oversight

Evaluation of FHFA's Management of Legal Fees for Indemnified Executives

Published by the Federal Housing Finance Agency, Office of Inspector General on 2012-02-22.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

          FEDERAL HOUSING FINANCE AGENCY
            OFFICE OF INSPECTOR GENERAL



              Evaluation of FHFA’s Management of
              Legal Fees for Indemnified Executives




EVALUATION REPORT: EVL-2012-002             DATED: February 22, 2012
                                       FEDERAL HOUSING FINANCE AGENCY
                                         OFFICE OF INSPECTOR GENERAL

                                                  AT A GLANCE
      Evaluation of FHFA’s Management of Legal Fees for Indemnified Executives
                                                                         .
Why FHFA-OIG Did This Evaluation                                         0What FHFA-OIG Found
The Federal National Mortgage Association (Fannie Mae) and               4FHFA confronts a challenging balance of interests. On the
the Federal Home Loan Mortgage Corporation (Freddie Mac)                  one hand, it is interested in avoiding potential losses by
(collectively, the Enterprises) have spent considerable sums to           effectively defending ongoing lawsuits against Fannie Mae
defend themselves and former senior executives in class action            and Freddie Mac. On the other hand, FHFA has an interest
lawsuits and other legal matters. Notably, in the case of three           in controlling significant costs, particularly the tens of
former Fannie Mae senior executives, between 2004 and October             millions of dollars of payments made to attorneys and others
31, 2011, the Enterprise paid out in advances $99.4 million in            involved in representing former senior executives.
legal expenses for their defense in lawsuits, investigations, and
                                                                          FHFA has some, albeit limited, tools available to curtail
administrative actions. The lawsuits, now consolidated in a single
                                                                          litigation. For example, FHFA recently issued a regulation
securities fraud case pending in the District of Columbia, allege that
                                                                          that makes shareholder claims arising out of successful class
the three executives supported questionable accounting practices
                                                                          action litigation the lowest priority in any reorganization
that produced inflated prices of Fannie Mae stock, ultimately
                                                                          of FHFA’s regulated entities, and that gives FHFA, the
resulting in substantial shareholder losses. Discovery is now
                                                                          Enterprises’ conservator, the discretion not to pay securities
complete and the case awaits trial. Further, of the $99.4 million,
                                                                          litigation claims during their conservatorships. Based on the
Fannie Mae has paid as advances $37 million since September
                                                                          new regulation, the Treasury Department’s $183 billion
2008, when it was placed into conservatorship by the Federal
                                                                          investment in the Enterprises will be accorded repayment
Housing Finance Agency (FHFA or the Agency). Freddie Mac has
                                                                          priority ahead of litigation claims. That, and the view that
paid as advances $10.2 million in legal defense costs for former
                                                                          the Enterprises will not be able to earn enough to repay
senior executives since its conservatorship commenced. FHFA,
                                                                          Treasury’s investment and emerge from conservatorships,
as the Enterprises’ conservator, has approved these payments.
                                                                          means that, for all practical purposes, it is unlikely that
More recently, on December 16, 2011, the Securities and                   Fannie Mae and Freddie Mac will ever be in a position to
Exchange Commission (SEC) filed suit in New York against six              pay litigation claims. FHFA recently made that argument
other former Fannie Mae and Freddie Mac senior executives. To             in an effort to stay the pending District of Columbia
date, the Enterprises have advanced and continue to advance the           securities fraud case. However, the effort was unsuccessful
executives’ legal expenses. Members of Congress and others have           and the regulation is now the subject of legal challenge.
questioned the level and appropriateness of the legal expense
                                                                          FHFA-OIG believes that, given the significant amounts of
payments, especially in light of the very large federal government
                                                                          taxpayer money involved and the issue’s high visibility,
investment in the Enterprises ($183 billion as of December 2011).
                                                                          FHFA must continue to scrutinize intensively the
FHFA, Fannie Mae, and Freddie Mac believe that based on
                                                                          Enterprises’ advances in order to limit costs.
applicable law the Enterprises are obliged to advance legal expenses
of former and current executives, unless there is a final
adjudication that they acted in bad faith.                                What FHFA-OIG Recommends
The FHFA Office of Inspector General (FHFA-OIG) conducted                 FHFA-OIG recommends that FHFA: (1) work to limit
this evaluation to assess FHFA’s oversight of the Enterprises’            legal expenses to the extent possible and reasonable; and
payments of legal expenses incurred by former senior executives.          (2) continue to control costs of legal expenses.

Evaluation Report: EVL-2012-002                                                                    Dated: February 22, 2012
TABLE OF CONTENTS
TABLE OF CONTENTS ................................................................................................................ 3
PREFACE ....................................................................................................................................... 4
BACKGROUND ............................................................................................................................ 6
   Overview of FHFA, the Enterprises, and the Conservatorships .............................................. 6
   Enterprise Bylaws and Indemnification Agreements with Current and Former Senior
   Executives ................................................................................................................................ 7
   Pertinent Pending Securities Litigation Involving the Enterprises and Former Senior
   Executives ................................................................................................................................ 7
   Selected Advances to Former Senior Officers....................................................................... 10
         Fannie Mae’s Advances to Three Former Officers .......................................................10
         Freddie Mac Advances ..................................................................................................11
         Fannie Mae and Freddie Mac Advances to Six Former Officers..................................11
   FHFA Rationales for Approving Legal Expenses ................................................................. 11
   Tools for Managing Legal Expenses ..................................................................................... 12
         Narrowing the Reach of Indemnification Agreements .................................................13
         Making Greater Use of Directors and Officers Insurance ............................................14
         Invoking the New FHFA Conservatorship Regulation .................................................15
         Using Cost Control Measures .......................................................................................17
FINDINGS .................................................................................................................................... 22
   1.    FHFA Confronts a Challenging Balance of Interests .................................................. 22
   2.    FHFA Has Limited Tools Available to Curtail Current Litigation Expenses .............. 22
   3.    FHFA Can Do More to Oversee Ongoing Enterprise Legal Expenses ........................ 23
CONCLUSION ............................................................................................................................. 25
RECOMMENDATIONS .............................................................................................................. 25
SCOPE AND METHODOLOGY ................................................................................................ 26
APPENDIX ................................................................................................................................... 27
         FHFA Comments on Findings and Recommendations .................................................27
ADDITIONAL INFORMATION AND COPIES ........................................................................ 29




           Federal Housing Finance Agency Office of Inspector General • EVL-2012-002 • February 22, 2012
                                                                       3
                                     Federal Housing Finance Agency

                                        Office of Inspector General

                                               Washington, DC



PREFACE
FHFA-OIG was established by the Housing and Economic Recovery Act of 2008 (HERA),1
which amended the Inspector General Act of 1978.2 FHFA-OIG is authorized to conduct audits,
evaluations, investigations, and other activities of the programs and operations of FHFA; to
recommend policies that promote economy and efficiency in the administration of such programs
and operations; and to prevent and detect fraud and abuse in them.

This evaluation is one in a series of audits, evaluations, and special reports published as part of
FHFA-OIG’s oversight responsibilities. It is intended to assess FHFA’s supervision of the
processes by which the Enterprises3 advance payments for legal services provided to current and
former senior executives. Advancing payment of legal fees gained significant attention when
Fannie Mae’s advances of legal defense costs for three former senior executives, Franklin D.
Raines, J. Timothy Howard, and Leanne G. Spencer, became the focus of a hearing before
the House Financial Services Subcommittee on February 15, 2011.4

This evaluation was led by Director of Special Projects David Z. Seide, and Investigative
Counsel Stephen P. Learned contributed to its completion. FHFA-OIG appreciates the assistance
of all those who contributed to the preparation of this report.




