Introduction: Numerous plaintiffs have filed suits in various courts alleging that an agreement between the FHFA and Treasury, which has the effect of transferring all the earnings of the Federal National Mortgage Association, commonly known as Fannie Mae (OTCQB:FNMA) to Treasury, should be set aside. In May 2014, Bill Ackman of Pershing Square Capital Management, LLC presented a Fannie Mae history and valuation range for the common of $23 to $47 per share. The common stock of Fannie Mae is hovering around $3.60 as of early September 2014.

In addition to Pershing Square’s investment, Bruce Berkowitz of Fairholme Capital and Carl Icahn have both reportedly taken positions in Fannie. Clearly, very successful investors perceive value in Fannie in the face of the litigation risk. I thought it would be useful to the lay investor to read a summary and evaluation of the back and forth of the key legal arguments taken from the briefs for the Motions to Dismiss and Motions for Summary Judgment in suits filed by Perry Capital and Fairholme.

My primary motivation for writing this article was to search for thedisconfirming evidence that my long position in Fannie common was a good idea.

Reader’s warning: As investor articles go, reading summaries and evaluation of legal arguments is extremely dense and not for the faint of heart. To keep your interest peaked, remember that many tens of billions of dollars rest on how judges interpret these arguments.

Author’s Background: I have been a licensed attorney for 26 years working mostly in-house handling transactions and litigation. For five years, I was the general counsel for a small publicly traded company with mixed business and legal responsibilities. I also hold an MBA. I favor special event investing and successfully took positions in BP (NYSE:BP) after the Gulf spill, AIG (NYSE:AIG) warrants and in Delphi, Delta (NYSE:DAL) and General Growth (NYSE:GGP) after the bankruptcy filing of each. I have a long position in Fannie common.

Factual background: Congress enacted the Housing and Economic Recovery Act of 2008 (HERA) in response to the mortgage crisis. HERA created a new regulator for Fannie, the Federal Housing Finance Agency (FHFA). FHFA was authorized to assume control of Fannie as either a conservator or a receiver under certain conditions. FHFA elected to assume control of Fannie in September 2008, as a conservator. FHFA entered into a preferred stock purchase agreement (PSPA) with Treasury as a vehicle for Treasury to make investments in Fannie to preserve Fannie’s solvency. In exchange for Treasury committing to funding up to $100B to Fannie, the PSPA gave Treasury a number of rights, of which only the most relevant for the legal arguments will be discussed.

First, Treasury received 1 million senior preferred shares with a total liquidation preference of $1B (Treasury Stock). The liquidation preference would increase dollar for dollar for each draw upon Treasury. Second, the Treasury Stock was entitled to annual cash dividends equal to 10% of the liquidation preference or an “in-kind” dividend of 12% of the liquidation preference, which would be added to the existing liquidation preference. Third, the PSPA gave Treasury warrants for up to 79.9% of Fannie common at a nominal price.

In 2009, the PSPA was amended twice to first increase the amount of money Fannie could draw from Treasury and, second, provide a formula to calculate a now maximum amount of the draw. The amendments also required Fannie to reduce its portfolio annually by 10%.

On August 17, 2012, FHFA and Treasury amended the PSPA a third time in what was characterized by Treasury as a “net-worth sweep.” The third amendment (Sweep Amendment) replaced the fixed 10% dividend with a dividend equal to Fannie’s net worth above a capital reserve of $3B. Each year the capital reserve amount would decrease until in 2018 the capital reserve amount would be zero. Thus, starting in 2018, 100% of Fannie’s net worth would be paid to Treasury. Moreover, since all the payments were classified as “dividends” regardless of how much was paid in “dividends,” the amount owed to Treasury for Treasury’s advances would never be paid down. The Sweep Amendment also required Fannie to reduce its mortgage assets by 15% per year, until a floor of $250M was reached, by my calculation, in 2018.

