KMPG Memo On Motion For Summary Judgement

Case 1:04-cv-01639-RJL Document 937-1 Filed 08/22/11 Page 1 of 48
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 MEMORANDUM OF POINTS AND AUTHORITIES IN SUPPORT OF ITS MOTION FOR SUMMARY JUDGMENT 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
TABLE OF CONTENTS
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INTRODUCTION .......................................................................................................................... 1 ACCOUNTING AND AUDITING ................................................................................................ 3 ARGUMENT .................................................................................................................................. 6 I. PLAINTIFFS CANNOT SHOW THAT THE KPMG AUDITORS ACTED WITH SCIENTER ..................................................................................................................................... 6 A. The Undisputed Evidence Negates Any Claim that Accounting Policy Disagreements Show Auditor Fraud ............................................................................... 8 1. Plaintiffs Cannot Show That No Reasonable Accountant Could Have Accepted Fannie Maes Approach to FAS 133 When OFHEO, Other Major Financial Institutions, the Big Four Accounting Firms, the Staff of the SEC, and Plaintiffs Own FAS 133 Expert Say Otherwise ............................ 14 Plaintiffs Cannot Show That No Reasonable Accountant Could Have Accepted Fannie Maes Use of a Precision Threshold When Plaintiffs Subject Matter Expert Says Auditing Literature Supports This Concept ............. 17 Plaintiffs Cannot Show That No Reasonable Accountant Could Have Accepted Fannie Maes FAS 115 Policy When Plaintiffs FAS 115 Expert Is Not Sure and Denies the Policy Could Be Used to Manipulate Earnings ........ 21
2.
3.
B.
Plaintiffs Cannot Claim No Audit At All .................................................................. 23 1. 2. Plaintiffs Do Not Dispute KPMGs Effort ........................................................... 23 Mr. Berliner Criticizes the Auditors Professional Judgments, Not Their Intent ..................................................................................................................... 25
C.
Plaintiffs Offer No Evidence Regarding KPMGs Auditing of Any Other Accounting Issue ........................................................................................................... 31
II. PLAINTIFFS HAVE FAILED TO ATTRIBUTE ANY OF THEIR CLAIMED DAMAGES TO ANY STATEMENT BY KPMG ....................................................................... 36 A. B. KPMG Cannot Be Liable for Statements Made by Others ........................................... 37 Plaintiffs Have Not Proven that KPMG Caused Any of Their Losses ......................... 39
CONCLUSION ........................................................................................................................... 41
TABLE OF AUTHORITIES Cases Acito v. IMCERA Grp., Inc. 47 F.3d 47 (2d Cir. 1995) ......................................................................................................... 29 Bouchard v. Am. Home Prods. Corp., NO. 3:98 CV 7541, 2002 WL 32597992 (N. D. Ohio May 24, 2002) ..................................... 12 Celotex Corp. v. Catrett, 477 U.S. 317 (1986) .................................................................................................................... 7 Cent. Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164 (1994) ............................................................................................................ 39, 41 *Dronsejko v. Grant Thornton, 632 F.3d 658 (10th Cir. 2011).............................................. 10, 34 Erica P. John Fund, Inc. v. Halliburton Co., 131 S. Ct. 2179, 2184 (2011) ...................................................................................................... 6 *Ernst & Ernst v. Hochfelder, 425 U.S. 185 (1976) .................................................................................................................... 7 Ferris, Baker Watts, Inc. v. Ernst & Young, LLP, 395 F.3d 851 (8th Cir. 2005) ...................................................................................................... 7 In re AOL Time Warner, Inc. Sec. Litig., 503 F. Supp. 2d 666 (S.D.N.Y. 2007) ................................................................................ 42, 43 In re Ceridian Corp. Sec. Litig., 542 F.3d 240 (8th Cir. 2008) .................................................................................................... 34 *In re IKON Office Sol. Inc., 277 F.3d 658 (3d Cir. 2002) ............................................................................... 8, 28, 29, 31, 34 In re MIVA, Inc. Sec. Litig., 2009 U.S. Dist. LEXIS 127748 (M.D. Fla. Aug. 25, 2009) .................................................... 42 In re Moodys Corp. Sec. Litig., 2011 WL 1237690 (S.D.N.Y. Mar. 31, 2011) .......................................................................... 42 In re REMEC Sec. Litig., 702 F. Supp. 2d 1202 (S.D. Cal. 2010) ............................................................................... 14, 15 In re The First Marblehead Corp. Sec. Litig., 639 F. Supp. 2d 145 (D. Mass. 2009) ....................................................................................... 15
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In re U.S. Office Prod. Sec. Litig., 326 F. Supp. 2d 68 (D.D.C. 2004) ............................................................................................ 10 In re Verifone Holdings, Inc. Sec. Litig., No. C 07-6140, 2011 WL 1045120 (N.D. Cal. Mar. 22, 2011) ................................................ 14 In re Williams Sec. Litig., 496 F. Supp. 2d 1195 (N.D. Okla. 2007), affirmed, 558 F.3d 1130 (10th Cir. 2009) ....................................................................... 9, 10, 12 *In re Worlds of Wonder Sec. Litig., 35 F.3d 1407 (9th Cir. 1994) .................................................................................. 6, 7, 9, 10, 17 *Janus Capital Grp., Inc. v. First Derivative Traders, 131 S. Ct. 2296 (2011) ............................................................................................ 39, 40, 41, 42 *La. Sch. Emps. Ret. Sys. v. Ernst & Young, LLP, 622 F.3d 471 (6th Cir. 2010) ...................................................................................................... 8 *Lattanzio v. Deloitte & Touche, LLP, 476 F.3d 147 (2d Cir. 2007) ................................................................................... 40, 41, 42, 43 Liberty Prop. Trust v. Republic Props. Corp., 577 F.3d 335 (D.C. Cir. 2009) .................................................................................................... 8 McNamara v. Pre-Paid Legal Serv., Inc., 189 F. Appx 702 (10th Cir. 2006) ........................................................................................... 15 Merck & Co., Inc. v. Reynolds, 130 S. Ct. 1784 (2010) ................................................................................................................ 7 Natl Junior Baseball League v. Pharmanet Dev. Grp. Inc., 720 F. Supp. 2d 517 (D.N.J. 2010) ............................................................................................. 7 *Pub. Emps. Ret. Assoc. of Colo. v. Deloitte & Touche LLP, 551 F.3d 305 (4th Cir. 2009) ...................................................................................................... 9 Roth v. OfficeMax, Inc., 527 F. Supp. 2d 791 (N.D. Ill. 2007) ..................................................... 31 *SEC v. Howard, 376 F.3d 1136 (D.C. Cir. 2004) .............................................................................................. 1, 8 *SEC v. Shanahan, ___ F.3d ___, No. 10-1820, 2011 WL 2803011 (8th Cir. July 19, 2011) ................................ 14 *SEC v. Steadman, 967 F.2d 636 (D.C. Cir. 1992) ............................................................................................ 1, 8, 9
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Semerenko v. Cendant Corp., 223 F.3d 165 (3d Cir. 2000) ..................................................................................................... 42 Stevens v. InPhonic, Inc., 662 F. Supp. 2d 105 (D.D.C. 2009) .......................................................................................... 35 Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148 (2008) .............................................................................................................. 6, 41 Zaremba v. General Motors Corp., 360 F.3d 355 (2d Cir. 2004) ..................................................................................................... 12 Statutes and Rules Private Securities Litigation Reform Act, 15 U.S.C. Sec. 78u-4 .................................................. 38 Securities and Exchange Act of 1934 Section 10(b) ................................................ 1, 6, 39, 40, 41
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INTRODUCTION Despite the image of the accountant as someone at a desk tallying columns of numbers, and the auditor as the person who checks the math, the courts have recognized three things about the current state of corporate accounting. First, the substantial body of guidance that is called Generally Accepted Accounting Principles (GAAP) is complex in its structure and highly judgmental in its application. Second, the independent auditor must exercise his or her professional judgment in conducting an audit under Generally Accepted Auditing Standards (GAAS) and in interpreting the results of those audit procedures. Third, since hindsight is always 20-20, these professional judgments are very easy to second-guess. Accordingly, when a plaintiff brings accusations against an independent auditor and publicly accuses that professional not only of error but of fraud, the plaintiff must meet a substantial burden of proof. To succeed on a claim against an independent auditor for securities fraud under Section 10(b), plaintiffs must prove the professional intended to defraud investors. At a minimum, that means such an extreme departure from the standards of ordinary care that it 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) (emphasis added) (internal quotation omitted), cited in In re Fed. Natl Mortgage Assn Sec., Derivative, & ERISA Litig., 503 F. Supp. 2d 25, 37 (D.D.C. 2007). This bar is high: even inexcusable neglect does not suffice. See SEC v. Howard, 376 F.3d 1136, 1143 (D.C. Cir. 2004). An intent to defraud means just that: an intent to defraud. Plaintiffs fall far short of this high bar. The undisputed record shows that KPMGs audit team was both highly qualified and devoted to this audit, amassing an approximately 40,000 page record of the work they performed. Plaintiffs acknowledge that KPMG considered and evaluated each of the accounting issues which the plaintiffs experts criticize. Plaintiffs agree
