Right now the biggest lawsuit in town is found in the multiple actions brought to set aside the Third Amendment to the Senior Preferred Stock Purchase Agreement (SPSPA) that was entered into between the Federal Housing Finance Administration (FHFA) and the United States Department of Treasury on August 17, 2012. Just yesterday in a misguided blockbuster opinion in Perry Capital LLC v. Jacob Lew, Secretary of Treasury, Judge Royce Lamberth of the District Court of the District of Columbia released both FHFA and Treasury from any obligations to the private shareholders of Fannie and Freddie, with a reading of both the Third Amendment and the applicable case law that cries out for reversal. In my work as a consultant to many of the institutional hedge funds that have invested in the junior preferred and common stock of Fannie and Freddie, I have always warned that any litigation against the government is a perilous activity because of the “enormous discretion” that federal judges give to the government no matter how outrageous its conduct. Unfortunately, Judge Lamberth misguided opinion has upheld that Amendment in all particulars, which takes the current law to new lengths in favor of the government. I cannot deal with all of the confusions and errors in his decision, but it is important to mention at least some of them here.

The Original Deal Misconstrued

The key provision of that agreement was that FHFA and Treasury agreed to a deal whereby the Treasury waived its right to receive fixed dividend payments from both Fannie and Freddie, in exchange for a full dividend sweep, under which all of the profits of Fannie and Freddie were paid over to United States Treasury – in perpetuity. This transaction made it impossible for Fannie and Freddie to ever repay the $188.5 billion that it had received from Treasury after the initial SPSPA of September 2008. This Amendment replaced the terms of the original stock certificates whereby Fannie and Freddie were required to pay 10 percent per annum or about $19 billion per year in dividends. The original certificates for Fannie and Freddie provided then provided as follows:
“‘Dividend Rate’ means 10.0%; provided, however, that if at any time the [GSE] shall have for any reason failed to pay dividends in cash in a timely manner as required by this Certificate, then immediately following such failure and for all Dividend Periods thereafter until the Dividend Period following the date on which the Company shall have paid in cash full cumulative dividends (including any unpaid dividends added to the Liquidation Preference pursuant to Section 8), the ‘Dividend Rate’ shall mean 12.0%.”
The italicized words are those of Judge Lamberth, who thought that it is proper to characterize the 12 percent deferred dividend option as “penalty,” which makes no sense at all. Essentially, what the government does is gain and entitlement to an additional sum of money if Fannie and Freddie “fail” to pay the money, which they do whenever they don’t pay it. The passage ends with the phrase “the ‘Dividend Rate’ shall mean 12.0%” because the 12 percent figure is a definitional not a penal matter. Provisions like this are common in all sorts of financial arrangements, and the natural meaning of the provision is that it confers another option on the borrower in the timing its repayments. But once this odd invocation of the notion of a penalty reads the 12 percent option out of the case, then Judge Lamberth buys lock, stock, and barrel, this improbable justification that both FHFA and Treasury put forward for the deal.

As FHFA further claims, the agency executed the Third Amendment to ameliorate the existential challenge of paying the dividends it already owed pursuant to the GSE securities Treasury purchased through the PSPA. “The [GSEs] were unable to meet their 10% dividend obligations without drawing more from Treasury, causing a downward spiral of repaying preexisting obligations to Treasury through additional draws from Treasury.”

The point is odd in all its particulars. There was as of August 2012 no downward spiral at all. Indeed, the companies were profitable. Nor could there be one even in principle if the 12 percent alternative dividend rate for deferred payments is still available to Fannie and Freddie. At this point, the conservator in question is supposed to be adverse to the Treasury, but it nonetheless prefers to give away all of the potential gains to the Treasury in exchange for being relieved of the 10 percent obligation which was not absolute in the first place. If any private trustee entered into that kind of deal with its preferred shareholder, he would end up in jail for dissipating the assets of the firm. But Judge Lamberth announces that the necessary and known total imbalance associated with the deal is of no consequence. He notes, correctly, that a conservator is supposed to nurse a business back to prosperity, and then engages in the inexcusable nonsequitur, “Here, the GSEs maintain an operational mortgage finance business and are, once again, profitable—two facts indicative of a successful conservatorship. Thus, the plaintiffs plead no facts demonstrating that FHFA has exceeded its statutory authority as a conservator.”

