Dan Mudd's Provocative Refusal To Settle The SEC's Stupid Case
Sooner or later, a litigator sits down with his client to explain why a negotiated settlement is preferable to trial. All litigation is a crapshoot and corporate defense lawyers are expensive. At the end of the day it doesn’t really matter who is right and who is wrong. What matters is the price you pay to walk away from a lawsuit and get on with your life.
Stubborn or principled?
Which is why five former executives from Fannie Mae and Freddie Mac — Richard Syron, Patricia Cook,Donald Bisenius, Enrico Dallavecchia, and Thomas Lund — chose to settle. They were all defendants in two SEC lawsuits alleging securities fraud. They all agreed to pay small penalties, mostly covered by insurance, and all incurred temporary restrictions, with regard to certifying new SEC filings, which were no more than meaningless gestures. No one was required to admit that he had ever done anything wrong. Litigation is a war of attrition and, four years after the complaints were originally filed, almost all of the opposing parties agreed to a face-saving armistice.
But there remained one holdout, a former Marine who demanded unconditional surrender. Daniel Mudd, Fannie Mae's CEO up until conservatorship, rejected the government's offer and proceeded with his motion for summary judgment dismissal. His stance, that the SEC's charges are utterly devoid of merit, is bound to have annoyed the SEC and District Court Judge Paul Crotty, who incurred many hours of additional work to dispose of a four-year-old case.
By taking direct aim at the legitimacy of the SEC's efforts, Mudd implicitly raises some uncomfortable questions. Why would the SEC devote so
many hours and resources to such highly publicized lawsuits when there was no
there there? And if the SEC's case could be dismissed out of hand, why would
Judge Crotty approve a $170 million settlement for a class action brought by
former Fannie Mae shareholders who alleged substantially identical securities
It was always a stupid case. Those questions were preempted by Judge Crotty's ruling against Mudd's summary judgement motion, and the case is set to go to trial. As for the legal merits, I agree with Mudd. It took me five minutes to figure out that the lawsuits were a joke when I first read the Fannie complaint in 2011. Though it took me a bit longer to explain why, here, here and here.
The SEC said that former GSE executives misled investors by understating the companies' risk exposures to subprime and Alt-A loans.
You have to remember that it's very hard to win a case alleging fraud under Federal securities statutes. The plaintiffs' heavy burden of proof is very much like a public figure's burden of proof when he wants to sue somebody for defamation. Both types of legal actions are about false statements. And the plaintiff can succeed only when he shows that the falsity of the statement is obvious, and that the person who made the statement knew he was being deceitful or showed a clear reckless indifference to the facts. In a securities case the falsehood must also be material.
It doesn't matter if you are Donald Trump or a Fannie Mae shareholder. If the defendant can demonstrate that he was confused or unaware that his remarks were misleading, then he cannot be held liable. In this instance, incompetence is a complete defense. Cases alleging securities fraud are tough to prove because it is so easy to muddy the waters; financial jargon can be very confusing, even to professionals.
Subprime and Alt-A are like liberal and conservative. Which raises the threshold problem with the SEC's case. erms like
Subprime and Alt-A are like liberal and conservative. Which raises the threshold problem with the SEC's case.Squishy t
erms like"subprime" and "Alt-A" are just like "liberal" or "conservative." Within the mortgage industry, subprime and Alt-A have different meanings in different contexts, and those meanings have evolved over time. The terms are interpreted differently by different people. Context is everything.
Which is why it is all but impossible to demonstrate that the GSEs' subprime and Alt-A exposures were materially false. The SEC and Judge Crotty suggest otherwise because they interpret these terms in ways that are simplistic and largely circular. For them, subprime loans are given by lenders who specialize in lending to people with impaired credit. And Alt-A loans involve reduced documentation. As I wrote way back:
The SEC’s definition of “Alt-A” is so broad as to be virtually meaningless. It designates as “Alt-A” any loan with “reduced documentation,” or “reduced and alternative documentation.” But those are terms could mean almost anything. “Reduced documentation” can refer to a loan for which the borrower proves his income with a W2 for last year in addition to a 1040 for the previous year. Or “reduced documentation” can refer to a “stated income/stated asset” loan, otherwise known as a liar loan.
How easily can someone get
confused? There are subprime borrowers and subprime loan products sold to prime
borrowers. The term subprime, in the context of a balance sheet lender, involves a panoply of factors, according to interagency guidance. But subprime has a completely different meaning when used in the context of a private label
securitization, where the term is defined by FICO cutoffs. For Moody's, a borrower with a FICO score of 624 is subprime, whereas a borrower with a FICO score of 626 is midprime Moreover a subprime or
Alt-A securitization may hold a portfolio heavily weighted with prime loans, as
illustrated by this graphic from Subprime Mortgage Credit Derivatives.