Background on the litigation: On July 7, 2013, Perry Capital, LLC (Perry) filed a four-count complaint in the US District Court for the District of Columbia (Case1:13-cv-01025-RLW) against the Department of the Treasury (Treasury) and the Federal Housing Finance Agency (FHFA). On July 10, 2013, Fairholme Fund, Inc. (Fairholme) and ten other plaintiffs filed a seven-count complaint also in the US District Court for the District of Columbia (Case 1:13-cv-01053) against Treasury and FHFA with substantially the same allegations and prayer for relief. Those cases, along with several others, have been consolidated.

The plaintiffs allege that as holders of preferred stock, they are entitled to periodic dividends and to a liquidation preference. The Sweep Amendment, effectively placing Fannie into liquidation after Fannie became profitable, deprives the plaintiffs of the dividends and liquidation preference they could reasonably expect given Fannie’s profits. The Sweep Amendment is in violation of law because:

1. FHFA exceeded its statutory authority by executing the Sweep Amendment because the Sweep Amendment was an effective wind-down of Fannie contrary to the powers of a conservator.
2. Treasury exceeded its statutory authority because the execution of the Sweep Amendment was a purchase of securities after 2009, the latest date under HERA authorizing Treasury to purchase Fannie securities.
3. FHFA’s and Treasury’s actions were a violation of the Administrative Procedures Action (“APA”) as arbitrary and capricious.
4. FHFA as conservator violated its contract with Fannie shareholders, FHFA’s duty of good faith and fair dealing, and FHFA’s fiduciary duty.

The complaints ask the court to issue an injunction setting aside the Sweep Amendment and prohibiting Treasury and FHFA from taking any further action pursuant to the Sweep Amendment.

Treasury and FHFA, separately, each filed combined motions to dismiss and motions for summary judgment. Perry and Fairholme then filed a combined cross motion for summary judgment. Treasury and FHFA each filed a reply to Perry and Fairholme’s motions. Perry and Fairholme then filed a combined reply. Going forward, Perry and Fairholme will be termed “Perry.”

Together, the complaints and motions number 556 pages with several hundreds of cited cases. To keep this manageable, the arguments must be summarized and many nuances lost, although I hope to capture the flavor and relative strength of the arguments. Since the main focus of the arguments were not the state law/common law claims of breach of contract, of duty of good faith and fair dealing and fiduciary duty claims, those claims are not discussed.

Freddie Mac securities are also a part of the litigation, but, for simplification, only Fannie will be referenced. This article will also only cover the legal issues raised in this litigation. It does not discuss the “takings” issues in the Federal Court of Claims.

Litigation Standard of Review: Matters are brought to court for an adjudication of the facts, when the parties cannot agree on the facts, and/or to have a ruling on the applicable law, when the parties cannot agree on the law. Here, FHFA and Treasury each filed motions to dismiss Perry’s complaint. In a motion to dismiss, the judge must accept as true all facts which the other party has alleged and must draw all reasonable inferences in that party’s favor. The judge must decide whether, accepting all material facts in the complaint as true, the complaint states a plausible claim.

Both sides have also moved for summary judgment. A summary judgment motion claims that the facts are not in dispute and asks for a judgment as a matter of law. Hence here, while the parties characterize the facts very differently, for purposes of these motions, the facts are not in dispute. The parties are arguing over the interpretation of law given the facts.

Government Motion to Dismiss: FHFA and Treasury (together, Government) urge that 1) Perry has no standing to bring the claim and the matter is not ripe for adjudication; and 2) the court lacks jurisdiction to hear the claim. If FHFA and Treasury prevail on either of their claims, the court must dismiss the suit. Each of these will be addressed in turn. After discussing the Government’s motions to dismiss, we will turn to the summary judgment arguments. While FHFA and Treasury have filed separate briefs and argue slightly different theories, for brevity their arguments and positions will be combined except if necessary to make a point. If summary judgment is granted for FHFA or Treasury, the Perry’s claims will have been held to have no merit as a matter of law.

Standing and Ripeness: To bring a claim, a plaintiff must have suffered an actual injury and the claim must not rest on contingent future events. A speculation of injury is insufficient but an “imminent or certainly impending” injury will suffice. Here, the Government points out that Perry is claiming an injury for loss of dividends and liquidation preference. Such loss, the Government argues, is purely speculative until Fannie is placed in liquidation under a receiver. If that should happen, Fannie preferred shareholders can assert any claim against the receiver at the proper time in the receivership. At that time, Perry will have full rights to pursue its claims.