1
    Public Law No. 110-289.
2
    Public Law No. 95-452.
3
 On September 6, 2008, soon after HERA’s enactment, Fannie Mae and Freddie Mac entered conservatorships
overseen by FHFA, and Treasury committed to purchase preferred stock issued by the Enterprises to maintain their
solvency. As of December 14, 2011, Treasury had provided $183 billion to the Enterprises.
4
 See An Analysis of the Post-Conservatorship Legal Expenses of Fannie Mae and Freddie Mac: Hearing Before the
H. Subcomm. on Oversight and Investigations of the Comm. on Financial Services, 112th Cong., 2 (Feb. 15, 2011),
available at http://financialservices.house.gov/UploadedFiles/112-4.PDF (hereinafter House Hearing).

           Federal Housing Finance Agency Office of Inspector General • EVL-2012-002 • February 22, 2012
                                                        4
This evaluation report has been distributed to Congress, the Office of Management and Budget,
and others and will be posted on FHFA-OIG’s website, www.fhfaoig.gov.




George Grob
Deputy Inspector General for Evaluations




       Federal Housing Finance Agency Office of Inspector General • EVL-2012-002 • February 22, 2012
                                                    5
BACKGROUND
Overview of FHFA, the Enterprises, and the Conservatorships

Fannie Mae and Freddie Mac are government-sponsored enterprises that support the nation’s
housing finance system by purchasing mortgages from loan sellers, which can then use the sales
proceeds to originate additional mortgages. The Enterprises retain investment portfolios that
generally consist of whole mortgages, mortgage-backed securities (MBS) (their own and private-
label MBS), and Treasury securities.5

In September 2008, due to the Enterprises’ mounting mortgage-related losses, FHFA placed
them into conservatorships. At the same time, Treasury agreed to provide financial support to
the Enterprises to help stabilize their financial condition. As of December 31, 2011, Treasury
has invested a total of $183 billion in the Enterprises in the form of purchases of shares of senior
preferred stock.

As the Enterprises’ conservator and regulator, FHFA is responsible for preserving their assets
and minimizing taxpayer losses. FHFA has delegated day-to-day management responsibilities to
Enterprise officers and oversight to their boards of directors. However, FHFA has retained the
power to review and approve board decisions, including those that relate to legal expenses.

Before the commencement of the conservatorships, both Enterprises operated as public
companies with shares trading on the New York Stock Exchange. Since the conservatorships
began, the Enterprises have continued to operate in their same corporate form and to make
periodic financial filings with the SEC, but they are no longer listed on the New York Stock
Exchange.6




5
    Each Enterprise may hold its own MBS in its portfolio.
6
 In mid-2010, Fannie Mae and Freddie Mac shares were delisted from trading on the New York Stock Exchange;
however, their shares continue to trade publicly on the Over-the-Counter Exchange. According to FHFA’s Acting
Director:
           At the time of the conservatorship, FHFA announced that it intended for the Enterprises to operate as going
           concerns with new CEOs and Boards of Directors and that they were to continue normal business
           operations in support of the mortgage markets.
Statement of Acting Director Edward J. DeMarco, House Hearing, at 3.



           Federal Housing Finance Agency Office of Inspector General • EVL-2012-002 • February 22, 2012
                                                             6
Enterprise Bylaws and Indemnification Agreements with Current and
Former Senior Executives

Both Fannie Mae and Freddie Mac, as part of the compensation and benefits packages provided
to their officers and directors, have obligations to indemnify officers and directors under
Enterprise bylaws or individual agreements. These bylaws and agreements follow state laws that
were adopted for corporate governance purposes by the Enterprises pursuant to regulation
(Delaware for Fannie Mae, Virginia for Freddie Mac). In
                                                                 What Are Indemnification
essence, indemnification obligates the Enterprises to pay
                                                                 Agreements?
all liabilities and expenses of the officers and directors –
including legal expenses – provided the officers and             An indemnification agreement is a
                                                                 contract in which one party agrees
directors were acting within the scope of their authorities.
                                                                 to protect another party against
Moreover, the agreements obligate the Enterprises to             certain future claims or losses. In
advance the payments of legal expenses incurred during           the context of the Enterprises,
the course of legal proceedings.                                 indemnification obligates them to
                                                                             pay all liabilities and expenses –
For Freddie Mac, these obligations can be excused only if                    including legal expenses – of their
the indemnified officer or director is found to have                         officers and directors, to the extent
engaged in reckless or willful misconduct or a knowing                       not prohibited by applicable law,
violation of a criminal statute. Fannie Mae agreed that if                   Enterprise bylaws (which set rules
                                                                             for corporate operations), or by an
the officers or directors were made “a party or threatened
                                                                             indemnification agreement.
to be made a party” or called as a witness “to any                           Indemnification occurs upon a final
Proceeding,” they would be indemnified for “[e]xpenses ...                   determination that it is merited after
actually and reasonably incurred ... in connection with                      proceedings have ended. Until that
such Proceeding, if [they] acted in good faith and in a                      time, fees are only “advanced” to
manner [they] reasonably believed to be in or not opposed                    officers and directors and are
                                                                             subject to requests for repayment.
to the best interests of Fannie Mae ....”
                                                                             What Are Advances?
Pertinent Pending Securities Litigation
Involving the Enterprises and Former Senior                                  Legal fees and expenses are
                                                                             “advanced” when they are paid
Executives                                                                   prior to any final adjudication of a
                                                                             director’s or officer’s actions. A
The Enterprises, along with their former senior executives,                  final adjudication of bad faith or
have been named as defendants in a number of class action                    breach of fiduciary duty would
lawsuits alleging securities fraud and seeking billions of                   result in the obligation to repay any
dollars in damages.7 Once FHFA became conservator of                         advances made.
Fannie Mae and Freddie Mac, it intervened in these cases

7
  Class action lawsuits are brought by one or more plaintiffs on behalf of a large group of other similarly-situated
individuals and entities who share a common legal claim.

         Federal Housing Finance Agency Office of Inspector General • EVL-2012-002 • February 22, 2012
                                                           7
in its capacity as conservator.8

One significant pending multi-district case, filed against Fannie Mae in 2004 in the federal
district court for the District of Columbia, concerns conduct by the Enterprise and its former
senior officers (hereinafter District of Columbia class action). The complaint in this case alleges
that from 2000 through 2004, Fannie Mae and three former senior executives – former Chief
Executive Officer Franklin D. Raines, former Chief Financial Officer J. Timothy Howard, and
former Controller Leanne G. Spencer – engaged in practices that artificially inflated the price of
Fannie Mae’s publicly traded stock. The lawsuit’s allegations are based on a special
examination undertaken by FHFA’s predecessor agency, the Office of Federal Housing
Enterprise Oversight (OFHEO).9 In a report of its review, OFHEO found that the three former
officers knowingly manipulated earnings to maximize their bonuses, while improperly
neglecting accounting systems and internal controls and misleading the regulator and the public.

