Ex. 2, Berliner Tr. at 646:16-19. Mr. Berliner did nothing to determine whether the goal was realistic. Ex. 2, Berliner Tr. at 646:19-647:2. Q. Now, you would agree with me that it is appropriate for companies to set aggressive goals, would you not? A. As long as they are realistic. Q. Did you perform any analysis to determine whether or not Fannie Mae's goal of double-digit earnings growth during the period 1999 to 2003 was realistic? A. No. Id. at 646:16-647:2.
62.
63.
64.
65.
66. 67.
68.
Even after Fannie Mae restated its financial statements to correct all of the alleged errors in its financial statements, its 2003 earnings were about $8.00 per share, beating the $6.46 per share goal by a large margin. Ex. 36, 2004 Form 10K at F-4. Mr. Berliner was unaware that Fannie Mae did not have to resort to accounting fraud to meet its target. Ex. 2, Berliner Tr. at 183:10-184:3.
69.
C.
KPMG and Internal Audits 70. Mr. Berliner asserts that KPMG erroneously concluded that it could rely on certain internal controls at Fannie Mae in conducting its audits. Ex. 22, Berliner Rep. at 1-20. He notes that Fannie Mae later concluded it had numerous material weaknesses in internal controls. Ex. 22, Berliner Rep. at 2-10. KPMG relied in some respects on Internal Audit to conduct certain testwork. KPMG met with internal auditors and internal audit management frequently and concluded that internal audit was qualified to perform certain testwork. Ex. 2, Berliner Tr. at 205:5-206:2; Ex. 40, KPMG-CIV-00000263; Ex. 60, KPMG-CIV00016928. Mr. Berliner admits that KPMG examined the internal audit function and that: In form, the structure of [the Office of Audit] appeared appropriate, and KPMGs audit work papers throughout the Class Period document this apparent proper relationship between [the Office of Audit] and senior management. Ex. 22, Berliner Rep. at 2-3. KPMG noted that an independent Quality Assessment Review by the Investment Training and Consulting Institute, Inc. gave Fannie Maes Office of Audit the highest rating possible. Ex. 59, KPMG-CIV 00016367 at 6369. The review singled out for praise Fannie Maes [d]evelopment of innovative processes which include automated work papers, risk assessment models/tools and internal quality assurance program and [c]ommitment to a strong internal control environment throughout Fannie Mae. Ex. 59, KPMG-CIV 00016367 at 6369. The report also said that, the depth of talent exhibited by Fannie Mae's [Internal Audit] staff was very impressive. Id. at 6374. Mr. Berliner claims that OA was criticized in a third party Quality Assessment Review during the Class Period. Ex. 2, Berliner Rep. at 2-7. Mr. Berliner did not disagree with the findings of the Quality Assessment Review: he was simply unaware of the actual findings when he said the report criticized the internal auditors. Ex. 2, Berliner Tr. at 223:10-229:8. Contrary to Mr. Berliners assertion that the internal auditors had no training in FAS 133 (which he described as a significant departure from the auditing standard of due professional care, Ex. 22, Berliner Rep. at 207), they did in fact have training and indeed more training than Mr. Berliner. Ex. 2, Berliner Tr. at 403:18-405:9 KPMG was aware that OFHEO reviewed the performance of Fannie Maes Office of Audit. Ex. 66, KPMG-CIV-00020347. OFHEO concluded at the time as to the Office of Audit: The scope of [internal] audit work performed is appropriate, and the [internal] audit work is complete, and that the [internal] audit functions exceed safety and soundness standards. Ex. 37, OFHEO Rep. to Congress (2001) at 16, 17, 19; Ex. 38, OFHEO Rep. to Congress (2002) at 44.
71.
72.
73.
74.
75. 76.
10
77.
OFHEO concluded that Fannie Maes internal control framework and the management of that framework exceeded safety and soundness standards. Ex. 37, OFHEO Rep. to Congress (2001) at 16; Ex. 38,OFHEO Rep. to Congress (2002) at 44. OFHEOs examiners reviewed Fannie Maes internal controls each year during the Class Period, using dozens of examiners over the course of the entire year, and concluded that Fannie Maes internal controls exceeded safety and soundness standards. Ex. 2, Berliner Tr. at 608:22-611:3. Mr. Berliner did not review the OFHEO examinations. Ex. 2, Berliner Tr. at 611:21-612:6. Mr. Berliner did not review Fannie Maes internal controls and could not offer any independent opinion on the state of such controls. Ex. 2, Berliner Tr. at 55:14, 209:15-210:5, 592:4-12, 600:10-15, 708:7-711:5. Mr. Berliner has not identified any specific alleged internal control weakness that dates back to the class period. Ex. 2, Berliner Tr. at 207:13-20. The systems Fannie Mae built to computerize the FAS 133 accounting did what they were intended to do. Ex. 4, Barron Tr. at 114, 116-17; Ex. 2, Berliner Tr. at 100-01, 127:12-21. It was Fannie Maes precision threshold policy that led to the restatement in the FAS 91 area, as opposed to internal control weaknesses. Ex. 2, Berliner Tr. at 495:14-20. Fannie Maes system of classifying debt securities (FAS 115) was operating as described, and if Fannie Mae's accounting were viewed as permissible, Mr. Berliner would not have found fault with KPMG's auditing in the FAS 115 area. Ex. 2, Berliner Tr. at 546:4-19.
78.
79. 80.
81. 82.
83.
84.
D.
Fannie Maes Accounting for Derivatives (FAS 133) 85. Mr. Berliner criticizes KPMG for accepting major deviations from GAAP in Fannie Maes hedge accounting policy that were known to KPMG and documented in its workpapers. Ex. 22, Berliner Rep. at 3-14. He said that KPMG recognized that there were departures from GAAP but felt comfortable accepting those departures on the basis of materiality. Id. at 3-13. Mr. Berliner quotes the following email by KPMG partner Harry Argires in his expert report: I do know that the SEC has taken the 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 demonstrate an immaterial departure. Ex. 22, Berliner Rep. at 3-15.
11
He also quotes a KPMG work paper: Therefore, although the Deminimus test is not in strict compliance with FAS 133, KPMG has indicated that as long as the dollar offset method is used to measure ineffectiveness recorded in the P&L, that the deminimus test (using 10 bps) threshold is an immaterial departure from GAAP and results in a materially consistent impact to the P&L. Ex. 22, Berliner Rep. at 3-19. And Mr. Berliner quotes a Fannie Mae document as well: [W]e stated in our hedge guidelines that we would test the hypothesis that ineffectiveness was immaterial on an annual basis [and] [o]ur tests . . . confirmed our belief. Ex. 22, Berliner Rep. at 3-16. Mr. Berliner testified that KPMG documented that it considered it to be a violation of GAAP, again, with an immaterial effect. Ex. 2, Berliner Tr. at 329:15-330:4.
86.
Well before Fannie Mae was required to implement the standard, KPMG recognized that FAS 133 would be significant to Fannie Maes financial reporting. Because FAS 133 was scheduled to go live on January 1, 2001, KPMG identified the implementation of FAS 133 as a critical audit objective during the planning process for the audit of Fannie Maes financial statements for the yearending December 31, 2000. Ex. 2, Berliner Tr. at 294:20-295:2; Ex. 85, KPMGCIV-00039531-36. In reviewing Fannie Maes planned implementation of FAS 133, KPMG used highly trained and qualified auditors. Ex. 26, Lhotka Rep. at 15. Plaintiffs expert does not criticize the qualifications of KPMGs auditors. Ex. 2, Berliner Tr. at 119:19-22. KPMG also used its Department of Professional Practice as a resource. Ex. 93, Theobald Tr. at 58:17-63:4; Ex. 118, KPMG-CIV-0039526-30 at 9529. The audit team prepared an audit program to guide the testing of Fannie Maes implementation process. KPMG separated the audit program into four stages: Stage 1 Understanding the process and risk identification; Stage 2 Audit procedures evaluating effectiveness of controls; Stage 3 Additional audit procedures based on final risk assessment; and Stage 4 Conclude on audit objectives. Ex. 87, KPMG-CIV-00045702-6. KPMG took steps to understand Fannie Maes use of derivatives and how it intended to account for them. Ex. 104, KPMG-CIV-00192914-65, at 2914; Ex. 2, Berliner Tr. at 295:3-296:7, Ex. 26, Lhotka Rep. at 52-55. KPMG reviewed Fannie Maes Derivative Accounting Guidelines (DAG), a 475-page document that set forth Fannie Maes FAS 133 accounting policy. Ex 2, Berliner Tr. at 295:14-296:2.
87. 88. 89. 90.
91.
92.
12
93.