that auditors must exercise professional judgment and that KPMG did exercise its judgment. At bottom, plaintiffs case is that KPMG decided wrong. That, however, is not fraud. Just how far short these plaintiffs fall is shown in the opinions and testimony of their own experts: Robert Berliner, their auditing expert; John Barron, their expert on FAS 133 and hedge accounting; and Sharon Fierstein, their expert on FAS 91 and FAS 115. Mr. Berliner criticizes KPMG for accepting Fannie Maes accounting policies (or parts of them), but in each instance plaintiffs accounting experts contradict him. He claims that no reasonable accountant could have accepted Fannie Maes approach to hedge accounting under FAS 133, while Mr. Barron was forced to concede such an interpretation was used by other major accounting firms and their clients, and ultimately agreed with by the staff of the SEC. The part of Fannie Maes FAS 91 policy he criticizes was, according to Ms. Fierstein, perfectly appropriate for an auditor to use and supported by the audit literature. The part of Fannie Maes FAS 115 policy he claims might have been used to manipulate earnings was not, according to Ms. Fierstein, even capable of doing so. Adding to plaintiffs failure to show any intent to defraud, plaintiffs fail to do what is necessary to show that any statement by KPMG caused them injury. The United States Supreme Court has recently clarified that an outside auditor can only be liable for the statements it makes, here KPMGs three audit opinions. The Court also has made clear that plaintiffs must prove loss causationthat KPMGs audit opinions were the cause of their losses. Yet plaintiffs own damages expert agrees that the dates on which KPMG spoke were not the dates on which Fannie Maes stock price became inflated. He affirmatively denies this, just as he denies that the stock price even moved on any date that KPMG spoke. Plaintiffs' sweeping damages theory is that they may collect for the political fallout after the accounting dispute became public, and inflation
before the class period even began. This unprecedented approach does not satisfy plaintiffs burden to show that any damage was caused by KPMGs statements. These undisputed facts do not support any reasonable conclusion that KPMGs conduct approximated an intent to deceive the investing public. Nor do they provide evidence that KPMG is the cause of any loss to plaintiffs. For each of these reasons, summary judgment in favor of KPMG should be granted. ACCOUNTING AND AUDITING Fannie Mae published annual audited financial statements, initially disseminating them itself and later filing them with the SEC. SUMF 3. KPMG served as Fannie Maes independent auditor throughout the class period. Id. A companys financial statements are prepared by its management. SUMF 4 (Fierstein Rebuttal Rep.; Berliner Tr.). Those financial statements are to be prepared in accordance with Generally Accepted Accounting Principles, or GAAP. GAAP is a term of art that encompasses a wide range of acceptable principles. SUMF 5 (Berliner Tr.). Applying these accounting principles to particular transactions can require a significant degree of professional judgment. SUMF 6 (Berliner Tr.). Management must make reasonable estimates based on information that may or may not be complete. SUMF 7 (Berliner Tr.). 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. SUMF 8 (Berliner Tr.). Fannie Mae was a large, financially sophisticated organization with personnel who were highly qualified in accounting and financial matters. SUMF 2 (Berliner Tr.; Fierstein Tr.). KPMGs role as the independent auditor was limited to expressing an opinion on these financial statements taken as a whole. SUMF 11 (Berliner Tr.). Auditors do not express an opinion or provide any assurance about the future earnings of the company, 3
the quality of its management or the quality of its corporate governance. SUMF 12 (Berliner Tr.). Moreover, during the relevant period, auditors were not required to report on the effectiveness of a companys internal controls; Section 404 of the Sarbanes Oxley Act, which introduced that requirement, was not effective until after the class period. SUMF 11 (Berliner Tr.). KPMG offered no opinion on, and made no representation to investors about, the effectiveness of Fannie Maes internal controls. SUMF 11, 13 (2003 10-K). The standards governing the auditors conduct are known as Generally Accepted Auditing Standards ("GAAS). SUMF 14 (Berliner Rep.). Those standards recognize that [t]he performance of an audit is a complex process and that no auditor (and no audit opinion) can offer a guarantee or insurance or absolute assurance about the financial statements. SUMF 15 (Miller GAAS Guide; AICPA Professional Standards). The auditor does not and cannot look at everything: an audit involves the selective testing of the data being audited. SUMF 15 (AICPA Professional Standards). Deciding what to test and how, and assessing the implications of the results for the audit, all are fundamentally based on professional judgment: 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. SUMF 15. (Miller GAAS Guide); (Berliner Tr. ([A]n auditor is obligated only to obtain reasonable assurance that the financial statements are free of material misstatements.); Lhotka Rep.). 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. SUMF 20 (AICPA Professional Standards). 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. SUMF 20 (AICPA Professional Standards). 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: 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. SUMF 13 (2003 10-K) (emphasis added). In sum, an audit does not seek perfection, and an unqualified audit report is not a representation that a companys financial statements are perfect. Rather, the auditor looks for evidential matter that can show whether or not the companys accounting is fairly presented in accordance with GAAP. SUMF 16-17 (AICPA Professional Standards; Berliner Tr.). The auditor must exercise a great degree of professional judgment in determining which evidence to gather, how to go about doing so, and whether the evidence provides reasonable assurance that the financial statements present fairly, in all material respects the companys financial position. SUMF 18-19 (Berliner Tr.). Reasonable auditors can disagree on these points, as even 5
plaintiffs expert acknowledged. SUMF 18-19 (Berliner Tr.); see also In re Worlds of Wonder Sec. Litig., 35 F.3d 1407, 1426 (9th Cir. 1994). ARGUMENT To prevail on a fraud claim under Section 10(b) of the Securities and Exchange Act of 1934, plaintiffs must prove: (1) a material misrepresentation or omission by the defendant; (2) scienter; (3) a connection between the misrepresentation or omission and the purchase or sale of a security; (4) reliance upon the misrepresentation or omission; (5) economic loss; and (6) loss causation. Stoneridge Inv. Partners, LLC v. Scientific-Atlanta, Inc., 552 U.S. 148, 157 (2008); Erica P. John Fund, Inc. v. Halliburton Co., 131 S. Ct. 2179, 2184 (2011). Rule 56 of the Federal Rules of Civil Procedure mandates the entry of summary judgment, after adequate time for discovery . . . against a party who fails to make a showing sufficient to establish the existence of an element essential to that partys case, and on which that party will bear the burden of proof at trial. Celotex Corp. v. Catrett, 477 U.S. 317, 322 (1986). This memorandum of law focuses on plaintiffs failure to prove the second element (scienter) and the sixth element (loss causation) as to KPMG. I. PLAINTIFFS CANNOT SHOW THAT THE KPMG AUDITORS ACTED WITH SCIENTER Scienter by an outside auditor is not to be inferred lightly. That element does not turn on whether KPMG may have gotten the accounting wrong. See Ferris, Baker Watts, Inc. v. Ernst & Young, LLP, 395 F.3d 851, 855 (8th Cir. 2005) (Allegations of GAAP violations are insufficient, standing alone, to raise an inference of scienter. (internal quotation omitted)). [Scienter] requires more than a misapplication of accounting principles. Worlds of Wonder,, 35 F.3d at 1426 (alteration in original) (internal quotation omitted); see also Natl Junior Baseball League v. Pharmanet Dev. Grp. Inc., 720 F. Supp. 2d 517, 557 (D.N.J. 2010) (citing
cases). Instead, scienter is an intent to deceive, manipulate, or defraud and connotes intentional or willful conduct designed to deceive or defraud investors by controlling or artificially [inflating] the price of securities. Ernst & Ernst v. Hochfelder, 425 U.S. 185, 193, 199 (1976). Plaintiffs must prove that KPMG not only made a material misstatement, but that it did so with an intent to deceive not merely innocently or negligently. Merck & Co., Inc. v. Reynolds, 130 S. Ct. 1784, 1796 (2010). In this Circuit, scienter cannot be found without proof of either intentional wrongdoing or extreme recklessness. See Liberty Prop. Trust v. Republic Props. Corp., 577 F.3d 335, 342 (D.C. Cir. 2009) (internal quotation omitted). Extreme recklessness, in turn, is not merely a heightened form of ordinary negligence; it connotes 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. Steadman, 967 F.2d at 641-42 (D.C. Cir. 1992) (alteration in original) (internal quotation omitted). As the D.C. Circuit has explained, [i]t is not enough that the defendants action or omission is derived from inexcusable neglect. Howard, 376 F.3d at 1143 (quoting Sundstrand Corp. v. Sun Chem. Corp., 553 F.2d 1033, 1047 (7th Cir. 1977)). Rather, scienter requires at least a state of mind closer to conscious intent than to gross negligence. Id. at 1143 n. 10 (internal quotation omitted); Steadman, 967 F.2d at 642. The standard for proving scienter against a companys independent auditor is particularly exacting: plaintiffs must prove, with admissible evidence, highly egregious conduct that demonstrates a mental state so culpable that it approximate[s] an actual intent to aid in the fraud being perpetrated by the audited company. La. Sch. Emps. Ret. Sys. v. Ernst & Young, LLP, 622 F.3d 471, 479 (6th Cir. 2010) (internal citation omitted); In re IKON Office Sol. Inc.,
277 F.3d 658, 667 (3d Cir. 2002); Pub. Emps. Ret. Assoc. of Colo. v. Deloitte & Touche LLP, 551 F.3d 305, 313 (4th Cir. 2009); In re Williams Sec. Litig., 496 F. Supp. 2d 1195, 1289 (N.D. Okla. 2007) (emphasis in original), affirmed, 558 F.3d 1130 (10th Cir. 2009). In an oft-quoted summation of the standard of proof: The [plaintiff] must prove that the accounting practices were so deficient that the audit amounted to no audit at all, or an egregious refusal to see the obvious, or to investigate the doubtful, or that the accounting judgments which were made were such that no reasonable accountant would have made the same decisions if confronted with the same facts. Worlds of Wonder, 35 F.3d at 1426 (quoting SEC v. Price Waterhouse, 797 F. Supp. 1217, 1240 (S.D.N.Y. 1992)); see also Steadman, 967 F.2d at 642-43. The undisputed facts show plaintiffs have failed to meet this burden. A. The Undisputed Evidence Negates Any Claim that Accounting Policy Disagreements Show Auditor Fraud Plaintiffs auditing expert, Robert Berliner, concludes that KPMGs audits for the years ended December 31, 2001, 2002 and 2003 violated professional standards. His primary objection is not to the auditors efforts, but to their conclusions. He says that the auditors should have objected to the companys interpretations of certain accounting standards: FAS 133 (derivatives and hedge accounting), FAS 91 (amortization premiums and discounts) and FAS 115 (classification of securities).1
Most of Mr. Berliners criticisms merely repackage his complaints about these three accounting policies: KPMGs independence was compromised because it failed to object to Fannie Maes accounting in these areas; KPMG lacked due care because it permitted this erroneous accounting that did not comply with GAAP; the audits were not adequately planned because KPMG failed to conduct more procedures around these three accounting issues; KPMG did not obtain a sufficient understanding of Fannie Maes internal controls as they related to these three accounting issues; insufficient evidential matter was obtained because KPMG did not object to this accounting; and its audit reports incorrectly stated that the accounting complied with GAAP because the accounting in these three areas was wrong. See SUMF 228 (Berliner Rep.).
