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Fannie Ex-Execs Want Suit Dropped

Franklin D. Raines, left, and J. Timothy Howard testify at a 2004 House Financial Services Committee hearing on accounting irregularities at Fannie Mae.
Franklin D. Raines, left, and J. Timothy Howard testify at a 2004 House Financial Services Committee hearing on accounting irregularities at Fannie Mae. (By Susan Biddle -- The Washington Post)
By Annys Shin
Washington Post Staff Writer
Wednesday, October 5, 2005

Former Fannie Mae chief executive Franklin D. Raines and former chief financial officer J. Timothy Howard have asked a federal judge to dismiss a shareholder lawsuit against them on the grounds that the plaintiffs have not produced any "direct evidence" that Raines and Howard knew about the company's accounting problems or intended to deceive investors, according to pretrial motions filed over the summer.

The pleadings, filed jointly by the two executives, represent the most public defense Raines and Howard have offered since they were forced from Fannie Mae last year amid allegations that they flouted accounting rules to boost earnings, which in turn triggered millions of dollars in bonuses for themselves and other top executives.

Attorneys for Raines and Howard disputed the claim that they were motivated by the lure of bonus checks and stock options, saying their compensation was not tied to reported earnings but to an alternate measure of profitability. The plaintiffs countered that the accounting violations affect that statistic as well.

Raines's and Howard's lawyers also took issue with the allegation that the two former executives knew of and disregarded a September 2002 memo from Roger L. Barnes, then a manager in Fannie Mae's controller's division, that warned of "serious financial improprieties." They contended in the court filings that his claims were thoroughly investigated and largely had to do with accounting issues other than the ones that have called into question as much as $10.8 billion in previously reported earnings.

Along with leading to the departures of Raines and Howard, the accounting scandal has spawned investigations by the Securities and Exchange Commission and federal prosecutors, prompted Fannie Mae to commission its own independent probe into what happened, and led Congress to consider legislation tightening regulation of the company and its companion in the mortgage industry, Freddie Mac.

Raines and Howard's arguments are "classic securities law defenses," said University of Mississippi law professor Mercer E. Bullard.

To keep the case moving forward, the plaintiffs will have to convince U.S. District Judge Richard J. Leon that the executives understood "the choices they were making, the likely impact of those choices and that there was a lack of transparency to the markets about the choices they were making," said Duke University law professor James D. Cox.

The plaintiffs' case relies heavily on the detailed September 2004 report of Fannie Mae's accounting problems prepared by the company's chief regulator, the Office of Federal Housing Enterprise Oversight, as well as other public documents. It cites comments, for example, that Howard made to OFHEO examiners that one of the company's "goals" when it came to accounting for derivatives was "minimizing earnings volatility."

Derivatives are complex investments used to lower a company's risk of losing money on shifts in interest rates, but they can generate losses. OFHEO's report concluded that the company used improper accounting techniques to hide derivatives losses -- a fact the plaintiffs attribute to the desire by executives to meet earnings targets and trigger bonuses.

They contend that Raines misled investors during a July 2003 conference call with Wall Street analysts in which he discussed in detail the company's application of the rules that govern accounting for derivatives. Managers at Fannie Mae "made no effort to try to smooth . . . earnings or to in any way distort what the actual impact . . . was on Fannie Mae," Raines said.

During the same conference call, when asked by an analyst whether Fannie Mae "used any accounting judgment that either its employees or its auditors found debatable," Raines replied: "The answer to that is clearly no. We have not. If we had, I would have violated the law in certifying our financial results."

As with other aspects of the complaint, attorneys for Raines and Howard said in their response that the plaintiffs have produced no evidence to show that Raines did not believe what he was saying at the time.

The plaintiffs also accuse Raines and Howard of profiting from the accounting violations when they sold a combined $20 million worth of Fannie Mae stock.

In the court filings, they defended their stock sales, contending they were scheduled in advance and that they represented less than 5 percent of each executive's holdings.

Staff researcher Magda Jean-Louis contributed to this report.

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