After issuing its report, OFHEO, along with the SEC, entered into settlements with Fannie Mae
on May 23, 2006. Fannie Mae’s settlement with the agencies included an agreement to pay $400
million in restitution and penalties and undertake a plan of corrective action. The Enterprise did
not admit to liability, however. In December 2006, OFHEO instituted separate administrative
actions against the three former senior executives, charging them with using improper
accounting methods designed to generate unearned bonuses.

In April 2008, OFHEO agreed to settle the administrative actions against the three former senior
executives prior to a final adjudication as to whether they had acted in bad faith.10 Under the
terms of the three stipulations and consent orders, the individuals agreed to make combined total
payments of about $31 million.11 Notably, the settlements did not include any admissions of
wrongdoing by anyone and did not address the issue of indemnification of legal expenses by
Fannie Mae. Although it is common practice for many federal government agencies to settle
civil enforcement actions without admissions of liability, the practice has recently become the
subject of substantially greater scrutiny in the aftermath of a federal district court opinion in




8
    “Intervened” refers to the legal procedure by which a third-party joins an on-going lawsuit.
9
 OFHEO issued its final report in May 2006. See Report of Special Examination of Fannie Mae (May 2006),
available at www.fhfa.gov/webfiles/747/FNMSPECIALEXAM.pdf.
10
     See below for further discussion of this issue.
11
  Raines and Howard agreed to pay $24.5 million and $6.4 million, respectively; Spencer agreed to pay $275,000.
The form of payment varied by individual, but included donations of proceeds from the sale of Fannie Mae stock,
payments to the United States, surrender and relinquishment of claims related to Fannie Mae stock options, and the
loss of other benefits.

            Federal Housing Finance Agency Office of Inspector General • EVL-2012-002 • February 22, 2012
                                                            8
November 2011. The decision in question was critical                       What Is Summary Judgment?
of the SEC entering into civil settlements without
                                                                           A summary judgment motion is a
requiring admissions of guilt.12
                                                                           request made to a judge, typically
                                                                           prior to the commencement of trial but
The District of Columbia class action commenced in
                                                                           after pre-trial discovery has been
2004, and the class was certified in 2008. FHFA                            completed, for a ruling on the merits
intervened in the case in October 2008. Discovery                          of a legal claim. It is granted only
recently concluded with 67 million pages of documents                      when a judge concludes there is no
produced and over 120 depositions taken. Motions for                       genuine dispute as to any material fact
summary judgment have been filed and briefing and                          and that the moving party is entitled to
                                                                           a judgment as a matter of law.
court submissions have been completed.13 As of
February 13, 2012, a trial date had not been set.

Fannie Mae and Freddie Mac are also the subject of a number of additional class action lawsuits
alleging securities fraud and other violations. For example, Freddie Mac and its former senior
executives have been named as defendants in class action and shareholder derivative suits filed
in Ohio and Virginia.14 And Fannie Mae, Freddie Mac, and their former officers also face
federal class action lawsuits in New York, alleging misrepresentations and omissions about the
Enterprises’ financial conditions during the period before the Enterprises entered
conservatorships.15

On December 16, 2011, after conducting a multi-year investigation, the SEC filed suit against six
former senior officers of Fannie Mae and Freddie Mac: Daniel H. Mudd, Enrico Dallavecchia,
Thomas A. Lund, Richard F. Syron, Patricia L. Cook, and Donald J. Bisenius.16 The SEC also
announced that it had entered into non-prosecution agreements with both Enterprises.17 The


12
  See SEC v. Citigroup Global Markets, Inc., 11-cv-7387 (JSR) (S.D.N.Y. Nov. 28, 2011). On December 15, 2011,
the SEC appealed the ruling.
13
     “Briefing” refers to the written legal documents provided to the judge in support of and in opposition to pleadings.
14
  Ohio Public Employees Retirement System v. Freddie Mac, Syron, et al, 4:08-cv-160 (N.D. Ohio); and In re
Freddie Mac, Derivative Litigation, 1:08-cv-773 (E.D. Va) (dismissed on procedural grounds, 2011 WL 1691998
(4th Cir., May 5, 2011)).
15
  In re Fannie Mae 2008 Securities Litigation, 08-cv-07831-PAC (MDL-No.2013); In re Fannie Mae ERISA
Litigation, 09-cv-01350-PAC (MDL No. 2013); and Kuriakose v. Freddie Mac, Syron, et al., 08-cv-7281
(S.D.N.Y.).
16
  SEC v. Daniel H. Mudd, Enrico Dallavecchia & Thomas A. Lund, 11-cv-9202 (RLC) (S.D.N.Y.);and SEC v.
Richard F. Syron, Patricia L. Cook & Donald J. Bisenius, 11-cv-9201 (RJS) (S.D.N.Y.).
17
  SEC Press Release, SEC Charges Former Fannie Mae and Freddie Mac Executives with Securities Fraud (Dec.
16, 2011), available at http://www.sec.gov/news/press/2011/2011-267.htm. Non-prosecution agreements are
agreements that the SEC enters into with parties in which the SEC agrees not to prosecute the particular party, and
the party agrees to a series of undertakings, typically including cooperation with the SEC.

            Federal Housing Finance Agency Office of Inspector General • EVL-2012-002 • February 22, 2012
                                                             9
complaints allege that the six executives misrepresented the degree to which the Enterprises were
exposed to subprime mortgages in violation of the federal securities laws.

Selected Advances to Former Senior Officers

Fannie Mae’s Advances to Three Former Officers

Between 2004 and October 31, 2011, Fannie Mae advanced $99.4 million in legal expenses to
cover the representation of Raines, Howard, and Spencer in connection with government
investigations and lawsuits stemming from accounting irregularities uncovered in 2004.
Included in that amount is $37 million that FHFA has permitted Fannie Mae to advance to the
three since the beginning of the conservatorship. Figure 1 breaks down the $99.4 million in legal
fee payments made to each executive over time.

Figure 1: Breakdown of $99.4 Million in Legal Expenses Paid on Behalf of Three Former
          Fannie Mae Executives, January 1, 2004, to October 31, 2011

     $35,000,000

     $30,000,000

     $25,000,000

     $20,000,000

     $15,000,000

     $10,000,000

      $5,000,000

             $0
                     2004      2005       2006      2007       2008      2009      2010       2011

                                       Raines       Spencer       Howard




The $99.4 million and $37 million sums do not include payments that Fannie Mae has made in
other class action lawsuits alleging misconduct on the part of other former Fannie Mae officers
who are also parties to indemnification agreements.



       Federal Housing Finance Agency Office of Inspector General • EVL-2012-002 • February 22, 2012
                                                    10
Freddie Mac Advances

From September 6, 2008, through October 31, 2011, Freddie Mac advanced approximately $10.2
million for the legal representation of its officers and directors in a variety of investigations and
lawsuits, some of which are described herein.

Fannie Mae and Freddie Mac Advances to Six Former Officers

With respect to the securities enforcement lawsuits that the SEC recently filed against three
former Fannie Mae senior officers (Mudd, Dallavecchia, and Lund) and three former Freddie
Mac senior officers (Syron, Bisenius, and Cook), to date, the Enterprises have paid the six
former executives’ legal expenses pursuant to bylaws and indemnification agreements.

