Free Memorandum of Contentions of Fact and Law - District Court of Federal Claims - federal

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IN THE UNITED STATES COURT OF FEDERAL CLAIMS

No.94-522C (Judge Williams) ______________________________________________________________________________ FIRST ANNAPOLIS BANCORP, INC. Plaintiff

v. THE UNITED STATES, Defendant

DEFENDANT'S CONTENTIONS OF FACT AND LAW

STUART E. SCHIFFER Deputy Assistant Attorney General JEANNE E. DAVIDSON Acting Director KENNETH M. DINTZER Assistant Director Of Counsel: TIMOTHY ABRAHAM MELINDA HART MARK PITTMAN DELISA M. SANCHEZ Trial Attorneys February 23, 2007 RICHARD B. EVANS Trial Attorney Commercial Litigation Branch Department of Justice 1100 L Street, N.W. Washington, D.C. 20530 Tele: (202) 353-7760 Fax: (202) 305-7643 Attorneys for Defendant

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TABLE OF CONTENTS Page TABLE OF AUTHORITIES . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . iv INTRODUCTION . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 CONTENTIONS OF FACT . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 I. II. III. IV. Pre Voluntary Supervisory Conversion Background . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3 First Federal's Voluntary Supervisory Conversion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5 First Federal's July 1988 Report Of Examination . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 First Federal's Viability Depended Upon Projected Profits From Its Service Corporations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10 The Service Corporation Profits Did Not Materialize As Projected And, As Expected, First Annapolis Lost Money On Its Core Operations . . . . . . . . . . . . . . . . . 12 First Annapolis Continued To Lose Money After June 1989 . . . . . . . . . . . . . . . . . . . . . . 14 Despite First Annapolis' Asset Quality Deteriorating Rapidly In 1989, It Failed To Recognize Any Credit Losses Between June 1989 And December 1989 . . . . . . . . . . 17 First Annapolis' Delinquent Loans And Their Impact On Profitability . . . . . . . . . . . . . . 18 First Annapolis' Criticized And Classified Assets Increased Substantially Between June 1989 And December 1989 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20 First Annapolis' Failure To Properly Classify Its Problem Assets Caused Its Losses To Be Understated And Its Capital To Be Overstated During The Last Six Months Of 1989 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21 The Enactment Of FIRREA . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 First Annapolis' Performance Following The Enactment Of FIRREA . . . . . . . . . . . . . . . 23 First Annapolis' January 1990 Report Of Examination . . . . . . . . . . . . . . . . . . . . . . . . . . 26

V.

VI. VII.

VIII. IX.

X.

XI. XII. XIII.

XIV. The Failure Of First Annapolis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28

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XV.

The Specific Loan Losses Identified By The Examiners In Connection With The January 16, 1990 Report Of Examination Were Unrelated To The Breach . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 A. B. C. Bayside Marina . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 31 Dennis Blaeuer Entities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33 Northhampton Office Park . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 34

XVI. The General Loan Losses Identified By The Examiners In Connection With The January 16, 1990 Report Of Examination Were Unrelated To The Breach . . . . . . . . 35 A. B. C. "Various Commercial Loans" . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 "Real Estate Owned" . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 "Various Mortgage Loans" . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36

CONTENTIONS OF LAW . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 36 I. II. The Date Of The Breach Is December 7, 1989 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 Bancorp Is Not Entitled To An Award Of Restitution . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 A. B. Restitution Is Not Proper Because The Contract Cannot Be Unwound . . . . . . . . 41 The Government's "Breach" Was Not A Total Breach Of Bancorp's Contract . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44 Allowing Bancorp Full Restitution Would Be An Unfair Windfall . . . . . . . . . . . 49

C. III. IV. V.

Bancorp Is Not Entitled To An Award Of Reliance Damages . . . . . . . . . . . . . . . . . . . . . 50 Bancorp Is Not Entitled To A Jury Verdict . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 Bancorp's Tax Gross-Up Claim Is Untenable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 A. Non-Taxable Damage Awards Are Ineligible For Tax Gross-Up Treatment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 This Court Lacks Subject Matter Jurisdiction Over Bancorp's Tax Gross-Up Claim . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57

B.

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C.

A Tax Gross-Up Award Would Constitute An Impermissible Windfall To Bancorp . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58

OBJECTIONS TO PLAINTIFF'S EXHIBIT & WITNESS LISTS . . . . . . . . . . . . . . . . . . . . . . . 59 A. B. Exhibit List . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 Witness List . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59

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TABLE OF AUTHORITIES FEDERAL CASES Admiral Fin. Corp. v. United States, 57 Fed. Cl. 418 (2003) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46 Admiral Fin. Corp. v. United States, 378 F.3d 1336 (Fed. Cir. 2004) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 44, 46, 50 Alaska Pulp Corp., Inc. v. United States, 48 Fed. Cl. 655 (2001) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46 American Capital Corp. v. United States, 63 Fed. Cl. 637 (2005) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 American Capital Corp. v. United States, 472 F.3d 859 (Fed. Cir. 2006) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51, 52 American Federal Bank, FSB v. United States, 68 Fed. Cl. 346 (2005) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 Ariadne Financial Services Pty. Ltd. v. United States, 133 F.3d 874 (Fed. Cir. 1998) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38 Assurance Co. v. United States, 813 F.2d 1202 (Fed. Cir. 1987) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 Aurigemma v. Arco Petroleum Prods., 734 F. Supp. 1025 (D. Conn. 1990) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 Bank of America, FSB v. United States, 51 Fed. Cl. 500 (2002) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38, 39 Bank of America, F.S.B. v. United States, 67 Fed. Cl. 577 (2005) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56 Bluebonnet Sav. Bank, F.S.B. v. United States, 339 F.3d 1341 (Fed. Cir. 2003) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49, 53 Bluebonnet Sav. Bank v. United States, 266 F.3d 1348 (Fed. Cir. 2001) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53, 54 Boyajian v. United States, 423 F.2d 1231 (Ct. Cl. 1970) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 -iv-