Many courts have recognized that disputes about the interpretation and application of accounting rules go to the heart of an auditors professional judgment. The Ninth Circuit explained the appropriateness of summary judgment in favor of an auditor where plaintiffs faulted the firm for concurring with its clients accounting: In essence, the plaintiffs concede[d] that [the auditor] made a sufficient investigation into WOWs finances but contend that [the auditors] ultimate resolution of the accounting issues regarding those finances was incorrect. That contention is not sufficient to establish scienter. Worlds of Wonder, 35 F.3d at 1426. Any legitimate dispute over the reasonableness of the accounting interpretation defeats a claim of fraud. Dronsejko v. Grant Thornton, 632 F.3d 658, 667 (10th Cir. 2011) (dismissing a securities fraud claim alleging an accounting interpretation was wrong); Williams, 496 F. Supp. 2d at 1289 ([T]he GAAP and GAAS violations must be coupled with evidence that the violations were the result of the auditors fraudulent intent to mislead investors.); In re U.S. Office Prod. Sec. Litig., 326 F. Supp. 2d 68, 77 (D.D.C. 2004) ([A] mere publication of inaccurate accounting figures or failure to follow [GAAP], without more, does not establish scienter. (internal citation omitted)). Here, indisputably qualified experts have opined that each of the interpretations Mr. Berliner criticizes was appropriate under GAAP: Timothy S. Lucas, KPMGs FAS 133 expert, is the former Director of Research and Technical Activities of the Financial Accounting Standards Board (or 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 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. SUMF 255 (Lucas Rep.). 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 9
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. SUMF 256 (Holder Rep.). 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. SUMF 257 (Lhotka Rep.; Lhotka Tr.).
The best that plaintiffs can hope for is a battle of the experts. But these cases make clear that a battle of the experts is not enough when the claim is fraud. As one court noted: [The disputed] items involved complex issues of accounting as to which reasonable accountants could reach different conclusions. Indeed . . . the Court heard diametrically opposing views from experts as to the reasonableness of [the] accounting and audit judgments. It follows that no finding of fraud or recklessness can rationally be made in this case. SEC v. Price Waterhouse, 797 F. Supp. 1217, 1241 (S.D.N.Y. 1992)) (internal quotations omitted). Even if disputes over the interpretation of accounting standards could make out a case for fraud, plaintiffs here have failed to make that case. They put forward an auditing expert, Robert Berliner, who admits he has no experience auditing with any of these accounting standards. SUMF 231 (Berliner Tr.). He has audited only two companies in the financial services industry, neither of which used derivatives or purchased mortgage loans. SUMF 236 (Berliner Tr.). He performed his last audit nearly thirty years ago. SUMF 230 (Berliner Tr.). None of the three accounting standards he singles out even existed at that time. SUMF 231 (Berliner Tr.). He does not consider himself to be an expert on any of these standards, and has no particular training on any of them. SUMF 234-35 (Berliner Tr.). Mr. Berliner admits that not only the accounting standards, but the relevant auditing standards have changed significantly since he last performed an audit. SUMF 230-31 (Berliner Tr.). He does not know what procedures auditors commonly perform when they are auditing transactions covered by these 10
accounting standards. SUMF 232 (Berliner Tr.). In short, Mr. Berliner agrees that he is criticizing KPMG auditors for auditing under standards that he has no personal experience applying and on which he has received no training. SUMF 242 (Berliner Tr.). Courts have excluded experts for less. See Williams, 496 F. Supp. 2d at 1244-45 (an expert who lacked specific expertise in the relevant area cannot rely on general qualifications; excluding expert); Zaremba v. General Motors Corp., 360 F.3d 355, 359 (2d Cir. 2004) (an expert whose only relevant experience was acquired in litigation consulting excluded); Bouchard v. Am. Home Prods. Corp., No. 3:98 CV 7541, 2002 WL 32597992, at *5 (N.D. Ohio May 24, 2002) (doctors testimony excluded on the subject of FDA labeling because he did not have any specific expertise on this topic outside his work in litigation). However many times he may have testified on other accounting issues, when it comes to these accounting standards and these audit procedures, Mr. Berliner cannot say that what the KPMG auditors did was any different than what any other auditor was doing. Even if admissible, such testimony cannot show malpractice, much less fraud. Mr. Berliner conceded at his deposition that the KPMG auditors were highly qualified, had extensive experience in the financial industry, and included subject-matter experts. E.g. SUMF 25-26, 30 (Berliner Tr.).2 More significantly, he conceded that these highly-qualified auditors believed Fannie Maes accounting policies were reasonable and in accordance with GAAP. SUMF 115, 130, 171 (Berliner Tr.) (conceding KPMG believed the precision threshold was a reasonable application of FAS 91, that he has no basis to disagree with KPMGs
Kenneth Russell (KPMGs engagement partner when the companys FAS 91 and FAS 133 policies were developed), Mark Serock (the engagement partner during the Class Period) and Harry Argires (a manager and then a second partner on the audits), each had experience auditing financial companies and each was a designated KPMG Derivatives, Hedging and Financial Instruments Specialist. SUMF 26-31.
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contemporaneous conclusion that an assumption of inconsequential or no ineffectiveness was reasonable under FAS 133, and not disputing that KPMG believed the financial statements were correct in all material respects). Asked point blank if he had any reason to doubt whether the intent of Fannie Mae's FAS 91 and FAS 133 policies was to preserve the accuracy and utility of Fannie Mae's 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. SUMF 9 (Berliner Tr.) (emphasis added). These admissions alone are sufficient to defeat a claim of fraud. In re REMEC Sec. Litig., 702 F. Supp. 2d 1202, 1243 (S.D. Cal. 2010) (granting summary judgment as defendants statement that he acted in good faith sufficiently rebutted any argument that the statements were so false he must have been aware of them). Mr. Berliner further admits the KPMG auditors made their judgments transparent. The judgments that he describes as clearly erroneous were clearly laid out in KPMGs working papers. SUMF 46-48. Mr. Berliner turned to KPMGs working papers to identify the FAS 133 policies he did not like. SUMF 47 (Berliner Rep.). A KPMG memorandum walked through the entire FAS 91 estimation process. SUMF 46. Mr. Berliner discusses the memorandum at length and notes it was included in the work papers for each audit. Id. For FAS 115, too, he quotes the work papers for the policy and affirms they make it clear what the supposedly erroneous policy was. SUMF 48 (Berliner Rep.). As other courts have noted, [t]his transparency is not the behavior one would expect from an intentional or severely reckless violator of the securities laws. SEC v. Shanahan, ___ F.3d ___, No. 10-1820, 2011 WL 2803011, at *6 (8th Cir. July 19, 2011) (affirming rejection of claim); see also In re Verifone Holdings, Inc. Sec. Litig., No. C 07-6140, 2011 WL 1045120, at *8 (N.D. Cal. Mar. 22, 2011)
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(dismissing claims because the open and notorious nature of the conduct defeated any showing of scienter). Not only did KPMG clearly lay out the accounting policies and its judgments about them in its work papers, KPMG gave those work papers to Fannie Maes regulator. OFHEOs access to and review of these work papers on several occasions during the class period are documented in its reports to Congress. SUMF 220 (OFHEO Reps. to Congress (2002-2003) (OFHEOs conclusions that KPMGs audit plan included all the necessary activities and operations, and that KPMGs conclusions were supported by its work papers). Making the supposed fraud freely available to an independent third partymuch less a federal regulatordefeats any claim of scienter. McNamara v. Pre-Paid Legal Serv., Inc., 189 F. Appx 702, 713 (10th Cir. 2006) (unpublished) (dismissing claims based on disclosure to the SEC, among others); REMEC Inc., 702 F.Supp.2d at 1246 (dismissing claims based on disclosure to auditors); In re The First Marblehead Corp. Sec. Litig., 639 F. Supp. 2d 145, 163 (D. Mass. 2009) (dismissing claims based on public disclosures). Thus, in an opinion focused on questioning KPMGs professional judgments, Mr. Berliner admits that he cannot say KPMGs judgments were any different than those of any other auditor at the time, that the judgments made reflected KPMGs actual beliefs, and that those judgments were made transparent by KPMG for both internal and external review. Any of those undisputed facts are enough to show the absence of scienter. Here, there is more: there is also the testimony of plaintiffs own accounting experts. Those experts not only disclaimed any opinion criticizing the KPMG audits, (SUMF 252, 254 (Fierstein Tr., Barron Tr.), as explained below, their testimony repeatedly contradicted any claim of auditor fraud.
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1.