The Government also argues that Perry, suing as a shareholder, has no standing under the derivative injury rule. The derivative injury rule prevents shareholders from suing, on their own behalf, for injuries done to the corporation, even if that injury results in a loss of value of the shares. The alleged injury here is to Fannie.

Further, the Government argues: “HERA … empowered FHFA to ‘take over the assets of and operate [Fannie] with all the powers of [Fannie’s ] shareholders, directors and … officers’ and to ‘conduct all business of[Fannie].'” Hence, all rights of the shareholders were transferred to FHFA and courts have interpreted this language to preclude a shareholder’s right to bring derivative suits.

The Government finally argues that HERA limits Perry’s claims to what Perry would have been entitled to if FHFA had liquidated Fannie at the time of the initial conservatorship. Hence, Perry’s claim was fixed at the time of the appointment of FHFA as conservator and the subsequent Sweep Amendment can have no effect on that claim.

Perry replies that the Sweep Amendment shifts all the net assets of Fannie to Treasury, making it impossible for the preferred holders to receive anything either in dividends or in liquidation. That in and of itself is an actual injury sufficient to have standing. Moreover, not all rights of the shareholders were transferred to FHFA. Rights personal to the shareholders, such as the right to receive payments, are not transferred to a conservator. The derivative shareholder rule does not apply when shareholders assert a direct personal interest, as here, even if the corporation’s rights are also implicated.

Perry has two replies to the argument that HERA limits Perry’s claim and hence there is no effect on Perry’s claim by the Sweep Amendment. First, the statute the government cites, 12 USC §4617(e)(2), only limits the liability of FHFA as a receiver if FHFA acts to create a limited life entity. FHFA has never exercised this authority since FHFA is acting as a conservator, not a receiver. Thus, the provision has no effect. Second, the Government’s argument that a plaintiff’s claim is limited to valuation at the time a receiver is appointed would lead to the absurd result that a shareholder would have no claim to assets if the receiver obtained a windfall in liquidation in excess of the claims against the regulated entity.

Author’s View: The injury to Fannie shareholders is real as reflected by the market. The Sweep Amendment effectively sets in place a current requirement to transfer all profits to the Government, making it impossible for Fannie to ever repay the Government draws. This leaves no assets for shareholders even though the Government is currently collecting amounts in excess of the Government’s contributions to Fannie. Perry has a stronger argument than the Government that Perry has been injured and should have standing.

Jurisdiction: The Government claims that HERA prohibits the court from ruling on Perry’s complaint: “Except as provided in this section or at the request of the Director [of FHFA], no court may take any action to restrain or affect the exercise of power or of functions of [FHFA] as a conservator or a receiver.” HERA, 12 USCA § 4617(f). Any setting aside of the Sweep Amendment would “affect” the FHFA. The Government argues that courts have interpreted HERA that so long as FHFA is acting within FHFA’s statutory authority, there can be no judicial review of FHFA’s actions. Moreover, since HERA provides that “[FHFA] may, at the discretion of the Director [of FHFA], be appointed conservator or receiver for the purpose of reorganizing, rehabilitating, or winding up the affairs of a regulated entity”, HERA, 12 USCA §4617(a)(2), even if FHFA were to wind down Fannie in the Sweep Amendment, that wind down is within FHFA’s statutory authority.

Carefully reread the language quoted in the preceding paragraph: it is critical for this and several of the Government’s other arguments that will be covered later. Many pages of legal wrangling were spent over that language becausebillions depend on how a court interprets that language.

Perry claims that HERA has no application to Treasury. Thus, suit against Treasury is not prohibited by §4617(f). Treasury’s arguments that the court has no jurisdiction all apply to FHFA, not to Treasury. As to FHFA, Perry argues that the limits on judicial review apply only when FHFA is acting within FHFA’s statutory powers and courts have maintained jurisdiction when the conservator acts “beyond, or contrary to, its statutorily prescribed, constitutionally permitted, powers or functions.” Since the complaint alleges that FHFA (as well as Treasury) acted outside its authority by arbitrarily and capriciously executing and carrying out the Sweep Amendment, the inquiry by definition is outside the §4717(f) prohibition.