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Canfield v. Reynolds, 631 F.2d 169 (2d Cir.1980) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 Centex Corp. v. United States, 55 Fed. Cl. 381 (2003), aff'd, 395 F.3d 1283 (Fed. Cir. 2005) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57 Citizens Fed. Bank, F.S.B. v. United States, 59 Fed. Cl. 507 (2004) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57 Clark v. Commissioner, 40 B.T.A. 333 (1939) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55, 56 Columbia First Bank, F.S.B. v. United States, 60 Fed. Cl. 97 (2004) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 Commercial Fed. Bank, F.S.B. v. United States, 59 Fed. Cl. 338 (2004) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56 Dawco Construction, Inc. v. United States, 930 F.2d 872 (Fed. Cir. 1991) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53, 54 Electronic and Missile Facilities, Inc. v. United States, 416 F.2d 1345 (Ct. Cl. 1969) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37 First Annapolis Bancorp, Inc. v. United States, ­ Fed. Cl. ­, 2007 WL 314885 (Fed. Cl.) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . passim First Heights Bank, F.S.B. v. United States, 57 Fed. Cl. 162 (2003), aff'd, 422 F.3d 1311 (Fed. Cir. 2005) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57 First Nationwide Bank v. United States, 51 Fed. Cl. 762 (2002) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41, 43 Flora v. United States, 357 U.S. 63 (1958) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 Freeman v. Commissioner, 33 T.C. 323 (1959) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55, 56 Glendale Federal Bank, F.S.B. v. United States, 239 F.3d 1374 (Fed. Cir. 2001) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41, 52

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Glendale Fed. Bank, F.S.B. v. United States, 378 F.3d 1308 (Fed. Cir. 2004) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 Hansen Bancorp, Inc. v. United States, 53 Fed. Cl. 92 (2002) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 46 Hansen Bancorp, Inc. v. United States, 67 Fed. Cl. 411 (2005) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37, 44 Hansen Bancorp, Inc. v. United States, 367 F.3d 1297 (Fed. Cir. 2004) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . passim Home Sav. of Am., F.S.B. v. United States, 399 F.3d 1341 (Fed. Cir. 2005) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56 Hort v. Comm'r of Internal Revenue, 313 U.S. 28 (1941) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 Hughes Comm. Galaxy, Inc. v. United States, 271 F.3d 1060 (Fed. Cir. 2001) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52 LaSalle Talman Bank, F.S.B. v. United States, 45 Fed. Cl. 64 (1999) rev'd on other grounds, 317 F.3d 1363 (Fed. Cir. 2003) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41 LaSalle Talman Bank, F.S.B. v. United States, 317 F.3d 1363 (Fed. Cir. 2003) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 42, 49 LaSalle Talman Bank, F.S.B. v. United States, 462 F.3d 1331 (Fed. Cir. 2006) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56 Landmark Land Co., Inc. v. United States, 256 F.3d 1365 (Fed. Cir. 2001) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52 Local Oklahoma Bank, N.A. v. United States, 59 Fed. Cl. 713 (2005), aff'd, 452 F.3d 1371 (Fed. Cir. 2006) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57 Mobil Oil Exploration and Producing Southeast, Inc. v. United States, 530 U.S. 604 (2000) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45, 46 Mola Development Corp. v. United States, 74 Fed. Cl. 528 (2006) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37, 38, 40

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Myerle v. United States, 33 Ct. Cl. 1 (1897) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57 Nat'l Controls Corp. v. Nat'l Semiconductor Corp., 833 F.2d 491 (3d Cir. 1987) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52 Old Stone Corp. v. United States, 450 F.3d 1360 (Fed. Cir. 2006) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51, 52, 53 Petrofsky v. United States, 488 F.2d 1394 (Ct. Cl. 1973) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 Plaintiffs in Winstar-Related Cases v. United States, 37 Fed. Cl. 174 (1997) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37, 38, 39 Raytheon Prod. Corp. v. Comm'r, 144 F.2d 110 (1st Cir. 1944) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 54 Reflectone, Inc. v. Dalton, 60 F.3d 1572 (Fed. Cir. 1995) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 53 Shore v. United States, 9 F.3d 1524 (Fed. Cir. 1993) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 Southern Pac. Co. v. Darnell-Taenzer Lumber Co., 245 U.S. 531 (1918) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 57 Southwest Investment Co. v. United States, 63 Fed. Cl. 182 (2004) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45, 46 Stone Forest Indus., Inc. v. United States, 973 F.2d 1548 (Fed. Cir. 1992) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 United States v. Gotcher, 401 F.2d 118 (5th Cir. 1968) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55, 56 United States v. Winstar Corp., 518 U.S. 839 (1996) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 Westfed Holdings, Inc. v. United States, 407 F.3d 1352 (Fed. Cir. 2005) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51 Yankee Atomic Elec. Co. v. United States, 112 F.3d 1569 (Fed. Cir. 1997) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58

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STATE CASES Bernstein v. Nemeyer, 570 A.2d 164 (Conn. 1990) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 FEDERAL STATUTES 12 U.S.C. §§ 1463-1464 (1989) Financial Institutions Recovery, Reform and Enforcement Act of 1989, Pub.L. No. 101-73, 103 Stat. 183 ("FIRREA") . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . passim 12 U.S.C. § 1464(t)(2)(A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 12 U.S.C. § 1464(t)(2)(B) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 12 U.S.C. § 1464(t)(2)(C) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 12 U.S.C. § 1464(t)(3)(A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 12 U.S.C. § 1464(t)(9)(A) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 12 U.S.C. § 1464(t)(9)(C) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 12 U.S.C.A. § 1818(e)(7)(A) (FDIA § 8(e)(7)(A)) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30 26 U.S.C. § 61 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 26 U.S.C. § 118(a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55 26 U.S.C. § 6103 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 59 28 U.S.C. § 1491 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58 FEDERAL RULES AND REGULATIONS 12 C.F.R. § 561.13 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7 12 C.F.R. § 561.16c(d)(3) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8 12 C.F.R. § 563.13 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4 12 C.F.R. § 563b.24(b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11 12 C.F.R. § 563b.26(b)(2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6, 11