The sad mistake in this analysis is that it forgets to ask to whom the conservator owes its fiduciary duty. To Judge Lamberth it is just fine for the conservator to give away all its assets in exchange for the release of a debt that it could never (given the 12 percent option) be required to pay. But the conservator here is supposed to deal at arm’s length with the government, and not act in cahoots with it. It is therefore impossible to accept the proposition that FHFA did not exceed its statutory authority, because if this wholesale giveaway is within the scope of its duties, then no action ever could exceed that position.
Wishing Away the Right to Sue

In order to reach the opposite conclusion Judge Lamberth takes refuge in a key provision of the Housing and Economic Recovery Act (HERA) that provides in its role of conservator the FHFA succeeded to “all rights, titles, powers, and privileges of the regulated entity, and of any stockholder, officer, or director of [Fannie Mae].” 12 U.S.C. § 4617(b)(2)(A)(i). At one level, the introduction of the term “stockholder” could be read to say that the stockholders of the company have no rights at all against FHFA. But this argument cannot be correct. Taken in its literal form, it would mean that the day after the conservatorship were formed, FHFA at any time could just give all of its assets to the federal government for nothing in exchange, leaving the shareholders helpless to protest. But clearly that position would be so extreme as to constitute a taking of their private property.

Judge Lamberth brushes aside that point on the ground that HERA is a simple regulatory statute that does not take away any “cognizable” property interest even though all their dividend, liquidation and control rights are extinguished—a total wipeout. His position amounts to the remarkable assertion that any asset that is held in corporate form is fair game for government pickings, so that by his warped logic, the government could throw any corporation into conservatorship and then strip it of its assets, and say no harm done at all.

It is for precisely this reason that the correct interpretation of HERA reads into it an exception to HERA in cases where there is “a manifest, disabling and irreconcilable” conflict of interest that prevents FHFA from suing Treasury. Indeed, as the Ninth Circuit wrote in County of Sonoma v. FHFA, the bar on judicial review is not available to “restrain or affect the exercise of powers or functions of [FHFA] as conservator or receiver.” Yet note the flip side. “Conversely, the anti-judicial review provision is inapplicable when FHFA acts beyond the scope of its conservator power.”

It is important to see how this distinction plays out in different settings. Initially, such a conflict is not found in those situations where FHFA pursues claims against third persons, where it would be a manifest inconvenience to allow for any divided authority over the claim. Just that result was found for example recently by District Court Judge Amy Jackson in Estate of Sweeney v. United States Treasury where in 2009 FHFA rejected a proposed that that it sell off some of its low-income housing tax credits (“LIHTCs”) to private parties. These tax credits would only have been of value to Fannie and Freddie if they could use then to set off against income from others sources, which Fannie and Freddie could not do in 2009. The point of the proposed sale was to allow Fannie and Freddie to receive an infusion of cash by selling about $2.6 billion in tax credits. When FHFA decided not to pursue any litigation against Treasury, the shareholders brought a derivative action on behalf of the corporation against Treasury. They lost when Judge Berman succinctly noted, “only the Conservator may bring suit on behalf of Fannie Mae.”

Yet Judge Jackson did not treat conflict of interest exception as empty, but noted that it had been applied against the Federal Deposit Insurance Corporation (FDIC), in situation much like the current dispute over the Third Amendment, “because of the FDIC’s conflict of interest by which it is both alleged to have caused the breach and controls the depository institution” that was in FDIC receivership. In my view, Judge Jackson was correct to include that no such conflict existed in the dispute before her, where both the shareholders and FHFA want to get the maximum value the LIHTCs, and just disagreed as to whether a sale makes sense at this time. At this point, Judge Jackson is surely correct to conclude, “whether or not to spend Fannie Mae’s assets on a lawsuit against Treasury is plainly the type of business decision Congress entrusted to the Conservator in HERA.” It is also worth noting that even with hindsight the decision of Treasury on this point looks perfectly defensible now that Fannie and Freddie have proved profitable enough to benefit from those tax credits. The same conclusion properly holds for Sonoma County where the Ninth Circuit held that it was clearly within FHFA’s core powers not to purchase for its portfolio certain liens created under certain “property-assessed clean energy (“PACE”) programs.” Both cases involve the standard application of the business judgment rule.

In contrast with Estate of Sweeney and Sonoma County, the suits brought by Perry, Fairholme & Arrowhead to set aside the Third Amendment fall squarely into the judicially recognize conflict of interest exception. No longer is the question of whether it makes sense for both FHFA and Treasury to buy some assets from third parties. Indeed, the suits brought in this case are not derivative actions against third parties brought on behalf of Fannie and Freddie. Rather they are actions against the Treasury and FHFA for the direct injuries that their actions have caused to the private shareholders of both companies. The ultimate legal challenge in this case is whether FHFA in breach of its fiduciary duties to the private shareholders of Fannie and Freddie gave away their assets to the government through the one-sided dividend sweep.