The DAG explained and diagramed how each transaction worked and set out the parameters that would have to be satisfied for Fannie Mae to assume that its hedging transactions created no ineffectiveness. Ex. 98, KPMG-CIV-00108327801; Ex. 2, Berliner Tr. at 282:7-283:22. KPMG reviewed each of the 67 proposed transactions in the DAG and how Fannie Mae intended to account for them, and KPMG concluded that the proposed accounting treatment for each was reasonable. Ex. 101, KPMG-CIV00138847; Ex. 2, Berliner Tr. at 278:16-279:3. Prior to implementation, Fannie Mae performed testing to demonstrate that where it intended to assume no ineffectiveness, such ineffectiveness would be inconsequential. See Ex. 9, Boyles Tr. at 209:16-210:22; Ex. 15, Matt Johnson SEC Tr. at 85:17-87:20. KPMG reviewed this analysis. Ex. 18, Russell SEC Tr. at 230:19-231:8; see also Ex. 2, Berliner Tr. 313:7-314:19. KPMG auditors met with several Fannie Mae personnel to discuss the FAS 133 Accounting System, including specifically the scope of the project, system functionality, system flows between various functions and the control and management reports produced by the system. The meeting also addressed the timing of the implementation of the various FAS 133 Accounting System components. Ex. 89, KPMG-CIV-00045790; Ex. 2, Berliner Tr. 295:3-13. Consistent with the audit program, the auditors tested the effectiveness of the controls in mitigating the identified risks. Ex. 26, Lhotka Rep. at 54; Ex. 2, Berliner Tr. 301:4-305:22, 295:14-300:9. KPMG performed walkthrough testing of the FAS 133 System to determine if the system was properly classifying hedge transactions. Ex. 90, KPMG-CIV00045827; Ex. 2, Berliner Tr. 296:3-7. KPMG auditors relied on personnel from KPMGs Information Risk Management Group (IRM), its computer auditing specialists, to assist in selecting a sample of ten transactions for testing. Ex. 84, KPMG-CIV-00034349; Ex. 2, Berliner Tr. at 268:3-18, 296:8-12. The auditors then followed the system for each transaction, step by step, to gain an understanding of the operation. Based on the results of its testing, KPMG concluded that the items tested were properly classified by the system and noted no exceptions to the hedge accounting policies. Ex. 90, KPMG-CIV-00045827. The IRM also confirmed that, based on the testing, the system identified and correctly classified the transactions. Ex. 114, KPMG-CIV-00045872; Ex. 2, Berliner Tr. at 268:3-18, 296:14-21. During its year-end work, KPMG performed several procedures around Fannie Maes FAS 133 implementation:
94.
95.
96.
97.
98.
99.
100.
101.
102.
13
Gained an understanding of the derivatives and hedging processes and the related controls Tested the valuation and correlation of hedge positions Determined that the Hedge Accounting Policy Manual policies and procedures were reasonable Reviewed the transactions in the Hedge Accounting Policy Manual and determined that the accounting treatment is reasonable Gained an understanding of the FAS 133 Accounting System and using walkthroughs determined how the system and interfaces with other systems worked Tested a sample of transactions to ensure that the FAS 133 Accounting System was properly classifying hedge transactions as cash flow hedges, fair value hedges, or hedges that did not qualify Reviewed the functionality and system controls of the FAS 133 Accounting System to ensure that the system logic agrees with the requirements of FAS 133 Reviewed the FAS 133 Accounting System documentation Reviewed the appropriateness of standard journal entries and determined that the entries were properly recording derivative and hedging activities Reviewed the general ledger reconciliations and determined that procedures were in place to ensure proper recording of the transactions
Ex. 88, KPMG-CIV-00045784; Ex. 92, KPMG-CIV-00047697; Ex. 94, KPMGCIV-00083098; Ex. 2, Berliner Tr. at 295:3-301:3; Ex. 26, Lhotka Rep. at 53-55. 103. KPMG concluded that Fannie Mae had appropriately addressed the implementation of FAS 133, that it was prepared to adopt the new standard on January 1, 2001, and that Fannie Maes proposed FAS 133 accounting complied with GAAP. Ex. 86, KPMG-CIV-00039919. The focus of KPMGs audit work for the years ended December 31, 2001, 2002 and 2003 was to obtain reasonable assurance that Fannie Maes derivative and hedging transactions continued to comply with the Companys policies and that the controls and the FAS 133 Accounting System continued to operate appropriately. E.g., Ex. 75, KPMG-CIV-00034093; Ex. 47, KPMG-CIV00002806; Ex. 62, KPMG-CIV-00018475; Ex. 26, Lhotka Rep. at 57-61. KPMG again obtained an understanding of how Fannie Mae processed derivative and hedging transactions, identified the key financial statement assertions and 14
104.
105.
identified and tested the design of key controls related to the audit objectives. Ex. 75, KPMG-CIV-00034093; Ex. 47, KPMG-CIV-00002806; Ex. 62, KPMG-CIV00018475. 106. KPMGs work papers documented the procedures that were performed to test both the design and operational effectiveness of the controls over the accounting for derivative and hedging activities. The controls tested include: interface controls, reconciliations, access controls, authorization controls, segregation of duties controls, management reviews, configuration controls, and exception reports. E.g., Ex. 76, KPMG-CIV-00034158; Ex. 77, KPMG-CIV-00034172; Ex. 81, KPMG-CIV-00034208; Ex. 63, KPMG-CIV-00018514; Ex. 48, KPMG-CIV00002851; Ex. 2, Berliner Tr. 256:10-257:2, 302:4-305:22. KPMG also reviewed and assessed the results of the work of the Office of Audit. Ex. 79, KPMG-CIV-00034193; Ex. 80, KPMG-CIV-00034197. In addition to its original test work, the Office of Audit performed additional testing related to FAS 133 controls and accounting related items at KPMGs request. Ex. 78, KPMG-CIV-00034180; Ex. 2, Berliner Tr. at 301:4-305:22, 258:16-261:5. KPMG also reviewed the draft financial statement disclosures to assess whether the presentation and disclosure complied with the requirements of FAS 133. Ex. 83, KPMG-CIV-00034258. KPMG performed analytical procedures related to derivative and hedging activities. KPMG concluded that the derivative values were reasonably stated and that sufficient audit evidence had been obtained to support the conclusion that derivatives were properly valued and were completely and accurately recorded. Ex. 82, KPMG-CIV-00034211. In 2003, Fannie Mae conducted another mathematical analysis of the amount of ineffectiveness that might be created by using its +/- 7 day rule, which confirmed its original analysis that any ineffectiveness would be inconsequential. Ex. 50, KPMG-CIV-00003282. KPMG reviewed this analysis. Id.; Ex. 2, Berliner Tr. at 315:4-317:14 (noting that Mr. Berliner does not dispute that the amount of ineffectiveness would be de minimus to Fannie Mae). KPMG believed that any ineffectiveness created by the companys seven-day policy [w]ould not have a material effect on the financial statements. Ex. 2, Berliner Tr. at 314:5-19. KPMG documented that it believed that ineffectiveness caused by another of Fannie Maes hedging policies was immaterial. Ex. 2, Berliner Tr. at 329:18330:4. KPMG was comfortable that the ineffectiveness was not material. Ex. 22, Berliner Rep. at 3-13; see also Ex. 2, Berliner Tr. 314:11-16. 15
107. 108.
109.
110.
111.
112.
113.
114.
115.
Mr. Berliner has no basis to disagree with KPMGs contemporaneous conclusion that the assumption of inconsequential or no ineffectiveness was reasonable under FAS 133. Ex. 2, Berliner Tr. at 313:7-314:19. When Fannie Mae sought to bring an additional strategy within its FAS 133 policy and proposed that it had adequate documentation to support hedge accounting, KPMG said no. Ex. 51, KPMG-CIV-00003595. At various times during the class period, Fannie Mae and KPMG raised issues with the Financial Accounting Standards Board (the FASB) related to the Companys derivatives accounting. For example, in 2001, Fannie Mae proposed applying the Derivatives Implementation Group (DIG) issue G-20 to cash-flow options, which would have shielded Fannie Maes income statement from fluctuations in value arising from changes in the time value of the options. Ex. 71, KPMG-CIV-00031587; Ex. 2, Berliner Tr. at 156:2-8. KPMG had a different interpretation of this guidance, despite the fact that Fannie Maes position was a reasoned interpretation of the standard. After further discussions with Fannie Mae, the auditors consulted with KPMGs national office, and the national office agreed with the auditors interpretation. Ex. 71, KPMG-CIV-00031587; Ex. 2, Berliner Tr. at 156:9-158:10; Ex. 2, Berliner Tr. at 156:2-158:10. Fannie Mae then consulted with the FASB, which agreed with KPMGs interpretation. Ex. 71, KPMG-CIV-00031587. Fannie Mae booked the changes in the time value of purchased options each period through income. This generated significant income volatilitythe amount recorded in 2001 for all options was $40 million in losses, in 2002 it was over $4.55 billion in losses, and in 2003 it was $2.18 billion in losses. Ex. 35, 2003 Form 10-K at 163. The volatility recorded in a single quarter could approach $2 billion. Id. at 172. This was significant and unpredictable volatility. Ex. 2, Berliner Tr. at 185:7-15. Booking the changes in the time value of purchased options was inconsistent with what one might expect if executives intended to manipulate accounting policies to smooth earnings. Q. Right. What is the jagged line that you see going up and down? A. That's the GAAP earnings. Q. And what is the smoother line? A. That's the core earnings, the operating earnings, with the removal of the purchased option expense.
116.
117.
118.
119. 120.
121. 122.
16