FHFA Rationales for Approving Legal Expenses

From the inception of the conservatorships, FHFA has approved advances of legal expenses
incurred by directors and officers under Enterprise indemnification obligations. One rationale
articulated by the Agency as justifying its decision to approve the advances is that paying
defense costs reduces the likelihood of a successful claim against the Enterprises that could
conceivably be borne by taxpayers. Indeed, during Congressional testimony on the topic of
Fannie Mae legal expenses, FHFA’s Acting Director said:

            the defense that is being put up here is defense against a suit that, if successful,
            would presumably result in a claim against Fannie Mae, Fannie Mae in
            conservatorship being backed by the taxpayer.18

The Acting Director has also emphasized that indemnification is needed as a recruitment and
retention tool in order to attract and retain skilled officers and directors.19 Fannie Mae’s chief
executive officer echoed these sentiments in his Congressional testimony.20

18
     House Hearing, at 15.
19
  Statement of Acting Director Edward J. DeMarco, House Hearing, at 5. In his written statement, the Acting
Director said:
            At the time the Enterprises were placed into conservatorship, it was important to avoid losing
            personnel who could help reduce the costs to the taxpayer from their large portfolios and business
            activities and who could be distracted by an absence or potential absence of indemnification.
            Adding new employees to the staffs of the Enterprises would not be possible without
            indemnification.
House Hearing, at 5.
20
     The chief executive officer testified that:
            [The] obligation [to advance legal expenses] derives from Article 6 of our bylaws, which Fannie
            Mae’s shareholders adopted in 1987. It is also governed by the contracts that Fannie Mae’s Board
            Federal Housing Finance Agency Office of Inspector General • EVL-2012-002 • February 22, 2012
                                                            11
FHFA also believes that existing indemnification agreements have been written so as to make the
Enterprises contractually obligated to advance legal expenses. For example, in the District of
Columbia class action, the plaintiffs allege that Raines, Howard, and Spencer engaged in
misconduct while acting in their capacity as officers of Fannie Mae. In FHFA’s and Fannie
Mae’s view, these allegations triggered Fannie Mae’s obligation to advance legal expenses on
behalf of the former officers under their indemnification agreements. The agreements provide
that those officers are entitled to advances until a final disposition of such proceedings, including
all appeals. They believe the presumption supporting advances remains until a determination is
made that they are not entitled to indemnification, such as when they did not act in good faith or
in a manner they reasonably believed was in the Enterprise’s best interest. Notwithstanding the
seriousness of OFHEO’s allegations against the three former officers in its administrative action
in 2006, all three officers settled with OFHEO in 2008 without admissions of guilt or findings of
liability. Consequently, in light of applicable law and regulation, FHFA and Fannie Mae
determined the officers were entitled to continued advances of legal fees absent a final
adjudication that their conduct disqualified them.21

Tools for Managing Legal Expenses
Given the billions of dollars at risk in the pending class actions and the tens of millions of dollars
expended to defend the cases, both FHFA and the Enterprises have strong interests in managing
both the risks and costs. FHFA and the Enterprises possess a number of tools to manage legal
expenses. Some are common to large companies, others are not. FHFA also confronts
challenges in using some of these tools because their current or future availability is open to
question and no one tool appears to resolve the issue fully.


         has entered into with each of its officers and directors. Our Conservator affirmed these contracts
         in 2008. Where they apply, the Company’s obligation to advance legal expenses is always
         mandatory. If Fannie Mae were to refuse to honor this obligation, we would undoubtedly be sued
         and likely be subject to additional costs.
         Corporations throughout America make provisions similar to ours in order to attract and retain strong and
         experienced officers and directors.
         Since 2009, Fannie Mae has put in place a new Board of Directors and senior executive team. It would not
         have been possible for the Company to recruit and retain these professionals without offering advancement
         protections and applying them consistently.
House Hearing, at 7.
21
  Under its bylaws and Delaware law, Fannie Mae need not indemnify the officers if it is finally adjudicated that
they did not “act in good faith and in a manner [that they] reasonably believed to be in or not opposed to the best
interests of Fannie Mae.” Under such circumstances, Fannie Mae may seek to recapture legal fees already
advanced. To ensure repayment of legal fees advanced, the indemnification agreement between Fannie Mae and
indemnified officers provides that they will “reimburse such amount if it is finally determined, after all appeals by a
court of competent jurisdiction that [they are] not entitled to be indemnified against such Expenses by Fannie Mae
as provided by this Agreement ….”

         Federal Housing Finance Agency Office of Inspector General • EVL-2012-002 • February 22, 2012
                                                          12
Narrowing the Reach of Indemnification Agreements

As the conservator of Fannie Mae and Freddie Mac, FHFA is authorized by statute to reject or
repudiate contracts. FHFA made a determination at the inception of the conservatorships not to
repudiate any indemnification agreement or bylaw provision, and has not revisited the question
since that time.22 Although FHFA could have conceivably exercised this authority soon after the
conservatorships commenced (in September 2008), its availability in at least some instances
appears to be open to question as time progresses.

HERA authorizes a conservator of an Enterprise to repudiate contracts to which the Enterprise is
a party when the conservator determines, in its sole discretion, that performance of the contract is
burdensome and that disaffirmance or repudiation “will promote the orderly administration of the
affairs” of the Enterprise.23 However, HERA further requires the conservator to make a
determination “within a reasonable period” of time after being appointed as conservator.24
FHFA’s recent conservatorship rule, adopted in mid-2011 and discussed further below, defines a
reasonable period under HERA as 18 months following appointment of a conservator or
receiver.25 Given the passage of time, rejecting indemnification agreements that were operating
at the time the conservatorship commenced could present legal risks. In addition, HERA permits
parties to repudiated service contracts to sue to recover compensatory damages for work
performed prior to repudiation plus their litigation costs.26 FHFA, thus, has asserted that
repudiating indemnification obligations could potentially be costly if former officers brought
lawsuits challenging repudiation.27


22
     FHFA’s Acting Director testified about the determination at a Congressional hearing as follows:
           It was made at the time the conservatorship was established by my predecessor …. So the
           determination was made at that point, and that is not, at this point, a determination to be revisited.
House Hearing, at 8.
23
     12 U.S.C. § 4617(d)(1).
24
     12 U.S.C. § 4617(d)(2).
25
     12 C.F.R. § 1237.5(b).
26
  12 U.S.C. § 4617(d)(3) & (7). HERA contains a provision permitting the FHFA Director, under certain
conditions, to prohibit indemnification payments, although the provision does not appear to apply to this situation.
HERA’s definition of “indemnification payment” is limited to a payment or reimbursement “for any liability or legal
expense with regard to [an] administrative proceeding or civil action instituted by the Agency which results in a final
order under which such person – (i) is assessed a civil money penalty; (ii) is removed or prohibited from
participating in conduct of the affairs of the regulated entity; or (iii) is required to take any affirmative action to
correct certain conditions resulting from violations or practices, by order of the Director.” 12 U.S.C. § 4518(e)(1),
(2) & (5) (italics added). According to FHFA’s Acting Director, “[u]nder HERA, FHFA’s authority is limited to
denying indemnification in certain agency administrative actions; it does not apply to regulatory investigations of
other agencies or judicial proceedings.” See Statement of Acting Director Edward J. DeMarco, House Hearing, at 4.
27
     The Acting Director testified before Congress:

            Federal Housing Finance Agency Office of Inspector General • EVL-2012-002 • February 22, 2012
                                                             13
The Enterprises may also possess the ability to limit by contract the size and duration of future
indemnification agreements. FHFA and the Enterprises could consider limiting the scope of
future agreements by using techniques commonly employed to control costs in insurance
programs. Those techniques include:

               Capping total or specific payments at pre-determined amounts;

               Using preferred providers who agree to manage their costs;

               Pre-approving payments;

               Electing to settle FHFA enforcement proceedings only if the officer or director admits
                to liability; and

               Modifying future indemnification agreements to permit denying indemnification in
                situations that fall short of final adjudications by a court.

