Free Reply to 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 REPLY TO PLAINTIFF'S RESPONSE TO DEFENDANT'S MOTION FOR LEAVE TO NOTIFY THE COURT OF SUPPLEMENTAL AUTHORITY In our motion for leave to notify the Court of supplemental authority, we notified the Court of Sterling Savings Association. v. United States, 80 Fed. Cl. 497, 517-18 (2008) ("Sterling"), wherein this Court held that incremental assets cannot yield as high a return as actual assets. This Court noted that Sterling's model assumed that its incremental assets would have "achieved the same profitability as Sterling's actual asset[s] . . . ." Id. at 517. The Court rejected this assumption in Sterling's model because it ignores "the law of diminishing returns." Id. As this Court explained, "thrifts will borrow their least expensive funds first, and when that source of funds is exhausted, they will move to a more expensive source, and when the more expensive source is exhausted they will move to an even more expensive source." Id. "With regards to assets, thrifts will invest in the most profitable assets first, and then move to the less profitable assets." Id. Consequently, incremental assets cannot earn as high a rate of return as the thrift's actual assets. Id. at 517-18. We explained that this Court's reasoning is fatal to Northeast's claim because, during the period for which Northeast claims lost profits, its actual assets and liabilities resulted in a negative return. Tr. 877 (Baxter); DX 3001; Tr.1786-87 (Fischel). Thus, Northeast is asking the

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Court to assume that Northeast's incremental assets and liabilities would have achieved far higher, indeed, infinitely higher, returns than its actual assets. This of course makes no sense. As our experts demonstrated in this case, and as this Court held in Sterling, "banks like all of the firms exploit their best opportunities first." Tr. 2491-92 (Thakor); Gov. Br. at 45-46; see Sterling, 80 Fed. Cl. at 517. As Northeast's actual returns were negative, and any incremental investments would presumably fare even worse, Northeast is not entitled to any lost profits. In its response to our two paragraph motion, plaintiff spent six pages arguing that Sterling's model suffered from other infirmities in addition to its violation of the law of diminishing returns. This argument is irrelevant. We never contended that the remainder of Sterling's claim was flawless, nor that its model is identical to Northeast's. We simply noted, as this Court did in Sterling, that the law of diminishing returns applies to all firms. See also Citizens Fin. Servs., FSB v. United States, 64 Fed. Cl. 498, 511-514 (2005) aff'd 170 Fed. Appx. 129 (Fed. Cir. 2006). Plaintiff's response to our motion for leave fails to identify any reason why Northeast is exempt from these universal economic principles. In an additional effort to obfuscate this point, plaintiff erroneously asserts that Northeast was profitable and that Dr. Baxter's model was "both conservative and in step with the bank's actual experience." Pl. Br. at 6 (emphasis in original). That assertion, as we have repeatedly demonstrated, is simply wrong. Even plaintiff's expert has admitted as much. Dr. Baxter explicitly admitted that during the two years where his model generates $72 million of his alleged $112 million in total lost profits, the actual bank had reported losses. Tr. 952-53. (Baxter). That is, the actual bank had both negative reported earnings as well as negative core earnings. Consequently, plaintiff's model claims infinitely higher returns for incremental assets 2

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than the negative returns of its actual assets. This makes no sense and is directly contrary to this Court's holdings in Sterling and Citizens. Plaintiff accuses us of a "myopic fixation on the returns of Northeast's so-called "core earnings." Pl. Br. at 6. It is, however, Northeast's effort to diminish the importance of its negative core earnings that is myopic. Core earnings, as defined by plaintiff's own expert, are the income from the assets and other operations less the cost of liabilities, general and administrative costs, and loan losses. Tr. 863-65 (Baxter). Dr. Baxter admitted that the lost profits that he alleges in his model "would fit anybody's definition of core earnings." Tr. 863. Core earnings result when "the income from the assumed assets is large enough to cover the costs of the liabilities funding them, the general and administrative expenses, and any loan losses." Tr. 865. "Not one penny" of Northeast's alleged lost profits result from gains on sales or from accounting adjustments. Tr. 864. Yet, in real life Northeast never generated any core earnings. Dr. Baxter does not dispute that Northeast never generated core earnings during any five-year period. Tr. 867-68; 873-74; 876-78 (Baxter). Thus, although its actual capital and its actual assets consistently generated negative core earnings, Northeast claims that its hypothetical assets would have generated huge, positive core earnings. Given the law of diminishing marginal returns, Northeast's claim simply makes no sense. Moreover, as important as core earnings are in assessing a financial institution's profitability, this measure of earnings is particularly important in Winstar cases. As the Supreme Court explained, in supervisory acquisitions the acquiring thrifts were allowed to accrete into income over a short period an amount that is roughly equal to the amount of supervisory goodwill. The goodwill was to be amortized over a much longer period. This "resulted in a net 3

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paper profit" over the initial years after the acquisition. United States v. Winstar Corp, 518 U.S. 839, 852-853 (1996) (emphasis added). "The difference between amortization and accretion schedules thus allowed acquiring thrifts to seem more profitable than they in fact were." Id. at 853. Thus, the reported earnings that Northeast boasts of were simply "paper" earnings that allowed it "to seem" profitable. The Supreme Court explained that not only were the earnings fictitious, but they were not repeatable after the merger's initial years. "The downside of a faster accretion schedule, of course, was that it exhausted the discount long before the goodwill asset had been fully amortized. As a result this treatment resulted in a net drag on earnings over the medium and long terms." Id. at 853 n.8. This Court recognized the same phenomenon and held that "core earnings" are the true measure of profitability. Suess v. United States, 52 Fed. Cl. 221, 226-27 (2002). Indeed, Northeast itself recognized that core earnings are the appropriate measure of profitability and value. PX 211 at 2362-63; see also Tr. 1782-85 (Fischel). Finally, even if, notwithstanding the Supreme Court's admonition to the contrary, we could somehow ignore that Northeast's reported earnings included "paper profits" and that the profits are not only fictitious but unsustainable, Northeast's reported earnings, even including these "paper profits," amounted to a minuscule return on assets from 1982 to 1991 of only 2.7 basis points. PX 1401 at 2441; Tr. 881-82 (Baxter). By comparison, Dr. Baxter's incremental portfolio alleges profits of 81 basis points. Tr. 883 (Baxter). As (1) Sterling makes clear, incremental assets cannot earn as high a return as actual assets, and (2) Northeast's actual assets, even when inflated by the "paper profits" of the acquisition returned only 2.7 basis points, there is simply no reason to believe that incremental assets would have generated any profits.

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Case 1:92-cv-00550-MCW

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Respectfully submitted, MICHAEL F. HERTZ Deputy Assistant Attorney General

/s/ Jeanne E. Davidson 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

April 14, 2008

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Case 1:92-cv-00550-MCW

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CERTIFICATE OF FILING I hereby certify that on April 14, 2008, a copy of foregoing "DEFENDANT'S REPLY TO PLAINTIFF'S RESPONSE TO DEFENDANT'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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