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12 C.F.R. § 567.2(a)(1)-(b) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 12 C.F.R. § 567.5(a)(1),(2) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 12 C.F.R. § 567.6 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 12 C.F.R. § 567.8 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23 12 C.F.R. § 567.9(a) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 22 54 Fed. Reg. 46,845 (11/8/89) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40 RCFC App. A . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1 Rev. Rul. 81-277, 1981 WL 165965 (IRS RRU) (1981) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 56 MISCELLANEOUS John D. Calamari & Joseph M. Perillo, The Law of Contracts, § 15.4 (4th ed. 1998) . . . . . . . . 41 5 Arthur Linton Corbin, Corbin on Contracts §1102, at 548 (1964) . . . . . . . . . . . . . . . . . . . . . . 41 3 Dan B. Dobbs, Law of Remedies §12.7(5) (2d ed. 1993) . . . . . . . . . . . . . . . . . . . . . . . . . . . 50 3 E. Allan Farnsworth, Farnsworth On Contracts, §12.1 at 151 (2d ed. 1998) . . . . . . . . . . . . . . 52 3 E. Allan Farnsworth, Farnsworth On Contracts, 193 (2d ed. 1998) . . . . . . . . . . . . . . . . . . . . . 49 Restatement (Second) of Contracts §241, cmt. a (1981) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 Restatement (Second) of Contracts §241, cmt. d (1981) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 Restatement (Second) of Contracts §243(4) (1981) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45 Restatement (Second) of Contracts §344(b) (1981) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 51, 52 Restatement (Second) of Contracts §351 (1981) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 52 Restatement (Second) of Contracts §373 (1981) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43, 44 Restatement (Second) of Contracts §384 (1981) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 43 Restatement (Second) of Contracts §384, cmt. a (1981) . . . . . . . . . . . . . . . . . . . . . . . . . . . 41, 43

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IN THE UNITED STATES COURT OF FEDERAL CLAIMS FIRST ANNAPOLIS BANCORP, INC., Plaintiff, v. THE UNITED STATES, Defendant. ) ) ) ) ) ) ) ) )

No. 94-522C (Judge Williams)

DEFENDANT'S CONTENTIONS OF FACT AND LAW Pursuant to Appendix A of the Rules of the United States Court of Federal Claims ("RCFC") and the Court's February 7, 2007 order, defendant, the United States, respectfully submits its memorandum of contentions of fact and law. INTRODUCTION On January 31, 2007, the Court found that a contract was created between plaintiff, First Annapolis Bancorp, Inc. ("Bancorp"), and the Government in conjunction with Bancorp's acquisition and conversion of First Federal Savings and Loan Association of Annapolis ("First Federal") on August 13, 1988. First Annapolis Bancorp, Inc. v. United States, ­ Fed. Cl. ­ , 2007 WL 314885 (Fed. Cl.) at 2 ("Liability Opinion"). The Court further held that certain provisions of the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 ("FIRREA") breached that contract in December 1989. Id. at 23.1 The principal issues to be

Significantly, the breach was not the enactment or implementation of FIRREA, Pub. L. No. 101-73, 103 Stat. 183, codified, in relevant part, at 12 U.S.C. §§ 1463-1464 (1989), but only those provisions of FIRREA which contrasted with the terms of the contract. Indeed, recognizing this distinction, the Court found that Bancorp failed to prove that the enactment of FIRREA breached the forbearance regarding investments in service corporations. First Annapolis, Slip Op. at 23 n.18. In fact, the terms of the contract shifted the risk of regulatory change regarding investments in service corporations to Bancorp. See PX 3 at 2 ("In the event any regulation or statute referred to herein is amended or succeeded by another statute,

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decided by the Court during the March 2007 trial are whether Bancorp is entitled to either restitution or reliance damages, and, if a recovery is appropriate, whether it is entitled to a tax gross-up.2 The evidence at trial will establish that Bancorp cannot sustain its burden of proving that it was damaged as a result of the breach. Bancorp claims $13,665,907 in restitution. Bancorp is not entitled to restitution for three reasons: (1) it is impossible to unwind the contract and restore the parties to their pre-contract positions; (2) Bancorp cannot prove that the Government's "breach" (the alleged failure to honor the forbearances) was a total or material breach; and (3) awarding Bancorp $13,665,907 would result in an unfair windfall, making the Government bear the downside risk of Bancorp's investment. On January 16, 2007, in its initial Appendix A filing, Bancorp, for the first time in this litigation, alleged an additional theory for reliance damages in the amount $14,165,874, and a tax-gross up of any recovery, which it has since quantified as "at least $5,470,000 in additional damages." Pl. Br. filed Feb. 1, 2007. Bancorp cannot prove that its alleged reliance damages were proximately caused by the breach or that they were foreseeable. In addition, Bancorp has provided no evidence to support its new claim for $499,967, the balance of the capital it raised in

regulation or rule, then any reference to any such regulation or statute shall be deemed to refer to such regulation or statute as amended or the statute, regulation or rule which succeeds any such regulation or statute."). Bancorp has abandoned its previous damage claims for lost profits, hypothetical cost of replacement, and Fifth Amendment takings by representations to the Court and to counsel. We respectfully request that the Court issue an order acknowledging the abandonment of these damages claims so we may narrow our trial preparation, and for completeness of the record. In addition, the Court should order Bancorp to amend its witness lists to conform to its revised contentions of fact and law so the scope of its witnesses' testimony is properly limited. -22

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1988, which it alleges it spent performing the contract with the Government. Furthermore, Bancorp is not entitled to a tax gross-up of any kind because: (1) this Court lacks subject matter jurisdiction to entertain such a claim; (2) any award would not be taxable; and (3) any such award would be a windfall. CONTENTIONS OF FACT I. Pre Voluntary Supervisory Conversion Background 1. First Federal Savings and Loan Association of Annapolis ("First Federal") was

originally organized in 1903, and joined the Federal Home Loan Bank ("FHLB") System in 1933. JX 89 at 0079. 2. By the 1980s, First Federal's primary business was "attracting deposits from the

general public through its 25 full-service branch offices in Maryland and making adjustable-rate mortgage loans (`ARMs') secured by first mortgage liens on residential and commercial property, including construction loans." JX 89 at 0124. 3. In addition, through its five wholly-owned subsidiary service corporations and

one affiliated company, First Federal offered mortgage banking and discount brokerage services; engaged in joint ventures with local developers, contractors, and investors involving the development of land for residential and commercial uses and construction of homes and commercial structures; operated an insurance agency; performed title and closing work for residential and commercial customers; and financed mobile homes. JX 89 at 0125. 4. Delta Financial Corporation, Inc. ("Delta") was First Federal's "principal

subsidiary" and was "engaged in investing in the acquisition, development, and construction of residential and commercial real estate. As of March 31, 1988, Delta was a partner or co-venturer