With regard to the last option and by way of example, Department of Justice (DOJ) regulations
allow, in certain situations, DOJ to pay for federal employees to be represented by private
counsel in legal proceedings.28 But these regulations further permit DOJ to cease payment of
private legal expenses if the Department “[d]etermines that the employee’s actions do not
reasonably appear to have been performed within the scope of his employment.”29 In other
words, DOJ does not necessarily wait to see whether an employee loses at trial and is finally
adjudicated liable before deciding whether it shall bear the costs of the employee’s defense.30

However, all of the foregoing approaches do not appear to address indemnification agreements
already in place.

Making Greater Use of Directors and Officers Insurance
It is common for large companies to secure for their directors and officers insurance policies that
sometimes include the payment of legal defense costs by the insurer. Although that option could
conceivably limit ongoing legal expenses, it is not without its costs and limitations. Further, one

           Even if action were employed ‒ under separate language on conservatorship relating to
           terminating contracts ‒ HERA provides for a party’s right to challenge in court for damages
           caused by such action. The result, therefore, would likely be more legal expenses and recovery by
           the parties of any denied advances. Such an outcome would be a direct cost to the taxpayers.
House Hearing, at 5.
28
     See 28 C.F.R. § 50.16.
29
     28 C.F.R. § 50.16(c)(2)(ii).
30
     See 28 C.F.R. § 50.15(a).

            Federal Housing Finance Agency Office of Inspector General • EVL-2012-002 • February 22, 2012
                                                          14
Enterprise has secured a type of Directors’ and Officers’ Insurance Policy (D&O) that requires
that it bear directly legal expenses.

Fannie Mae purchased limited D&O liability coverage. D&O coverage consists of three types:
A-side, B-side, and C-side. A-side provides coverage to individual executives when they are not
indemnified by the company (either because the company is legally prohibited from providing,
the company refuses to provide, or the company is incapable of providing indemnification). B-
side provides coverage for the corporation for its costs when it indemnifies a director or officer
(Freddie Mac has purchased such coverage). C-side provides coverage to the company itself for
securities claims brought against the company.

In the case of Raines, Howard, and Spencer, Fannie Mae’s D&O policy consists of A-side
coverage only. The policy provides that the insurer will pay the coverage but only when “the
Company has not indemnified and is not permitted to indemnify the Insured Persons for such
Loss.” Since Fannie Mae has advanced funds to the officers and has been, to date, not prohibited
from making such advances, it appears that this coverage has not been invoked.

In the future, FHFA could consider broadening the scope of the Enterprises’ D&O coverage. For
example, they could both procure B-side coverage, which may be available given that –
according to FHFA’s General Counsel – Freddie Mac has secured such coverage. But that step
could entail higher short-term costs in the form of higher insurance premiums. FHFA and the
Enterprises may determine that the long-term benefits in the form of savings on litigation
advances outweigh shorter-term costs.31

Invoking the New FHFA Conservatorship Regulation

FHFA recently has published a new regulation that could, if successfully implemented, end
certain litigation against the Enterprises. But the availability of the regulation is uncertain
because it is currently the subject of legal challenge.




31
  By way of example, an analogous approach that is employed by DOJ includes reimbursing employees who elect
to purchase professional liability insurance for the cost of extra premium payments. See Talking Points Regarding
Professional Liability Insurance, available at http://hr.commerce.gov/Practitioners/
EmployeeRelations/DEV01_006383.

         Federal Housing Finance Agency Office of Inspector General • EVL-2012-002 • February 22, 2012
                                                        15
On June 20, 2011, FHFA issued a final rule establishing a
framework for conservatorship and receivership                       What Are Subordinated
                                 32
operations for the Enterprises. The final rule, which                        Obligations?
became effective on July 20, 2011, provides that claims by
                                                                An obligation that is “subordinated”
current or former shareholders (including securities            is inferior to other obligations that
litigation claims) will receive the lowest priority in a        have not been subordinated. In
receivership, on par with equity shareholders, behind:          bankruptcy matters, subordinated
(1) administrative expenses of the receiver (or an              claims are typically paid only after
immediately preceding conservator); (2) other general or        non-subordinated claims have been
                                                                paid.
senior liabilities of the regulated entity; and (3) obligations
subordinated to those of general creditors. Moreover, the
final rule also provides that FHFA, as conservator, will not pay securities litigation claims
against a regulated entity during conservatorship, unless the Director of FHFA determines it is in
the interest of the conservatorship.

In other words, application of this regulation could mean that even if the plaintiffs in the pending
District of Columbia class action win and obtain a monetary judgment against Fannie Mae, in
any reorganization, such as receivership, that judgment would be subordinated to all other claims
by all other creditors. That would appear to be especially significant because one popular view
point is that the Enterprises will never earn sufficient amounts to repay current debts – which
include the $183 billion owed to Treasury – let alone future ones. That point was made by the
Acting FHFA Director in a recent speech:

           It ought to be clear to everyone at this point, given the Enterprises’ losses since
           being placed into conservatorship and the terms of the Treasury’s financial
           support agreements, that the Enterprises will not be able to earn their way back to
           a condition that allows them to emerge from conservatorship. (Emphasis
           added).33

Accordingly, if the Enterprises are unable to make any payments with respect to legacy securities
claims, there would appear to be little value in having them continue to participate in ongoing
litigation.34

32
     76 Fed. Reg. 35724 (June 20, 2011).
33
  See September 19, 2011, speech of FHFA Acting Director, at 5, available at http://www.fhfa.gov/webfiles/
22617/NCSpeech91911.pdf.
34
   FHFA recently invoked this argument, albeit unsuccessfully, when it moved for a stay of the pending District of
Columbia securities class action against Fannie Mae for the duration of FHFA’s conservatorship of Fannie Mae, or
alternatively until the suit challenging the Agency’s conservatorship regulation is resolved. In legal proceedings, a
“stay” is a court order stopping further legal action or proceedings until a future event occurs or the order is
suspended or terminated. The district court denied FHFA’s stay motion. See In re Fannie Mae Securities
Litigation, 1:04-cv-01639 (D.D.C Nov. 14, 2011).
           Federal Housing Finance Agency Office of Inspector General • EVL-2012-002 • February 22, 2012
                                                          16
On the other hand, the validity of the regulation remains an open question because on August 26,
2011, the lead plaintiffs in the District of Columbia class action filed a complaint challenging the
regulation on constitutional and statutory grounds.35 FHFA has answered the complaint
(denying the challenges), and the parties have filed summary judgment motions in the district
court.
In summary, while FHFA’s new regulation provides a possible legal avenue for ending litigation
against the Enterprises and thereby limiting further legal expenditures, its uncertain legal status
poses additional challenges for FHFA. At the same time, although the new regulation, if upheld,
may effectively remove Fannie Mae as a defendant in the District of Columbia class action
lawsuit, it will not by itself eliminate Fannie Mae’s advances and indemnification obligations to
former directors and officers. For example, the lawsuit could proceed against the individuals
named as defendants even without Fannie Mae. Such is the case with the recent SEC lawsuits
against six former executives of Fannie Mae and Freddie Mac, but not the Enterprises
themselves. The new regulation does not address the Enterprises’ obligations to indemnify the
former executives.

