kmpg memo on motion for summary judgement

IN THE UNITED STATES DISTRICT COURT FOR THE DISTRICT OF COLUMBIA

In re Fannie Mae Securities Litigation

MDL No. 1668 Civil Action No. 1:04-cv-01639 (RJL)

KPMG LLP’S 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

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

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TABLE OF CONTENTS

Page

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 Mae’s 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

2. Plaintiffs Cannot Show That No Reasonable Accountant Could Have Accepted Fannie Mae’s Use of a Precision Threshold When Plaintiffs’ Subject Matter Expert Says Auditing Literature Supports This Concept ............. 17

3. Plaintiffs Cannot Show That No Reasonable Accountant Could Have Accepted Fannie Mae’s FAS 115 Policy When Plaintiffs’ FAS 115 Expert Is Not Sure and Denies the Policy Could Be Used to Manipulate Earnings ........ 21

B. Plaintiffs Cannot Claim “No Audit At All” .................................................................. 23

1. Plaintiffs Do Not Dispute KPMG’s Effort ........................................................... 23

2. Mr. Berliner Criticizes the Auditors’ Professional Judgments, Not Their Intent ..................................................................................................................... 25

C. Plaintiffs Offer No Evidence Regarding KPMG’s 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. KPMG Cannot Be Liable for Statements Made by Others ........................................... 37

B. Plaintiffs Have Not Proven that KPMG Caused Any of Their Losses ......................... 39

CONCLUSION ........................................................................................................................... 41


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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 Moody’s 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. App’x 702 (10th Cir. 2006) ........................................................................................... 15

Merck & Co., Inc. v. Reynolds, 130 S. Ct. 1784 (2010) ................................................................................................................ 7

Nat’l 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


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. Nat’l

Mortgage Ass’n 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 KPMG’s 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


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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 Mae’s 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 Mae’s 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 Mae’s 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 Mae’s 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 KPMG’s three audit opinions. The Court also has made clear that plaintiffs must prove loss

causation—that KPMG’s 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

Mae’s 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


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before the class period even began. This unprecedented approach does not satisfy plaintiffs’

burden to show that any damage was caused by KPMG’s statements.

These undisputed facts do not support any reasonable conclusion that KPMG’s 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 Mae’s

independent auditor throughout the class period. Id.

A company’s 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.).

KPMG’s 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,


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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 company’s 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 Mae’s 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 auditor’s 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 company’s


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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).

KPMG’s audit reports, included in and filed with Fannie Mae’s 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 Mae’s 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 company’s financial statements are perfect. Rather, the auditor looks for

“evidential matter” that can show whether or not the company’s 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 company’s financial position.

SUMF ¶¶ 18-19 (Berliner Tr.). Reasonable auditors can disagree on these points, as even


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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 party’s 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 Nat’l Junior

Baseball League v. Pharmanet Dev. Grp. Inc., 720 F. Supp. 2d 517, 557 (D.N.J. 2010) (citing


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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 defendant’s 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 company’s 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.,


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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 KPMG’s 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 company’s interpretations of certain accounting standards: FAS 133

(derivatives and hedge accounting), FAS 91 (amortization premiums and discounts) and FAS

115 (classification of securities).1

1 Most of Mr. Berliner’s criticisms merely repackage his complaints about these three accounting policies: KPMG’s independence was compromised because it failed to object to Fannie Mae’s 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 Mae’s 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.).


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Many courts have recognized that disputes about the interpretation and application of

accounting rules go to the heart of an auditor’s 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 client’s accounting:

In essence, the plaintiffs concede[d] that [the auditor] made a sufficient investigation into WOW’s finances but contend that [the auditor’s] 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 auditor’s 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, KPMG’s 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 KPMG’s FAS 91 expert. Professor Holder received the AICPA’s Gold Medal of Distinguished Service, its highest honor, and has been twice included among the


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accounting profession’s “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 KPMG’s 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


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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) (doctor’s 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 Mae’s 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 KPMG’s

2 Kenneth Russell (KPMG’s engagement partner when the company’s 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 defendant’s 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 KPMG’s working

papers. SUMF ¶¶ 46-48. Mr. Berliner turned to KPMG’s 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)


13

(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 Mae’s regulator. OFHEO’s 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) (OFHEO’s

conclusions that KPMG’s audit plan included all the necessary activities and operations, and that

KPMG’s conclusions were supported by its work papers). Making the supposed fraud freely

available to an independent third party—much less a federal regulator—defeats any claim of

scienter. McNamara v. Pre-Paid Legal Serv., Inc., 189 F. App’x 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 KPMG’s professional judgments, Mr.