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in 26 acquisition and development projects with real estate developers, builders and contractors." Delta provided "a portion of the acquisition, development and construction funds to such projects as a lender, advancing monies to the partnership or joint venture to fund acquisition and development expenses as required." JX 89 at 0080. 5. As with most other thrifts, First Federal experienced losses beginning in the early

1980s. Indeed, First Federal reported net losses for each fiscal year beginning with the fiscal year ending September 30, 1981. By March 31, 1988, First Federal had a deficit in retained earnings of approximately $68.0 million. JX 89 at 0070. 6. Additionally, in 1986, First Federal suffered losses of more than $35 million from

a failed hedging strategy. First Federal elected to defer recognition of most of these losses. By letter dated May 18, 1987, the FHLBB informed First Federal that it had concluded its review with respect to the 1986 hedge program and that losses of $16,865,702 were required to be recognized immediately. DX 2045 at 1142-1143. 7. The FHLBB further informed First Federal that, upon recognition of these losses,

"First Federal's regulatory capital will fall significantly below the minimum level of regulatory capital required by Insurance Regulation 563.13 . . . It is therefore imperative that the board of directors develop a timely and viable plan for the infusion of new capital into the institution." DX 2045 at 1143. 8. Accordingly, on July 5, 1987, First Federal entered into a Supervisory Agreement

with the FHLBB. This Supervisory Agreement was in response to significant losses First Federal had incurred in connection with its hedging program, First Federal's actions in improperly accounting for these losses, and First Federal's excessive investments in service

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corporations. The Supervisory Agreement severely restricted First Federal's ability to (1) engage in interest rate futures or financial options, and (2) to invest in service corporations. DX 20, DX 100. II. First Federal's Voluntary Supervisory Conversion 9. In response to the FHLBB's direction to First Federal to produce a plan for the

immediate infusion of new capital, the thrift's board of directors began considering a plan for First Federal's voluntary supervisory conversion. JX 5 at 1054. 10. By letter dated June 5, 1987, First Federal informed the FHLBB that it was

"proceeding to effect a supervisory conversion as expeditiously as possible." DX 9 at 2603. 11. Shortly thereafter, Bancorp was formed for the purpose of becoming a savings

and loan holding company and acquiring First Federal in connection with its voluntary supervisory conversion. JX 89 at 0064. 12. On November 5, 1987, Bancorp submitted its holding company application and

debt application to the FHLBB, and First Federal submitted its application for voluntary supervisory conversion to the FHLBB. DX 50; JX 83. 13. After a series of amendments, the FHLBB deemed First Federal's conversion

application complete on February 26, 1988. DX 95. 14. On July 21, 1988 the FHLBB issued resolutions 88-602 and 88-603 approving (1)

the voluntary supervisory conversion of First Federal from a federally-chartered mutual savings and loan association to a federally-chartered stock savings bank, known as First Annapolis, and (2) Bancorp's acquisition of First Annapolis. JX 92; JX 93.

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15.

FHLBB resolution number 88-603 required that: "On the date of consummation

of the acquisition, merger and conversion, [Bancorp] shall make a capital contribution to [First Annapolis] through the purchase of common stock in a minimum amount equal to the greater of $11 million or an amount sufficient to raise the net worth of [First Annapolis] to 1% of total liabilities on a GAAP basis as specified in 12 C.F.R. Part 563b.26(b)(2)." JX 93 at 0103. 16. According to 12 C.F.R. §563b.26(b)(2): "As part of the plan of conversion the

prospective acquirer shall (i) infuse sufficient capital at the conversion to enable the institution to achieve a ratio of net worth to total liabilities, computed on the basis of generally accepted accounting principles of at least one percent (1%) of total liabilities and (ii) agree in writing with the Corporation that the acquirer will infuse additional capital as necessary to enable the institution to increase its regulatory capital on a scheduled basis in order to comply with the Board's regulatory capital requirements in effect from time to time within five years of the date of conversion, and agree that upon failure to achieve scheduled regulatory capital levels on or before the due date or to adhere in all material aspects to the business plan submitted as part of the supervisory conversion application, the acquirer shall be subject to such sanction as the Board, in connection with its approval of the supervisory conversion application, directs to be included in the written agreement . . ." (emphasis added). 17. On July 21, 1988, the FHLBB sent a letter ("Forbearance Letter") to First

Annapolis outlining the regulatory forbearances granted in connection with First Federal's voluntary supervisory conversion into First Annapolis and Bancorp's simultaneous acquisition of First Annapolis. JX 91

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18.

By letter dated August 5, 1988, the FHLBB informed First Federal that "it [was]

First Annapolis' obligation to increase its regulatory capital in order to achieve each annual benchmark and to achieve the regulatory capital amount specified (in the Business Plan) at the end of the fifth year." The FHLBB further informed First Federal that First Annapolis would be subject to any successor regulations that may be in effect after the initial five years following the conversion. JX 94 at 0984-5. 19. On August 12, 1988, Bancorp and the Federal Savings and Loan Insurance

Corporation ("FSLIC") entered into the Regulatory Capital Maintenance/Dividend Agreement ("RCMDA"), which defined First Annapolis' Regulatory Capital Requirement as "capital increased on a scheduled basis for five years as set forth in the Business Plan of the Plan of Conversion, and, thereafter, at any given time, thereafter, computed in accordance with 12 C.F.R. § 561.13, or any successor regulation thereto." JX 99 at 1446. 20. First Federal's Revised Regulatory Business Plan set forth its capital benchmarks

for the first 3 years after its conversion at 1.8%, 2.1%, and 2.4% percent of liabilities, respectively. JX 134 at 0521. 21. Pursuant to section II.A of the RCMDA: "As long as [Bancorp] controls the New

Institution, [Bancorp] will cause the Regulatory Capital of the New Institution to be maintained at a level at or above the Regulatory Capital Requirement and as necessary, will infuse sufficient additional capital, in a form satisfactory to the Supervisory Agent, to effect compliance with such requirement and cure a Regulatory Capital Deficiency during the first quarter after which the New Institution fails to meet its Regulatory Capital Requirement." JX 99 at 1447.

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22.