Plaintiffs Cannot Show That No Reasonable Accountant Could Have Accepted Fannie Maes Approach to FAS 133 When OFHEO, Other Major Financial Institutions, the Big Four Accounting Firms, the Staff of the SEC, and Plaintiffs Own FAS 133 Expert Say Otherwise
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 work papers. SUMF 85. This complex standard is at the center of plaintiffs claims, and is the subject of a separate memorandum of law jointly submitted by all defendants. KPMG will not repeat the entirety of that discussion here. Mr. Berliner, with no knowledge of what auditors do under the new accounting and auditing standards governing this area, adds nothing to that discussion. As explained in that joint memorandum, Fannie Mae had on several occasions shared with OFHEO both its accounting policy and the details of its entire portfolio. OFHEO determined that Fannie Maes approach was pretty consistent with what other financial institutions were doing. Joint 133 Motion at 11. Plaintiffs admitted as much when they elicited testimony by a defense expert from one such major financial institution that, in almost every instance, this institution had applied FAS 133 in such a manner. SUMF 126 (Mills Tr.). The implementation guidance from Big Four accounting firm Ernst & Young accepts a remarkably similar approach, id. (Ernst & Young implementation guide), while PricewaterhouseCoopers called it the historical perspective on the standard, id. (PricewaterhouseCoopers guidance). It was shared by KPMGs FAS 133 expert, Timothy S. Lucas, who was the Director of Research and Technical Activities of the FASB at the time that FAS 133 was promulgated and spent more time on FAS 133 than any other project to which he was assigned. SUMF 255 (Lucas Rep.). Plaintiffs own FAS 133 expert admitted frankly that no one has figured out what to do with this yet. SUMF 127 (Barron Tr.). The SEC staff, he testified, eventually changed their interpretation of FAS 133 and decided to support an approach no different in substance than the
14
one KPMG had accepted. SUMF 128 (Barron Tr.). It is difficult to imagine a record that better contradicts a claim that no reasonable accountant would have made the same decision if confronted with the same facts. Worlds of Wonder, 35 F.3d at 1426. Mr. Berliner does not question that KPMG worked hard to understand how Fannie Mae applied FAS 133 to its hedging transactions. The procedures the auditors undertook in this area were extensive. SUMF 86, 113 (Lhotka Rep.; KPMG work papers; Berliner Tr.). KPMGs efforts began long before the standard even became effective, and KPMG had identified FAS 133 as a critical audit objective in its 2000 audit. SUMF 86 (Berliner Tr.; KPMG work papers). The auditors took the steps needed to understand how Fannie Mae used derivatives. SUMF 91, 102, 105 (Berliner Tr.; KPMG work papers). They reviewed Fannie Maes 475page Derivative Accounting Guidelines (DAG). SUMF 92-94 (Berliner Tr.; KPMG work papers).3 They brought in computer specialists. SUMF 99-101 (KPMG work papers). They tested the valuation and correlation of hedge positions, tested the classification of hedge transactions, and reviewed journal entries and reconciliations. SUMF 102 (KPMG work papers). The auditors tested both the design and operational effectiveness of the controls over this accounting, including interface, reconciliations, access, authorization, segregation of duties, management reviews, configuration, and exception reports. SUMF 105-6 (KPMG work papers). Mr. Berliner does not question that the auditors undertook these procedures, many of them year after year after year. Rather, citing snippets of KPMG workpapers, plaintiffs seem to advance the notion that although KPMG worked hard to understand Fannie Maes application of a complex standard to a
As noted in Section I.C below, the auditors did not always agree that the accounting Fannie Mae initially proposed qualified under FAS 133.
15
complex portfolioand although the companys approach is considered reasonable by financial institutions, accounting firms and regulators alikethe auditors nonetheless knew it was wrong. Any suggestion that the KPMG work papers acknowledge Fannie Maes accounting was not materially in accordance with GAAP is seriously misleading. The undisputed evidence shows, to the contrary, that the engagement team concluded that Fannie Maes financial statements were appropriate under GAAP and any differences were not material to the analysis. Mr. Berliner himself is insistent that the auditors believed any deviations from GAAP were immaterial to the financial statements taken as a whole. He repeatedly made that point, as when he asserts that KPMG recognized that there were departures from GAAP but felt comfortable accepting those departures on the basis of materiality. SUMF 85 (Berliner Rep.). At his deposition, he conceded that KPMG thought any ineffectiveness created by the companys seven-day policy [w]ould not have a material effect on the financial statements. SUMF 112 (Berliner Tr.). Looking at another policy, he testified that KPMG documented that it considered it to be a violation of GAAP, again, with an immaterial effect. SUMF 85 (Berliner Tr.). The KPMG documents Mr. Berliner quotes likewise make that point over and over again.4 Such statements repeat what the financial institutions, accounting firms and regulators cited
Often, the point is made clear simply by shifting Mr. Berliners emphasis in the quotation, as in the following observation by KPMG partner and derivatives specialist Harry Argires: 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. SUMF 85 (Berliner Rep., quoting KPMG work paper) (emphasis shifted); SUMF 85 (Berliner Rep., quoting Fannie Mae document) ([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.) (emphasis shifted); SUMF 85 (Berliner Rep., quoting KPMG work paper)([D]eminimus test . . . threshold is an immaterial departure from GAAP.) (emphasis shifted).
16
above acknowledgedthat a slightly-less-than-perfect match is not the same thing as a perfect one, but the difference is inconsequential. Mr. Berliner never disputes that the auditors believed the financial statements were correct in all material respects. SUMF 130 (Berliner Tr.). That, however, is the only statement the auditors ever made: that in KPMGs opinion, the Fannie Mae financial statements presented fairly, in all material respects, its financial position. Mr. Berliner, far from showing that KPMG intended to defraud investors, proves that the auditors had no such intent. 2. Plaintiffs Cannot Show That No Reasonable Accountant Could Have Accepted Fannie Maes Use of a Precision Threshold When Plaintiffs Subject Matter Expert Says Auditing Literature Supports This Concept
When Fannie Mae purchases a mortgage loan from a lender, it may pay more than the remaining principal balance of the loan (a premium) or less than the remaining balance (a discount). SUMF 132 (Holder Rep.; 2003 10-K). FAS 91 requires those premiums and discounts to be classified as adjustments to the carrying amount of loans receivable in a company's balance sheet, which 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. SUMF 136 (FAS 91 4, 15, 18). Estimating this constant effective yield was not easy for a mortgage portfolio of Fannie Maes size and diversity. SUMF 145 (Fierstein Rep.). Fannie Mae grouped its vast portfolio of loans, and estimated the average life of each group. SUMF 147 (Holder Rep.). Because mortgages can be prepaid, Fannie Mae had to project prepayment activity. SUMF 135, 137, 139. And because prepayments can depend on interest rates, Fannie Mae has to project interest rates well into the future. All those projections are rolled up into a single estimate, Fannie Maes net investment in loans. SUMF 147 (Holder Rep.). At least once each quarter during the Class Period, Fannie Mae tested the continuing reasonableness of its estimate, including a shock 17
test projecting prepayments if interest rates were higher or lower by one percentage point and by one-half a percentage point. SUMF 152 (Office of Audit work paper; KPMG work paper). Mr. Berliner objects to none of this. Rather, he focuses narrowly on the fact the auditors accepted that if this process produced a result within a narrow range around Fannie Maes current estimate, that result confirmed the reasonableness of the estimate, so that a change in estimate was not required unless the difference exceeded a precision threshold. KPMG, he opines, turn[ed] a blind eye to this purported GAAP violation. See SUMF 183 (Berliner Rep.). As noted above, Mr. Berliner admits that he is not an expert in FAS 91 and is not plaintiffs expert on FAS 91. SUMF 234, 246 (Berliner Tr.). Plaintiffs subject matter expert on FAS 91 is Ms. Fierstein.5 While Ms. Fierstein opined that the precision threshold was an error, her testimony contradicts any claim of auditor fraud. She concluded that a precision threshold may have been appropriate for use by KPMG when it assessed Fannie Maes SFAS 91 calculations; auditing literature supports this concept. SUMF 170 (Fierstein Rebuttal Rep. (emphasis added); Fierstein Tr.). In this, she agrees with KPMGs FAS 91 expert, who noted that a reasonable difference between estimates would not be considered a likely misstatement under the auditing literature. SUMF 172 (Holder Rep.) (citing AICPA Professional Standards). These plain admissions that auditing literature supports the use of the threshold and that it may have been
As with Mr. Berliner, there are serious questions as to Ms. Fiersteins qualifications. Ms. Fierstein has never audited a company that utilized FAS 91 accounting, or gained experience on that standard other than through litigation consulting, has never published on FAS 91, and has done nothing else to distinguish herself as a FAS 91 expert. SUMF 247 (Fierstein Rep.). Before working on litigation matters, Ms. Fierstein claims only that she knew how [FAS 91 accounting was] done generally. SUMF 248 (Fierstein Tr.).
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appropriate for use by KPMG negates any claim that no reasonable accountant could have accepted Fannie Maes conclusions.6 Ms. Fierstein went further, however, and added that the precision threshold was presumptively immaterial to the auditors. She testified that, given the size of Fannie Mae, even $135 million was not quantitatively material. SUMF 155 (Fierstein Tr.; Berliner Tr.). The threshold presented to KPMG in the audits never exceeded this amount, and typically was substantially less.7 A process that, according to plaintiffs own subject matter expert, reduces any possible error to a presumptively immaterial amount cannot create an obvious danger of misleading investors. Ms. Fierstein also contradicts any notion that the auditors turn[ed] a blind eye to the precision threshold. She opines that it was the KPMG auditors who, prior to the class period, had pushed Fannie Mae to develop a more objective and transparent methodology. SUMF 159 (Fierstein Rep.). The entire complex process that resultedand Mr. Berliners criticisms are limited only to the last part, the precision thresholdwas documented by three KPMG partners
Mr. Berliner himself appears to agree, so long as the term precision threshold is changed to sensitivity analysis. He agreed that a sensitivity analysis is not unusual, especially when an estimate is subject to significant uncertainty. SUMF 167 (Berliner Tr.). He agreed that an analysis producing a result close to an existing estimate increases confidence in that estimate. SUMF 168 (Berliner Tr.). He agreed that whether or not a sensitivity analysis was close enough to support the existing estimate is a matter of judgment. SUMF 169 (Berliner Tr.). In his opinion, a 5% difference was not out of bounds but would depend on the financial statements of the entity that was making that estimate. SUMF 169 (Berliner Tr.). Notably, the precision threshold was capped at one percent (1%) of net interest income, and a fraction of 1% of the overall estimate. See footnote 7, below. 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. SUMF 157 (2000 Annual Information Statement). Thus, the threshold was slightly more than 1/100th of one percent of the total estimate. The amounts that Mr. Berliner claims were not recorded during the Class Period are $6.4 million in 2001, $78.8 million in 2002 and $119.5 million in 2003. SUMF 158 (Berliner Rep.).