Using Cost Control Measures

In the absence of a definitive approach that cuts off advances of legal expenses or ends ongoing
litigation, Fannie Mae and Freddie Mac have taken steps to administer the payment of advances
and otherwise manage the costs generated by lawsuits against their indemnification-eligible
directors and officers. Although these programs have produced cost savings, FHFA has not
independently evaluated them.

           Fannie Mae’s Program

Fannie Mae has implemented a set of billing guidelines by which the law firms representing it
and its current and former employees have agreed to abide. The guidelines provide, among other
things, that:

              The billing rate for each biller is assessed by the biller’s experience level, tied to a
               particular geographic area;

              The minimum unit of billable time is one tenth of an hour (six minutes);

              Distinct tasks must be listed separately and timed individually. Block billing, in
               which tasks are aggregated, is not permitted;




35
     Ohio Public Employees Retirement System v. Federal Housing Finance Agency, 1:11-cv-01543-RJL (D.D.C.).
           Federal Housing Finance Agency Office of Inspector General • EVL-2012-002 • February 22, 2012
                                                        17
            The level of skill required to perform a task is determined by Fannie Mae’s auditing
             firm;

            Document review must be billed in one of three ways:

                  o Level 1 review: general relevance and sorting/organization;

                  o Level 2 review: issue-spotting, degree of relevance, and privilege;

                  o Level 3 review: targeted review of documents for use in deposition
                    preparation,36 production, motions, and for other purposes;

            Generally, Fannie Mae will pay for only one attorney at a deposition, status
             conference, or other hearing;37

            Fees for administrative tasks, such as technical and secretarial support, or tasks that
             employ, supervise, and evaluate the legal professionals of the firm or calculate or
             resolve billing issues, are disallowed; and

            Paralegals are expected to perform tasks commensurate with their skill level, thereby
             eliminating the need for attorneys to perform the same tasks.

Fannie Mae has retained an outside auditing firm to review advances that it makes to cover its
directors’ and officers’ legal fees (i.e., adherence to its legal fee guidelines). Fannie Mae
provided FHFA-OIG with a report that states that, during the period from March 2007 to March
2011, Fannie Mae was billed $72.7 million by the law firms representing Raines, Howard, and
Spencer. Fannie Mae’s auditing firm reviewed these bills and recommended reductions in the
amount of $12.1 million for an overall savings of 16.6% of the amount billed.38


36
  A deposition is a judicial proceeding conducted outside the presence of the presiding judge during which counsel
for a litigant may question a witness under oath in order to obtain information relevant to the litigation. See Fed. R.
Civ. P. Rules 30 and 31.
37
  If more than one attorney attends and expects to be paid, then the law firm must justify its request for an exception
to the policy. In this regard, Fannie Mae necessarily relies upon the judgment of its lawyers to approve a departure
from its guidelines.
38
  The auditing firm has performed this service for a percentage charge on the gross amount of the audited bills.
Fannie Mae’s General Counsel advised that the auditing firm reviews each invoice line by line, flags questionable
charges, and asks the submitting law firm for clarification of the highlighted items. In some cases the law firms
abandon the questioned charges that the auditing firm had flagged. In other cases the law firms are successful in
justifying the charges to the auditing firm. Sometimes the law firms are unsuccessful, and the auditing firm
recommends that their charges be disallowed or paid at lower rates. In all cases, Fannie Mae makes the final
decision. In a small percentage of cases, Fannie Mae either reinstates a charge that the auditing firm recommends
should be disallowed or reduced or – just the opposite – declines to pay the full amount that the auditing firm
approved. For a discussion of cost control guidance for a corporation faced with substantial legal fees, see ACC
         Federal Housing Finance Agency Office of Inspector General • EVL-2012-002 • February 22, 2012
                                                          18
Fannie Mae’s cost control measures also include its active participation in the defense of the
District of Columbia class action. Joint defense meetings are held at which tasks are allocated
among the lawyers to reduce inefficiencies.39 Fannie Mae also told FHFA-OIG that for the past
two years it has largely frozen the billing rates for the law firms representing its indemnified
parties.

         Freddie Mac’s Program

Like Fannie Mae, Freddie Mac has implemented a set of billing guidelines for law firms
representing its indemnified current and former employees. Under its guidelines:

            Payment is made for attorney and paralegal services and not for administrative
             services, such as secretaries, word processors, librarians, technical, or administrative
             personnel;

            The billing rate for an attorney or paralegal is determined with reference to the
             attorney’s or paralegal’s experience level and tied to a particular geographic area;

            The minimum unit of billable time is one tenth of an hour;

            Distinct tasks must be listed separately and timed individually. Block billing is not
             permitted;

            The staffing of a project is left to the discretion of the firm, but Freddie Mac requires
             each project to be handled in the most effective and efficient manner; and

            Generally, Freddie Mac will pay for only one attorney at a deposition.

Freddie Mac has required indemnification firms to reduce their hourly rates and has retained a
third party vendor to review bills submitted by such counsel, effective January 1, 2012. Freddie
Mac’s cost control measures also include joint defense agreements between Freddie Mac’s
outside attorneys and law firms retained to represent its current and former directors and officers.
For example, in at least one of the recent class action lawsuits against Freddie Mac and its
officers and directors, Freddie Mac obtained an agreement with counsel for the indemnified
parties that Freddie Mac would take the lead in drafting a motion to dismiss to avoid duplication



Value-Based Fee Primer, available at www.acc.com/advocacy/valuechallenge/toolkit/upload/acc-value-based-fee-
primer.pdf.
39
  Because Fannie Mae’s obligation to advance legal expenses of its current and former directors and officers is
owed to each such director and officer, not to a claim or class of claims, each director and officer has been provided
with separate legal counsel, presumably in order to avoid conflicts of interest. The attorneys representing Messrs.
Raines and Howard share information and coordinate activities and strategies.
         Federal Housing Finance Agency Office of Inspector General • EVL-2012-002 • February 22, 2012
                                                          19
of effort.40 Freddie Mac officials acknowledged, however, that beyond this early stage of the
proceedings, more individualized defense work is necessary and that, as cases proceed, the
Enterprise will face increasing legal fees for the indemnified defendants.

Freddie Mac’s internal legal staff, prior to 2012, screened the bills submitted by law firms
representing its indemnified parties. Freddie Mac told FHFA-OIG that, since the Enterprise was
placed in conservatorship in 2008, its in-house screening reduced advances paid on behalf of
directors and officers by approximately 3.1%.