On August 13, 1988, the conversion became effective and First Annapolis opened

for business. The purchase method of accounting was used to record the voluntary supervision conversion. Under the purchase method of accounting, all assets and liabilities acquired were adjusted to fair value as of the acquisition date. "The cost in excess of net assets acquired (goodwill) resulting from the valuation [of assets and liabilities] amounted to approximately $65 million and [in accordance with generally accepted accounting principles] is being amortized over 15 years using the straight-line method." JX 3 at 0834. III. First Federal's July 1988 Report Of Examination 23. At the time of First Federal's stock conversion, the FHLB of Atlanta was

conducting a regular examination of First Federal. The examination had commenced on July 11, 1988, and concluded on August 19, 1988 ("July 1988 ROE"). DX 118 at 0002. 24. According to the July 1988 ROE, the examiners' review of 18 major loans

totaling $49.7 million disclosed consistent underwriting and construction loan disbursement deficiencies which contributed to criticized assets totaling $43.8 million as of April 30, 1988. DX 118 at 0023. The examiners' also noted that First Federal's underwriting and disbursement deficiencies indicated "imprudent lending practices." DX 118 at 0025. 25. The examination revealed that, between March 31, 1988 and April 30, 1988, First

Federal's level of classified assets increased by more than $12 million; however, its level of general valuation allowances remained the same. DX 118 at 0031. Consequently, the July 1988 ROE explained that: "Given the level of substandard and doubtful assets, the present level of general valuation allowances is inadequate and, thus, the association is in violation of section 561.16c(d)(3) of the insurance regulations." DX 118 at 0031.

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26.

The July 1988 ROE noted that First Federal's recent poor operating performance

was a "result of a severely mismatched asset/liability structure, large losses from hedging activities, and losses from service corporations." DX 118 at 0034. 27. According to the July 1988 ROE, the five service corporations (or subsidiaries) of

First Federal had combined losses of $1.0 million and $599,179 for the year ending December 31, 1987, and the six months ending June 30, 1988, respectively. The total subsidiary losses for these periods were attributable to Delta. DX 118 at 0034-35. 28. The July 1988 ROE also noted that First Federal "is substantially dependent upon

service corporation, fee, and other sources of income to overcome the earnings deficit inherent in the balance sheet." DX 118 at 0036. 29. At the conclusion of the July 11, 1988 ROE, regulators assigned First Federal a

composite rating of 4, which would normally have subjected First Federal to RD 3a. DX 392 at 0537. However, according to the December 31, 1989 regulatory plan, the regulators agreed to waive RB 3a because First Annapolis was operating under a capital forbearance agreement. 30. By letter dated December 28, 1988, the FHLBB forwarded a copy of the July 11,

1988, report of examination to the board of directors at First Annapolis. DX 267 at 0111. 31. The July 11, 1988 ROE highlighted "First Annapolis' present weak overall

financial condition, which continues to be aggravated by regulatory violations and operating deficiencies. The volume and nature of supervisory concerns reflect unfavorably upon the overall administration of the institution and pose a risk to First Annapolis' long-term viability." DX 267 at 0112.

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32.

Additionally, the FHLBB "strongly suggest[ed] that the board perform an internal

assessment of itself, the institution's management team and the current organizational structure, and determine the capability of existing resources to successfully implement the recapitalization plan and restore the institution to a satisfactory condition." DX 267 at 0112. IV. First Federal's Viability Depended Upon Projected Profits From Its Service Corporations 33. In connection with the conversion, First Annapolis prepared a business plan,

which Bancorp included with its holding company application. JX 87 at 0514-0653; JX 134. First Federal's Board of Directors approved this business plan on October 21, 1987, and titled the document the "Revised Regulatory Business Plan." JX 134 at 0515. 34. The Revised Regulatory Business Plan projected total net income of $12.6

million over the three years ending December 1990. JX 134 at I-5 and 0516. However, over this same three-year period, income from service corporations was projected to total $16.7 million or 133 percent of projected net income.3 JX 134 at I-5; DX 118 at 0030. 35. In other words, while First Annapolis projected that it would lose approximately

$4.1 million on its core operations, those losses would be offset by the anticipated profits from the service corporations. DX 69 at 0403. Thus, the "viability of [First Annapolis] would only be possible with the income generated from the service corporations." DX 634 at ¶10; DX 2074 at 0758.

Profits from Delta were expected to account for nearly $14 million of the $16.7 million in service corporation profits. JX 134 at 48. Between fiscal year ending September 30, 1982 and fiscal year ending June 30, 1988, Delta's cumulative net income totaled $1,896,481. DX 2007 at 2005, DX 2012 at 0013, DX 2027 at 0449, DX 2050 at 0026, DX 2136 at 2099. -10-

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36.

While the regulators' February 1988 "analysis demonstrate[d] that the $11 million

capital infusion combined with the successful implementation of the proposed business plan satisfie[d] the viability criteria of Sections 563b.24(b) and 563b.26(b)(2)" (DX 69 at 0403), the regulators also recognized that the "income generated through service corporation activity [was] crucial to the viability of the converted institution." DX 69 at 0405. 37. In a July 15, 1988 letter from the FHLBB to First Federal, the regulators again

recognized that "the profitability of First Federal, as indicated in the institution's business plan, is dependent upon income generated by the service corporation . . . ." By then, however, the regulators had become "concerned that the institution's investment in such projects continues to increase while projected profit decreases." DX 2457 at 0152. 38. By letter dated July 25, 1988, First Federal responded to the concerns expressed

by the FHLBB in its July 15, 1988 letter. DX 2458. First Federal "wish[ed] to assure [the FHLB-Atlanta] that the projected profits [from service corporation investments] as shown on Exhibit A will be accomplished. A majority of the projects have existing contracts of sale, which justify the conservative projections. As you are aware, these projects have been reviewed by Deloitte, Haskins & Sells, Akin Gump, Dickstein, Shapiro & Morin, The National Bank of Washington and are presently being reviewed by your examiners. The viability or value assigned to any project has not been questioned by any of these groups." DX 2458 at 0334. 39. In connection with the July 1988 ROE, the examiners reviewed 10 of First

Federal's service corporations' 38 joint ventures. The examiners' "review did not reveal material weaknesses with management's assumptions upon which the total profit projections were based. However, this review disclosed that some projected profits may be realized later

