Letter to SEC Chairman Cox Regarding Fannie Mae
P.O. Box 19312
Washington, D.C. 20036
September 25, 2006
Chairman Christopher Cox
Securities and Exchange Commission
100 F Street, NE
Washington, DC 20549
Dear Chairman Cox,
As you continue to investigate the Fannie Mae accounting debacle, we are writing to urge you to seek civil sanctions, including disgorgement, from senior executives who profited directly from the misconduct at Fannie Mae, and that you urge the Department of Justice to give careful consideration to criminal prosecution of these individuals.
In May, the Securities and Exchange Commission and the Office of Federal Housing Enterprise Oversight (OFHEO) entered into a settlement with Fannie Mae for its accounting misconduct, requiring payment from Fannie Mae of $400 million in penalties and what you have described as perhaps the largest restatement of earnings in corporate history.
As you noted in announcing the settlement with Fannie Mae,
Congress created Fannie Mae to expand homeownership by increasing mortgage financing. Fannie Mae describes itself as “an instrument of national policy” and as “a private company with a public mission.”
For that reason, today’s announcement is especially bitter — because it underscores a breach of trust. Fannie is the largest private borrower in the nation, second only to the Federal Government, and it is a major player in the derivative markets, as well.
At the time the settlement was announced, OFHEO released its explosive report on the unethical corporate culture at Fannie Mae, “Report of the Special Examination of Fannie Mae.”i
The OFHEO report documents an astonishing variety of accounting tricks and pervasive mis-, mal- and non-feasance by senior management and Fannie Mae’s board of directors. All of the checks and balances that should have prevented Fannie Mae’s misconduct failed. This group abdication is very serious, and worthy of a very serious response.
As OFHEO documented, the problems at Fannie Mae started at the top:
Although the actions of many members of senior management shaped Fannie Mae’s culture, it was influenced to the greatest extent by Franklin Raines, who called for doubling Fannie Mae’s earnings per share in five years, molded the Enterprise’s compensation program to heighten incentives to achieve that goal, and gave CFO Timothy Howard extraordinary power and authority; and by Mr. Howard, who was most responsible for Fannie Mae’s corporate strategy and its execution.ii
The Board of Directors, OFHEO found, utterly failed in its duties:
The Board refrained from demanding accountability from the Chairman and other senior executives in numerous ways. Specifically, the Board abandoned its checks-and-balances oversight responsibilities; acquiesced in allowing management unbridled authority over its agenda, materials, and minutes; did not adopt and impose policies requiring that all critical accounting policies and major transactions be vetted before it or its designated committee; and acquiesced in allowing the Chairman to concentrate power in the Chief Financial Officer and then to seat him on the Board, which enhanced the power and influence of executive Board members. In fact, the Board allowed management to determine with little opposition the information it received and missed many opportunities for meaningful oversight. iii
Meanwhile, in a too familiar story, Fannie Mae’s internal accounting mechanisms and its external auditors, KPMG, contravened safety and soundness standards.
It would be hard to explain this institutional-wide failure, but for one factor identified by OFHEO: Top executives at Fannie Mae had a personal and very substantial financial interest in undertaking or enabling the pervasive manipulations. Perhaps the most important explanatory statement in the devastating OFHEO report is this: “Fannie Mae tied major portions of executive compensation to EPS [earnings per common share], a metric easily manipulated by management.”iv As OFHEO states, “The executive compensation program provided strong incentives for senior management to engage in improper earnings management and other unsafe and unsound practices.”v The structure of the executive compensation created the incentive for Fannie Mae to “smooth” its earnings — to ensure that it met its targets but did not exceed them.
Top officers at Fannie Mae benefited personally from the ensuing wrongdoing.
According to OFHEO vi, each of Fannie Mae’s most heavily compensated executives derived more than half of their massive payouts from compensation components tied to attaining EPS goals:
- Fannie Mae CEO and Chair Franklin Raines obtained $90,128,761 in compensation from 1998 to 2003. Of this amount, $52,815,708 was derived from components tied to attaining EPS goals.
- Fannie Mae CFO Timothy Howard received $30,155,029 in compensation from 1998 to 2003. Of this amount, $16,764,405 was derived from components tied to attaining EPS goals.
- Fannie Mae Vice Chair Jamie Gorelick received $26,466,834 in compensation from 1998 to 2003. Of this amount, $14,898,778 was derived from components tied to attaining EPS goals.