Q. And the fact that the GAAP earnings is going up and down in this chart, that is inconsistent with what one might expect if executives intended to manipulate accounting policies to smooth earnings, isn't it? MR. SOMMERS: Object to form. THE WITNESS: It certainly would appear that way, yes. Ex. 2, Berliner Tr. at 163:6-20; see also id. at 429:9-17. 123. If KPMG had acquiesced to Fannie Maes original approach, it would have eliminated billions of dollars of volatility on Fannie Maes financial statements. Ex. 2, Berliner Tr. at 156:9-12. Mr. Berliner testified that saying no [is] not easy because the client may have devoted considerable resources, time and effort and money in the development of a standard and they might be very disinclined to make modifications of that standard and so they might view an auditors telling them that the standard doesnt comply with GAAP as negativism on the part of their external auditor. Ex. 2, Berliner Tr. at 429:9-17. In another instance, KPMG revisited some of the FAS 133 accounting treatment that it had previously approved and, upon reconsideration, concluded it did not qualify for hedge accounting. Ex. 13, Boyles Apr. 12, 2005 SEC Tr. at 140:1320. Fannie Mae and KPMG consulted the FASB about this issue. This time, the FASB thought KPMG was too restrictive. Ex. 13, Boyles Apr. 12, 2005 SEC Tr. at 140:21-145:1; Ex. 10, Boyles Aug. 3, 2004 OFHEO Tr. at 245:19-250:22; Ex. 11, Boyles Aug. 24, 2004 OFHEO Tr. at 164:4-168:7; Ex. 100, KPMG-CIV00135047; Ex. 2, Berliner Tr. at 443:11-444:22. KPMGs conclusion that Fannie Maes approach to assuming no ineffectiveness under FAS 133 was GAAP compliant was consistent with conclusions reached by other major accounting firms and other major financial institutions. See Ex. 107, FMCIV-03 03091798 (advice in Ernst & Young implementation guide); Ex. 110, FMCIV-10-11170007-08 (historical perspective described in PricewaterhouseCoopers manual); Ex. 7, Mills Tr. at 156:22-157:7 (I would say in almost every instance the fair value was other than zero, but to the extent it was an immaterial amount [another financial institution] would still apply the assumption of no ineffectiveness.). The Big Four accounting firms acknowledged ongoing confusion on this issue, and plaintiffs FAS 133 expert admitted frankly that no one has figured out what to do with this yet. Ex. 4, Barron Tr. at 257:3-259:8; Ex. 5, Barron Tr. Ex. 15A at 5-6. Even the SEC staff, plaintiffs FAS 133 expert testified, had changed their interpretation of FAS 133 and decided to support an approach no different than that KPMG had accepted. Ex. 4, Barron Tr. at 241:2-12. 17
124.
125.
126.
127.
128.
129.
Mr. Berliner criticizes KPMG for assessing the inherent risk of misstatement due to potential errors in the valuation of derivatives as moderate. Ex. 22, Berliner Rep. at 1-9. Fannie Maes restatement in the area of derivatives had nothing to do with valuation issues whether Fannie Mae correctly estimated the current fair market value of derivatives it owned but rather hinged on whether Fannie Maes hedge accounting policy itself was appropriate. Ex. 2, Berliner Tr. at 166:8-21, 262:16-263:6. Mr. Berliner does not dispute that the KPMG auditors believed the financial statements were correct in all material respects. Ex. 2, Berliner Tr. at 126:1-14.
130. E.
Fannie Maes Accounting for Amortization of Premiums and Discounts (FAS 91) 131. Because interest rates are constantly changing between the date that mortgage loans are made by lenders to consumers and the date on which Fannie Mae buys such loans from lenders, the values of such loans fluctuate. If interest rates go down after a loan is made, the loan will be more valuable because the loan is earning a higher interest rate than one could then obtain. If rates go up after a loan is made, the loan will be less valuable because one can no longer lend money at as favorable a rate. Ex. 25, Holder Rep. at 3; see also Ex. 25, Holder Tr. at 9:915 (authenticating report). Thus, when Fannie Mae buys loans from mortgage originators, it typically pays more or less than the face amounts of those loans (i.e., the original amount lent or the unpaid principal balance of the loans). Ex. 25, Holder Rep. at 3. These differences represent premiums (where Fannie Mae pays more than the balance of the loan) and discounts (where Fannie Mae pays less). Ex. 25, Id.; see also Ex. 35, 2003 Form 10-K at 42. Fannie Mae has to account for and report these premiums and discounts. Id. The return on the loan what Fannie Mae expects to receive on its loan purchase, more commonly referred to as the effective yield depends not only on the loan balance and stated interest rate but also on the amount that Fannie Mae paid for the loan. Ex. 25, Holder Rep. at 4. The effective yield also depends on when the principal amount of the loan is repaid. Ex. 25, Holder Rep. at 4. When a loan is prepaid, Fannie Mae receives the principal amount and any accrued interest immediately, but interest that it had hoped to earn through the full life of the loan will not be received. Id. Exactly when any given loan will be repaid is unknown because there are a variety of unpredictable factors that affect the timing of repayment. Ex. 25, Holder Rep. at 9. When interest rates decrease, borrowers often refinance: borrowers take out new loans at more favorable rates and then use the proceeds of the new loan to repay their outstanding loans in full. Changes in the speed at which loans are prepaid can affect a company's estimate of the effective yield on those loans. Id. at 4.
132.
133.
134.
135.
18
136.
FAS 91, Accounting for Nonrefundable Fees and Costs Associated with Originating or Acquiring Loans and Initial Direct Costs of Leases, requires premium and discount to be classified as adjustments to the carrying amount of loans receivable in a company's balance sheet. Ex. 30, FAS 91 4, 15. These amounts are recognized as an adjustment of yield over the life of the loan . . . to arrive at periodic interest income . . . at a constant effective yield on the net investment in the receivable. Ex. 30, FAS 91 15, 18. As mortgage loans may be prepaid at any time, the life of the loan or a group of loans is unknown but can be estimated. Cf. Ex. 24, Fierstein Rebuttal Rep. at 11. If prepayments can be reasonably estimated, companies may consider estimates of future principal prepayments when determining a constant effective yield. Ex. 30, FAS 91 19. Prepayments are often influenced by changes in interest rates, which may cause borrowers to refinance their loans, but prepayments can also be influenced by factors unrelated to the mortgage loan, such as general and localized economic growth rates, marriages, divorces, job transfers and deaths. Ex. 25, Holder Rep. at 9. Future events and their effects cannot be perceived with certainty; estimating, therefore, requires the exercise of judgment. Thus accounting estimates change as new events occur, as more experience is acquired, or as additional information is obtained. Ex. 23, Fierstein Rep. at 1-18 at n. 15 (quoting paragraph 10 of Accounting Principles Board (APB) Opinion No. 20). A high level of judgment and extensive subjectivity was involved in the FAS 91 amortization estimates. See Ex. 2, Berliner Tr. at 340:11-341:2. If a difference arises between the prepayments anticipated and the actual prepayments received, then the company shall recalculate the effective yield to reflect actual payments to date and anticipated future payments. The net investment in the loans shall be adjusted to the amount that would have existed had the new effective yield been applied since the acquisition of the loans. Ex. 30, FAS 91 19. The adjustment resulting from the change in estimate is colloquially referred to as a catch-up. Fannie Maes net mortgage portfolio was $706.8 billion at the end of 2001, $801 billion the end of 2002 and $901.8 billion at the end of $2003. Ex. 35, 2003 Form 10-K at 58. Fannie Mae had net discounts of $2.1 billion in 2001, but net premiums of $472 million and $3.7 billion in 2002 and 2003. Ex. 35, 2003 Form 10-K at 43. This reflected a decreasing interest rate environment during the class period. Id. The process of estimating prepayment speeds at Fannie Mae was necessarily complex due to the size and diversity of its portfolio. See Ex. 23, Fierstein Rep. 19
137. 138.
139.
140.
141. 142.
143.
144.
145.