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than originally estimated." DX 118 at 0035. The examiners also, prophetically, noted that "considering the speculative nature of these real estate ventures, any change in market conditions can have a substantial negative impact on profits booked." DX 118 at 0035 (emphasis added). 40. After the voluntary supervisory conversion was completed, First Annapolis

prepared a revised business plan dated January 5, 1989 ("January 1989 Business Plan"), which was approved at the October 26, 1988 meeting of First Annapolis' Board of Directors. JX 135 at 0868 and 0870. 41. The January 1989 Business Plan projected total net income for the three-year

period ending September 1991 of $8.51 million. JX 135 at 0882 and 0872. 42. The ability to generate the $8.51 million in total net income, however, was - once

again - dependent upon the service corporations realizing profits of $15 million. JX 135 at 0875, 0882. Thus, just like the October 1987 Revised Regulatory Business Plan, the January 1989 Business Plan projected losses from core operations that would be offset by profits from service corporation investments. 43. Therefore, the plan concluded "continued forbearance for the savings bank on

overinvestment in subsidiaries [was] crucial for maintaining a viable institution." JX 135 at 0875. V. The Service Corporation Profits Did Not Materialize As Projected And, As Expected, First Annapolis Lost Money On Its Core Operations 44. As projected, First Annapolis lost money on its core operations ­ albeit

substantially more than expected. The service corporation profits, moreover, did not materialize in the amounts hoped for and they were not sufficient to offset the higher-than-projected losses that First Annapolis realized from its core operations. -12-

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45.

During the nine-month period ending June 1989, while First Annapolis projected

losses (before goodwill amortization and extraordinary items) of nearly $1.5 million on its core operations, its actual losses totaled approximately $4.2 million. DX 2120 at 1550, 0704, and 0486. 46. Furthermore, while First Annapolis projected income from its service

corporations of $3.3 million during this same nine-month period, its actual income was less than $1.9 million. DX 2120 at 1550, 0704, and 0486. 47. The combination of higher than expected losses from operations and lower than

expected profits from service corporation investments resulted in First Annapolis realizing an actual loss (before goodwill amortization and extraordinary items) of nearly $2.4 million versus a projected profit of nearly $1.9 million ­ a difference of approximately $4.3 million in just nine months. DX 2120 at 1550, 0704, and 0486. 48. According to the January 1989 Business Plan, as of September 1988, First

Annapolis' regulatory capital to total liabilities ratio was 2.31 percent. JX 135 at 0879. The January 1989 Business Plan also projected that by June 1989 First Annapolis' regulatory capital to total liabilities ratio would be 2.42 percent. JX 135 at 0889 and 0879. 49. In addition, First Annapolis' January 1989 Business Plan projected that, as of

June 1989, not only would First Annapolis exceed its June 1989 benchmark requirement, but it would also exceed its June 1990 and June 1991 requirements. JX 135 at 0889. 50. First Annapolis' actual regulatory capital to total liabilities ratio as of June 1989

was 1.99 percent, which was substantially less than the 2.42 percent ratio that First Annapolis

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projected just six months earlier.4 Furthermore, First Annapolis' actual June 1989 regulatory capital ratio did not exceed the June 1990 and June 1991 benchmarks, as projected in the January 1989 Business Plan. 51. Since First Annapolis did not meet its June 1990 and June 1991 regulatory capital

benchmarks as of June 1989, as projected, First Annapolis would either have to shrink, raise capital or become profitable ­ something it had not done since prior to fiscal year 1981 ­ in order to meet its future benchmarks. JX 89 at 0070. 52. Further, unless First Annapolis was able to stop generating losses ­ again, a feat it

had not accomplished since prior to fiscal year 1981 ­ it would soon fail to meet its 1.80 percent regulatory capital benchmark requirement. 53. In fact, the only thing that could save First Annapolis from failure would be if it

were somehow able to generate profits and avoid having to recognize substantial credit losses due to a deterioration in asset quality. First Annapolis was unable to do either. VI. First Annapolis Continued To Lose Money After June 1989 54. First Annapolis continued to lose money after June 1989, just as it had done in

each fiscal year since 1981. JX 89 at 0070. For example, during the quarter ended September 1989, while First Annapolis projected total net income of over $1.2 million, it actually lost approximately $84,415. DX 2120 at 0129.

This ratio was calculated by dividing the regulatory capital of $15.1 million by the total liabilities of $760.4 million. JX 3 at 0824, 0846. -14-

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55.

Due to its losses, by September 30, 1989, First Annapolis' regulatory capital

(including all of the goodwill) to total liabilities ratio had fallen to 1.88 percent and only exceeded its 1.80 percent regulatory capital requirement by $582,494.5 DX 365 at 1422. 56. During the month of October 1989, First Annapolis reported a loss on core

operations of $1.2 million, a loss on service corporations of $43,896, and a total loss of $1.3 million. Much of the loss on core operations can be traced to a significant shortfall between projected and actual net interest income and a significant overage between projected and actual non-interest expense. JX 58 at 1543-44. 57. As discussed in more detail below, despite rapidly deteriorating asset quality, the

$1.2 million loss from core operations was not the result of First Annapolis recognizing credit losses. In fact, during October 1989, First Annapolis actually recorded "negative" loan loss provisions, which increased earnings and decreased loan loss reserves.6 JX 58 at 1543. 58. As a result of the loss it experienced in October 1989, First Annapolis' regulatory

capital (including all the goodwill) to total liabilities ratio had fallen to 1.77 percent as of October 31, 1989. Thus, as of the end of October 1989, First Annapolis failed to meet its 1.80 percent regulatory capital requirement. JX 58 at 1545. 59. This negative trend in financial results continued in November and December

1989. More specifically, First Annapolis lost nearly $1.2 million in November 1989, and nearly

As discussed in more detail in Section VII, First Annapolis only met its regulatory capital benchmark as of September 1989 because it failed to recognize credit losses despite the significant decline in asset quality that had occurred since June 1989. In fact, during the four-month period ending October 1989, First Annapolis recorded "negative" loan loss provisions of $599,685. JX 58 at 1543. -156

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$1.1 million in December 1989. These losses were due to a combination of continued losses on core operations and minimal profits from service corporations. JX 61 at 1643. 60. Once again, the losses realized in November and December 1989, were not due to

First Annapolis recording significant credit losses. JX 61 at 1642. Instead, these results were exactly what First Annapolis had projected, losses from core operations ­ and what the regulators were concerned about ­ service corporation profits not meeting expectations. DX 118 at 0035; DX 2457 at 0152. 61. By November 1989 and December 1989, First Annapolis' regulatory capital

(including all of the goodwill) to total liabilities ratio had fallen to 1.65 percent and 1.55 percent, respectively. Therefore, as of November 1989 and December 1989, First Annapolis failed to meet its 1.80 percent regulatory capital benchmark ratio by approximately $1.1 million and $1.9 million, respectively. DX 2294 at 1612; JX 61 at 1645. 62. First Annapolis faired no better during the first four months of calendar 1990.