Author’s View: The Government essentially argues that any action taken to rehabilitate or liquidate a regulated entity is within FHFA’s powers and hence precluded from judicial review. This seems extremely poor public policy in view of the judicial balance of powers function to ensure that agencies only act within statutory authority. Since Perry is alleging that the Government acted arbitrarily and capriciously contrary to another statute, the APA, a court should not dismiss the claim out of hand.

By happy circumstance, a court in a related Fairholme litigation before the US Court of Claims addressed the same Government argument. In Fairholme v. the United States, Case 1-13-cv-000465-MMS, the Government opposed Fairholme’s discovery on a takings claim caused by the Sweep Amendment agreement also citing §4617(f). On July 16, 2014, the judge in that case denied the Government’s motion saying:

[R]ather than turning a blind eye to a case and immediately dismissing it from its docket merely because the case concerns the FHFA, the proper approach is for a court to examine the factual underpinnings and legal contentions presented by the complaint, in order to determine whether the exercise of its jurisdiction is proper.

Two caveats: First, the Court of Claims decision was to permit the discovery to proceed prior to ruling on the Government’s motion to dismiss. That court did not yet rule on the pending motion to dismiss before that court. Second, the Court of Claims decision is at best only persuasive, not binding on other District Courts. Still, the same reasoning would apply pending motion to dismiss in this case and should be encouraging to Perry.

On the motions to dismiss, Perry has the stronger argument. The litigation should be permitted to go forward.

Motions for Summary Judgment: These arguments will be initially taken from Perry’s perspective. The summary judgment arguments fall logically into two groups.

First, Perry argues that each of FHFA and Treasury violated statutory limitations on each of their authority by entering into the Sweep Amendment.

Second, Perry argues the actions of each of FHFA and Treasury were arbitrary and capricious in that each of them violated the requirements of the Administrative Procedures Act. The APA will be discussed later.

The Government essentially says each argument fails as a matter of law. Let’s address the back and forth of the argument for each group in turn.

Did either of FHFA and Treasury violate statutory limits on their authority by entering into the Sweep Amendment?

FHFA first:

Perry argues that FHFA chose to act as a conservator. As a conservator, FHFA has statutory duties to “preserve and conserve” Fannie’s assets to put Fannie “in a sound and solvent condition.” For Perry, “rehabilitation with a view to a return to viability as a going concern” defines and limits FHFA’s powers. Perry distinguishes the conservator’s functions from those of a receiver who acts to liquidate and wind up the affairs of a company.

Perry then cites numerous Government press releases and testimony before Congress to the effect that the express purpose of the Sweep Amendment was to wind down Fannie.

The Government’s response is to assert that under §4617(a)(2), quoted above, conservators and receivers have “substantially overlapping powers.” Under§4617(a)(2), FHFA has the authority to “wind up,” which includes shrinking Fannie’s operations to prepare Fannie for liquidation. In either case, the Sweep Amendment is not a wind-up of Fannie but merely a shrinking of Fannie’s operations, which is well within the FHFA’ s authority. The 15% annual portfolio reduction requirement is only an acceleration of the prior 10% annual portfolio reduction requirement.

Author’s View: The Government is not “liquidating” or “winding down” Fannie through the portfolio reduction. Given Fannie’s unprecedented market share since 2008, reducing Fannie’s portfolio to a mere $250B is not a liquidation. FHFA, however, elected to act as a conservator. The distinction between the powers of conservators and receivers is well established in law. The Government argues that the sweeping of Fannie’s net worth is within its powers under §4617(a) (2), which appears to combine the powers of conservators and receivers. This argument is not persuasive. If adopted, it would blur many critical distinctions between the two well established in law. By agreeing to transfer all of Fannie’s net assets in a quarterly sweep, FHFA violated a conservator’s duty to “preserve and conserve” Fannie’s assets.

Now Treasury:

Both sides agree that Treasury’s authority to enter into the PSPA and purchase Fannie securities was granted under HERA and that authority expired on December 31, 2009.