         FHFA Oversight

FHFA can enhance its oversight to provide reasonable assurance that the legal fees advanced for
officers and directors are reasonable and supported. According to both the Government
Accountability Office (GAO) and the Office of Management and Budget (OMB), the
establishment of internal controls is essential to providing “reasonable assurance” that an
agency’s objectives are met, including “the safeguarding of assets.”41

Much guidance exists in this area for FHFA to consider. For example, DOJ has issued billing
guidelines for the Office of the United States Trustee that can be compared with the guidelines
utilized by Fannie Mae and Freddie Mac.42

On September 7, 2011, FHFA responded to a Congressional inquiry concerning its oversight of
Enterprise legal fees by noting that it maintains “weekly” contact with the Enterprises’ legal

40
  A motion to dismiss is a request made to a judge in a civil suit, typically prior to the commencement of trial and
pre-trial discovery, for a ruling on the merits of a legal claim. It is granted only when a judge concludes the civil
complaint fails to state a claim upon which relief can be granted. See Fed. R. Civ. P. 12(b)(6).
41
  See GAO, Standards for Internal Control in the Federal Government, GAO/AIMD–00.21.3.1 (Nov. 1999); and
OMB, Management’s Responsibility for Internal Control, OMB Circular No. A-123 Revised (Dec. 2004). For
recent Inspectors General reports addressing controls on legal fees paid by government agencies, see Special
Inspector General for the Troubled Asset Relief Program, Treasury’s Process for Contracting for Professional
Services under TARP (Apr. 14, 2011), available at
http://www.sigtarp.gov/reports/audit/2011/Treasury's%20Process%20for%20Contracting%20for%20Professional%
20Services%20under%20TARP%2004_14_11.pdf; and SEC Office of Inspector General, SEC’s Oversight of the
Securities Investor Protection Corporation’s Activities (Mar. 30, 2011), available at www.sec-
oig.gov/Reports/AuditsInspections/2011/495.pdf.
42
   The United States Trustee Program is a component of DOJ responsible for overseeing the administration of
bankruptcy cases and private trustees under 28 U.S.C. § 586 and 11 U.S.C. § 101 et seq. The United States Trustee
guidelines provide, in part, that: (1) time entries be kept “contemporaneously with the services rendered in time
periods of tenths of an hour;” (2) services “be noted in detail and not combined or ‘lumped’ together, with each
service showing a separate time entry;” (3) tasks “performed in a project which total a de minimis amount of time
can be combined or lumped together if they do not exceed .5 hours on a daily aggregate;” (4) “[t]ime entries for
telephone calls, letters, and other communications … give sufficient detail to identify the parties to and the nature of
the communication;” and (5) “[i]f more than one professional from the applicant firm attends a hearing or
conference, the applicant explain the need for multiple attendees.”

         Federal Housing Finance Agency Office of Inspector General • EVL-2012-002 • February 22, 2012
                                                          20
departments to remind them of the need to contain legal costs. As a result, according to the
Agency, the Enterprises:

           have taken steps including working to maintain legal fees at prior year levels,
           avoiding duplicative legal representation and assuring that reviews occur of legal
           expenses as permitted under state laws that have resulted in ongoing pressure on
           all outside counsel to restrain costs. Such reviews are permissible to determine
           whether fees are reasonable by reference to fees customarily charged, quality of
           legal representation, amount involved in litigation, time and labor required and
           novelty and complexity of questions presented.43

However, the Agency indicated that it has not provided “new guidelines at this time” because
“the issue of reasonable legal fees remains a function of what courts consider to be appropriate
and … what actions have been found to be acceptable to the courts to address reasonableness,
such as review of fees by a third party.”44 Nonetheless, the Agency agreed that it “will look at
guidance on appropriate actions that would conform to judicial standards and seek to restrain
legal expenses.”45 FHFA-OIG believes that the recommendations contained in this report
provide the Agency with models that should be considered to achieve these ends consistent with
the nature of its authorities and the business form of the Enterprises.




43
     Letter to Chairman Neugebauer from FHFA’s General Counsel, September 7, 2011.
44
     Id.
45
     Id.

           Federal Housing Finance Agency Office of Inspector General • EVL-2012-002 • February 22, 2012
                                                        21
FINDINGS
1. FHFA Confronts a Challenging Balance of Interests

In its role as conservator of Fannie Mae and Freddie Mac, FHFA has an interest in preserving
and conserving the Enterprises’ assets by avoiding potential financial and reputational losses. To
that end, it has an ongoing interest in aggressively defending ongoing lawsuits against Fannie
Mae and Freddie Mac, especially lawsuits seeking hundreds of millions or billions of dollars in
damages.

On the other hand, FHFA has a potentially competing interest in controlling significant ongoing
Enterprise costs. Without question, the tens of millions of dollars advanced to defend the three
former Fannie Mae executives are very significant expenditures that demand intensive scrutiny
by FHFA and Fannie Mae. Given the significant amounts of money involved – over $99 million
in legal expenses for three former Fannie Mae officers alone – and the issue’s high visibility,
FHFA must continue to scrutinize intensively the issue in order to limit costs.

2. FHFA Has Limited Tools Available to Curtail Current Litigation Expenses

A variety of tools are available to FHFA to curtail legal expenses. However, it appears that no
one tool is ideal, and using each tool has potential risks and costs.

      Rejecting Contracts. As conservator, FHFA could invoke HERA to disaffirm
       indemnification agreements it regards as burdensome to the Enterprises. But rejection
       has legal risks, particularly where it can be shown that FHFA did not act within a
       reasonable period of time after being appointed conservator. Moreover, under HERA the
       repudiated party has the right to sue to recover compensatory damages.

      Directors’ & Officers’ Insurance. FHFA could work with the Enterprises to seek more
       expansive forms of D&O insurance than they currently carry. But such insurance, even if
       available, may carry sufficiently high premiums to make it not cost effective. Further, it
       would not likely cover pre-existing legal claims.

      New Conservatorship Regulation. FHFA could continue to assert the argument that,
       because the Enterprises are in conservatorship and they are unlikely to fully satisfy their
       debts to Treasury, the new regulation empowers the conservator to deny payment of
       securities litigation judgments against the Enterprises; thus, the pending class action
       lawsuits are moot and should be dismissed. However, as discussed above, the regulation
       is subject to legal challenge.


       Federal Housing Finance Agency Office of Inspector General • EVL-2012-002 • February 22, 2012
                                                    22
        Capping or Requiring Pre-Approval of Legal Expenses. FHFA could exercise its
         authority as conservator and impose caps on or require pre-approval of Enterprise legal
         expenditures. But such measures could be subject to challenge.

        Seeking Admissions of Liability. Were FHFA and other government agencies to secure
         admissions of liability as conditions for settling civil enforcement proceedings, such
         admissions could be used as a basis for denying indemnification under existing
         indemnification agreements. But such admissions are yet to become common practice
         for FHFA or other agencies.

        Non-Adjudicated Denials of Indemnification. FHFA could consider including
         provisions in future indemnification agreements that allow FHFA to deny
         administratively indemnification based on determinations made short of a final
         adjudication by a court.

3. FHFA Can Do More to Oversee Ongoing Enterprise Legal Expenses

Beyond the foregoing tools, FHFA is in a position to ensure that the Enterprises are employing
uniform standards and best practices to control future legal expenses. However, FHFA relies on
Fannie Mae and Freddie Mac to administer their indemnification obligations. The Agency has
never independently validated the Enterprises’ processes for determining the reasonableness or
validity of the legal services provided on behalf of their executives or the bills presented for such
services.

To their credit, Fannie Mae and Freddie Mac have independently developed programs to
administer their indemnification agreements. Freddie Mac claims to have downwardly
“adjusted” its indemnified legal fees by 3.1%, and Fannie Mae’s legal billing contractor has
recommended reductions of approximately 16.6% of the amounts billed. The key feature of each
Enterprise’s program is its billing guidelines by which the Enterprise determines what is
reasonable. Essentially, bills that meet the requirements of the guidelines and are appropriately
justified are paid.46

The distinctions between the Enterprises’ guidelines are most notable in two of their features:
document review and representation at depositions. These features are crucial to controlling
effectively the costs occasioned by civil litigation. Most of the cost of civil litigation is
generated by the parties’ efforts to gather evidence from each other in the pretrial arena.
Evidence gathering is done primarily by the parties demanding documents from each other,

46
   Both guidelines contain similar baseline provisions and prohibitions. For example, both require law firms to bill
in six minute increments. Both guidelines also prohibit law firms from “block” billing and billing for
“administrative” services and “startup” legal time and for first or business class travel.