Berliner admits that he cannot say KPMG’s judgments were any different than those of any other

auditor at the time, that the judgments made reflected KPMG’s 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.


14

1. Plaintiffs Cannot Show That No Reasonable Accountant Could Have Accepted Fannie Mae’s 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

Mae’s 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 Mae’s 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 KPMG’s 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


15

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.). KPMG’s

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 Mae’s 475-

page “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 Mae’s application of a complex standard to a

3 As noted in Section I.C below, the auditors did not always agree that the accounting Fannie Mae initially proposed qualified under FAS 133.


16

complex portfolio—and although the company’s approach is considered reasonable by financial

institutions, accounting firms and regulators alike—the auditors nonetheless knew it was wrong.

Any suggestion that the KPMG work papers acknowledge Fannie Mae’s 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 Mae’s 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 company’s

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

4 Often, the point is made clear simply by shifting Mr. Berliner’s 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).


17

above acknowledged—that 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 KPMG’s 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 Mae’s 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

Mae’s 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 Mae’s

“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


18

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 Mae’s

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 Mae’s SFAS 91 calculations; auditing

literature supports this concept.” SUMF ¶ 170 (Fierstein Rebuttal Rep. (emphasis added);

Fierstein Tr.). In this, she agrees with KPMG’s 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

5 As with Mr. Berliner, there are serious questions as to Ms. Fierstein’s 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.).


19

appropriate for use by KPMG” negates any claim that “no reasonable accountant” could have

accepted Fannie Mae’s 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 resulted—and Mr. Berliner’s criticisms are

limited only to the last part, the precision threshold—was documented by three KPMG partners

6 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.

7 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 Mae’s 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.).


20

and one KPMG manager, and then reviewed each year. SUMF ¶¶ 159-61 (KPMG work papers;

Fierstein Tr.). Each quarter, KPMG reviewed Fannie Mae’s calculations and had detailed

discussions about the amortization process. SUMF ¶ 159 (KPMG work papers; Berliner Tr.).

The auditors brought in a specialist from KPMG’s Structured Finance Group to recalculate

amortization factors and examine the company’s 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 Mae’s 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

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 company’s response to the allegations. SUMF ¶ 180 (Berliner Tr.). Mr. Berliner found no grounds upon which to criticize KPMG’s review of that investigation or the investigation itself. SUMF ¶ 181 (Berliner Tr.). He even declined to opine that the


21

3. Plaintiffs Cannot Show That No Reasonable Accountant Could Have Accepted Fannie Mae’s 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 Mae’s 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-for-

sale [“AFS”], or trading.” SUMF ¶ 185 (FAS 115 ¶ 6). Mr. Berliner quotes Fannie Mae’s

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 KPMG’s 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, let’s say, on the 10th of the month and then you don’t designate it until the end of the month, I would have to think about whether that qualifies as [at] acquisition or not. . . . I can’t give you an answer right now.

whistleblower’s allegations evidenced a material misstatement of the financial statements. SUMF ¶ 181 (Berliner Tr.). Ultimately, he was forced to concede that, “I don’t believe [Mr. Barnes’] allegations related to the threshold policy.” SUMF ¶ 182 (Berliner Tr.).

9 Again, the basis for Ms. Fierstein’s 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.).


22

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 Mae’s 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 you’re 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, that’s correct.

SUMF ¶ 196 (Fierstein Tr.).


23

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 danger—much less an obvious one—of 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 KPMG’s Effort

While Mr. Berliner criticizes KPMG’s 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 Mae’s

Financial Standards group (in charge of developing company accounting policy) devoted to


24

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 Mae’s

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 KPMG’s 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 Mae’s 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.).

KPMG’s 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


25

more than five percent (5%) of KPMG’s 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 KPMG’s 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 KPMG’s 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 Mae’s financial statements. SUMF ¶ 226 (KPMG memoranda). On this record, there is

no basis to disdain all KPMG’s 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


26

criticisms—and many are demonstrably wrong—the 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 Company’s 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 KPMG’s efforts in discovering a risk but is purely a

challenge to KPMG’s professional judgment concerning how to respond: “I don’t 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 management’s 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 Mae’s 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 IKON’s 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 auditor’s] independent, external audit.”)


27

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 don’t 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


28

in internal control as of December 31, 2004. SUMF ¶ 70 (Berliner Rep.). Mr. Berliner

acknowledges that KPMG did not issue any report on Fannie Mae’s 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 Mae’s 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 not—indeed, cannot—say 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 KPMG’s 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.