The challenges raised in the litigation to set aside the Third Amendment raise the quintessential conflict of interest situation where every extra penny that goes to the Treasury is a penny less to the private shareholders of Fannie and Freddie. To be sure, the Treasury has the power to block any third party transaction that it thinks will deplete the available assets of Fannie and Freddie. But, contrary to Judge Lamberth’s protestation it has no power unilaterally to force FHFA to turn over all the net profits of Fannie and Freddie. That is why Treasury sought and obtained the contractual modification via the Third Amendment with FHFA, in a transaction that is now being attacked vigorously as being wholly unfair to the private shareholders. For Justice Lamberth to say that “FHFA’s Justifications for Executing the Third Amendment Are Irrelevant for § 4617(f) Analysis” is to issue the government a blank check to do whatever it wants whenever it wants. The preservation of the rule of law depends on holding government officials to their duties just as if they were private persons. The willingness to give government a free fire zone in which they can act as they please without having to justify their actions in a court of law is too audacious to stand.

Fortunately, Judge Lamberth does not represent the only game in town. Concurrently, litigation is also taking place in the Court of Federal Claims before Judge Margaret Sweeney, who has prudently refused to grant the government a summary judgment and has ordered discovery to take place on all the issues that are relevant to any proper resolution of this dispute. She has asked for information of whether Fannie and Freddie were profitable at the time of the Third Amendment’s dividend sweep, whether the government knew this information, and whether government officials introduced the sweep solely to deprive private shareholders of the value of their claims. As the discovery in that claim goes forward, Judge Lambeth’s sweeping decision will come to be seen for the massive judicial injustice that it surely is.
***In a bit of very unfortunate time, just before Lamberth’s opinion had come down, I had published an earlier analysis of Estate of Sweeney, much of which is included here. I have removed that post on the grounds of its premature obsolescence. The basic analysis of the underlying issues remains the same.

The WSJ’s Improbable Defense of Judge Lamberth’s Indefensible Decision in Perry Capital

In my previous two posts on Forbes.com, found here and here, I have attacked for a variety of reasons the recent memorandum opinion of Judge Royce Lamberth in Perry Capital LLC v. Lew, which he issued before discovery and without hearing oral arguments from either.  In this post, still writing as a consultant for several institutional investors, I refer to those statutory provisions that Judge Lamberth (the Perry Capital opinion) either ignored or misconstrued.  In my judgment, these errors of omission and misinterpretation, when joined with the mistakes I referred to in the earlier posts, are so serious and one-sided, that he should withdraw his decision, in order to reconsider this position.

More specifically, the Perry Capital opinion plays fast and loose with the statutory framework of the 2008 Housing and Economic Recovery Act (HERA) in ways that paint a totally false picture of its treatment of three key points. First the opinion seriously misstates the rights and duties of the Federal Housing Finance Agency (FHFA) as a conservator.  Second, it seriously misstates the authority of Treasury under HERA.  Third, he refuses to allow any evidence on the possible collusion between FHFA and Treasury in fashioning the Third Amendment.

First, let’s examine FHFA’s rights and duties. In his opinion, Judge Lamberth quotes 12 U.S.C. § 4617(a)(2), which provides “[FHFA] may, at the discretion of the Director, be appointed conservator or receiver for the purpose of reorganizing, rehabilitating, or winding up the affairs of a regulated entity.” His implication is that both conservators and receivers have all the powers listed in this section. But he fails to quote the provision that deals exclusively with the duties of FHFA as conservator:
12 U.S.C. 4617(b)(2) (D) Powers as conservator

The Agency may, as conservator, take such action as may be—

(i) necessary to put the regulated entity in a sound and solvent condition; and

(ii) appropriate to crry on the business of the regulated entity and preserve and conserve the assets and property of the regulated entity.

Note that this last provision does not refer to any ability of the conservator to “wind up” the operations, which is a power given exclusively to a receiver. Nor does it contemplate in the slightest, as Judge Lamberth suggests in footnote 20 any “fluid progression” that allows FHFA secretly to morph itself from a conservator to a receiver, without going through any formal process to work that change. It is wholly incorrect for him to write “FHFA can lawfully take steps to maintain operational soundness and solvency, conserving the assets of the GSEs, until it decides that the time is right for liquidation. See 12 U.S.C. § 4617(b)(2)(D) (“[p]owers as conservator”).” The cited section, quoted in full above, negates that fanciful suggestion. That conclusion is reinforced by 12 U.S.C. § 4617(b)(2)(E), immediately following, which addresses separately the “additional powers as receiver” to organize a liquidation of assets. The choice of form matters. The FHFA needs to initiate a formal proceeding to make the shift from one role to the other, which it has never attempted.