Perry’s argument is that the Sweep Amendment, executed on August 17, 2012, exchanged a fixed 10% dividend and a quarterly commitment fee for the net worth sweep of all of Fannie’s assets above a declining capital reserve with its many changed rights, essentially created a new class of securities. The creation of a new class of securities for consideration constitutes a new purchase of securities. Since that purchase was after December 31, 2009, the Sweep Amendment was outside Treasury’s statutory authority.

Treasury responds that HERA provides that “The authority of the Secretary of the Treasury to hold, exercise any rights received in connection with, or sell, any obligations or securities purchased [from Fannie] is not subject to the [December 31, 2009 limitation].” The PSPA included a provision allowing the parties to amend it: the “Agreement may be waived or amended solely by a writing executed by both parties hereto.” Thus, the Sweep Amendment was an exercise of an existing right to amend the PSPA. Moreover, since FHFA did not issue additional shares of stock and Treasury did not commit any additional funds, there was no “purchase.”

So now the argument is over whether the Sweep Amendment was pursuant to an existing right and whether the changes under the Sweep Amendment constituted a “purchase.”

Perry replies that a “right” is something that can be exercised unilaterally. The “right” Treasury quotes is not a “right” since it requires FHFA consent. “Stating that Treasury and FHFA could amend the Agreement by mutual consent thus did not add to (or subtract from) the bundle of rights Treasury possessed prior to executing the Purchase Agreements.”

Treasury’s response is that “rights” need not be unilateral: courts regularly speak of the “right to contract,” which requires mutual consent.

The back and forth about whether the execution of the Sweep Amendment was a “purchase” of new securities is a little hairier. Perry argues that the common meaning of the term “purchase” under Treasury regulations, the Uniform Commercial Code and Black’s Law Dictionary means an exchange for consideration. Moreover, under the securities laws, an amendment, which causes a significant change of the nature of the investment is a purchase under the fundamental change doctrine. Perry concludes that the Sweep Amendment in which Treasury received a variable sweep, which netted $130B as of June 2013, in consideration of an annual fixed dividend of $19B and the waiver of the periodic commitment fee, was a significant change in the nature of the security, and hence, a purchase. If a purchase, that purchase occurred after Treasury’s authority ended.

Treasury’s response is to argue that the common meaning of “purchase” actually excludes the Sweep Amendment since no funds or securities changed hands. The fundamental change doctrine Perry advocates is applied by courts to determine standing under §10(b) of the Securities Exchange Act for investors whose securities were subject to an involuntary conversion. That doctrine has no application to a modification to a contract consented by both parties.

Author’s View: Treasury’s argument that the PSPA language permitting the PSPA to be “amended solely by a writing executed by both parties hereto” conveys a right to amend is pure horsepucky. Any business attorney knows that language is standard boilerplate used to ensure that subsequent dealings between the parties will not change the terms of an agreement without a writing. It is designed to preserve the original agreement.

That said, many judges were primarily litigators in private practice, not business or transactional counsel. It’s not outside the realm of possibility for a former litigator turned judge to be persuaded. The judge in this case is Royce C. Lambert. His entire practice has been as a government attorney. With the exception of six years early in his career with the Judge Advocate General’s office, his entire career has been in or supervising litigation.

The “purchase” argument is more nuanced. Certainly there was a very significant exchange of rights under the PSPA to the tune of over $100B. Whether that exchange was a “purchase” such as to render the Treasury’s actions outside its authorization is not clear from the briefs. The stronger argument is that the securities laws and Treasury’s own regulations do define “exchanges” as being sales for purposes of standing and taxation. If the exchange is a sale, then there must be a purchase. Treasury’s argument that there was no purchase because no funds changed hands flies in the face of the basic law of contract that even a “peppercorn” can be sufficient consideration.

Did either of FHFA or Treasury violate the Administrative Procedures Act in executing the Sweep Amendment?

Interesting to note, Perry only has to persuade a court that either one of the parties, FHFA or Treasury violated the APA to have the Sweep Amendment potentially set aside.