You thought the SEC wants to protect investors?
You thought the SEC wants to protect investors?To me the smoking gun--the incontrovertible proof that the SEC never sought to "protect" investors, only to fabricate a bogus media narrative intended to malign the government sponsored enterprises and their former executive teams--can be found the original settlement agreement executed between the SEC and Fannie Mae. The smoking gun is not what the agreement said but what it didn't say. It didn't say that Fannie should change the way it discloses subprime and Alt-A loans.
Judge Crotty'sdecision is ten times more deceitful than anything written or said by Dan Mudd. Like the SEC, Crotty faults Mudd for stating, in the 2006 10-K, that Fannie had only $5 billion in subprime loan exposure, because that number excluded loans originated under Fannie's special affordability programs, known as Enhanced Authorization and My Community Mortgage, which represented another $50+ billion in loans. Except Mudd alerted everyone in his 2006 letter to shareholders that the affordability products were counted separately from subprime loans:
Affordability products: To provide an alternative to risky subprime products, we have purchased or guaranteed more than $53 billion this year in Fannie Mae loan products with low down payments, flexible amortization schedules, and other features.
The SEC and Judge Crotty Ignore Materiality: SEC v. Mudd is in the Second Circuit, where, following
The SEC and Judge Crotty Ignore Materiality: SEC v. Mudd is in the Second Circuit, where, followingIBEW Local Union v. Royal Bank of Scotland, the standards for materiality follow those set by SEC Staff Accounting Bulletin: No. 99. According to a Paul Weiss analysis:
The Royal Bank of Scotland court was clear that materiality should be assessed from a quantitative and qualitative perspective at the motion to dismiss stage and that the importance of a business segment to a company alone is insufficient to overcome the presumption of immateriality for allegations relating to less than 5% of an item on a registrant’s financial statement. The 5% threshold generally refers to a 5% impact on net income. Read my earlier pieces to see why a reallocation of Fannie's subprime and Alt-A exposures would not have anything close to a 5% impact on net income.
Judge Crotty ignores the Second Circuit decision relies instead on an egregious type of false equivalency:
Misleading statements are material if “a reasonable investor would have considered [them] significant in making investment decisions.”Ganino v. Citizens Utils. Co., 228 F.3d 154, 162 (2d Cir. 2000) (citation omitted). FNMA’s failure to include EA, MCM, and lender-selected low-documentation loans in its quantification of its subprime and Alt-A exposure understated FNMA’s exposure to those types of loans by hundreds of millions of dollars. Such exposure would have been particularly “important to investors because of the volatility in the housing and secured-transaction markets.” In re MBIA, Inc., Sec. Litig., 700 F. Supp. 2d 566, 586 (S.D.N.Y. 2010) (holding that a failure to disclose that 1% of the insurers’ portfolio was exposed to assets backed in part by residential-mortgage-backed securities was material).
In re MBIA, Inc. was primarily about CDOs and CDO-squareds, which had loss rates eight or nine times higher than the loss rates on Fannie's "undercounted" mortgages. MBIA misled investors because it failed to disclose that those "Multi-Sector" CDOs were comprised almost entirely of deeply subordinated tranches of RMBS deals. The fatal flaw of structured finance CDOs was that they ignored the impact of subordination. One of the dirty little secrets of CDOs is that they were always packed with the subordinate tranches of other CDOs. MBIA presented those subordinated CDO investments as investments in "ABS" (asset backed securities, anther term that can mean anything) rather than as hyper-subordinated pieces of RMBS deals.
The MBIA case and Judge Crotty's decision, exemplify a point I've made repeatedly. Corruption in finance is often rooted in corruption of language.
Dan Mudd has described this case as politically motivated. Let's not forget that the Chairman of the SEC acted politically when he lied to Congress and accused Fannie of concealing $11 billion in derivative losses.
2 comments - Dan Mudd's Provocative Refusal To Settle The SEC's Stupid Case
Does anyone see the same fervor when defendants are big corporations?
Rarely we see Law enforcement agencies admitting their mistakes and withdrawing the cases when it comes to individual defendants.
We need independent panels consisting of various stakeholders, to evaluate such cases and recommend whether the cases need to be pursued.
This will make Law enforcement agencies more efficient and effective.
Why would the SEC devote so many hours and resources to such highly publicized lawsuits when there was no there there?
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