Free Response to Motion - District Court of Federal Claims - federal

Case 1:92-cv-00550-MCW

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IN THE UNITED STATES COURT OF FEDERAL CLAIMS NORTHEAST SAVINGS, F.A., Plaintiff, v. THE UNITED STATES, Defendant. ) ) ) ) ) ) ) ) ) )

No. 92-550C (Judge Williams)

DEFENDANT'S RESPONSE TO PLAINTIFF'S MOTION FOR LEAVE TO NOTIFY THE COURT OF SUPPLEMENTAL AUTHORITY Defendant, the United States, respectfully submits this response to the motion of plaintiff, Northeast Savings, F.A. ("Northeast"), for leave to file as supplemental authority the decision of the United States Court Federal Claims in Anchor Savings Bank, F.S.B. v. United States, 81 Fed. Cl. 1 (2008). As we demonstrate below, contrary to plaintiffs' contentions, Anchor does not support Northeast's claims for lost profits, wounded bank expectancy damages, or a tax grossup.1 I. ANCHOR DOES NOT SUPPORT NORTHEAST'S LOST PROFITS CLAIM In Anchor, the Court held that the plaintiff, Anchor Savings Bank, FSB ("Anchor"), was entitled, among other things, to $137,595,000 in lost profits attributable to the sale of a subsidiary. Anchor, 81 Fed. Cl. at 153. We disagree, but, even assuming the Court is correct, Anchor is inapplicable to this case.

The Court has not entered judgment in Anchor, and the pending award will be subject to appeal upon entry of judgment.

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A.

Northeast's Lost Profits Claim Is Inconsistent With Its Track Record Of Unprofitability

At trial, Dr. Nevins Baxter, Northeast's expert, conceded that Northeast never generated core earnings during any five-year period before or after the breach. Tr. 867-78 (Baxter). In an attempt to sidestep this fatal flaw in its lost profits model, Northeast claims that Anchor holds that actual earnings are "irrelevant" to a lost profits analysis. Motion, at 2, quoting Anchor, 81 Fed. Cl. at 55 (citing LaSalle Talman Bank, F.S.B. v. United States, 45 Fed. Cl. 64, 90 (1999). That claim is incorrect. In Anchor, we argued that post-breach profitability resulting from steps taken to achieve compliance with FIRREA2 was not an appropriate basis for the award of lost profits to a thrift that was not profitable prior to the breach. Anchor, 81 Fed. Cl. at 54-55. The Court disagreed, holding that Anchor's post-breach profits might have been even higher absent the breach than they were in the real world. Id. at 55. This holding has no application here because, as Dr. Baxter conceded, Northeast had no track record of profitability either before or after the enactment of FIRREA. Thus, although Anchor apparently holds that a profitable thrift may be entitled to lost profits on the theory that it would have been even more profitable absent the breach, that holding does not assist Northeast because Northeast's actual assets and liabilities resulted in a negative return after the breach, Tr. 874, 877 (Baxter); DX 3001; Tr. 1786-87 (Fischel). Thus, our expert, Dr. Anjan Thakor, correctly concluded, consistent with Anchor, that its "but for" assets and liabilities would also have resulted in a negative return, resulting in no damages. Absent a track record of core earnings, Northeast cannot be awarded lost profits.
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Financial Institutions Reform, Recovery and Enforcement Act, of 1989, Pub. L. No. 101-73, 103 Stat. 183 (1989). 2

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Northeast also claims that its lost profits claim is supported by Anchor's holding that actual earnings of a subsidiary divested as a result of the breach may form the basis for the seller thrift's lost profits claim. Motion, at 2, citing Anchor, 81 Fed. Cl. at 90, 107-08. Attempting to capitalize on this finding, Northeast contends that it should be entitled to its claimed lost profits because the wholesale assets it divested as a result of the breach earned, after March 31, 1990, a "positive net spread." Motion, at 2. This contention is baseless for several reasons. First, it is undisputed that Dr. Baxter did not track the performance and earnings of the assets actually divested by Northeast. Tr. 2447 (Thakor). Therefore, the Anchor reasoning relied upon is inapposite. Another portion of the Anchor opinion, however, is on point in recognizing that, absent an ability to track the actual performance of an asset divested as a result of the breach, "a lost profits claim appears to be speculative as a matter of law." Anchor, 81 Fed. Cl. at 120, citing Columbia First Bank, FSB v. United States, 60 Fed. Cl. 97, 119-20 (2004); see also Sterling Savings Assn. v. United States, 80 Fed. Cl. 497, 516-17 (2008); Citizens Fin'l Servcs. v. United States, 64 Fed. Cl. 498, 510-15 (2005). Because Dr. Baxter has made no attempt to track the performance of the specific assets and liabilities that Northeast would have included on its balance sheet absent the breach, Northeast's lost profits claim must fail as a matter of law. Even if, contrary to fact, Northeast had established that the actual assets and liabilities divested by Northeast earned a positive net spread after divestiture, Northeast is nonetheless not entitled to lost profits because the assets and liabilities would not have remained on the balance sheet. The assets and liabilities were based upon a risk controlled arbitrage ("RCA") strategy that Northeast's regulators, and Northeast itself, determined to be too risky to continue prior to the enactment of FIRREA. PX 211, p. 2365 (Northeast letter to regulators acknowledging that 3