FHFA first:

Before discussing the arguments, a little legal background is necessary. The Administrative Procedures Act (“APA”) regulates federal agency actions. An agency may only act within its statutory authority and must compile a contemporaneous administrative record to support its decisions. To set aside an agency action, a court must conclude that the action was “arbitrary and capricious, an abuse of discretion, or otherwise not in accordance with the law.” In making that determination, a court will examine the administrative record.

Perry quotes Judge Lambert, the judge in this case, opining in another case that:

Judicial review of agency action under the APA is generally confined to the administrative record. The record is comprised of those documents that were before the administrative decision maker. A court should consider neither more nor less than what was before the agency at the time it made its decision. It is the agency’s responsibility to compile for the court all information it considered either directly or indirectly.

Perry then argues that since the FHFA did not compile a contemporaneous administrative record, the court has no grounds on which to sustain the FHFA’s action in entering into the Sweep Amendment.

FHFA’s position is that agency actions must be upheld so long as there is a rational basis for the action. FHFA did file a “Document Compilation,” which reflects the considerations that the FHFA took into account in exercising the Sweep Amendment. Moreover, Perry cites no authority for its argument that the absence of an administrative record compels vacating the Sweep Amendment. Since Perry has not pointed out any omitted document, FHFA’s decision should be accorded the “strong presumption of regularity.” FHFA argues that courts accord great deference to agency actions, particularly when the agency actions involve “technical expertise and informed predications about the likely course of future events” and should do so here.

Perry responds that the “strong presumption of regularity” applies only after an agency has compiled an administrative record. Here, Perry observes, the Document Compilation shows no document memorializing the agency’s independent assessment of the Sweep Amendment, but only post hocjustifications prepared for this litigation. Without an administrative record, FHFA cannot justify the Sweep Amendment, which must be vacated

Author’s View: FHFA is being disingenuous in arguing that Perry has not pointed out any omitted documents because discovery has not yet been conducted in this case. Without discovery, it’s highly unlikely that Perry would have the kind of document knowledge necessary to point out specific omitted documents.

If Perry is correct on the law, and accurately applies Judge Lambert’s quote, that the court is generally limited to reviewing the agency record, it’s hard to see how FHFA wins this one. FHFA does not directly contradict Perry, but argues the great deference courts give agency decisions and argues the factors FHFA claims to have taken into consideration. That argument fails with Perry’s retort that agency deference applies only after the agency has compiled an administrative record. I think the most telling point is the public policy that the very purpose of the APA is to hold an agency to a transparent process of decision making. FHFA’s position seems the very heart of after the fact justification for a $100B decision. Not good public policy, seemingly contrary to the Lambert quote and, I think, ultimately a loser for FHFA.

Now Treasury:

A little more background: Treasury argues that before the Sweep Amendment was put in place, Fannie was in a downward spiral. Fannie profits were not enough to pay the 10% dividend, so Fannie had to draw on Treasury’s commitment to pay the 10% dividend to Treasury. This in turn increased the total draw from Treasury and made the next 10% dividend higher still. Avoiding this downward spiral was Treasury’s reason for entering into the Sweep Amendment, which exchanged the fixed 10% dividend and periodic commitment fee for the variable net worth sweep.

Perry sets out what it believes is the applicable law, that an agency must have engaged in “reasoned decision making,” then argues that the record shows flaws in Treasury’s decision making process. Those process flaws, according to Perry, violated the APA.

The flaws Perry advances were:

1. Treasury used stale and inaccurate projections of Fannie’s profitability and the impact of the Sweep Amendment;
2. Treasury never considered alternatives to the Sweep Amendment;
3. Treasury ignored factors that were statutorily required to be considered.

(Perry advances a fourth flaw based on alleged breaches of duties to the shareholders, which are already noted to not be covered in this article.)

Let’s take the back and forth arguments of each in turn.