More specifically, in January 1990, it reported a net loss of nearly $1.1 million, which ­ as expected ­ was due to significant net losses from core operations. JX 65 at 1730. 63. Due to this latest loss, First Annapolis' regulatory capital (including all goodwill)

to total liabilities ratio equaled 1.38 percent, which resulted in a regulatory capital shortfall of over $3 million versus the 1.80 percent benchmark requirement. JX 62 at 1672. 64. In February 1990, First Annapolis recorded a net loss of $13.3 million. JX 65 at

1730. This loss was due in large part to the nearly $8 million in credit losses and the $4.9

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million in service corporations losses that First Annapolis recorded during the month.7 JX 65 at 1729-30. 65. In March 1990, and April 1990, First Annapolis reported additional losses of

approximately $1.3 million during each month. Again, as expected, the March and April losses were primarily due to the negative earnings that First Annapolis was experiencing on its core operations, which could not be offset by profits from its service corporation. JX 68 at 0013. 66. As of April 1990, First Annapolis' regulatory capital (including all goodwill) to

total liabilities ratio was a negative 0.25 percent. JX 68 at 0016.8 67. In total, between August 12, 1988, and April 30, 1990, First Annapolis realized

losses of $23.7 million (after the amortization of goodwill) and nearly $16.4 million (before the amortization of goodwill). JX 68 at 0016. That is, the losses experienced by First Annapolis after the conversion exceeded the $13.7 million in capital Bancorp infused into First Annapolis. VII. Despite First Annapolis' Asset Quality Deteriorating Rapidly In 1989, It Failed To Recognize Any Credit Losses Between June 1989 and December 1989 68. First Annapolis' October 1987 Revised Regulatory Business Plan projected total

loan loss provisions of less than $1.7 million over the three-year period ending December 31, 1990. JX 134 at 0516 and I-5.

Incredibly, in January 1990, which was only one month before recording an $8 million loan loss provision, First Annapolis recorded a "negative" loan loss provision of $288,249. JX 65 at 1729. In other words, First Annapolis actually reduced its provision for loan losses. In the "Background" section of its Liability Opinion, the Court stated that: "As of May 31, 1990, First Annapolis would have met the 1.8% capital benchmark . . . ." Slip Op. at 13. The Court's statement was attributed to an unsupported affidavit executed by Douglas Parran in support of this litigation; however, we will demonstrate at trial that this assertion is false. -178

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69.

First Annapolis' January 1989 business plan projected loan loss provisions

totaling just $612,000 for the three years ending September 1991. JX 135 at 0872 and 0882. 70. First Annapolis' June 1989 Revised Business Plan projected loan loss provisions

totaling just $124,000 during the five years ending March 1994. JX 136 at 0556. 71. In other words, First Annapolis' profitability was dependant upon it incurring

only minimal loan losses. First Annapolis' projected loan losses, like its projected profitability, turned out to be wildly optimistic. 72. As described in more detail below, despite the substantial increase in delinquent

loans and criticized assets after June 1989, First Annapolis recorded "negative" credit losses of $299,810 during the six-month period ending December 1989. DX 2294 at 1610; JX 61 at 1642. Thus, rather than recording additional credit losses to account for the deterioration in asset quality that it was experiencing, First Annapolis ­ remarkably ­ did the exact opposite and reduced its loan loss allowances, which served to artificially inflate its capital. VIII. First Annapolis' Delinquent Loans And Their Impact On Profitability 73. During its April 19, 1989 Board of Directors meeting, First Annapolis approved a

policy governing when interest income should stop being accrued (i.e., recorded as income) on delinquent loans. JX 46 at 1012-13. When this policy was adopted, First Annapolis' delinquent loans totaled approximately $13.1 million. JX 46 at 1012. 74. By July 1989, however, the amount of First Annapolis loans that were more than

30-days past due had increased by $45.2 million to nearly $58.3 million. DX 2210 at 0517. 75. By September 1989, loans more than 30 days past due had increased another $24

million to $82.3 million. DX 365 at 1410.

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76.

Despite this tremendous increase in delinquent loans, First Annapolis recorded

"negative" loan loss provisions of $401,350 during the quarter ending September 1989. DX 2120 at 0128. 77. According to the OTS' January 16, 1990 report of examination ("January 1990

ROE"), "during the 12 months ended December 31, 1989 the level of real estate owned and loans on non-accrual has increased from 1.2% of assets to 7.1% of assets, which is cause for significant concern and is indicative of an extremely serious asset quality problem." DX 397 at 0139 and 0149. 78. The examiners further observed that the majority of the increase (61.9 percent) in

real estate owned and loans on non-accrual status "has occurred since June 30, 1989." DX 397 at 0161. 79. The impact of this substantial increase in delinquent loans, combined with First

Annapolis' policy to stop accruing interest once a loan became delinquent for a specific period of time, contributed to First Annapolis' interest income declining from $5.8 million in September 1989, to $5.1 million in October 1989, and to First Annapolis missing its projected interest income target of $5.9 million by $800,000. DX 365 at 1420; JX 58 at 1543. 80. Furthermore, it was the decline in interest income - not loan losses - that played a

key role in First Annapolis realizing a $1.2 million loss on its core operations during October 1989. JX 58 at 1544. 81. The January 16, 1990 ROE also commented on the impact of delinquent and non-

accrual loans on the profitability of First Annapolis. According to the examiners: "During the year ended December 31, 1989, the reserve for uncollected interest increased from $464,971 to