Second, Treasury’s authority under HERA. Indeed, the stringent limits on FHFA referred to above fit into the parallel limitations that HERA imposes on Treasury. In footnote three the Perry Capital opinion has this to say about the key provisions in HERA:

The purpose of HERA’s provision authorizing Treasury to invest in the GSEs was, in part, to “prevent disruptions in the availability of mortgage finance”—disruptions presumably due to the challenges confronting the GSEs in 2008. See 12 U.S.C. § 1455(l)(1)(B); 12 U.S.C. § 1719(g)(1)(B) (“Emergency determination required[.] In connection with any use of this [purchasing] authority, the [Treasury] Secretary must determine that such actions are necessary to—(i) provide stability to the financial markets; (ii) prevent disruptions in the availability of mortgage finance; and (iii) protect the taxpayer.”

The passage is accurate insofar as it goes, but it does not go far enough, because it ignores the sections just before and just after it.  Thus Judge Lamberth does not deal with 12 U.S.C. § 1719(g)(1)(A), which makes it clear that any bailout requires the “mutual agreement between the parties,” such that the Secretary cannot unilaterally impose a deal.  Similarly he ignores 12 U.S.C. § 1719(g)(1)(C),  which lists among the relevant considerations “[t]he corporation’s plan for the orderly resumption of private market funding or capital market access,” and further “[t]he need to maintain the corporation’s status as a private shareholder-owned company. The Third Amendment, which precludes any return to the private market, is flatly inconsistent with these provisions.   Nor does he mention that there is not one single reference to a receiver or receivership in this entire section of HERA that deals with Treasury’s powers.  Any modification of the initial 2009 deal to impose a receivership is beyond the powers of Treasury.  The same fate should await the de facto liquidation under the Third Amendment.

Third, Treasury’s oversight of FHFA. The Perry Capital opinion does quote section 4617, (a)(1)(7) which notes  that when acting “When acting as conservator or receiver, the Agency shall not be subject to the direction or supervision of any other agency of the United States or any State in the exercise of the rights, powers, and privileges of the Agency.”  That provision appears to preclude FHFA from taking directions from Treasury as the plaintiffs alleged.  Nonetheless, this section is dismissed in the opinion as irrelevant because of defect in the plaintiff’s pleadings.

However, “records” showing that Treasury “invented the net-worth sweep concept with no input from FHFA” do not come close to a reasonable inference that “FHFA considered itself bound to do whatever Treasury ordered. The plaintiffs cannot transform subjective, conclusory allegations into objective facts.

The Perry Capital opinion appears to concede indirectly that the Treasury came up with this idea on its own but, nonetheless, dismisses the plaintiff’s contention as “conclusory allegations.”  It is at this point, that the procedural posture of the claim matters.  At no point, did Judge Lamberth allow for any discovery to establish the nature of that connection. That seems wrong.  And, at no point does the opinion make reference to the Jeffrey Goldstein memo of December 20, 2010, reported by Gretchen Morgenson of the New York Times, with its bald assertion that “’the administration’s commitment to ensure existing common equity holders will not have access to any positive earnings from the G.S.E.’s in the future.” Nor has anyone proffered any independent work by FHFA preparatory to the Third Amendment that might bear on the supervision issue.  Judge Lamberth should have surely allowed for discovery on this key issue, which he refused to do.

I regard these deficiencies as incurable, and Judge Lamberth should rethink this opinion. He already senses the uneasiness of the situation when he writes:

It is understandable for the Third Amendment, which sweeps nearly all GSE profits to Treasury, to raise eyebrows, or even engender a feeling of discomfort. But any sense of unease over the defendants’ conduct is not enough to overcome the plain meaning of HERA’s text.

Judge Lamberth’s decision flunks his own test. It is not possible to show fidelity to HERA’s text by ignoring or misreading its most salient provisions.  If Judge Lamberth does not reconsider his opinion, the Court of Appeal should instruct him to do so in no uncertain terms.  And in the interim, Judge Margaret Sweeney should continue with her discovery on all disputed questions of fact until the full record comes out.