1) Stale and inaccurate projections of Fannie’s profitability and the impact of the Sweep Amendment. The arguments here are a morass of conflicting representations and conclusions about many presentations and documents challenging to distill down. In essence, Perry points out that the July 2012 projections used to justify the Sweep Amendment used financial data from October 2011, which was much more pessimistic than data available in June 2012, which showed Fannie had beaten the most optimistic projections. Moreover, Treasury failed to consider the tens of billions of dollars in deferred tax assets in making its evaluation. Yet, Fannie recognized those deferred tax assets shortly after the Sweep Amendment was signed, increasing Treasury’s dividend by $50B.

Treasury’s response is very interesting. Treasury points to the conclusions in many of these documents, which supported its thesis that there was no guarantee going forward that Fannie would be profitable. Moreover, the fact that Treasury engaged in a variety of analyses, all of which arrived at the same conclusion, is a sign of the strength of Treasury’s process. The size of the subsequent dividends under the Sweep Amendment was a surprise to Treasury. With regard to the timing of the recognition of the $50B deferred tax asset: “The possibility of that one-time gain, the timing of which could not be predicted, simply was not material to the problem that Treasury and FHFA sought to address by entering into the [Sweep Amendment].”

Author’s View: The wrangling about the interpretation of the various documents is epic. Yet, a few facts emerge. Treasury had reason to know that Fannie would be profitable before entering into the Sweep Amendment. Given the timing of the Sweep Amendment, and the lack of arms length negotiation, it defies credulity that the $50B in tax deferred funded distributions, and the subsequent dividends so much in excess of the fixed 10% dividends, were pure happenstance. Treasury argues that consistency of conclusion in its studies is a credit to the validity of its process and decision. Given the many detailed objections Perry raises based on the data in these documents, and the many prior and contemporaneous FHFA and Treasury statements that taxpayers, not shareholders, would receive all the value of Fannie, it’s hard not to conclude that Treasury cherry picked facts to support a pre-ordained result.

2) Treasury never considered alternatives to the Sweep Amendment. Perry argues that the APA requires, and in order for an agency decision to accorded deference, the agency must consider “reasonably obvious alternative[s].” Perry argues three different alternatives were obvious given the facts and events at the time. Here, Treasury only considered the net worth sweep option. Thus, Treasury’s failure violated the APA and Treasury’s decision should be accorded no deference.

Treasury’s reply is to argue the viability of Perry’s alternatives, of which there was none. Treasury also asserts that “Treasury’s decision to enter into the [Sweep] Amendment cannot ‘be found wanting simply because the agency failed to include every alternative device and thought conceivable by the Mind of Man.'”

Author’s View: Here again the briefs spend many pages, this time over the viability of the options Perry say were obvious but not considered. Yet, Treasury, while never conceding that any Perry option had any viability, never counters Perry’s base assertion: that Treasury never considered any option but variations on the Sweep Amendment. If agency action must be based on a consideration of reasonably obvious options, then Treasury’s position must fall. In my professional experience with agency actions based on Environmental Impact Statements and EPA records of decision, agencies routinely consider alternatives that are obvious, yet impractical, for the sake of compiling the administrative record. Treasury’s failure to consider alternatives in a matter of this significance is glaring.

1. Treasury ignored factors, which were statutorily required to be considered.Perry’s view of the law is: “Agency action is arbitrary and capricious if the administrative record lacks ‘any discussion of a statutorily mandated factor,’ as such absence ‘leaves [the court] with no alternative but to conclude that the agency failed to take account of [a] statutory limit on its authority.”

Perry asserts that Treasury was required by HERA to make findings that Treasury’s actions would provide stability to the financial market, prevent disruptions in the availability of mortgage finance and protect the taxpayer. These findings were to be based on specific factors such as the need to maintain Fannie’s status as a private shareholder owned company. Perry argues that Treasury made those findings in the administrative record for the Second Amendment to the PSPA, but not the [Third] Sweep Amendment. Moreover, Treasury never explains in the administrative record how entering into the Sweep Amendment was within Treasury’s authority.

Treasury’s view of the law is “Judicial review of agency action under the APA is meant to ensure that the agency ‘examine[d] the relevant data and articulate[d] a satisfactory explanation for its action.'” Moreover, “[a] reviewing court ‘must affirm the decision if we find that it is not contrary to law, that it is supported by substantial evidence and based upon a consideration of the relevant factors, and if we determine that the conclusions reach have a rational connection to facts found.'”