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and one KPMG manager, and then reviewed each year. SUMF 159-61 (KPMG work papers; Fierstein Tr.). Each quarter, KPMG reviewed Fannie Maes calculations and had detailed discussions about the amortization process. SUMF 159 (KPMG work papers; Berliner Tr.). The auditors brought in a specialist from KPMGs Structured Finance Group to recalculate amortization factors and examine the companys methodology. SUMF 164 (KPMG work papers). KPMG also assessed and re-assessed the reasonableness of the threshold itself. The threshold was based on the range of quoted prepayment speeds that could be obtained for the same mortgage loan. SUMF 149 (KPMG work papers). Any one of those estimates, all from reputable firms, could have been considered reasonable. SUMF 149 (KPMG work papers). Going forward, KPMG continued to observe the spreads in dealer-estimated pre-payment speeds, and found that the models produced widely varied projections. SUMF 162 (Tascher Tr.). The auditors observed that Fannie Maes prepayment estimates were generally within the high-low range of the industry estimates. SUMF 163 (KPMG work papers). It is Mr. Berliner, not KPMG, who turns a blind eye to the evidence.8
In his report, Mr. Berliner asserted that KPMG's acceptance of Fannie Mae's FAS 91 accounting policy continued even after it was alerted to a whistleblower's allegations of the possibility of earnings management due to Fannie Mae's misapplication of this policy. SUMF 175 (Berliner Rep.). He asserted further that [i]n violation of GAAS, KPMG failed to expand its audit procedures in response to these allegations. SUMF 175 (Berliner Rep.). His deposition testimony on this subject amounts to one long retraction. Mr. Berliner admitted that the allegations were followed by a series of urgent meetings and a major investigation by the company. SUMF 176 (Berliner Tr.). He conceded that KPMG did expand its audit procedures in response to these allegations, and that it did so in a number of ways. KPMG expanded its testing of manual adjustments. SUMF 177 (Berliner Tr.). Mr. Berliner admitted that KPMG reviewed Mr. Barnes allegations as to anomalous amortization factors. SUMF 178 (Berliner Tr.). KPMG performed additional procedures to respond to the risk of a possible illegal act. SUMF 179 (Berliner Tr.). The auditors consulted with forensic specialists, who reviewed the companys response to the allegations. SUMF 180 (Berliner Tr.). Mr. Berliner found no grounds upon which to criticize KPMGs review of that investigation or the investigation itself. SUMF 181 (Berliner Tr.). He even declined to opine that the
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3.
Plaintiffs Cannot Show That No Reasonable Accountant Could Have Accepted Fannie Maes FAS 115 Policy When Plaintiffs FAS 115 Expert Is Not Sure and Denies the Policy Could Be Used to Manipulate Earnings
Finally, Mr. Berliner criticizes KPMG for accepting Fannie Maes application of FAS 115. SUMF 184 (Berliner Rep.). FAS 115 provides that [a]t acquisition, an enterprise shall classify debt securities into one of three categories: held-to-maturity [HTM], available-forsale [AFS], or trading. SUMF 185 (FAS 115 6). Mr. Berliner quotes Fannie Maes description of its practice:
SUMF 184 (Berliner Rep.). Mr. Berliner calls this month-end accounting an obvious violation of GAAP. SUMF 184 (Berliner Rep.). Again, plaintiffs subject matter expert was Ms. Fierstein, and again her testimony rejects any inference that a GAAP violation shows scienter.9 One of KPMGs experts observed that there was nothing unusual in a company doing its accounting at month-end. SUMF 190 (Lhotka Tr.). Ms. Fierstein was asked point-blank about such a situation. She responded: 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 would have to think about whether that qualifies as [at] acquisition or not. . . . I cant give you an answer right now.
whistleblowers allegations evidenced a material misstatement of the financial statements. SUMF 181 (Berliner Tr.). Ultimately, he was forced to concede that, I dont believe [Mr. Barnes] allegations related to the threshold policy. SUMF 182 (Berliner Tr.).
9
Again, the basis for Ms. Fiersteins expertise is elusive. She 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. SUMF 250 (Fierstein Tr.). She claimed only that she has read the accounting standard a lot. SUMF 249 (Fierstein Tr.).
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SUMF 191 (Fierstein Tr.). Plainly, the answer is not obvious to plaintiffs own subject matter
expert. Indeed, Ms. Fierstein claimed only a narrow GAAP violation in this area. Before Fannie Mae entered the securities into its accounting system at month end, it temporarily housed these securities in a different computer system. That system automatically labeled all securities HTM. SUMF 188 (KPMG work paper). According to Ms. Fierstein, this was sufficient to taint the entire portfolio. SUMF 184 (Fierstein Rep.). She admits that there would have been no taint if this computer used another label or, as noted above, maybe no label at all. SUMF 191 (Fierstein Tr.). Mr. Berliner tries to make a fraud case out of this temporary label by saying KPMG failed to consider whether the month-end accounting was a tool to manipulate Fannie Maes financial statements (without saying any manipulation ever occurred). SUMF 184 (Berliner Rep.). Here, Ms. Fierstein flatly shuts him down. First, she admitted the HTM label was correct in substance: Fannie Mae did in fact hold the HTM securities to maturity. SUMF 207 (Fierstein Rep.). Second, she explained that while the designation can affect the carrying value on the balance sheet, picking one over the other does not affect the income statement. SUMF 195-96 (Fierstein Tr.). In other words, 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. SUMF 196 (Fierstein Tr.).
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She might have added a third: both values were disclosed in the financial statements. While Fannie Mae carried mortgage securities classified HTM at cost, Fannie Mae also disclosed the fair value of such securities for all to see. SUMF 205 (2003 Form 10-K). And Fannie Mae actually had gains on such securities that it was not booking by virtue of the HTM classification. SUMF 206 (2003 Form 10-K) (fair value of HTM mortgage securities was $486.1 billion at year-end 2003, $10.9 billion higher than the amount at which Fannie Mae was carrying such securities; chart contains similar disclosure for 2002 and 2001). There was no manipulation for KPMG to miss. And there was no dangermuch less an obvious oneof misleading investors. * * *
For each of these supposed violations, Mr. Berliner concedes that KPMG identified the right accounting rule, understood how Fannie Mae was applying that rule, and designed and conducted testing that confirmed Fannie Mae was doing what it said it was doing. His complaint is with the accounting policy itself. In each case, the accounting policy is supported by the opinions of indisputably qualified experts. The most plaintiffs can hope to show is that there are qualified experts on both sides of these issues, but that is not auditor fraud. It is, instead, a prime example of why the courts have refused to allow such claims to proceed in 10b-5 cases. B. Plaintiffs Cannot Claim No Audit At All 1. Plaintiffs Do Not Dispute KPMGs Effort
While Mr. Berliner criticizes KPMGs audits for 2001, 2002 and 2003, he does not opine that KPMG conducted no audit at all in any (much less all) of these three years. Such a claim is impossible. Mr. Berliner conceded that KPMG assembled a highly qualified audit team. SUMF 25-26, 30 (Berliner Tr.). He confirmed that this highly-qualified team did extensive planning. SUMF 37-38 (Berliner Tr.). KPMG had monthly meetings with Fannie Maes Financial Standards group (in charge of developing company accounting policy) devoted to 23
discussing those policies, pursuant to what Mr. Berliner conceded was a good practice. SUMF 40, (Berliner Tr.; Berliner Rep.). KPMG performed analytical reviews of Fannie Maes balance sheet and its income statement, and analyzed its strategic, business and audit risks. SUMF 37-43 (Berliner Tr.). The auditors documented their understanding of the business in detail. SUMF 39 (Berliner Rep.; Berliner Tr.). KPMG identified the key business processes for each significant class of transactions, the business and financial statement controls governing that process, and how each process related to KPMGs audit objectives. SUMF 39, 43, 50, 52-53 (Berliner Tr.). Mr. Berliner testified that KPMG considered the significant issues and critical accounting policies identified during the engagement in determining the scope and results of its audit procedures. SUMF 55 (Berliner Rep.). He admitted that KPMG documented its audit objectives, overall and by each key process, that it documented how those audit objectives related to the financial statement assertions, that it made an assessment of the risk of significant misstatement for each audit objective, that it developed the planned audit procedures that were used to gain the necessary audit evidence, and that it considered the need for additional audit procedures. SUMF 49-57 (Berliner Tr.). According to Mr. Berliner: For each audit KPMG identified key control objectives and activities and developed a joint audit plan to test certain controls in collaboration with Fannie Maes internal audit department . . . [and] tested key controls that were not tested by internal audit. SUMF 53 (Berliner Tr.). The auditors devoted well over 10,000 hours to the audits. SUMF 34 (Serock Decl.). KPMGs working papers alone span approximately 40,000 pages. SUMF 35 (Serock Decl.). Those materials are sufficiently vast that Mr. Berliner, who had put at least 650 hours into his opinions, and had been involved in the matter for at least four years before that, reviewed no
24
more than five percent (5%) of KPMGs working papers. SUMF 237-40 (Berliner Tr.). As another court held, when granting summary judgment after Mr. Berliner likewise conceded that the audit firm had spent substantial effort on the annual audit, [t]his alone defeats a claim of recklessness. Danis v. USN Comm., 121 F.Supp.2d 1183, 1195 (N.D. Ill. 2000). Notably, OFHEO too reviewed KPMGs audits. During the class period, it concluded in no uncertain terms that both the internal and external audit functions had the appropriate independence, and that the auditors performing the work possessed appropriate professional proficiency. SUMF 219-20 (OFHEO Rep. to Congress (2001-2003)). During the class period, OFHEO also published its conclusion that KPMGs audit plan included all the necessary activities and operations, and its 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. SUMF 220 (OFHEO Reps. to Congress (2002-2003)). 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. SUMF 226 (KPMG memoranda). On this record, there is no basis to disdain all KPMGs work as no audit at all. 2. Mr. Berliner Criticizes the Auditors Professional Judgments, Not Their Intent
In fact, Mr. Berliner does not try to claim that KPMG conducted no audit at all. He admitted that the auditors planned their audits, he just thinks they did not plan them appropriately in his judgment. SUMF 244 (Berliner Tr.). The auditors risk assessment process, according to Mr. Berliner, was appropriate, but their execution of it was not adequate. SUMF 244 (Berliner Tr.). The auditors did assess the risk of misstatements and developed audit procedures, but not adequately. SUMF 244 (Berliner Tr.). Whatever the merits of such
25
criticismsand many are demonstrably wrongthe most they can show is an error of judgment.10 But the allegation here is not malpractice: plaintiffs claim fraud. Challenges to the appropriateness of this procedure or the adequacy of that conclusion do nothing to show the kind of extreme recklessness the courts in this Circuit require. a. The Companys EPS Goal Does Not Show Fraud by the Auditor
Mr. Berliner repeatedly complains that KPMG should have altered its audit procedures (in ways never specified) because Fannie Mae had an ambitious EPS goal. He calls the goal excessive, and says KPMG should have assessed it as a high risk area. SUMF 58 (Berliner Rep.). Mr. Berliner admits that KPMG identified the EPS goal, that KPMG recognized the increased risks resulting from this focus on EPS, and that the KPMG auditors took steps to make sure the engagement team understood its impact. SUMF 59 (Berliner Rep.). His criticism, again, has nothing to do with KPMGs efforts in discovering a risk but is purely a challenge to KPMGs professional judgment concerning how to respond: I dont think they gave sufficient attention to it in the design of their procedures. SUMF 59 (Berliner Tr.). His criticisms are strikingly similar to those rejected in In re IKON: The simple fact that [the auditor] identified IKON managements strong preference for favorable earnings, standing alone, does not raise an inference of scienter sufficient to survive a summary judgment motion predicated on the absence of scienter. IKON, 277 F.3d at 671; see also Acito v. IMCERA Grp.,
10 Many also are irrelevant. For example, Mr. Berliner criticizes KPMG for assessing as moderate the
inherent risk of misstatement due to potential errors in the valuation of derivatives. SUMF 129 (Berliner Rep.). However, he concedes that Fannie Maes restatement had nothing to do with whether it correctly estimated the current fair market value of derivatives it owned. SUMF 129 (Berliner Tr.). Such objections cannot support a claim. In re IKON, 277 F.3d at 672 (While IKONs internal controls may well have been unreliable during fiscal year 1997, the record, except with respect to the fourth quarter, does not connect these internal control deficiencies to [the auditors] independent, external audit.)