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"RCA is an inappropriate risky activity that should not be allowed as a permissible activity."); Tr. 1486-87 (Kovac). As Dr. Baxter admitted, even if an investment has a positive return, the investment "by definition," "would reduce value if the return is not commensurate with the risk that particular activity is imposing on the bank. . . ." Tr. 1042 (Baxter). Consequently, competent management would, "by definition," terminate any activity whose risk exceeds its return even if the return is positive. Tr. 1043 (Baxter). Thus, Northeast, "by definition," had compelling reasons, totally unrelated to the breach, to terminate its RCA activity. See id. Consequently, absent the breach, Northeast would not have realized the returns allegedly earned by the divested assets. Similarly, the record is undisputed that, during the period covered by Dr. Baxter's model, Northeast changed its assumption about the direction of interest rates. Whereas, prior to the breach, Northeast structured its assets and liabilities based upon its assumption that interest rates would fall, after the breach its portfolio was restructured to benefit from an increase in interest rates. DX 3023; Tr. 1875-81 (Fischel); DX 4007; Tr. 2172-83 (Bankhead). Thus, even in a nonbreach world, Northeast would not have retained assets that would benefit from a decrease in interest rates. Tr. 2550-52, 2564, 2591-92 (Thakor); Tr. 983 (Baxter). See Glendale Federal Bank v. United States, 43 Fed. Cl. 390, 401 n. 3 (1999) (Court rejected Dr. Baxter's model in its entirety because the forgone portfolio was "premised upon interest rates falling" which was "inconsistent with Glendale's expectations that interest rates would rise.").

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Finally, Northeast's argument ignores the fact that, even if it had retained all of its goodwill, Northeast would have needed to shrink to $5.2 billion in assets. Tr. 2953-54 (Bankhead). Thus, Northeast cannot demonstrate that the assets it divested would have been retained absent the breach even if it had not altered its interest rate strategy. Consequently, Northeast did not meet its burden of proving that the elimination of goodwill from regulatory capital caused lost profits. B. Northeast's Lost Profits Were Not Foreseeable

Northeast incorrectly claims that our post-trial brief advocates a foreseeability standard that is narrower than the standard applied in Anchor. Motion, at 3. First, the standard we applied is based upon precedent of the United States Court of Appeals for the Federal Circuit that requires a plaintiff to prove that "both the magnitude and the type of damages were foreseeable." Post-trial Brief, at 51. Landmark Land Co. v. United States, 256 F.3d 1365, 1378 (Fed. Cir. 2001). Moreover, Northeast's alleged damages would not have been foreseeable even under the Anchor standard. In Anchor, the Court held that lost profits may be a foreseeable consequence of the elimination of supervisory goodwill from regulatory capital if "a reasonable person could have foreseen the type of use [plaintiff] made of its supervisory goodwill and that a profitable enterprise would be sacrificed if [plaintiff] lost its supervisory capital." Anchor, 81 Fed. Cl. at 80. Northeast cannot meet this standard. As demonstrated above, Northeast was never profitable throughout its 20 year history, including the period when it possessed the goodwill eliminated by FIRREA. Tr. 867-78 (Baxter). Therefore, it could not have been foreseen by a reasonable person that a thrift unable to build a track record of profitability when it had the goodwill on its books would have become 5

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profitable if the goodwill had not been eliminated by FIRREA. Indeed, Dr. Baxter is forced to engage in "revisionist history" in order to create a "but for" model that generates profits. As explained above, although Northeast generated huge losses in the 1990s because it believed that interest rates would rise, Dr. Baxter's model is counterfactual in that it assumes the opposite. In other words, he assumes that, absent the breach, Northeast would have believed that rates would fall and would have generated profits by acquiring assets and liabilities that benefitted from such an interest rate environment. Even applying the Anchor standard, no reasonable person would have foreseen that, absent a breach, Anchor would have pursued a profitable strategy in the "but for" world when it chose an unprofitable strategy in the actual world. Therefore, Northeast's alleged lost profits were not foreseeable under any standard. II. NORTHEAST IS NOT ENTITLED TO A TAX GROSS-UP Anchor does not support Northeast's claim for a tax "gross-up." Northeast seeks a tax "gross-up" of damages claimed for replacement of capital provided to the seller of troubled credit unions acquired by Northeast's holding company, allegedly as a result of the breach. DX 285 at ¶ 58.3 As demonstrated in our post-trial briefs, Northeast is not entitled to damages for the issuance of capital in connection with the credit union acquisition, for reasons including: (1) Northeast did not meet its burden of proving that the capital would not have been infused absent the breach; (2) Northeast's former chief executive officer, Mr. Kirk Walters, conceded that the credit union acquisition occurred independent of the breach; and (3) Northeast failed to meet its

