Tuesday, August 14, 2012

Federal Judge Allows SEC Action against Fannie Mae Senior Officers to Proceed; Second Circuit Substantial Assistance Standard Used

A federal judge ruled that an SEC action alleging securities fraud against the former CEO of Fannie Mae for misleading investors about the GSE’s level of exposure to risky subprime loans could proceed. The court, using the recent Second Circuit test for substantial assistance announced in SEC v. Apuzzo, held that aiding abetting fraud charges against the CEO and two other former Fannie Mae senior officers, the chief risk officer and an executive vice president, could also proceed. As a threshold matter, the court said that the Federal National Mortgage Association is not an exempt independent establishment of the United States under Section 3(c) of the Exchange Act. (SEC v. Mudd, et al., 11 Civ. 09202, Aug. 10, 2012)

Rather, Fannie Mae is a private corporation whose stock is listed on the exchange and is publicly traded.  FNMA is managed and controlled by a board of directors, noted the court, who are elected by the shareholders. FNMA pays its own way; it raises its operational expenses by generating revenue and does not receive federal appropriations.  Of course, conceded the court, FNMA furthers an important federal mission and is subject to regulation by HUD, but these facts are not dispositive when weighed against the other factors. Additional external indicia supported the court’s conclusion:  the defendants in this action are not represented by the federal government; money judgments against FNMA are not paid from the US Treasury; and FNMA is not exempt from federal taxes.

Moreover, the court noted that Congress had two opportunities to designate FNMA an independent establishment within the meaning of Section 3(c), in 1938, when FNMA was created, and in 1968, when FNMA was reorganized into a government sponsored private corporation, but Congress never designated FNMA as an independent establishment.

FNMA is a shareholder-owned private corporation that voluntarily registered under the Exchange Act in 2003, and has since then been required to file periodic and current reports with the SEC. In registering under the Exchange Act, FNMA explicitly acknowledged that voluntary Exchange Act registration would also subject Fannie Mae to the provisions of the Exchange Act, and to the SEC’s enforcement jurisdiction thereunder.

The court also reasoned that, as a matter of policy, exempting FNMA’s employees from liability for their false and misleading public statements would contravene the Exchange Act’s purpose of protecting the investing public from false public filings.  Accordingly, the Exchange Act’s purpose suggests that Section 3(c) does not apply to FNMA or the defendants.   The court concluded that FNMA is not an independent establishment under Section 3(c), and that the defendants are not exempt from liability.

The court also ruled that the SEC adequately alleged that FNMA’s quantitative subprime and reduced documentation loans were false because they failed to include all loans that fell within FNMA’s subprime and reduced documentation description. Thus, the SEC has adequately alleged that FNMA’s quantitative subprime disclosures were misleading.

The SEC adequately alleged that FNMA and the CEO committed a primary securities law violation by materially misstating FNMA’s subprime and reduced documentation loan exposure, and that the defendants had actual knowledge of this violation. To state an aiding and abetting claim under Section 20(e) of the Exchange Act, the SEC must also adequately allege substantial assistance by the aider and abettor in the primary securities fraud.

Employing a standard very recently announced by the Second Circuit Court of Appeals in SEC v. Apuzzo, the district court said that in order to satisfy the substantial assistance component of aiding and abetting the SEC must show that defendants in some sort associated themselves with the venture, that they participated in it as in something that they wished to bring about, and that they sought by their actions to make it succeed. The SEC has done so here, said the court.

The SEC plausibly alleged that the CEO, the chief risk officer and the executive vice president consciously assisted the venture to misstate FNMA’s subprime and reduced loan documentation  exposure in an active way. The SEC said that they received and reviewed FNMA’s periodic filings and that the chief risk officer drafted FNMA’s first definition of subprime, contained in its Form12b-25. The CEO commented on multiple drafts of each periodic filing and met with the other two senior officers individually to discuss the SEC filings.  The CEO signed, and the other two defendants sub-certified, all of FNMA’s 10-Ks and 10-Qs during the relevant period, and approved the Form 12b-25.

Further, the SEC alleged that the CEO and the chief risk officer spoke to investors on conference calls and repeated FNMA’s misleading disclosures while emphasizing that FNMA’s subprime exposure was “immaterial,” and constituted approximately “zero percent” of FNMA’s book of business. In the court’s view, these allegations were sufficient at this juncture to show that the senior officers associated themselves with the venture, participated in it as in something that they wished to bring about, and sought by their actions to make it succeed. The court denied the defendant’s motion to dismiss the SEC’s complaint.