26
Inc. 47 F.3d 47, 54 (2d Cir. 1995) (If scienter could be pleaded on that basis alone, virtually every company in the United States that experiences a downturn in stock price could be forced to defend securities fraud actions). The claim here is, if anything, substantially weaker. Mr. Berliner admits that this EPS goal was consistent with what Fannie Mae had achieved in the past, that the growth in its EPS correlated to the growth in the size of its portfolio, that the company was halfway to doubling the size of the portfolio before the class period even began, and that the class period coincided with a nationwide housing boom. SUMF 60, 62-64 (Berliner Tr.). Faced with these facts, Mr. Berliner retreated sharply. I dont know that I would say [the EPS goal was] excessively aggressive, he testified. SUMF 65 (Berliner Tr.). It would be appropriate if realistic, he conceded, and then conceded he had done nothing to determine whether the goal was realistic. SUMF 66-67 (Berliner Tr.). Most directly, even after Fannie Mae restated its financial statements to correct all of the alleged errors in its previous financial statements, its 2003 earnings were about $8.00 per share, beating the $6.46 per share goal by a large margin. SUMF 68 (2004 10-K). Mr. Berliner admitted that he was entirely unaware that Fannie Mae did not have to resort to accounting fraud to meet its target. SUMF 69 (Berliner Tr.). That admission leaves the basis for his opinion dubious, and it also defeats any claim that KPMG committed fraud in the audit for not calling the EPS goal a high risk. b. Alleged Material Weaknesses in Internal Controls Do Not Show Fraud
Mr. Berliner asserts that KPMG erroneously concluded that it could rely on certain internal controls at Fannie Mae in conducting its audits. SUMF 70 (Berliner Rep.). In support of this claim, he notes that Fannie Mae later concluded that it had numerous material weaknesses
27
in internal control as of December 31, 2004. SUMF 70 (Berliner Rep.). Mr. Berliner acknowledges that KPMG did not issue any report on Fannie Maes internal controls as of December 31, 2003, December 31, 2002, or December 31, 2001, the only audit years in question. SUMF 11 (Berliner Tr.). Thus, KPMG could have made no misstatement to investors in that regard, and neither plaintiffs nor Mr. Berliner claim otherwise. Moreover, 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. SUMF 245 (Berliner Tr.). He acknowledged that he has not identified any particular control weakness that dated back to the class period. SUMF 245 (Berliner Tr.). Rather, he assumes that some (or perhaps all) of these internal control weaknesses must have existed during 2003, as well as during 2002, and even during 2001. He then assumes that KPMG must have relied on some (or all) of these controls in its audits of the 2003, 2002 and even 2001 financial statements. He next assumes that this reliance (or some of it) on flawed controls must have violated professional standards, though he does notindeed, cannotsay how. SUMF 245 (Berliner Rep.). This chain of unsupported inferences falls far short of Rule 26(a)(2)(B)(ii) of the Federal Rule of Civil Procedure and the Expert Protocol in this case, which required Mr. Berliner to set forth the basis for his opinion. Perhaps most important, Mr. Berliner fails to connect KPMGs supposed failure due to its unspecified reliance on these unidentified controls to any material misstatement in plaintiffs 300-plus page Complaint. Mr. Berliner does not even connect a control weakness to any of the alleged accounting errors as to which he claims KPMG conducted its audits improperly.11 See
11 He disclaims any connection. Both he and plaintiffs FAS 133 expert admitted that the systems
Fannie Mae built to computerize the FAS 133 accounting did just what they were intended to do.
28
Roth v. OfficeMax, Inc., 527 F. Supp. 2d 791, 801 (N.D. Ill. 2007) (An allegation that defendants should have known about internal control deficiencies based on nothing more than later acknowledgement of such weaknesses amounts to pleading fraud by hindsight.); see also IKON, 277 F.3d at 672 (granting summary judgment where the record . . . does not connect these internal deficiencies to [the auditors] independent, external audit.). Finally, Mr. Berliner acknowledged that 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. SUMF 77-78 (Berliner Tr.; OFHEO Rep. to Congress (2001) (Fannie Maes internal control framework and the management of that framework exceeded safety and soundness standards.)). He can say nothing to the contrary: just as he never bothered to look at the companys internal controls, he never bothered to look at OFHEOs examinations. SUMF 79 (Berliner Tr.). This contemporaneous evidence itself shows (at most) that reasonable minds could differ. Plaintiffs cannot argue otherwise merely by ignoring these indisputable facts. c. Mr. Berliners Criticisms of Fannie Maes Internal Auditors Cannot Show That KPMG Committed Fraud
Mr. Berliner does not question the competence and experience of the KPMG team, but instead questions the competence of the companys internal auditors (the Office of Audit, or OA). SUMF 70 (Berliner Rep.). Mr. Berliner admits that KPMG examined the internal audit function and that: In form, the structure of OA appeared appropriate, and KPMGs audit work papers throughout the Class Period document this apparent proper relationship between OA and
SUMF 82 (Barron Tr.; Berliner Tr). Mr. Berliner also admitted that it was Fannie Maes precision threshold policy (not the internal controls over the process) that led to the restatement in the FAS 91 area. SUMF 83 (Berliner Tr.). He admitted that Fannie Maes system of classifying debt securities (FAS 115) was operating as described, and that if Fannie Mae's accounting were permissible, he would not be finding fault with KPMG's auditing in the FAS 115 area. SUMF 84 (Berliner Tr.).
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senior management. SUMF 71 (Berliner Rep.). Whatever the merits of his opinion about the companys internal auditors, that is worlds away from showing that the KPMG external auditors committed fraud.
12
Perhaps nothing makes this point more clear than the fact that both Fannie Maes regulator and an independent consulting firm reviewed the internal auditors and agreed with KPMG. During the Class Period, OFHEO publicly concluded: The scope of [internal] audit work performed is appropriate, and the [internal] audit work is complete, and the internal audit functions exceed safety and soundness standards. SUMF 219 (OFHEO Reps. to Congress (2001-2002). In hindsight, Mr. Berliner thinks OFHEO was wrong, but it is the very existence of contrary opinions on this very subject that negates fraudparticularly given Mr. Berliners pointed refusal to say OFHEO lacked a rational basis for its opinion. SUMF 225 (Berliner Tr.). Mr. Berliner claims that OA was criticized in a third party Quality Assessment Review during the Class Period. SUMF 73 (Berliner Rep. at 2-7). That independent review in fact gave Fannie Maes Office of Audit its highest possible rating. SUMF 72 (Investment Training and Consulting Inst., Inc. Quality Assessment Review). The outside firm 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. SUMF 72 (Investment Training and Consulting Inst., Inc. Quality Assessment Review). The report also
12 Underscoring this point, several criticisms are based on matters Mr. Berliner admits KPMG did not
know about. SUMF 243 (Berliner Rep. (KPMG may not have been privy to this e-mail.); (I am not aware of any evidence that KPMG was present for or aware of this.); Berliner Tr. ([T]heres no indication that KPMG ever saw this e-mail), ([T]here is no evidence that KPMG was aware or should have been aware of this speech)).