Although Northeast's motion is not clear on the point, see, e.g., Motion at 5, Northeast does not seek a tax "gross-up" of its lost profits damages, and such a claim would be baseless, because the Court has already acknowledged that a tax "gross-up" of profits which would have been taxable absent the breach is unwarranted. Citizens Fed. Bank v. United States, 59 Fed. Cl. 507, 521 (2004). 6

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burden of proving that it incurred actual costs as a result of the capital issuance in conjunction with the acquisition. Post-trial brief, at 56-65; Post-trial reply brief, at 55-65. Even if it were, however, a tax "gross-up" of the award would not be appropriate because Northeast never even attempted to prove that the damages would be treated as taxable income. Home Savings of America F.S.B. v. United States, 399 F.3d 1341, 1356 (Fed. Cir. 2005). Indeed, Northeast's expert, Dr. Baxter, merely assumed that the credit union-related damages would be taxable without analysis. Tr. 748:20-750:22, 848:5-13 (Baxter). In Anchor, the Court acknowledged, in support of its preliminary holding that tax "grossup" should be awarded,4 that Dr. Baxter testified that damages in the form of stock proceeds and mitigation costs would have been taxable. Anchor, 81 Fed. Cl. at 134. As stated above, no such testimony was offered in this case. Further, our Northeast tax expert, Dr. Grant Clowery, affirmatively testified that an award of costs associated with the credit union acquisition would not be taxable. See, e.g., Tr. 1561-69 (Clowery); Post-trial reply brief, at 66-67. Thus, this case has nothing in common with Anchor, and Northeast is not entitled to a tax "gross-up" of its claim for costs associated with the credit union acquisition. III. NORTHEAST IS NOT ENTITLED TO WOUNDED BANK EXPECTANCY DAMAGES IN THE FORM OF INCREASED FDIC DEPOSIT INSURANCE PREMIUMS At trial, Northeast claimed that, absent the elimination of goodwill by FIRREA, the thrift would have paid $1.3 million less in Federal Deposit Insurance Corporation ("FDIC") insurance

The Anchor Court has not yet awarded the plaintiff in that case a tax "gross-up," but has asked the parties to provide additional analysis. Anchor, 81 Fed. Cl. at 135. Therefore, Northeast's reliance upon Anchor to support its claim for a tax "gross-up" is premature as well as incorrect. 7

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premiums. We demonstrated that Northeast is not entitled to the damages for the following reasons: (1) Northeast's capital position was deficient even before the breach, thus justifying increased deposit insurance premiums; Post-trial reply brief, at 71; (2) absent the invalid lost profits projected by Dr. Baxter, Northeast would have been capital deficient even absent the breach; id. at 70; (3) the breach caused Northeast to take measures that decreased its risk, thus justifying a decrease, rather than an increase, in deposit insurance; id. at 72; and (4) Dr. Baxter's calculation of the allegedly increased premium suffers from numerous mechanical errors; id., citing Tr. 2382-84 (Bankhead); DX 4030; and (5) the benefits of the breach far exceed the alleged increase in the premium. Post-trial reply brief, at 72. In Anchor, the Court rejected our argument that goodwill would not have improved the plaintiff's risk of loss for purposes of calculating FDIC insurance premiums, which are based upon capital position and examination ratings. Anchor, 81 Fed. Cl. at 150-51. The Court's analysis, however, does not apply here, because, as shown above, among other things, Northeast would have been capital deficient even absent the breach, and the thrift suffered from a low examination rating prior to the enactment of FIRREA. Therefore, the Court should reject Northeast's claim for increased FDIC insurance deposit premiums. CONCLUSION For the reasons stated herein, in addition to the reasons set forth in our post-trial briefs, Northeast's claim for damages should be denied.

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Respectfully submitted, MICHAEL F. HERTZ Deputy Assistant Attorney General

JEANNE E. DAVIDSON Director

s/ Kenneth M. Dintzer

KENNETH M. DINTZER Assistant Director

s/ Tarek Sawi by s/ Elizabeth M. Hosford

OF COUNSEL: SCOTT AUSTIN ELIZABETH M. HOSFORD Senior Trial Counsel

TAREK SAWI Senior Trial Counsel Commercial Litigation Branch Civil Division Department of Justice Attn: Classification Unit, 8th Floor 1100 L Street, N.W. Washington, D.C. 20530 Telephone: (202) 616-0323 Facsimile: (202) 307-0972 Attorneys for Defendant

May 9, 2008

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CERTIFICATE OF FILING I hereby certify that on May 9, 2008, a copy of foregoing "DEFENDANT'S RESPONSE TO PLAINTIFF'S MOTION FOR LEAVE TO NOTIFY THE COURT OF SUPPLEMENTAL AUTHORITY" was filed electronically. I understand that notice of this filing will be sent to all parties by operation of the Court's electronic filing system. Parties may access this filing through the Court's system.

s/ Elizabeth M. Hosford _________________________ Elizabeth M. Hosford

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