Treasury points out that the purpose of the Sweep Amendment was to “eliminate the vicious circle of [Fannie] paying dividends to Treasury, drawing funds back from Treasury, and paying further dividends on those draws.” Treasury then defends at great length the reasonableness of the vicious circle concern and the appropriateness of the Sweep Amendment to address that concern. Treasury argues, too, that Treasury made findings for the first and second amendments because those amendments increased Treasury’s commitment to Fannie. Since the Sweep Amendment did not increase Treasury’s commitment, i.e., no funds were exchanged, it was not necessary for Treasury to make findings. This is particularly true since the authority for the Sweep Amendment was derived from rights previously granted under the PSPA.

Author’s View: Treasury implicitly admits it never made what Perry alleges are statutorily required findings in the administrative record. Citing to contemporaneous documents that Treasury claims factually support its decision is not the same as making findings. Treasury’s approach could arguably have been made to obscure that omission: instead of addressing Perry’s contentions point by point, Treasury makes an omnibus argument that the Sweep Amendment was the result of reasoned decision making. If Perry is correct on the law, and I have already said that Treasury’s rights argument is, well, this time let’s say not well founded, and the APA requires explicit findings, not after the fact justifications, Perry wins this one.

Final Thoughts

I ask the legal reader’s indulgence and understanding. Reducing 556 pages to twelve pages demands many editorial choices and simplifications. A better job could be done and I invite others to do so. With two exceptions I have not read the underlying cases or statutes but limited myself to the flavor and power of the briefs. The two cases I did read were to settle in my own mind which litigant was more accurate when the briefs bickered that the other side was mis-citing a case. In both instances, in my opinion, Perry was more accurately citing the case.

The reader should remember two things when thinking back over the arguments. First, for the Government to win the motion to dismiss, only one argument of three arguments has to succeed. Second, for Perry to win, only one argument of about seven has to succeed.

An interesting note about the briefs, not apparent from the arguments themselves, is the implicit difference in the world views underlying Perry’s and the Government’s positions, which occasionally come out explicitly.

Perry views the FHFA’s role as a conservator as analogous to a reorganizing bankruptcy trustee. A trustee is appointed to stabilize the debtor, secure financing, rationalize the operations and financial structure of the debtor and eventually return the debtor to either the original or new equity holders. In contrast, the Government’s perspective is that without its massive financial support Fannie would be worthless. Thus, the shareholders had no expectation of any value in their shares. What strikes many commentators as outrageous, that the Sweep Amendment was entered into just as Fannie became operationally profitable and just before Fannie recognized the deferred tax assets seems to leave the Government incredulous that anyone would think their behavior anything but arms length and above board.

Another interesting feature is the evolution of the Government’s public statements about the case. As cited in both sets of briefs, when FHFA became the conservator, the public statements were about the conservator’s duties to maintain and preserve Fannie for the benefit of the shareholders. As time went by, again as quoted in both sets of briefs, the Government’s position morphed to Fannie being held for the benefit of the taxpayers. This is particularly intriguing given that, to my memory, the Government never changed its public stance in the General Motors (NYSE:GM), Chrysler or AIG bailouts. In my view, this shift in the Government’s public stance adversely colors the Government’s arguments. The Government’s briefs, while very well written, in light of the massive permanent transfer of assets from the shareholders to Treasury and the public changes in policy pronouncements, come across, in my opinion, in hindsight as tawdry after-the-fact justifications.

I first read the briefs looking for the disconfirming evidence that my long position in Fannie was a good idea. I read the briefs with my finger metaphorically poised over the “sell” button waiting for the Government’s dispositive argument. Instead, time and again, after working through pages of very well written arguments, I was shocked to discover the essential weakness of the Government’s position behind the rhetoric. I wrote this article in a further effort to find that disconfirming evidence. After all, if an investment is too good to be true, then it is too good to be true. My reasoning was that if I could understand the arguments well enough to distill 556 pages down to 12 pages, I would find the Government’s dispositive argument and realize the error of my investment before it was too late.

I remain long Fannie common.