Right now litigation is going forward on multiple fronts in the multi-billion battle over who gets the billions of dollars in new cash flow and deferred tax assets now that Fannie Mae and Freddie Mac have both turned profitable.  The government strategy is to draw matters out by resisting discovery and insisting that none of the private shareholders of Fannie and Freddie have standing to bring their claims.

For over eighteen months now, I have analyzed and commented on these law suits as a consultant for several of the institutional investors who have stakes in the outcome of the litigation.  My current judgment is that the government is on the losing end of this long-running tug-of-war for two reasons.

First, the information sought in discovery is relevant to establish the level of cooperation between the Federal Housing

English: The Colonial Revival headquarters of Fannie Mae, designed by architect Leon Chatelain, Jr. in 1956, located at 3900 Wisconsin Avenue, N.W., in the Cathedral Heights neighborhood of Washington, D.C. (Photo credit: Wikipedia)

Financial Agency (FHFA) and the United States Treasury, which would allow them to be joined as defendants in the Court of Federal Claims.  The best the government can hope for is a protective order on how the information is used.  But it won’t be able to keep that relevant information out of the hands of the plaintiff.

Second, the government will not prevail in the argument that since it has “all rights” of the private shareholders under Section 4617(b)(2)(A) of the Housing and Recovery Act, it need pay no mind to the interests of the private shareholders.  No court will read the statute in a way that would allow for the de facto confiscation of all dividends, liquidation, and control rights, which is tantamount to a compensable taking under the Fifth Amendment.  Instead, courts will hold that FHFA has all the shareholder rights against third parties, but remains subject for suits under the takings’ claim and breach of fiduciary duty in its relationship with Treasury.

The time has now come to start thinking seriously about the remedies that should be awarded against the government if the private plaintiffs eventually win.  At this point, the delay added through the litigation is costly to the government.  It makes it highly likely that undoing the dividend sweep under the Third Amendment to Preferred Stock Purchase Agreements (PSPAs) will result in repayment to the government of all the cash that was advanced after September 2008.  By the end of September 2014, it is possible that the payments under the August 2012 Third Amendment to the PSPAs will be in excess of the 10 percent annual dividend currently payable under the original agreement on the senior preferred. In other words, the takings by the government will exceed the $188 billion previously advanced by U.S. taxpayers to Fannie and Freddie.  Within in a short period of time thereafter, the total payments are likely to exceed the amount of the advances plus interest.  What happens next?

According to Laurie S. Goodman, in her report, “A Realistic Assessment of Housing Finance Reform,” takes the position that the question of how these payments should be treated does not have an authoritative answer.  Goodman notes:

“It is interesting that the PSPAs did not contain any mechanism for Fannie and Freddie, if and when they became profitable, to pay back the government debt. That is, even if the GSEs were able to pay down the debt, they would not be permitted to do so under the terms of the PSPAs. This provides some indication of the thought process at the time: the GSEs were never provided with a mechanism to emerge from conservatorship because it was never expected they would do so. It may be possible for one to argue that Treasury was moving so quickly in 2008 that this possibility was overlooked; for it to be overlooked in 2009 as well seems unlikely.” (Page 12)

There is no question that the PSPAs do not contain any provision that sets out a mechanism for paying down Treasury’s liquidation preference (which technically speaking is not debt).  But Goodman in dwelling on the PSPAs fails to take into account the stock certificates in Fannie and Freddie, which do address this issue in explicit terms.  It is therefore wrong to draw any inferences about the “thought processes” of the parties who drafted these amendments.  A quick look at these certificates indicates that they were drafted by professional lawyers, whose business is to accurately reflect the basic understandings of their sophisticated clients.  Lawyers in dealing with complex corporate transactions routinely cover all contingencies that might arise over several years, so that any complex agreement may last.  In this particular instance, the two detailed provisions that are directed to the repurchase question give rise to a strong inference opposite to that which Goodman suggests.  These provisions were inserted at the behest of the parties.  Conservatorships are drafted with an eye toward their ultimate success, not their possible failure. They start from the assumption that the arrangement should be temporary and not permanent in nature, and that once the immediate peril is past, and the companies are returned to health, the conservatorship shall give way to “the orderly resumption of private market funding or capital market access.” Speed, not delay, is the dominant motif.