1-1, 1-4. 146. Fannie Maes hundreds of billions of dollars in loans represented mortgages entered into in many different years, on many different terms, in many different geographical locations, by people in many different economic circumstances. Ex. 25, Holder Rep. at 9. Prepayments had to be estimated for each pool of similar loans. Fannie Mae grouped its vast portfolio of loans and estimated the average life of each group accordingly. Ex. 25, Holder Rep. at 8. Prepayments had to be estimated for each pool of similar loans. Fannie Mae grouped its vast portfolio of loans and estimated the average life of each group accordingly. Id. Those projections were rolled up into a single estimate, Fannie Maes net investment in loans. Id. During the class period, Fannie Mae sought to factor the imprecision in estimating prepayments in two ways: (1) by taking an average potential catch-up using five data points based on set deviations from the base projected interest rate path; and (2) by using a threshold of precision within which Fannie Mae would conclude that its prior estimate continued to be reasonable and hence would not alter its prior estimate. Ex. 91, KPMG-CIV-00046334 at 6335-6336. In determining the size of the threshold, management observed that on any given day, there are a number of different quoted prepayment speeds for the same MBS security or loan by large, reputable dealers in the market. Ex. 91, KPMG-CIV0046334. They identified several independent, respected dealers publishing prepayment-rate estimates, each of which would be considered reasonable approximations of prepayment speeds under FAS 91. Id. Depending on which of those reasonable approximations were used, the FAS 91 catch-up calculation could fluctuate significantly. The difference in catch-up resulting from the use of these different, but reasonable, dealer estimates was approximately $70 million. Ex. 91, KPMG-CIV-0046334 at 6336. This was roughly equal to one percent of the Companys annual net interest income (NII), and thus one percent of NII was used as a proxy for the spread in dealer estimates. Ex. 91, KPMG-CIV-0046334 at 6336. At least once each quarter, Fannie Mae tested its estimate against its current projections, including a shock test projecting prepayments if interest rates were higher or lower by one percentage point and by one-half a percentage point. See, e.g., Ex. 49, KPMG-CIV-0002943; Ex. 65, KPMG-CIV-00020036; see also Ex. 35, 2003 Form 10-K at 43. If the difference between the potential catch-upas calculated by averaging the catch-up produced by the five rate pathswas within this range of plus/minus one percent of annual NII, Fannie Mae would conclude that its existing estimate remained reasonable and would not change it. Ex. 91, KPMG-CIV-0046334 at 6335-6336. If the potential catch-up was outside of this range, then it would 20
147.
148.
149.
150.
151.
152.
153.
book an adjustment to the edge of the range. Id. at 4336. 154. The precision threshold could not have caused Fannie Maes financial statements to be in error by any more than the size of the threshold itself. Ex. 3, Fierstein Tr. at 618:15-623:5. Ms. Fierstein admitted that $135 million was not quantitatively material to Fannie Maes financial statements. Ex. 3, Fierstein Tr. at 645:13-19; see also Ex. 2, Berliner Tr. at 343:17-345:9. The threshold for premium and discount was therefore not quantitatively material, because it never grew as large as $135 million. See, e.g., Ex. 103, Amortization Sensitivity Chart, 3rd Quarter, 2003, KPMG-CIV-00177467. Calculated as no more than one percent of related revenue, which was net interest income, the initial threshold was $70 million. At year-end 2000, Fannie Maes net investment in loans was $607.4 billion. Ex. 32, 2000 Annual Information Statement at 59. Thus, the threshold was slightly more than 1/100th of one percent of Fannie Maes total investment in loans. The amounts that Mr. Berliner claims were erroneously not recorded during the Class Period are $6.4 million in 2001, $78.8 million in 2002 and $119.5 million in 2003. Ex. 22, Berliner Rep. at 4-11-12. KPMG requested that Fannie Mae formalize its FAS 91 policy prior to the class period. Ex. 23, Fierstein Rep. at 1-7. After its implementation by Fannie Mae, KPMG performed testwork to evaluate Fannie Maes quarterly catch-up estimates. Three partners and a senior manager documented KPMGs understanding of the policy. Ex. 91, KPMG-CIV-00046334. KPMG met quarterly with the head of Fannie Maes Controllers Office and the Office of Financial Reporting to have a detailed discussion of the Companys amortization process and review the catch-up sensitivity charts for the quarter, which KPMG documented. E.g., Ex. 68, KPMG-CIV-00028913 at 915; Ex. 69, KPMG-CIV00029252 at 253; Ex. 65, KPMG-CIV-00020036 at 037; Ex. 67, KPMG-CIV00020910; Ex. 64, KPMG-CIV-00019340; Ex. 2, Berliner Tr. at 278:16-279:3. Where management changed its assumptions or modified its methodology, KPMG obtained an explanation for those changes. Ex. 2, Berliner Tr. at 279:5-9. KPMG also re-assessed the reasonableness of the threshold itself. KPMG observed whether the spreads in dealer-estimated pre-payment speeds were narrowing or expanding to determine if a change in the size of the precision threshold was necessary. Ex. 95, KPMG-CIV-00085642 at 5643-5645. In 2003, the engagement team again evaluated the reasonableness of Fannie Maes prepayment model in light of the dealer estimates in the market, by comparing Fannie Maes prepayment projections to contemporaneous projections by investment banks, including Citigroup and Lehman Brothers, and found that 21
155.
156.
157.
158.
159.
160. 161.
162.
the models produced widely varied projections. Ex. 21, Tascher Jan. 13, 2006 SEC Tr. at 308:5-22, 318:12-319:22. 163. The auditors observed that Fannie Maes prepayment estimates were generally within the high-low range of the industry estimates. Ex. 57, KPMG-CIV00005403; Ex. 53, KPMG-CIV-00005051; Ex. 55, KPMG-CIV-0005293. The auditors also consulted with a specialist from KPMGs Structured Finance Group, who reviewed the methodology of the Office of Audits recalculation of amortization factors for a sample of loan pools and concurred with the methodology. Ex. 55, KPMG-CIV-00005293-96 at 5295; Ex. 54, KPMG-CIV00005221. KPMGs Structured Finance Group also created a model and recalculated the unamortized balance, and verified that the amortization was calculated and recorded in accordance with FAS 91. Ex. 54, KPMG-CIV00005221. The auditors reviewed information that suggested that, although Fannie Maes ability to forecast prepayments had improved, significant imprecision remained in its modeling justifying the continued use of the precision threshold. See generally Ex. 56, KPMG-CIV-00005297 at 307. A 2002 report by Fannie Maes Office of Audit stated that the Companys prepayment estimates achieved a 90 percent correlation with actual prepayments. Ex. 56, KPMG-CIV-00005297 at 307. A sensitivity analysis is not unusual, especially when an estimate is subject to significant uncertainty. Ex. 2, Berliner Tr. at 354:16-21. An analysis producing a result close to an existing estimate increases confidence in that estimate. Ex. 2, Berliner Tr. at 356:11-22. Whether or not a sensitivity analysis was close enough to support the existing estimate is a matter of judgment. Ex. 2, Berliner Tr. at 357:17-358:2. A 5% difference would not be out of bounds but would depend on the financial statements of the entity that was making that estimate. Id. at 358:3-10. Q. Would you agree that the degree of confidence that you place in an estimate needs to be on a percentages basis? A. No. Q. Have you ever? A. Could be a subjective judgement [sic]. ...
164.
165.
166.
167. 168. 169.
22
Q. Would you agree that if a legitimate sensitivity analysis produced a number five percent different than the estimate, that would not be a reason to alter materially the estimate? A. It would depend upon the financial statements of the entity that was making that estimate. Id. at 357:17-358:10. 170. [A] precision threshold may have been appropriate for use by KPMG when it assessed Fannie Maes SFAS 91 calculations; auditing literature supports this concept. Ex. 24, Fierstein Rebuttal Rep. at 12; see also Ex. 3, Fierstein Tr. at 634:18-22. KPMG believed the precision threshold was reasonable application of FAS 91. Ex. 91, KPMG-CIV-00046334; Ex. 2, Berliner Tr. at 313:7-314:19 (conceding KPMG believed the precision threshold was reasonable application of FAS 91). Reasonable differences between estimates would not be considered a likely misstatement under the auditing literature. Ex. 25, Holder Rep. at 15 (citing Ex. 28, AU 312.36, 342.14). Fannie Mae presented charts in its disclosure documents showing the percentage impact that 50 and 100 basis point increases and 50 and 100 basis point decreases in the base refinance rate would have on its net income. Ex. 34, 2002 Form 10-K at 58; Ex 35, 2003 10-K at 43. Thus, KPMG observed that Fannie Mae disclosed what the impact would be on its financial results of immediate interest rate shocks of the size used in Fannie Maes five interest-rate path methodology. Ex. 34, 2002 10-K at 58; Ex. 35, 2003 10-K at 43. In his report, Mr. Berliner stated that KPMG's acceptance of Fannie Maes FAS 91 accounting policy continued even after it was alerted to a whistleblower's allegations of the possibility of earnings management due to Fannie Maes misapplication of this policy. Ex. 22, Berliner Rep. at 1-7. He asserted further that [i]n violation of GAAS, KPMG failed to expand its audit procedures in response to these allegations. Id. The allegations of an alleged whistleblower, Roger Barnes, were followed by a series of urgent meetings, Ex. 2, Berliner Tr. at 484:17-20, and a major investigation by the company. Id. at 496:2-3. In response to these allegations, KPMG expanded its testing of manual adjustments. Ex. 2, Berliner Tr. at 493:11-20. KPMG reviewed Mr. Barnes allegations as to anomalous amortization factors. Ex. 2, Berliner Tr. at 501:11-13. 23