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said that, "the depth of talent exhibited by Fannie Mae's IA staff was very impressive." SUMF 72 (Investment Training and Consulting Inst., Inc. Quality Assessment Review). Mr. Berliner did not disagree: he was simply unaware of the actual findings when he spoke. SUMF 73 (Berliner Tr.). Likewise, he repeatedly claimed that the internal auditors lacked FAS 133 training, something he called a significant departure from the auditing standard of due professional care. SUMF 74 (Berliner Rep.). At his deposition, Mr. Berliner was forced to admit not only that the internal auditors had such training, but that they had more training in FAS 133 than he did. SUMF 74 (Berliner Tr.). Whether or not Mr. Berliners opinion is supported or illusory, or better than the contrary conclusions reached by OFHEO and an independent review, nothing in his criticisms can show KPMG ever intended to commit fraud. C. Plaintiffs Offer No Evidence Regarding KPMGs Auditing of Any Other Accounting Issue In the end, Mr. Berliner abandons any analysis of what KPMG actually did and argues the restatement itself means fraud. He contends that the restatement identified errors in more than 30 different areas, and concludes: 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. SUMF 208 (Berliner Rep.). His argument is insufficient as a matter of law, and contrary to the evidence. It is hornbook law that a plaintiff does not show an error was fraudulent by showing that it was an error. E.g. IKON, 277 F.3d at 673 (internal citations omitted) (The discovery of discrete errors after subjecting an audit to piercing scrutiny post-hoc does not, standing alone, support a finding of intentional deceit or of recklessness.). Mr. Berliner conceded that a
31
restatement does not mean that KPMGs audits were subpar, much less extremely reckless. SUMF 22 (Berliner Tr.). More importantly, the argument that the number of violations or the size of a restatement creates an inference of scienter has been repeatedly rejected, including in this case. Fannie Mae Sec. Litig., 503 F. Supp. 2d at 41 ([T]he E&F plaintiffs argument that the magnitude of the fraud is sufficient itself for an inference that the Audit Committee defendants acted with scienter is plainly contradictory to the purposes of the PSLRA and is, at best, an oversimplification of the scienter concept. As one court noted: Allowing an inference of scienter based on the magnitude of fraud would eviscerate the principle that accounting errors alone cannot justify a finding of scienter. (quoting Fidel v. Farley, 392 F.3d 220, 231 (6th Cir. 2004)); see also In re Ceridian Corp. Sec. Litig., 542 F.3d 240, 246 (8th Cir. 2008) (affirming district courts rejection of contention that the sheer number of violations, and the magnitude of the restatements, give rise to an inference that defendants were at least severely reckless); Dronsejko, 632 F.3d at 669 (The magnitude of the restatement has nothing to do with [the auditors] scienter in applying [GAAP] presumably, the restatement would have been equally large had [the auditor] acted in good faith, negligently, recklessly, or, for that matter, intentionally.); Stevens v. InPhonic, Inc., 662 F. Supp. 2d 105, 119 (D.D.C. 2009) (rejecting plaintiffs argument that fraud could be inferred from a restatements magnitude, otherwise any publicly traded company that restated would be at risk of being hauled into court to atone for its actions, even if no facts are alleged to suggest it was caused by anything other than innocent mistakes.). Putting aside the three accounting policies discussed above, Mr. Berliner says nothing whatsoever about the auditing in any of these 30 different areas. His reports contain no discussion of KPMGs audit procedures in any of them, no explanation of what GAAS required
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for any of them, and no opinion on how KPMG violated those standards. KPMG has not identified a single decision allowing a plaintiff to claim a restatement showed audit fraud when the plaintiff failed to put in any evidence about what the auditors actually did in the restated areas. There are several reasons already in the record why this Court should not be the first. First, plaintiffs accounting experts did not opine on most of these areas because they concluded either that the issue was immaterial, or that the record evidenceeven with the massive record in this casedid not contain sufficient documentation to address the issue. SUMF 253 (Fierstein Tr.). For his part, Mr. Berliner offers no reason why he did not read 95% of the auditors work even to consider their auditing. Second, Fannie Mae restated accounting in many areas that had previously been cleared with the SEC staff. SUMF 210 (Aug. 3, 2004 Letter from J. Boyles to D. Nicolaisen; Interview of S. Blumenthal). Those areas include impairment of securities, cited by Ms. Fierstein. SUMF 208 (Fierstein Rep.). The same is true with respect to Fannie Maes accounting for buy-ups. SUMF 211 (Feb. 24, 2004 Letter from J. Boyles to D. Nicolaisen; Mar. 15, 2004 Letter from J. Boyles to G. Faucette). It is true of Fannie Maes accounting for combinations of certain interest-only and principal-only securities. SUMF 212-13 (Apr. 28, 2004 Letter from J. Boyles to D. Nicolaisen). With respect to Fannie Maes valuation of a guaranty asset and corresponding guarantee liability, Fannie Mae cleared two policies with the SEC staff. SUMF 214 (May 30, 2003 Letter from J. Boyles to G. Faucette; Feb. 24, 2004 Letter from J. Boyles to D. Nicolaisen; May 4, 2003 Letter from J. Boyles to D. Walker). In some of these areas, a second Big Four accounting firm had expressed its opinion that Fannie Maes accounting was in accordance with GAAP. SUMF 209 (Apr. 28, 2004 Letter from J. Boyles to D. Nicolaisen) (impairments and security combinations). In at least one, Fannie Mae changed back to the
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original accounting, admitting that it and SUMF 215 (Mar. 21, 2008 Letter from S. Swad and A. Piszel to C. Hewitt). Such evidence cannot be squared with a claim of fraud. Third, even Mr. Berliner conceded that KPMG in fact said no to its client on many occasions. E.g. SUMF 118 (Berliner Tr.). In 2001, Fannie Mae proposed applying certain guidance from the Derivatives Implementation Group (DIG) to its cash-flow hedging transactions that used options. SUMF 116-17 (KPMG work papers). The issue was important: the answer would have eliminated billions of dollars of volatility on Fannie Maes financial statements. SUMF 123 (Berliner Tr.). Mr. Berliner himself was eloquent about the pressures of such a situation: Now, thats 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. SUMF 123 (Berliner Tr.). Nonetheless, the KPMG engagement team said no. Fannie Mae asked the engagement team to consult with KPMGs national office. The national office agreed with the engagement team. SUMF 118 (Berliner Tr.). Fannie Mae and KPMG then consulted with the FASB, which agreed with KPMGs interpretation. SUMF 119 (KPMG work paper). Id. Fannie Mae recorded more than $6.75 billion in losses on its audited financial statements during the class period. SUMF 120 (2003 10-K). Mr. Berliner agreed this was significant and unpredictable volatility. SUMF 121 (Berliner Tr.). Asked if that is inconsistent with what
34
one might expect if executives intended to manipulate accounting policies to smooth earnings, Mr. Berliner replied: It certainly would appear that way, yes. SUMF 122 (Berliner Tr.). In another instance, KPMG revisited the FAS 133 accounting treatment that it had previously approved and, upon reconsideration, concluded some of it did not qualify for hedge accounting. SUMF 124 (Boyles Tr.). Again, Fannie Mae and KPMG consulted the FASB. This time, the FASB thought KPMG was too restrictive. SUMF 125 (Boyles Tr.; July 21, 2004 Letter to FASB; Berliner Tr.). It is impossible to conclude that KPMG was only rubber stamping Fannie Maes accounting policies when it insisted on a result that produced billions of dollars in volatility, was willing to reject accounting it had previously approved, and stood by an interpretation even the FASB thought was too restrictive. In virtually every area plaintiffs raise, the record contains instances when KPMG said no to Fannie Maes accounting. With respect to FAS 91, in the third quarter of 2002, Fannie Maes calculations showed that it was outside of the precision threshold. 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. SUMF 216-17 (Serock Tr.). 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. SUMF 116 (KPMG work paper). With respect to insurance accounting, the KPMG audit team said no to the accounting that Fannie Mae proposed for several transactions. SUMF 218 (KPMG work paper). Mr. Berliners claim that KPMG was only rubber stamping Fannie Maes accounting policies may have a rhetorical flourish, but flourish is not admissible evidence and rhetoric cannot avoid summary judgment.
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II.
PLAINTIFFS HAVE FAILED TO ATTRIBUTE ANY OF THEIR CLAIMED DAMAGES TO ANY STATEMENT BY KPMG This Court should also grant KPMG summary judgment on the independent ground that
plaintiffs fail to prove loss causation, as required under the Private Securities Litigation Reform Act, 15 U.S.C. Sec. 78u-4(b)(4), and Supreme Court precedent. To recover against a defendant, plaintiffs must prove that the defendant made a materially misleading statement that distorted the stock price, causing artificial inflation. Plaintiffs sole evidence on this point is the opinion of their expert on damages and loss causation, Professor Jarrell. But from reading Professor Jarrells two reports, one would not know that KPMG is a defendant in this litigation. He affirmatively opines that no inflation entered Fannie Maes stock price on the dates KPMG issued its three audit opinionsthe only statements that plaintiffs claim KPMG made. And Professor Jarrell makes no effort to tie KPMGs allegedly false audit opinions to subsequent stock price declines, which he says were caused by numerous other factors. On this record, plaintiffs have utterly failed to adduce sufficient evidence of loss causation. The United States Supreme Court has held that Section 10(b) imposes liability only on primary violators of Section 10(b), and that there is no liability for aiding and abetting. Cent. Bank of Denver, N.A. v. First Interstate Bank of Denver, N.A., 511 U.S. 164, 191 (1994). This led to some disagreement in the courts as to what made someone a primary violator, for example, whether it was sufficient for a defendant to have participated in the drafting of an alleged misrepresentation. This last term, the Supreme Court definitively resolved that uncertainty. To be held liable on a securities fraud claim, one must actually make the allegedly misleading statement. A defendant may not be held liable for statements made by others. Janus Capital Grp., Inc. v. First Derivative Traders, 131 S. Ct. 2296 (2011). Plaintiffs in Janus alleged that certain prospectuses contained misleading statements
36
drafted by another defendant (JCM). 131 S. Ct. at 2301. The Fourth Circuit had held that, by participating in the writing and dissemination of the prospectuses, JCM made the misleading statements contained in [those] documents. Id. (emphasis omitted) (quoting In re Mutual Funds Inv. Litig., 566 F.3d 111, 121 (4th Cir. 2009) The Supreme Court reversed. The Court noted that it had previously distinguished between those who are primarily liable (and thus may be pursued in private suits) and those who are secondarily liable (and thus may not be pursued in private suits). Id. at 2302 n.6. To ensure that this distinction ha[s] any meaning, the Court dr[e]w a clean line between the two the maker is the person or entity with ultimate authority over a statement and others are not. Id. Without control, the Court explained, a person or entity can merely suggest what to say, not make a statement in its own right, and therefore [o]ne who prepares or publishes a statement on behalf of another is not its maker. Id. at 2302. Accordingly, to prove a Section 10(b) claim against an issuers accountant, a plaintiff must allege a misstatement that is attributed to the accountant at the time of its dissemination, and cannot rely on the accountants alleged assistance in the drafting or compilation of a filing. Lattanzio v. Deloitte & Touche, LLP, 476 F.3d 147, 153 (2d Cir. 2007). Statements by other defendants cannot support liability, even if KPMG agreed with them. Only an affirmative statement to investors by KPMG can support a claim for damages against KPMG. A. KPMG Cannot Be Liable for Statements Made by Others As Mr. Berliner explains: The auditors report on a companys financial statements is the medium in which the accounting firm communicates its opinion. SUMF 258 (Berliner
13
13 The reasons that plaintiffs have failed to prove damages against any defendant are set forth in Defendants Joint Motion for Summary Judgment on Loss Causation, and KPMG joins in those arguments. KPMG addresses here plaintiffs complete failure to submit evidence attributing their alleged damages to any statement by KPMG.