The key provisions in the stock certifications offer ample support for that position, by addressing vital issues not covered either in the PSPAs or in the Third Amendment. Both stock certificates first establish the priority of the senior preferred over all other issues of preferred and all common stock in Section 1.  In section 2, the certificates state that the sellers of the senior preferred (e.g. Fannie and Freddie) have the option to pay dividends either 10 percent in cash or an in-kind payment at 12 percent on a deferred basis, by adding the amount of the deferred payment to the liquidation preferences owed to the holders of the senior preferred, which implies that the government at any time could sell these shares to third parties if it chooses.

Section 3 then, set outs “Optional Pay Down of Liquidation Preference” that specifies that “[f]ollowing termination of the commitment” of the Treasury to make further advances of cash for new senior preferred shares, “the Company may pay down the Liquidation Preference of all outstanding shares of the senior preferred stock pro rata, at any time, in whole or in part, out of funds legally available therefore.”  Since there are no unpaid cash dividends all, these payments immediately go to reduce the amount of the liquidation preference.

With or without the Third Amendment, the Treasury’s commitment to make further advances remains, even if no such advance has been made since the beginning of 2012.  But that commitment is of little if any value now that further advances from Treasury are no longer needed. Most critically, Section 4 addresses “Mandatory Pay Down of Liquidation Preference Upon Issuance of Capital Stock.”

Its exact provisions need to be quoted to grasp the full legal position. This section comes into play “if the Company shall issue any shares of capital stock (including without limitation common stock or any series of preferred stock) in exchange for cash at any time while the Senior Preferred Stock is outstanding.”  Note that this provision does not require the consent of that “the holders of record of the outstanding shares of the Senior Preferred Stock” (which need not be the US Treasury).  These shareholders receive full protection because Fannie and Freddie are obligated to “use the proceeds of such issuance . . . to pay down the Liquidation Preference of all outstanding shares of Senior Preferred Stock pro rata, out of funds legally available therefor. . .”

In sum, Section 4, of the senior preferred stock certificate in essence allows the trustees of Fannie and Freddie to go to the market at any time to raise new capital, including new capital with lower dividend coupons, to buy back the Treasury’s senior preferred.  Any loyal conservator of Fannie and Freddie would take advantage of this refinancing option to end the bailout arrangement, by paying off the senior preferred in full once Fannie and Freddie have sufficient capital to resume normal market operations. At this point, it is a fair inference that the Treasury commitment would end once that recapitalization is complete.  In light of this arrangement, it seems incorrect to argue, as does Goodman, that “the GSEs were never provided with a mechanism to emerge from conservatorship because it was never expected they would do so.” The mechanism is there as clear as day in the stock certificates and the repurchase option set out is fully consistent with the view that the government advances were, if possible, only a short-term backstop that Fannie and Freddie could refinance at any time with private capital.  Furthermore, FHFA would also refinance the expensive 10 percent preferred for cheaper preferred or common, once it became clear, as it is now, that these are healthy companies (in which case cheaper financing is available).

At this point, the Third Amendment cannot be used to wipe out the 10 and 12 percent dividend rates in the initial stock certificates.  Once the Third Amendment is declared illegal, as it should be, the extra payments to Treasury must be treated first as though they were a return of capital that calls for a dollar-for-dollar redemption of the senior preferred, thereby reducing the Treasury’s liquidation preference.  Once all those shares are redeemed, the remainder of the money paid over to Treasury should be treated as excess payments that must be repaid in full to Fannie and Freddie with interest.

Nothing else makes sense.  Suppose the government sought to just repay the extra money to Fannie and Freddie in order to reinstate the above-market 10 percent dividend. It still could not reasonably prevent Fannie and Freddie from exercising the mandatory repurchase under Section 4.  So why go through the charade of asking Fannie and Freddie raise additional capital to pay off the senior preferred in full when it has already been paid. Read together, Sections 3 and 4 make it impossible for the government to keep the highly favorable 10 percent dividend in place when it is no longer warranted by market conditions.

At this point, the government’s litigation strategy looks reckless. In slowing down the judicial proceedings, it only increases its financial exposure if it loses on its weak effort to uphold the Third Amendment.  Time does not erode any of Treasury’s financial obligations, but only adds more interest to the bill. Delay does not prejudice the plaintiff’s case.  It only runs up the government tab.  The government cannot run out the clock, so it should turn over all relevant documents now so that the case can be fully litigated on its merits.  Once the preferred stock certificates are read in tandem with the PSPAs, the government’s prospects look a lot grimmer than Laurie Goodman’s “realistic assessment” suggests.

Richard A. Epstein  is the Laurence A. Tisch professor of Law at NYU, senior fellow at the Hoover Institution, and senior lecturer at the University of Chicago Law School.