171.
172.
173.
174.
175.
176.
177. 178.
179. 180. 181.
KPMG performed additional procedures to respond to the risk of a possible illegal act. Ex. 2, Berliner Tr. at 487:6-10. The auditors consulted with forensic specialists, who reviewed the companys response to the allegations. Ex. 2, Berliner Tr. at 487:18-488:7. Mr. Berliner found no grounds upon which to criticize KPMGs review of that investigation or the investigation itself. Ex. 2, Berliner Tr. at 497:17-21. Mr. Barnes allegations did not evidence a material misstatement of the financial statements. Ex. 2, Berliner Tr. at 497:14-17. Mr. Barnes allegations did not relate to the precision threshold policy. Ex. 2, Berliner Tr. at 496:15-19, 501:14-16 (I dont believe [Barnes] allegations related to the threshold policy.). Mr. Berliner places quotation marks around the phrase turn a blind eye and then immediately cites to a KPMG document. Ex. 22, Berliner Rep. at 3-9 (citing Ex. 99, KPMG-CIV-00132852-3). The phrase turn a blind eye appears nowhere in that document.
182.
183.
F.
Fannie Maes Accounting for Debt Securities (FAS 115) 184. Mr. Berliner criticizes KPMGs acceptance of Fannie Maes application of FAS 115. Ex. 22, Berliner Rep. at 3-23. Ex. 22, Berliner Rep. (quoting Ex. 116, Deloitte-FNMA-M-027217-41 at7236). Ms. Fierstein opined that this tainted the portfolio. Ex. 23, Fierstein Rep. 2-9. Mr. Berliner described this as an obvious violation of GAAP that should have alerted KPMG to the possibility that the month-end convention could in fact be used as a tool to manipulate Fannie Maes financial statements. Ex. 22, Berliner Rep. at 3-22 to 3-23. 185. FAS 115 provides that [a]t acquisition, an enterprise shall classify debt securities into one of three categories: held-to-maturity [HTM], available-for-sale [AFS], or trading. Ex. 31, FAS 115 6. FAS 115 provides the criteria for classification of securities and the resulting accounting treatment: Debt securities that the enterprise has the positive intent and ability to hold to maturity are classified as held to maturity securities and reported at amortized cost. Debt and equity securities that are bought and held principally for the purpose of selling them in the near term are classified as trading securities and reported at fair value with unrealized gains and losses included in earnings. Debt and equity securities not classified as either held-to-maturity securities or trading securities are classified as available for sale securities and reported at fair value with unrealized gains
24
and losses excluded from earnings and reported in separate component of shareholders equity. Ex. 31, FAS 115 at 2 (emphasis added). 186. During the class period, Fannie Mae purchased mortgage-backed securities (MBS) for its portfolio. Ex. 45, KPMG-CIV-00001495 at 496. Most of the securities purchased by Fannie Mae were HTM, with a smaller percentage designated as AFS, and few or none designated as trading. Ex. 3, Fierstein Tr. at 689:19-690:2. HTM securities were accounted for at amortized cost, and, per FAS 115, changes in the market value of the security were not recorded in the financial statements. Ex. 31, FAS 115 7; Ex. 26, Lhotka Rep. at 87. AFS securities were carried at fair value, and adjusted to market value, or marked-to-market, on a periodic basis. Ex. 31, FAS 115 13; Ex. 26, Lhotka Rep. at 87. Changes in fair value were reflected in a balance sheet account but did not affect current income. Ex. 3, Fierstein Tr. at 704:7-17. When Fannie Mae purchased a security, the transaction was processed in Fannie Maes securities computer systems. Ex. 45, KPMG-CIV-00001495-515 at 508. The system required that traders enter a value for the security designation at the time of execution: for example, I for HTM, S for AFS, or R for Trading. Id.; Ex. 14, Douthit Tr. at 73:10-74:22. The default entry was I for HTM. Ex. 45, KPMG-CIV-00001495 at 508. The default assigned to each security at the time of trade had no relation to Fannie Maes intent or ability to hold the security to maturity. See generally Ex. 12, Boyles Dec. 7, 2004 OFHEO Tr. at 216:9-20. Unlike other financial institutions, such as banks, that are required to close their accounting records on a daily basis, Fannie Mae closed its books i.e., posted transactions to the general ledger at the end of the month. Ex. 12, Boyles Dec. 7, 2004 OFHEO Tr. at 216:9-20. In Mr. Lhotkas experience, it is not unusual for clients to record transactions on a monthly or other basis. Ex. 117, Lhotka Tr. at 265:2-18. Ms. Fierstein testified as follows: Q: What would have happened if there was simply no designation at all on the date of purchase and they designated everything at the end of the month? ... A: So if you actually purchased it, lets say, on the 10th of the month and then you dont designate it until the end of the month, I
187.
188.
189.
190.
191.
25
would have to think about whether that qualifies as [at] acquisition or not. . . . I cant give you an answer right now. Ex. 3, Fierstein Tr. at 694:10-695:8. If the securities had been designated in some other class, including AFS, a redesignation to HTM at month-end would not violate GAAP. Id. at 693:22-694:6. 192. 193. 194. Fannie Mae therefore classified its securities as HTM or AFS at the end of the month. See Ex. 12, Boyles Dec. 7, 2004 OFHEO Tr. 216:9-20. Fannie Mae did so as a matter of operational convenience. Ex. 45, KPMG-CIV00001495 at 508. Since most of Fannie Maes securities were designated as HTM, the month-end classification resulted in a relatively smaller number of securities having their computer designations changed to AFS. Ex. 3, Fierstein Tr. 686:15-687:4. A change in classification of securities from HTM to AFS and recognition of increases or decreases in their value would not affect a companys current earnings. Changes in the value of AFS securities are posted to Other Comprehensive Income (OCI) in the balance sheet. Ex. 45, KPMG-CIV00001495 at 508; Ex. 31, FAS 115 13; see also Ex. 26, Lhotka Rep. at 87; Ex. 3, Fierstein Tr. at 695:20-696:1. Since those changes do not flow through earnings, any improper designation of securities as HTM could not have been used to manipulate income in a quarterly period. Ex. 3, Fierstein Tr. at 705:11-16. As Ms. Fierstein testified: A. [I]f it was HTM today and it should have been AFS, you are correct that it would not be managing earnings because it would not flow through the income statement. . . . Q. Okay. So youre not opining that the impact of this alleged misclassification was that it enabled Fannie Mae to manage earnings quarter to quarter? A. That was not what I opined, thats correct. Ex. 3, Fierstein Tr. at 705:5-16. 197. KPMG obtained an understanding of Fannie Maes process for designating purchased securities as HTM or AFS. It performed a walk-through of the procedure and inquired of relevant personnel. Ex. 45, KPMG-CIV-00001495. KPMG was aware of Fannie Maes policy to classify purchased securities as either HTM or AFS during its standard month-end close process and found the 26
195.
196.
198.
practice to be reasonable and in accordance with GAAP. Ex. 46, KPMG-CIV00001585. 199. 200. 201. Fannie Mae put controls in place to ensure that no securities were transferred out of HTM after month-end. Ex. 3, Fierstein Tr. at 717-20:718-4. There was only one incident during the relevant period in which a security designated as HTM was subsequently sold. Ex. 46, KPMG-CIV-00001585. Fannie Mae investigated the incident and found no indication that this single instance was carried out in an effort to manipulate Fannie Maes earnings or any account balance. Ex. 46, KPMG-CIV-00001585. At the close of its investigation, Fannie Mae implemented additional controls, including implementation of additional written policies and provision of additional training to a variety of staff, in order to prevent any further mistaken reclassifications. Ex. 46, KPMG-CIV-00001585. KPMG took note of the single incident and assessed Fannie Maes revised controls. Ex. 46, KPMG-CIV-00001585. This sale was not made to manage earnings. Ex. 3, Fierstein Tr. at 719:1-2 (No, I dont think that one sale was used to manage earnings.). Both the carrying values (amortized cost) and the fair values of Fannie Maes mortgage securities were disclosed in the financial statements. Ex. 35, 2003 Form 10-K at 59-60, 137. Fannie Mae had gains on such securities that it was not booking by virtue of the HTM classification. Ex. 35, 2003 Form 10-K at 59-60, 137 (fair value of HTM mortgage securities was $486.1 billion at December 31, 2003, $10.9 billion higher than the amount at which Fannie Mae was carrying such securities; chart contains similar disclosure for 2002 and 2001 as well). Ms. Fierstein admitted that Fannie Mae did in fact hold the HTM securities to maturity. Ex. 23, Fierstein Rep. at 2-11.
202.
203. 204. 205.
206.
207. G.
Other Accounting Issues