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Rep.). Plaintiffs challenge only three statements by KPMG: its three audit opinions. Sec. Am. Compl., Docket No. 204 (SAC) 403-407; see also SUMF 259 (Berliner Rep.; Berliner Tr.). In light of the clear direction in Janus, plaintiffs themselves should readily agree that KPMG can have no liability for damages before the publication of its first audit report on April 1, 2002. Simply put, KPMG cannot have made a material misstatement until it spoke. Likewise, KPMG can have no liability after September 30, 2004. According to Professor Jarrell, the inflation in Fannie Maes stock price was reduced to zero. SUMF 275 (Jarrell Rep.; Jarrell Tr.). Plaintiffs do not claim that KPMG made any statements after that date. SAC 403-407; SUMF 276 (Jarrell Rep.; JREx. 6; Jarrell Tr.). To the contrary, they attribute any post-September inflation to statements made by others on October 6 and 7, 2004. SUMF 277 (Jarrell Rep.; JREx. 6; Jarrell Tr.). KPMG made no statements on those days. Id. Finally, KPMG can have no liability for any alleged increase in inflation on June 16, 2003, or July 30, 2003. KPMG made no statements on those dates, and plaintiffs attribute inflation on those dates to statements by others. SUMF 273 (Jarrell Rep.; JREx. 8); SUMF 272 (Jarrell Rep.); SAC 270-271. There is no grey area in the law; the Supreme Court has unequivocally stated that a defendant is only liable under Section 10(b) for material misrepresentations it made. See, e.g., Janus, 131 S. Ct. at 2302-03.
14
14 See also Stoneridge Inv. Partners, 552 U.S. at 162-63 (aiding and abetting liability is not authorized in suits by private parties under section 10(b)); Cent. Bank of Denver N.A., 511 U.S. at 177 (same); Lattanzio, 476 F.3d at 153 ( 10(b) imposes liability only on a person who makes a material misstatement or omission, and . . . there is therefore no liability for aiding and abetting).
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B.
Plaintiffs Have Not Proven that KPMG Caused Any of Their Losses In fact, plaintiffs have also failed to prove that KPMG caused any of the inflation their
expert claims to identify in Fannie Maes stock price. The undisputed evidence leading to this conclusion is the opinion and testimony of plaintiffs own damages expert. Central to any fraud-on-the-market case is proof that a statement by the defendant distorted the market price of the stock, causing artificial inflation.
15
In determining whether
plaintiffs have met this burden as to KPMG, the Court must consider the evidence against KPMG individually and separately. See Lattanzio, 476 F.3d at 153; In re AOL Time Warner, Inc. Sec. Litig., 503 F. Supp. 2d 666, 677 (S.D.N.Y. 2007). It is the principle underlying the Janus decision: a defendant can be liable only for what that defendant says, and not what other defendants might have said. Janus, 131 S. Ct. at 2305. 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. SUMF 270 (Jarrell Rep., JREx. 8, 6; Jarrell Tr.). They do not claim that KPMG had made any statement by that date. SUMF 271. KPMGs first audit opinion, on Fannie Maes 2001 financial statements, was published on April 1, 2002. SUMF 260 (2001 Information Statement). Plaintiffs damages expert denies that there was any change in inflation or even any statistically significant movement in Fannie Maes stock price on the date this opinion was issued. SUMF 261-262 (Jarrell Rep.; JRExs.
15 In re MIVA, Inc. Sec. Litig., No. 2:05-cv-201, 2009 U.S. Dist. LEXIS 127748, at **19-22 (M.D. Fla.
Aug. 25, 2009) (finding no loss causation where plaintiffs failed to tie the fraudulent statement[s] to the loss because the inflationary rate of the stock remained the same before and after the alleged fraudulent statements were made); see also Semerenko v. Cendant Corp., 223 F.3d 165, 184 (3d Cir. 2000) (requiring the purchase of a security at a price that is inflated due to an alleged misrepresentation as a necessary prerequisite for proving loss causation); In re Moodys Corp. Sec. Litig., No. 07 Civ 8375, 2011 WL 1237690, at * 10 (S.D.N.Y. Mar. 31, 2011) (the link between the misrepresentation and the price is severed by showing that the allegedly false information the market was absorbing was not causing the stock price to artificially inflate).
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8, 11; Jarrell Tr.). KPMGs second audit opinion, on Fannie Maes 2002 financial statements, was published on March 31, 2003. SUMF 263 (2002 10-K). Plaintiffs damages expert again denies there was either inflation or stock price movement on that date. SUMF 264-265 (Jarrell Rep.; JRExs. 8, 11; Jarrell Tr.). KPMGs third audit opinion, on the 2003 financial statements, was published on March 15, 2004. SUMF 266 (2003 10-K). For a third time, plaintiffs deny any inflation and any movement in the stock price. SUMF 267-68 (Jarrell Rep.; JRExs. 8, 11; Jarrell Tr.). Indeed, plaintiffs expert explicitly concedes that no inflation entered Fannie Maes stock price as a result of any KPMG audit opinion. SUMF 269 (Jarrell Tr.; Jarrell Rep.; JREx. 8.).16 Not only does plaintiffs damages expert fail to attribute any inflation to KPMGs audit opinions, he fails to attribute any part of his September 2004 declines to those statements. Rather, he purports to measure only the total effect of all the alleged misstatements by all defendants (plus direct and foreseeable results and other items, which are not recoverable in any event). See Motion for Summary Judgment for Failure to Prove Loss Causation at Section IV(B). That is insufficient on its face to meet plaintiffs burden of proof as to KPMG. Lattanzio, 476 F.3d at 158 (requiring plaintiffs to distinguish between losses caused by the auditors alleged misstatements and losses caused by other alleged misstatements or causes); AOL, 503 F. Supp. 2d at 677 (determining that loss causation was not pled where the plaintiffs predicate their losses on revelations regarding numerous factors beyond the scope of [defendant auditors] liability).
16 The KPMG Chart A, attached hereto, shows Jarrells inflation ribbon and that it remains
unchanged on any date relevant to KPMG.
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A few examples should be sufficient to show why. All the parties agree that information about a changing political and regulatory environment was part of a tangle of factors impacting the September 2004 stock price declines. See SUMF 278 (Jarrell Tr.; Jarrell Rep.). An audit opinion on a companys financial statements does not opine on the many political influences that might affect its operations, much less about future changes in the political climate. Politics is one stark example. The 1998 allegations are another. Plaintiffs claim a portion of the decline was due to OFHEOs allegation that management deferred $200 million in amortization in 1998. See SUMF 280 (Jarrell Tr.). There is no claim this deferral affected any figure on the 2001, 2002 or 2003 financial statements. Yet, Jarrell includes this in his undifferentiated September 2004 declines. SUMF 280 (Jarrell Tr.). Having refused to disaggregate any portion of the stock price declines in September 2004 to identify the causes of the decline, plaintiffs fail to show that any portion of these declines were attributable to KPMGs statements. Such a failure of proof is fatal. CONCLUSION The law is clear: in order to establish the kind of extreme recklessness that amounts to scientera state of mind tantamount to intent to defraudplaintiffs must prove by admissible evidence that KPMG conducted no audit at all. Yet, plaintiffs concede that KPMG conducted very substantial audits, affirmatively considered each of the disputed accounting issues, and came to considered judgments not only that the accounting was GAAP, but that it appropriately reflected the economics of Fannie Maes business. As such, there was no danger, much less an obvious danger of investors being materially misled. KPMGs motion for summary judgment as to scienter should therefore be granted and all claims dismissed.
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As an independent ground for summary judgment, the claims against KPMG fail because plaintiffs have not shown that KPMGs alleged misstatements caused any inflation in Fannie Maes stock. Nor has their expert made any effort to isolate stock price declinesif any caused by KPMGs opinions, as opposed to those caused by the other unrelated factors he concedes caused the stock price to decline. Without evidence of loss causation, KPMG is entitled to summary judgment. 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
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KPMG Chart A
Asserted Inflation $10 $9 $8 $7 $6 $5 $4 $3 $2 $1 $0
4/17/01 Asserted Inflation: $5.52
6/16/03 7/30/03 Change:Change: $2.47 $1.11
9/22/04 Change: $3.03 Start of Class Period 9/23/04 Change: $2.23 9/24/04 Change: $1.80 9/30/04 Change: $2.04
Inflation as of Market Close

Source: Expert Report of Gregg A. Jarrell dated 9/14/10, Exhibit 8

KMPG Memo On Motion For Summary Judgement

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Case 1:04-cv-01639-RJL Document 937-1 Filed 08/22/11 Page 1 of 48

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)

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unchanged on any date relevant to KPMG.

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Asserted Inflation $10 $9 $8 $7 $6 $5 $4 $3 $2 $1 $0

4/17/01 Asserted Inflation: $5.52

6/16/03 7/30/03 Change:Change: $2.47 $1.11

Inflation as of Market Close

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