There is a risk in companies for the managers to engage in creative accounting. Managers face the temptation to overestimate incomes and understate expenses or costs in order to project high profits. Once they are deemed to have hit their performance targets, they know they will be given great executive bonuses and rewards. Auditors come in to assist shareholders to deal with this principle agency problem. A failure by the managers and auditors to safeguard shareholder’s wealth results to chaos. This is what occurred in the Fannie Mae mortgage investment company.
The Legal History of Fannie Mae
The Federal National Mortgage association was founded in 1938. It was a government sponsored company however it become a public trading company 29 years later. It is commonly known as Fannie Mae. The company has faced several class actions in the recent years since 2004. A class action is whereby a large group of people brings a case against the same class of defendants. It is a common occurrence in the USA. In other European countries there have been changes that allow class actions. Consumer organizations can now bring claims on behalf of large group of consumers. A class action litigation rose against the Fan Mae Company in September 22, 2004. The Office of Federal Housing Enterprise Oversight (OFHEO) had found out that the company’s senior managers had distorted the financial results intentionally. They did not apply the acceptable accounting principles. It was done in order to portray smooth earnings growth every quarter. The company’s share price plummeted to $70.7 from $ 75.7 due the public reaction to the news. The OFHEO report on the irregular accounting practices of the company stated that practices were pervasive and reinforced by management. The company officials publicly denied the OFHEO findings.
The OFHEO Report Summary
It was reported that the company projected to the public that the company was one of the low-risk companies in the world which was not true. It had lapses in its risk management, internal controls, financial reporting and corporate governance. These lapses caused the company to overstate its income and capital by over $10.6 billion. The company took a significant amount of interest rate risk without proper disclosure to the public or investors. The company also had other significant exposures in the area of operations and in terms of their reputation. The company had taken a significant amount of interest risk exposure and when the interest rate fell for the period 2002-2003, the company incurred high economic losses in billions of dollars. The company was run in a way that provided incentives for the senior managers to inflate earnings (Bebchuk and Fried, 2005) The senior managers intentionally and deliberately manipulated the account statements so that it could be seen that they had hit the earnings targets. They did this so that they could receive huge bonuses and other executive rewards at the expense of the shareholders. The compensation of the Chairman and CEO, Franklin Raines was over $ 90 million, where over $ 50 million was compensation for achieving the earnings per share targets.
The company had issues with governance. The report revealed that the board was not able to act independently of the chairman and other senior officials. The board was further unable to note and arrest unsafe and unsound company practices. The company at that time had undergone rapid growth and a change in its accounting and legal requirements.
Furthermore, the board further took no action in correcting the anomalies even in the face of the revelations of improper earnings management at Freddie Mac and other high caliber firms. Even when the OFHEC started its special examination and an employee of the company at the office of the controller made the allegations of the improper earnings management at the company, the board took no action.
The senior management negligently failed to invest in accounting systems, staff, computer systems and other tools that would have assisted the company in having a robust and efficient internal control system (OFHEO, 2006). It would also have assisted them to comply with the proper accounting and GAAP principles. The report also revealed that the senior management has attempted to interfere with the OHFEC examination of the company accounts. The company had generated a request to the Inspector General of the Department of Housing and Urban Development (HUD) to investigate how OFHEC was carrying out the company’s investigation. Furthermore the company lobbied for a reduction in the agency’s appropriations till the director had been replaced. After the examination was carried out, the OFHEC made recommendations that would assist the company to take remedial and specific actions towards ensuring or enhancing sound internal controls and reporting frameworks.
The U.S Dept of Justice and the Securities and Exchange Commission (SEC) conducted its own independent investigations into the company accounts . They found it was true that the company’s accounts were not as per the Generally Accepted Accounting principles. In Dec 15, 2004, the company was commanded to restate their earnings back to the year 2001(Jikling, 2005). The accounting statements that the company submitted in Dec, 6, 2006 were restated and showed that
the previous company earnings had reduced by $6.3 billion. The Ohio Public Retirement System and the State teachers Retirement Council filed a consolidated class action against the company on March, 4 2005. The class action was against the company and three of its senior officials, Franklin Raines, former CEO and board chairman, Leanne Spencer, former controller and the former board chairman and chief financial officer, Timothy Howard. The defendants’ motion to dismiss was dismissed by Judge Leon as he saw that the plaintiff’s complaint was justified since the company had intended to lie to investors by using the wrong accounting principles.
This was not the end. The SEC and the OFHEO filed a fraud complaint against the company. On Dec 23, 2006, the company agreed to a joint settlement with both institutions for $400 million in government penalties. The senior officials were also presented with a further action as the OFHEO intended to recoup over $100 million that had been paid as bonuses to them irregularly. The plaintiffs on Aug 14, 2006 filed an amended consolidated class action where they now included KPMG LLP and Goldman Sachs & Co (Fannie Mae Litigation, 2007). KPMG had audited the company for over 30 years while Goldman Sachs had been the underwriter and architect for the company’s real estate mortgage. The OFHEO report had implicated the two firms in the reported anomaly. The two companies filed a motion to dismiss however the Judge only agreed to the Goldman’s Sach’s motion to dismiss.
It has been a long journey for the plaintiffs throughout the court proceedings. However the case has served as a case study for the government and investors to scrutinize other financial institutions even more. A financial institution should have solid accounting frameworks and principles for its sustainability.
Bebchuk, Lucian and Fried, Jesse. “Executive Compensation at Fannie Mae: A Case Study Of
Perverse Incentives, Nonperformance Pay, And Camouflage” February, 2005. Web. 7th June, 2011. < http://lsr.nellco.org>
Jikling, Mark. “Accounting Problems at Fannie Mae”. November, 15, 2005. Web. 7th June 2011.
OFHEA. “Report of the Special Examination of Fannie Mae”. FannieMae, May, 2006. Web. 7th
Fannie Mae Litigation. “Case Background and Status”. 2007. Web. 7th June, 2011.