208.
Mr. Berliner states in his report: In the Restatement . . . , Fannie Mae acknowledged other GAAP violations in more than 30 different areas . . . . The only plausible way that Fannie Maes financial statements could suffer from such significant GAAP violations in so many critical accounting areas is that KPMG was only rubber stamping Fannie Maes accounting policies. Ex. 2, Berliner Rep. at 6-3. Ms. Fierstein opined on the accounting for these issues in only a handful of areas, including impairment of securities. Ex. __, Fierstein Rep. at 3-1. OFHEO raised questions in May 2004 about whether Fannie Mae incorrectly
209.
27
accounted for impairments of debt securities and directed Fannie Mae to recalculate the proper asset impairment on the securities by close of business Friday, May 14, 2004. Ex. 105, FMCIV-02 00625642. KPMG believed Fannie Maes accounting complied with GAAP. Ex. 106, FMCIV-02 05878201 at 8211. A second Big Four accounting firm, Ernst & Young, expressed its opinion that Fannie Maes accounting was in accordance with GAAP. Id. 210. Fannie Mae and OFHEO asked the opinion of the SEC staff, which concluded that Fannie Maes accounting conformed to GAAP and that no restatement was necessary. Ex. 108, FMCIV-07-02128299; Ex. 112, HUD 00000599. In the restatement, Fannie Mae restated other accounting it had previously cleared with the SEC staff, including its accounting for buy-ups. Ex. 42, KPMG-CIV00000477; Ex. 41, KPMG-CIV-00000455. In addition, with respect to Fannie Maes accounting for combinations of certain interest-only and principal-only securities, OFHEO objected to the companys policy early in the special investigation. Again, another major accounting firm reviewed the policy and agreed it was reasonable. Ex. 106, FMCIV-02 05878201 at 8211. The issue was taken to the SEC staff, which asked Fannie Mae to account for such securities as OFHEO wished going forward, but not retrospectively, acknowledging the problem was a lack of clear accounting guidance. Ex. 109, FMCIV-07-02168358. With respect to Fannie Maes valuation of a guaranty asset and corresponding guarantee liability, Fannie Mae cleared two policies with the SEC staff: that the initial valuations would be equal, and that the company would reduce them by equal amounts if the related security was reacquired. Ex. 97, KPMG-CIV00092358; Ex. 42, KPMG-CIV-00000477-98; Ex. 102, KPMG-CIV-00159021. Then it restated both policies. Ex. 36, 2004 Form 10-K at 80-86. Then, after the restatement, Fannie Mae changed the initial valuation back to the original accounting, admitting that the original accounting and Ex. 111, Deloitte-FMNA-200800000028-43. H. Other Instances in Which KPMG Said No to Fannie Maes Accounting 216. With respect to FAS 91, in the third quarter of 2002, Fannie Maes calculation showed that it was outside of the precision threshold. Ex. 19, Serock Tr. at 202:20-206:17. Fannie Mae believed it would be within the threshold by the end of the year, only 90 days away, and said it did not need to book an adjustment. KPMG said no. 28
211.
212.
213.
214.
215.
217.
Fannie Mae booked the adjustment. Ex. 19, Serock Tr. at 202:20-206:17. 218. With respect to insurance accounting, the KPMG audit team did not agree with the accounting that Fannie Mae proposed for several transactions. Ex. 71, KPMG-CIV-00031587.
I.
OFHEOs Contemporaneous Reports 219. During the course of its audits, KPMG became aware of conclusions reached by OFHEO and reported to Congress regarding Fannie Maes operations. OFHEO issued several positive reports to Congress during the relevant period, stating: Fannie Maes internal control framework and the management of that framework exceeded safety and soundness standards. Ex. 37, OFHEO Rep. to Congress (2001) at 16. Fannie Mae implemented controls to properly address risks assessed by management, and had a reliable process for ensuring the timely resolution of control-related issues. Ex. 37, OFHEO Rep. to Congress (2001) at 16; Ex. 38, OFHEO Rep. to Congress (2002) at 23; Ex. 39, OFHEO Rep. to Congress (2003) at 37. The Company had established policies and procedures that delineate internal control processes and standards for the control environment, and management effectively ensured compliance with established internal controls. Ex. 37, OFHEO Rep. to Congress (2001) at 16; Ex. 38, OFHEO Rep. to Congress (2002) at 44; Ex. 39, OFHEO Rep. to Congress (2003) at 37. The scope of [internal] audit work performed is appropriate, and the [internal] audit work is complete. Indeed, the [internal] audit functions exceed safety and soundness standards. Ex. 37, OFHEO Rep. to Congress (2001) at 16-17; Ex. 38, OFHEO Rep. to Congress (2002) at 44. Management of the internal audit department was effective. Ex. 37, OFHEO Rep. to Congress (2001) at 16; Ex. 38, OFHEO Rep. to Congress (2002) at 44; Ex. 39, OFHEO Rep. to Congress (2003) at 35. Both the internal and external audit functions had the appropriate independence, and the auditors performing the work possessed appropriate professional proficiency. Ex. 37, OFHEO Rep. to Congress (2001) at 16; Ex. 38, OFHEO Rep. to Congress (2002) at 44; Ex. 39, OFHEO Rep. to Congress (2003) at 35. The [internal] auditors risk assessment process was effective. Ex. 37, OFHEO Rep. to Congress (2001) at 16; Ex. 38, OFHEO Rep. to Congress (2002) at 44; Ex. 39, OFHEO Rep. to Congress (2003) at 35.
29
220.
KPMG made available its work papers for OFHEOs review. Ex. 1, Serock. Decl. 11. OFHEOs 2002 and 2003 reports also evaluated KPMGs work and concluded: The external auditor's audit plan includes all activities and operations necessary to opine on Fannie Mae's financial statements and the quality of the company's controls. The communications from the external auditor to the Audit Committee are comprehensive, clear, direct and effective. The communications from the external auditor to the Audit Committee tie directly to the approved audit plan. The external auditor's individual and overall conclusions are supported by work papers that comport with established standards and among other things, demonstrate the extent of testing and verification performed by the external auditor.
Ex. 38, OFHEO Rep. to Congress (2002), OFHEO_MUL_00088274 at 83158316; Ex. 39, OFHEO Rep. to Congress (2003), OFHEO_MUL_00037336 at 7376-77. 221. As to derivatives, in July 2000, OFHEOs Director sent a letter to members of Congress influential in financial services regulation, stating, [w]e are pleased to report that both Fannie Mae and Freddie Mac are well positioned to be in compliance with FAS 133 by the implementation date of January 1, 2001. See Ex. 113, OFHEO_OD_00012793 at 95. In its 2002 Report to Congress, containing OFHEOs conclusions for its 2001 annual exam, OFHEO assured Congress that it had overseen Fannie Maes successful implementation of FAS 133 and was continuing to monitor Fannie Maes application of the standard. Ex. 38, OFHEO Rep. to Congress (2002) at 25 (OFHEO carefully scrutinizes Fannie Maes use of derivatives . . . [including] proctoring the implementation of FAS 133 . . . .). The 2002 Report to Congress contained a chart dedicated to the topic of Derivatives, stating: OFHEO evaluates the appropriateness of GAAP accounting for derivatives. Ex. 38, OFHEO Rep. to Congress (2002) at 29. The corresponding observations from OFHEOs evaluation of Fannie Mae state: FAS 133 implementation has been deliberate and well-documented with the necessary investments made to provide systems needed to ensure ongoing compliance. . . . Hedge records and accounting records reflect how derivatives are used. Ex. 38, OFHEO Rep. to Congress (2002) at 29-30. OFHEO concluded broadly that Fannie Maes internal control framework and the management of that framework exceeded safety and soundness standards.
222.
223.
224.
30
Ex. 37, OFHEO Rep. to Congress (2001) at 16, FMCIV-03 03496617 at 6635. 225. 226. Mr. Berliners declined to say OFHEO lacked a rational basis for its opinion. Ex. 3, Berliner Tr. at 218:19-219:2. As late as April and August 2004, in response to specific inquiries from KPMG, OFHEO told KPMG that it did not know of any material errors or misstatements in Fannie Maes financial statements. Ex. 58, KPMG-CIV00010626-27 (Apr. 2 and 12, 2004); Ex. 96, KPMG-CIV-00088080 (Aug. 6, 2004).
J.
Lead Plaintiffs Audit and Accounting Experts i. 227. 228. Robert Berliner Audit Plaintiffs offer Mr. Robert Berliner as their sole audit expert. No other plaintiffs expert opines regarding the conduct of KPMGs audits. Mr. Berliner criticizes KPMGs audit in regard to three accounting issues: FAS 133, 91 and 115. Ex. 22, Berliner Rep. at passim. Mr. Berliner also concludes that KPMGs independence was compromised because it failed to object to Fannie Maes accounting in these three areas (id. 6); KPMG lacked due care because it permitted this erroneous accounting that did not comply with GAAP (id. 3); the audits were not adequately planned because KPMG failed to conduct more procedures around these three accounting issues (id. 1); KPMG did not obtain a sufficient understanding of Fannie Maes internal controls as they related to these three accounting issues (id. 2); insufficient evidential matter was obtained because KPMG did not object to this accounting (id. 3); and its audit reports incorrectly stated that the accounting complied with GAAP because the accounting in these three areas was wrong (id. 4). See Ex. 22, Berliner Rep. passim. Mr. Berliner has been employed solely as a litigation consultant for the past 21 years and has been retained as an expert witness over 200 times. Ex. 2, Berliner Tr. at 14:16-20. Mr. Berliner last performed an audit in 1983, nearly 30 years ago. Ex. 2, Berliner Tr. at 20:5-10. Much of the literature that sets forth professional auditing standards has changed significantly since Mr. Berliner last performed an audit. Id. at 412:21-413:3. Mr. Berliner has not conducted an audit under any of accounting standards upon which he bases his opinions: all of those standards were promulgated after he last conducted an audit. Ex. 2, Berliner Tr. at 19:19-21:2; 409:17-412:7. Mr. Berliner does not know what procedures auditors do or do not perform when they are auditing transactions covered by FAS 133, 91 or 115. Ex. 2, Berliner Tr. at 411:16-412:7. 31
229.
230.
231.
232.
233.
Mr. Berliner has never conducted an audit under Statement on Auditing Standards No. 92 Auditing Derivatives, which was promulgated in 2001, simultaneous with the effective date of FAS 133. Ex. 2, Berliner Tr. at 413:4-15. Mr. Berliner does not consider himself to be an expert on FAS 133, FAS 91, or FAS 115. Ex. 2, Berliner Tr. at 403:12-408-4, 589:10-590:2. Mr. Berliner has no specific training under any of these standards. Ex. 2, Berliner Tr. at 405:6-409:16. Mr. Berliner has only audited two companies in the financial services industry, neither of which used derivatives or purchased mortgage loans. Ex. 2, Berliner Tr. at 21:3-14. Mr. Berliner reviewed less than 5% of KPMGs work papers. Ex. 2, Berliner Tr. at 62:10-14. Mr. Berliner did not review all of the documents cited by KPMGs auditing expert. Ex. 2, Berliner Tr. at 86:7-14. Mr. Berliner devoted approximately 650 hours to this engagement since being designated as an expert. Ex. 2, Berliner Tr. at 47:6-9; 57:2-7. Mr. Berliner was first hired four years before being designated as an expert. Ex. 2, Berliner Tr. at 56:3-7. Mr. Berliner delegated much of the writing of his report to his staff. Ex. 2, Berliner Tr. at 86:17-87:12. Mr. Berliner concedes that he is criticizing KPMG auditors for auditing under standards that he has no personal experience applying in an audit and on which he has received no training. Ex. 2, Berliner Tr. at 409:17-410:15. Berliner criticizes KPMG for materials that it never saw. Ex. 22, Berliner Rep. at 2-4 (KPMG may not have been privy to this e-mail . . . .); id. at 2-5 (I am not aware of any evidence that KPMG was present for or aware of this . . . .); see also Ex. 2, Berliner Tr. at 602:21-22 ([T]heres no indication that KPMG ever saw this e-mail . . . .); id. at 238:15-18 (agreeing that there is no evidence that KPMG was aware or should have been aware of that speech). Mr. Berliner admits that the auditors at KPMG planned its audit, but he claims they did not do it appropriately. Ex. 2, Berliner Tr. at 112:19-22. The auditors risk assessment process, according to Mr. Berliner, was appropriate, but their execution of it was not adequate. Id. at 113:11-15. The auditors did assess the risk of misstatements and developed audit procedures, but not adequately. Id. at 116:10-22. These words appear twenty-three times throughout his testimony. Adequately appears nine times. Ex. 2, Berliner Tr. at 106:19, 113:14, 116:14, 116:22, 117:10, 119:5, 401:15, 554:21, 555:1. Appropriately appears fourteen 32
234. 235. 236.
237. 238. 239. 240. 241. 242.
243.
244.
times. Id. at 112:16, 112:21, 216:5, 217:20, 218:5, 247:18, 255:16, 298:18, 308:20, 411:6, 547:21, 574:17, 603:6. 245. Mr. Berliner admitted he could not offer any independent opinion on the state of Fannie Maes internal controls and that he had never done any review of such controls. Ex. 2, Berliner Tr. at 55:1-4, 209:15-210:5, 592:4-12, 600:10-15, 708:7711:5. He did not identify any particular control weakness that dated back to the class period. Id. at 207:13-20. Mr. Berliner is not plaintiffs designated accounting expert and does not intend to opine on FAS 91, FAS 133 or FAS 115. Ex. 2, Berliner Tr. at 31:3-6, 40:9-41:6, 589:10-590:2. Sharon Sabba Fierstein Accounting Ms. Fierstein has never audited a company that utilized FAS 91 accounting, or gained experience on that standard other than through litigation consulting, and she has never published on FAS 91. Ex. 23, Fierstein Rep. at B-1; see Ex. 3, Fierstein Tr. at 94:14-95:5. Before working on litigation matters, Ms. Fierstein only knew how [FAS 91 accounting was] done generally. Ex. 3, Fierstein Tr. at 94:19-95:3. The basis for Ms. Fiersteins purported expertise on FAS 115 is that she has read the standard a lot. Ex. 3, Fierstein Tr. at 95:8-9. Ms. Fierstein has never audited a company that had to classify debt securities, nor been involved with the creation or implementation of accounting policies regarding the classification of debt securities. Ex. 3, Fierstein Tr. at 96:1-6. Ms. Fierstein has never testified at trial or served as an expert witness in any matter. Ex. 3, Fierstein Tr. at 139:1-3. Ms. Fierstein is offering no opinion on KPMGs audits. Ex. 3, Fierstein Tr. at 243:1-5. Ms. Fierstein testified that she addressed in her report only those accounting issues for which she felt she had sufficient documentation to address. Ex. 3, Fierstein Tr. at 111:3-14. Mr. Barron is offering no opinion on KPMGs audits. Ex. 4, Barron Tr. 13:6-10.
246.
ii. 247.
248. 249. 250.
251. 252. 253.
254. K.
KPMGs Experts 255. Timothy S. Lucas, KPMGs FAS 133 expert, is the former Director of Research and Technical Activities of the FASB. He was extensively involved in the FASB technical project on accounting for derivatives and hedging, which led to the issuance of FAS 133. During that same period, Mr. Lucas served as Chairman of 33
the Emerging Issues Task Force (EITF), a group of senior accounting professionals who met regularly with the FASB and the SEC to resolve financial reporting issues. Mr. Lucas spent more time on FAS 133 than any other project to which he was assigned while at the FASB. Ex. 115, Lucas Rep. at 1. Mr. Lucas opined that Fannie Maes approach to implementing FAS 133 was a reasonable and appropriate application of GAAP in the relevant time period. Id. at 2. 256. William Holder, a Professor of Accounting and Director of the SEC and Financial Reporting Institute of the University of Southern California School of Business, is KPMGs FAS 91 expert. Professor Holder received the AICPAs Gold Medal of Distinguished Service, its highest honor, and has been twice included among the accounting professions Top 100 People by Accounting Today. He is a recent member of several accounting and audit standard-setting bodies, including the AICPA Board of Directors and Accounting Standards Executive Committee. Ex. 25, Holder Rep. at 1. Joseph D. Lhotka, a CPA since 1963 and an audit partner since 1971, is KPMGs audit expert and opined on FAS 115. Lhotka has been a practicing auditor for four decades and has experience with the relevant accounting standards in the financial services audit context. Ex. 117, Lhotka Tr. 84:19-86:5; Ex. 26, Lhotka Rep. at 91-92. II. LOSS CAUSATION A. Plaintiffs Attribute No Artificial Inflation to KPMGs Statements 258. 259. The auditors report on a companys financial statements is the medium in which the accounting firm communicates its opinion. Ex. 22, Berliner Rep. at 4. The only KPMG statements alleged to have been materially misleading are its three audit opinions. SAC 403-407; Ex. 22, Berliner Rep. at 6; Ex. 2, Berliner Tr. 119:9-13. KPMGs first audit opinion during the class period was published in Fannie Maes publicly disseminated Information Statement on April 1, 2002. Ex. 33, 2001 Information Statement at 55. No artificial inflation entered Fannie Maes stock price on April 1, 2002. Ex. 27, Jarrell Rep. 245, JRExs.3 4, 8; Ex. 6, Jarrell Tr. at 272:17-273:21. There was no statistically significant movement in Fannie Maes stock price on April 1, 2002. Ex. 27, Jarrell Rep. Ex. 11 at 5. KPMGs second audit opinion issued during the class period was published on March 31, 2003. SAC 404; Ex. 35, 2003 Form 10-K at 146.
257.
260.
261. 262. 263.