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$3,367,634, indicating $2,902,662 of lost interest income for just the non-REO assets. The impact of this lost [interest] income has been most felt in the more recent months such as December 1989 during which the bank reserved $586,224 of uncollected interest, an amount which represents 53.3% of the $1.1 million net loss for the month." DX 397 at 0162. IX. First Annapolis' Criticized And Classified Assets Increased Substantially Between June 1989 And December 1989 82. During its June 15, 1988 Board of Directors meeting, First Federal's Board

approved an "Asset Classification Policy." JX 23 at 0461. This policy required that: "Once a problem asset has been identified, it will be classified `special mention', `substandard', `doubtful', or `loss'." JX 23 at 0466. 83. The decision on whether or not to classify an asset would be based upon many

factors including, but not limited to, the default and/or bankruptcy of the debtor, payment delinquency, and updated or new appraisals. JX 23 at 0466. 84. Classified assets are equal to the sum of assets categorized substandard, doubtful,

and loss. Criticized assets are equal to classified assets plus special mention assets. DX 397 at 0170. 85. As of June 1989, First Annapolis' special mention assets totaled $4.5 million and

its classified assets totaled $27.4 million, resulting in total criticized assets of $31.9 million. DX 2200 at 1239. 86. By September 1989, First Annapolis' special mention assets had increased to

nearly $32.3 million while its classified assets declined to $23.4 million, resulting in total criticized assets of over $55.6 million. JX 58 at 1549.

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87.

By October 1989, First Annapolis' special mention assets had increased to over

$44.9 million while its classified assets had declined to $11.8 million, resulting in total criticized assets of nearly $56.8 million. JX 58 at 1549. 88. By December 1989, First Annapolis' special mention assets had increased to over

$48 million while its classified assets had declined to $10.9 million, resulting in total criticized assets of nearly $58.9 million.9 DX 397 at 0150. X. First Annapolis' Failure To Properly Classify Its Problem Assets Caused Its Losses To Be Understated And Its Capital To Be Overstated During The Last Six Months Of 1989 89. Under First Federal's Asset Classification Policy, assets that were classified

special mention did not require valuation allowances, while assets classified substandard and doubtful required valuation allowances of 10 percent and 30 percent, respectively. JX 23 at 0461; DX 397 at 0150-51. 90. Therefore, by internally categorizing assets as special mention rather than

substandard, First Annapolis was not required to record a loan loss provision, despite total criticized assets increasing from $31.9 million in June 1989 to $56.8 million by December 1989 a 78 percent increase in just six months. 91. The evidence will show that management did not adequately classify its assets,

and in fact, management established just special mention designations for the vast majority of the thrift's non-performing assets. DX 397 at 0150.

According to First Annapolis' January 4, 1990 Capital Plan and its March 8, 1990 Amended and Restated Capital Plan, the "[r]esolution of all classified assets [was] of highest priority." DX 2311 at 0100; DX 2341 at 1102. -21-

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92.

Had management utilized reasonable classification criteria in assessing its non-

performing assets by applying at least substandard asset classifications to the special mention assets, First Annapolis would have had to increase general reserves by $4,264,634. DX 397 at 0151; DX 397 at 0162. 93. In fact, if First Annapolis had classified as substandard the $32.3 million in assets

it had classified special mention as of September 1989, the thrift would have recorded loan loss provisions of approximately $3.3 million. The recognition of this loan loss would have caused First Annapolis to fail its regulatory capital ratio benchmark as of September 1989. JX 58 at 1549. XI. The Enactment Of FIRREA 94. On August 9, 1989, Congress enacted FIRREA. FIRREA of 1989, Pub. L. No.

101-73, 103 Stat. 183. 95. FIRREA required the Director of the OTS to promulgate regulations establishing

a "tangible" capital requirement, a "leverage" or "core" capital requirement, and a "risk-based" capital requirement for thrifts. Id. 96. FIRREA and its implementing regulations (which were promulgated on

November 8, 1989 and became effective on December 7, 1989) required a savings institution to maintain tangible capital in an amount not less than 1.5 percent of the institution's adjusted total assets. 12 U.S.C. § 1464(t)(2)(B); 12 C.F.R. § 567.9(a). 97. Pursuant to the regulatory requirements put in place as of December 7, 1989,

tangible capital did not include any intangible assets, such as goodwill. 12 U.S.C. § 1464(t)(9)(C).

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98.

FIRREA and its implementing regulations also required an institution to maintain

core capital of three percent of its adjusted total assets. 12 U.S.C. § 1464(t)(2)(A); 12 C.F.R. § 567.8. 99. Pursuant to the regulatory requirements put in place as of December 7, 1989, core

capital was defined to exclude any unidentifiable intangible assets, including goodwill. 12 U.S.C. § 1464(t)(9)(A); 12 C.F.R. § 567.5(a)(1), (2). 100. Nevertheless, FIRREA and the accompanying regulations permitted a thrift to

include certain amounts of "qualifying supervisory goodwill" in the calculation of core capital. This limit was initially 1.5 percent of total assets. The limit declined gradually each year and was phased out entirely by December 31, 1994. 12 U.S.C. § 1464(t)(3)(A); 12 C.F.R. § 567.5(a)(1), (2). 101. Savings institutions were also required to maintain risk-based capital in an

amount greater than or equal to 6.4 percent of risk-weighted assets at December 31, 1989, 7.2 percent of risk-weighted assets as of December 31, 1990, and 8.0 percent of risk-weighted assets as of December 31, 1992. 12 U.S.C. § 1464(t)(2)(C); 12 C.F.R. §§ 567.2(a)(1)-(b), 567.6. 102. As with the core capital requirement and the regulatory requirements put in place

as of December 7, 1989, qualifying supervisory goodwill could be counted towards the riskbased capital requirement, and would be phased out over five years. 12 U.S.C. § 1464(t)(2)(C). XII. First Annapolis' Performance Following The Enactment Of FIRREA 103. By letter dated August 9, 1989, the FHLBB informed First Annapolis that: "As

noted in the June 1989 Thrift Financial Report, First Annapolis is reporting a gradual decline in its net interest margin, a significantly large increase in its non-interest operating expense, and a

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decline in income from its service corporations. These changes in income and expense have resulted in a significant loss for First Annapolis, significantly impacting the institution's regulatory capital level. Accordingly, in comparing such financial figures with First Annapolis' business plan, it appears that the institution's operating expenses are understated and the institution's net interest margin, net income, and regulatory capital projections are overstated. Based on such variations, it