29

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 auditor’s] independent, external audit.”).

Finally, Mr. Berliner acknowledged that OFHEO’s examiners reviewed Fannie Mae’s

internal controls each year during the Class Period, using dozens of examiners over the course of

the entire year, and concluded that Fannie Mae’s internal controls “exceeded safety and

soundness standards.” SUMF ¶¶ 77-78 (Berliner Tr.; OFHEO Rep. to Congress (2001) (Fannie

Mae’s “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 company’s internal controls, he never bothered to look at OFHEO’s 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. Berliner’s Criticisms of Fannie Mae’s 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 company’s 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 KPMG’s 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 Mae’s 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 Mae’s 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.).


30

senior management.” SUMF ¶ 71 (Berliner Rep.). Whatever the merits of his opinion about the

company’s 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 Mae’s

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 fraud—particularly given Mr. Berliner’s

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 Mae’s 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 Mae’s “[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]here’s 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”)).


31

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. Berliner’s 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 KPMG’s 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 Mae’s financial

statements could suffer from such significant GAAP violations in so many critical accounting

areas is that KPMG was only ‘rubber stamping’ Fannie Mae’s 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


32

restatement does not mean that KPMG’s 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 court’s 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

auditor’s] 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 restatement’s 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 KPMG’s audit procedures in any of them, no explanation of what GAAS required


33

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 evidence—even with the

massive record in this case—did 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 Mae’s 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 Mae’s 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 Mae’s 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 Mae’s 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


34

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 Mae’s

financial statements.” SUMF ¶ 123 (Berliner Tr.). Mr. Berliner himself was eloquent about the

pressures of such a situation:

Now, that’s 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 auditor’s telling them that the standard doesn’t 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 KPMG’s 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 KPMG’s 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


35

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 Mae’s 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 Mae’s accounting. With respect to FAS 91, in the third quarter of 2002, Fannie

Mae’s 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. Berliner’s claim that “KPMG was only ‘rubber stamping’ Fannie Mae’s accounting

policies” may have a rhetorical flourish, but flourish is not admissible evidence and rhetoric

cannot avoid summary judgment.


36

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

Jarrell’s two reports, one would not know that KPMG is a defendant in this litigation. He

affirmatively opines that no inflation entered Fannie Mae’s stock price on the dates KPMG

issued its three audit opinions—the only statements that plaintiffs claim KPMG made. And

Professor Jarrell makes no effort to tie KPMG’s 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


37

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 issuer’s accountant, a plaintiff

must allege a misstatement that is attributed to the accountant ‘at the time of its dissemination,’

and cannot rely on the accountant’s 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.13

A. KPMG Cannot Be Liable for Statements Made by Others

As Mr. Berliner explains: “The auditor’s report on a company’s financial statements is

the medium in which the accounting firm communicates its opinion.” SUMF ¶ 258 (Berliner

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.


38

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 Mae’s 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”).


39

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 Mae’s 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 Mae’s 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.

KPMG’s first audit opinion, on Fannie Mae’s 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

Mae’s 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 Moody’s 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”).


40

8, 11; Jarrell Tr.). KPMG’s second audit opinion, on Fannie Mae’s 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.). KPMG’s 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 Mae’s

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 KPMG’s 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

auditor’s] liability”).

16 The “KPMG Chart A,” attached hereto, shows Jarrell’s inflation ribbon and that it remains unchanged on any date relevant to KPMG.


41

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 company’s 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 OFHEO’s 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 KPMG’s 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

scienter—a state of mind tantamount to intent to defraud—plaintiffs 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 Mae’s business. As such, there was no danger, much less an

obvious danger of investors being materially misled. KPMG’s motion for summary judgment as

to scienter should therefore be granted and all claims dismissed.


42

As an independent ground for summary judgment, the claims against KPMG fail because

plaintiffs have not shown that KPMG’s alleged misstatements caused any inflation in Fannie

Mae’s stock. Nor has their expert made any effort to isolate stock price declines—if any—

caused by KPMG’s 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


KPMG Chart A

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

$0

$1

$2

$3

$4

$5

$6

$7

$8

$9

$10

Asserted Inflation 6/16/03

Change: $2.47

7/30/03 Change:

$1.11

4/17/01 Asserted Inflation: $5.52

Start of Class Period

Inflation as of Market Close

9/22/04Change: –$3.03

9/23/04Change: –$2.23

9/24/04Change: –$1.80

9/30/04Change: –$2.04


kmpg memo on motion for summary judgement

Documents