3
JREx refers to an exhibits to Mr. Jarrells expert report, which are all included in Exhibit 27 in the Evidentiary Appendix.
34
264. 265. 266. 267. 268. 269.
No inflation entered the stock on the date of the second audit opinion, March 31, 2003. Ex. 27, Jarrell Rep. 245 & Ex. 8; Ex. 6, Jarrell Tr. at 272:17-273:21. There was no statistically significant movement in Fannie Maes stock price on March 31, 2003. Ex. 27, Jarrell Rep. Ex. 11 at 10. KPMGs third audit opinion during the class period was published on March 15, 2004. SAC 406; Ex. 36, 2004 Form 10-K at 170. No inflation entered Fannie Maes stock price on March 15, 2004. Ex. 27, Jarrell Rep. 245 & Ex. 8; Ex. 6, Jarrell Tr. at 272:17-273:21. There was no statistically significant movement in Fannie Maes stock price on March 15, 2004. Ex. 27, Jarrell Rep. Ex. 11 at 14. No inflation entered Fannie Maes stock price as a result of any Fannie Mae financial statement, and therefore any KPMG audit opinion. Ex. 6, Jarrell Tr. at 272:17-273:21; Ex. 27, Jarrell Rep. 245 & Ex. 8. Plaintiffs assert that Fannie Maes stock was inflated by $5.52 per share on or before April 17, 2001, the first day of the Class Period. Ex. 27, Jarrell Rep. 245 & Ex. 8; Ex. 6, Jarrell Tr. at 267:21-268:9, 271:19-272:11. Plaintiffs do not claim that KPMG made any materially misleading statement on or before April 17, 2001. SAC 403-407. According to plaintiffs expert, stock price inflation remained constant for over two years, from April 17, 2001 to June 15, 2003, and then increased to $7.99 per share on June 16, 2003, and to $9.10 per share on July 30, 2003. Ex. 27, Jarrell Rep. 245 & Ex. 8. KPMG made no allegedly materially misleading statement on June 16, 2003 or July 30, 2003. Instead, plaintiffs attribute additional inflation on June 16, 2003, and July 30, 2003, to statements by others. Ex. 27, Jarrell Rep. 91-95, 245; SAC 270-271. Plaintiffs expert asserts that the inflation in Fannie Maes stock remained constant between July 31, 2003 and September 21, 2004. Ex. 27, Jarrell Rep. 245 & Ex. 8. By September 30, 2004, any inflation in Fannie Maes stock price was reduced to zero. Ex. 27, Jarrell Rep. 244 & Ex. 8; Ex. 6, Jarrell Tr. at 64:12-65:5. KPMG did not make any allegedly materially misleading statement after September 30, 2004. SAC 403-407; Ex. 27, Jarrell Rep. 241-242; Ex. 6, Jarrell Tr. at 229:13-230:6, 232:4-235:21. Professor Jarrell attributes any post-September inflation to statements made on
270.
271. 272.
273.
274.
275. 276.
277.
35
October 6 and 7, 2004, by others. Ex. 27, Jarrell Rep. 170-174, 177-179, 245; Ex. 6, Jarrell Tr. at 201:10-202:14. B. Plaintiffs Attribute Losses to Factors about which KPMGs Audit Opinions Did Not Speak 278. Information about a changing political and regulatory environment was a factor causing the September 2004 stock price declines. Ex. 6, Jarrell Tr. at 179:22180:15, 104:2-106:19; Ex. 27, Jarrell Rep. 119, 138, 147, 149. None of KPMGs audit opinions on Fannie Maes financial statements opined on the many political influences that might affect the companys operations. A portion of the stock price decline in September 2004 was due to OFHEOs allegation that management deferred $200 million in amortization in order to achieve bonus targets in 1998. Ex. 6, Jarrell Tr. at 93:19-94:1, 97:6-10, 160:10161:3. According to Professor Jarrells model, the alleged 1998 accounting decision caused at least a portion of the $5.52 of inflation he posits existed before KPMG spoke. Ex. 6, Jarrell Tr. at 271:19-272:11.
279. 280.
281.
Respectfully submitted this 16th day of August, 2011. /s/ F. Joseph Warin F. Joseph Warin (D.C. Bar No. 235978) John H. Sturc (D.C. Bar No. 914028) Scott Fink (pro hac vice) George H. Brown (pro hac vice) Andrew S. Tulumello (D.C. Bar. No. 468351) GIBSON, DUNN & CRUTCHER LLP 1050 Connecticut Avenue, N.W. Washington, D.C. 20036 Telephone: (202) 955-8500 Facsimile: (202) 467-0539 Counsel for KPMG LLP
.
36