- Then-Chief Operating Officer and current Fannie Mae CEO Daniel Mudd received $26,306,057 in compensation from 1998 to 2003. Of this amount, $14,562,380 was derived from components tied to attaining EPS goals.
- Executive Vice President Robert Levin received $26,418,623 in compensation from 1998 to 2003. Of this amount, $15,272,645 was derived from components tied to attaining EPS goals.
In general, when seeking to remedy corporate wrongdoing, it is important to include penalties for both the corporate entity and for executives responsible for the wrongdoing. Failure to sanction both the entity and the individuals enables too many escapes from accountability for key implicated parties, and fails to send a clear deterrent message.
In the case of Fannie Mae, the SEC and OFHEO have, via their settlement with Fannie Mae, imposed a fine and instituted significant structural remedies and restraints. The U.S. Attorney for the District of Columbia, Kenneth Wainstein, has indicated that there will be no criminal prosecution of Fannie Mae.
Still under consideration, however, is the matter of appropriate sanctions for individual misconduct. We urge that you give careful attention to applying the entire range of civil sanctions available, including fines, disgorgement and prohibitions on future service on publicly traded companies’ boards of directors.
Unless evidence emerges that contradicts the findings of the OFHEO report, the Fannie Mae case presents a classic set of precise facts and abuses for disgorgement and other sanctions. Here, according to OFHEO, it was the very collaboratively planned executive compensation system itself that drove the wrongdoing. Failure to obtain disgorgement from the senior executives who committed this wrongdoing, motivated in significant part by awareness of how the accounting manipulations would benefit their personal wealth, would be a gross injustice, and seriously undermine the deterrent message that the SEC and OFHEO properly desire to communicate in this case. Certainly the performance-based compensation of the wrongdoing executives and directors should be disgorged; and, given the harm to the corporation, it would be very appropriate to seek disgorgement as well of their non-performance-based compensation. The executives and directors’ munificent pay came while they oversaw or implemented practices that, as you have said, has forced Fannie Mae to undertake “one of the largest restatements in American corporate history” and cost the company more than $1 billion. Failure to disgorge non-performance-based compensation would leave the culpable officers and directors in the same position they would have been absent the earnings manipulation. In such a case, not only would there be no punitive component, but there would be little deterrent effect. The message to corporate America would be that, if you are caught, crime does not pay, but it doesn’t cost you anything either; and, if you can get away with wrongdoing, the rewards may be immense.
As described in OFHEO’s report, the executives and directors’ wrongdoing constituted not a one-time slip, or routinized corner-cutting, or even a series of improprieties. Rather, executives and directors structured the operations of the corporation in pursuit of manipulated outcomes. That is, they knowingly and intentionally engaged in an ongoing, pervasive pattern of manipulation and wrongdoing, and did so in such a way as to advance their own narrow pecuniary interests. Unless evidence emerges that contradicts the findings of the OFHEO report, the individuals who engaged in this longstanding, pervasive misconduct should be prohibited from serving as directors or officers of publicly traded corporations.
That the wrongdoing, as documented in the OFHEO report, was so pervasive and longstanding, and with such severe consequences for the corporation and its shareholders, suggests too that strong consideration should be given to criminal prosecution. The U.S. Attorney has announced that no criminal prosecution will be sought against Fannie Mae itself; the evidence in the OFHEO report strongly suggests that you should urge very careful consideration of criminal prosecution of implicated executives and officers. If manipulating earnings requiring a restatement of $10 billion and costing the firm and shareholders more than $1 billion, “coopting internal auditors and other managers,”vii and stonewalling their regulators — largely for the purpose of maximizing bonuses and other personal compensation — does not result in criminal prosecution, what scale of wrongdoing is required?
We look forward to your reply, and based on your public comments that civil penalties including disgorgement are under consideration, we hope that the SEC is planning to take aggressive action to sanction the individuals who carried out and facilitated the lengthy wrongdoing at Fannie Mae.
Ralph Nader Robert Weissman
i. Office of Federal Housing Enterprise Oversight (OFHEO), “Report of the Special Examination of Fannie Mae,” May 2006.
ii. OFHEO, p. 53.
iii. OFHEO, p. 281.
iv. OFHEO, p. 55.
v. OFHEO, p. 56.
vi. OFHEO, p. 58.
vii. Statement of OFHEO Director James B. Lockhart III, Before the Committee on Banking, Housing and Urban Affairs, U.S. Senate, June 15, 2006.