         Federal Housing Finance Agency Office of Inspector General • EVL-2012-002 • February 22, 2012
                                                         23
reviewing them, and then using the documents to conduct depositions of each other and third
party witnesses. Fannie Mae’s guidelines contain detailed controls on the type and amount of
services for which directors’ and officers’ lawyers may bill in connection with their reviews of
documents and attendance at depositions. Freddie Mac’s guidelines, on the other hand, are less
detailed, allowing counsel significantly wider latitude to bill for time and services in connection
with document review and depositions. For example:

          The Fannie Mae system prescribes three different tiers for billing for document
           review, depending on the nature of review, with the suggestion that the most basic
           review (general relevancy/sorting) be conducted at the paralegal level, while more
           senior counsel be utilized for things like issue spotting and deposition preparation.
           Freddie Mac’s system, by contrast, merely states that staffing is to be handled at
           minimal levels and that document review is to be conducted according to “applicable
           rules of procedure and/or customary and usual practice ….”

          Fannie Mae presumes that only one attorney will attend a deposition. In fact the
           Fannie Mae guidelines warn that if a second attorney is billed, the firm will likely be
           questioned on the matter before payment is approved. The Fannie Mae guidelines
           devote two full paragraphs to the issue. In contrast, the Freddie Mac guidelines
           address the issue in one sentence, combining “depositions,” with “hearings,”
           “arguments,” “meetings,” and “trials,” and stating (without further guidance) that
           “there may be a need [for] a ‘second chair.’”

          Both Fannie Mae and Freddie Mac specify that firms may not bill for activities
           performed by administrative staff. But only Fannie Mae specifies that paralegals may
           not be utilized for tasks typically handled by administrative staff.

Considering only the likely billing differences in document review (where Fannie Mae’s tiered
approach leaves less discretion to the biller) and depositions (where Freddie Mac is more
inclined to accept the necessity of a second chair), the anticipated cost savings realized by the
Enterprises could be significant.

FHFA-OIG notes that FHFA is now in a position to compare and contrast the Enterprises’
respective litigation management programs, to come to a conclusion about their relative
effectiveness, and to determine where changes, including uniformity, would be productive.




        Federal Housing Finance Agency Office of Inspector General • EVL-2012-002 • February 22, 2012
                                                     24
CONCLUSION
Fannie Mae and Freddie Mac have made and continue to make advances of tens of millions of
dollars to pay legal fees to defend former directors and officers in legal proceedings. The
magnitude of these advances demand intensive and on-going scrutiny by FHFA and the
Enterprises. As part of that scrutiny, FHFA needs to regularly review the tools it has available to
ensure that it is making the best decisions.

In addition, since it became their conservator, FHFA has overseen the Enterprises’
administration of their advances of fees and administration of bylaws and indemnification
agreements in a manner that could be improved. Fannie Mae and Freddie Mac have
independently developed similar, but distinct programs under which to administer their
indemnification obligations. FHFA should consider steps to ensure that the Enterprises are
employing uniform standards and best practices.

RECOMMENDATIONS
FHFA-OIG recommends that FHFA:

   1. Work to limit legal expenses to the extent possible and reasonable by:

           a. Narrowing the reach of future indemnification agreements;

           b. Considering making greater use of D&O insurance; and

           c. Continuing to invoke the new FHFA regulation establishing the primacy of claims
              in a receivership, in an effort to curtail costly litigation.

   2. Continue to control costs of legal expenses by:

           a. Identifying the best elements of Fannie Mae’s and Freddie Mac’s programs for
              administering advances and indemnification of legal expenses and developing
              standardized legal billing practices for both Enterprises; and

           b. Further developing FHFA oversight procedures.




        Federal Housing Finance Agency Office of Inspector General • EVL-2012-002 • February 22, 2012
                                                     25
SCOPE AND METHODOLOGY
Given the level of controversy associated with Fannie Mae’s advancing fees to cover the legal
expenses for its three former officers in the District of Columbia class action, FHFA-OIG
initiated this evaluation to: (1) determine the process by which FHFA’s Office of General
Counsel decided, at the time of conservatorship, to recommend that the Agency continue to
advance legal fees for the defense of the former officers; (2) identify the means by which the
Enterprise has controlled such expenses; and (3) assess FHFA’s oversight role in ensuring that
such expenses are reasonable and justified. For comparison purposes, FHFA-OIG also sought
and obtained information from Freddie Mac.

To address these issues, FHFA-OIG interviewed the General Counsels of Fannie Mae and
Freddie Mac and members of their staffs. FHFA-OIG also interviewed FHFA’s General
Counsel. In addition, FHFA-OIG examined: (1) memoranda supplied by FHFA’s Office of
General Counsel; (2) Fannie Mae’s and Freddie Mac’s billing guidelines for law firms
representing indemnified parties and other billing related documents, figures, and charts;
(3) DOJ’s United States Trustee Program’s guidelines for similar legal services in overseeing
bankruptcies; (4) indemnification agreements pertaining to Fannie Mae’s three former officers;
and (5) the pleadings, correspondence, and rulings in the securities class action lawsuit filed in
the District of Columbia.

This evaluation was conducted under the authority of the Inspector General Act and in
accordance with the Quality Standards for Inspection and Evaluation (Jan. 2011), which was
promulgated by the Council of the Inspectors General on Integrity and Efficiency. These
standards require FHFA-OIG to plan and perform an evaluation that obtains evidence sufficient
to provide reasonable bases to support the findings and recommendations made herein. FHFA-
OIG trusts that the findings and recommendations discussed in this report meet these standards.

The performance period for this evaluation was from February 2011 to November 2011.

FHFA-OIG provided FHFA an opportunity to respond to a draft report of this evaluation.
FHFA’s comments on FHFA-OIG’s draft report are reprinted in their entirety as an appendix.

FHFA-OIG appreciates the efforts of FHFA, Fannie Mae, and Freddie Mac management and
staff in providing information and access to necessary documents to accomplish this evaluation.




        Federal Housing Finance Agency Office of Inspector General • EVL-2012-002 • February 22, 2012
                                                     26
APPENDIX
FHFA Comments on Findings and Recommendations




     Federal Housing Finance Agency Office of Inspector General • EVL-2012-002 • February 22, 2012
                                                  27
Federal Housing Finance Agency Office of Inspector General • EVL-2012-002 • February 22, 2012
                                             28
ADDITIONAL INFORMATION AND COPIES


For additional copies of this report:

          Call the Office of Inspector General at: (202) 730-0880

          Fax your request to: (202) 318-0239

          Visit the OIG website at: www.fhfaoig.gov



To report alleged fraud, waste, abuse, mismanagement, or any other kind of criminal or
noncriminal misconduct relative to FHFA’s programs or operations:

          Call our Hotline at: 1-800-793-7724

          Send your complaint via facsimile to: (202) 318-0358

          E-mail us at: oighotline@fhfa.gov

          Write to us at: FHFA Office of Inspector General
                           Attn: Office of Investigation – Hotline
                           400 Seventh Street, SW
                           Washington, DC 20024




        Federal Housing Finance Agency Office of Inspector General • EVL-2012-002 • February 22, 2012
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