KMPG's Statement of Facts Re: Fannie

Transféré par

Informations du document

Description originale:

Titre original

Copyright

Formats disponibles

Partager ce document

Partager ou intégrer le document

Options de partage

Avez-vous trouvé ce document utile ?

Ce contenu est-il inapproprié ?

Droits d'auteur :

Formats disponibles

KMPG's Statement of Facts Re: Fannie

Transféré par

Droits d'auteur :

Formats disponibles

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 1 of 36

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)

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 2 of 36

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 3 of 36

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 4 of 36

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 5 of 36

28. 29. 30.

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 6 of 36

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 7 of 36

iii. 49. 50.

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 8 of 36

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 9 of 36

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 10 of 36

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 11 of 36

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 12 of 36

87. 88. 89. 90.

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 13 of 36

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 14 of 36

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 15 of 36

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 16 of 36

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 17 of 36

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 18 of 36

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 19 of 36

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 20 of 36

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 21 of 36

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 22 of 36

167. 168. 169.

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 23 of 36

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 24 of 36

179. 180. 181.

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 25 of 36

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 26 of 36

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 27 of 36

203. 204. 205.

Other Accounting Issues

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 28 of 36

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 29 of 36

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 30 of 36

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 31 of 36

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 32 of 36

234. 235. 236.

237. 238. 239. 240. 241. 242.

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 33 of 36

248. 249. 250.

251. 252. 253.

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 34 of 36

261. 262. 263.

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 35 of 36

264. 265. 266. 267. 268. 269.

Case 1:04-cv-01639-RJL Document 937-2 Filed 08/22/11 Page 36 of 36

Vous aimerez peut-être aussi