Richard Epstein December 16, 2015
The new round of Fannie and Freddie litigation – Jacobs v. The Federal Housing Finance Agency has opened up a second-front in the ongoing struggle between the preferred and common shareholders of Fannie Mae and Freddie Mac, often called Government Sponsored Enterprises, or GSEs, and the United States government. As an advisor to various institutional investors, I have already written at length on this issue. The federal takeover of Fannie and Freddie took place in two distinct phases. In the first phase, completed on September 6, 2008, Treasury replaced the private trustees of Fannie and Freddie with a receiver, the Federal Housing and Finance Agency (FHFA), which then appointed Edward DeMarco as conservator for both companies. Immediately thereafter, Treasury and FHFA agreed to a Senior Preferred Stock Purchase Agreement (SPSPA) under which Fannie and Freddie issued a new class of senior preferred stock to Treasury in exchange for a $200 billion line of credit (later extended to $300 billion) of new equity capital. Treasury’s new senior preferred carried a 10% annual dividend, but allowed both, without limitation, to defer payment of these dividends by assuming an “in kind” obligation to pay a 12% on the outstanding senior preferred.
Jacobs does not challenge the validity of the 2008 bailout. But the suit demands that FHFA and Treasury respect its terms today. Its target is the Third Amendment to the SPSPA consummated on August 17, 2012, between FHFA, as conservator, and the Treasury. That amendment implemented a net worth sweep (“sweep”) under which, with minor exceptions, all the new income received by Fannie and Freddie was paid over to Treasury as a dividend on its outstanding senior preferred stock. As recently recounted by New York Times reporter, Gretchen Morgenson, “(t)he timing of the 2012 profit sweep announcement was fortunate for the Obama administration.” The sums involved have been large enough, she notes, to help “the Treasury Department manage its debt during budget showdowns with Congress.
The sole purpose and consequence of this audacious move was to guarantee that Fannie and Freddie could never redeem the senior preferred by paying down any of $188 billion, no matter how profitable they became. The sweep is, and was meant to be, a wholly one-sided collusive deal, which was meant to make sure that the junior preferred and common shareholders of Fannie and Freddie would never receive a single penny.
The sweep came, moreover, at a most opportune time for the government, just when it became clear that Fannie and Freddie had turned a corner, so that the anticipated results were far better than those earlier expected. That potential financial windfall put the wheels in motion at Treasury to rework the deal on terms far more favorable to the government than the earlier deal. Morgensen reported that Adam Hodge, speaking for Treasury, declared that the sweep was needed to end a “vicious cycle” (referred to in litigation as a “death spiral”) in which the companies had to pay cash dividends even if they did not have the cash to make those payments.
Hodge is flatly wrong on both counts. First, there is no vicious cycle, death spiral or anything of the sort. The GSEs were not obligated to pay their dividends in cash at the 10% rate because they had the option to defer payments, i.e. pay in kind, at a 12% rate. If either GSE chose to do so, its accumulated indebtedness would rise, but there would be no fresh infusion of cash from Treasury. Moreover, Treasury for its part could always refuse to make future advances if it did not like how matters were progressing. In any event, there were no fresh advances from Treasury in the run-up to the general sweep, because none were needed. The companies were about to become massively profitable, generating sufficient cash to pay the 10% dividend currently, so that the in kind payment option did not matter—and, with its complete access to the relevant data, Treasury knew it. In its defense in the early litigation on the sweep, Treasury and FHFA justified their actions by telling courts there was a “death spiral.” The documents revealed in discovery showed no evidence of any such spiral that could impair the GSEs profitability, so this suggestion was quietly dropped later on.
Second, the ridiculous deal is not made a legally appropriate one because both parties to the Third Amendment were sophisticated. That might have been a defense had they been on opposite sides of the table, but in this case both were on the same side. Edward DeMarco, who represented FHFA, was a Treasury staffer from 1993 to 2003, where his policy work centered on the GSEs. Neither side, Treasury or FHFA acted as if it had any fiduciary duties to private shareholders even though both had such duties – Treasury as majority shareholder, FHFA as sitting in the shoes of the board of directors. At this point, with the two parties colluding on the same side of the table, the government’s sophistication counts as a reason to upset the deal and not to uphold it.
To see why, it is critical to note that the sweep itself revealed a fatal structural imbalance built into the Housing and Economic Recovery Act (HERA), passed in 2008 to deal with potential breakdowns in the financial system. HERA was drafted on the assumption that Treasury would deal at arm’s length with independent trustees for any bailout recipient. Accordingly, it instructed Treasury to protect taxpayer interests, by making sure that Treasury did not give overgenerous terms to any bailout recipient. The directors of the receiving entity could protect its shareholders. But Fannie and Freddie were stripped of that independent protection because FHFA as conservator was answerable only to Treasury, and not its shareholders. At no point did the FHFA conservator care whether sweep would benefit Fannie and Freddie’s junior preferred and common shareholders. Instead the two government agencies formed a united front with Treasury to defend it against any attack from shareholders. There is no doubt that if FHFA and Treasury were private parties, they could be exposed to serious civil and criminal liability under both the federal securities and various state laws, so egregious is their departure the standard business norms applicable to private fiduciaries and their business partners. The simple fact that FHFA and Treasury are on the same side of this lawsuit is conclusive evidence that FHFA abandoned its shareholder fiduciary duties in order to participate in a massive giveaway to the government.
The plaintiff class in Jacobs mounts a two-prong attack on the sweep. It first raises many of the issues so critical to suits brought by both Fairholme Capital and Perry Capital. Both cases are now on appeal to the District of Columbia Court of Appeals, after they were dismissed on a summary judgment motion in Perry Capital v. Lew(issued without the benefit of any oral argument or discovery) by Judge Royce Lamberth on September 30, 2014, a decision that I regard as unsound, on every major point that it addresses. Many of their earlier arguments are rehashed by FHFA and Treasury in their combined brief, but the responses to them should be restated anew in this context. In addition, the Jacobs class makes several arguments that the sweep is ultra vires, that is outside the power of FHFA under the Delaware General Corporation Law (DGCL), which imposes strict limits of the power of any corporation to issue preferred stock. I shall take up these issues, both procedural and substantive, in order.
Jacobs claims under HERA. The government brief opens with a grotesque mischaracterization of legal issue. In its view, the plaintiffs are asking the court to “re-write” the agreements that FHFA and Treasury entered into “to stabilize the Enterprises and the national economy.” Nothing could be further from the truth. The gist of the lawsuit is that the entire 2008 SPSPA should be enforced, and the sweep should be repudiated as a one-sided renegotiation of the original deal long after the residential mortgage market had become stabilized. The government notes the $188 billion advance, but falls silent when it comes to the more than $230 billion in dividends—$43 billion more than had been lent—it had received as of last summer. Properly treated $128 billion of the original $188 billion should have been treated as a redemption of senior preferred, leaving only $59 billion of preferred stock outstanding. Instead, the government, which has taken everything, falsely accuses the shareholders of seeking to “reward themselves at the expense of federal taxpayers,” without once mentioning that the past and future redemptions.
The government then makes the further dubious claim that the plaintiffs here should not be entitled to anything because they purchased their stock in the open market, and thus made no direct contribution to the capital of either Fannie or Freddie. But that populist appeal is subject to two decisive replies. First, it does not explain why small investors who have held their shares for long periods of time should be subject to the same shabby treatment that the government wishes to impose on the buyers of these shares. Second, the government’s argument ignores the standard rule by which purchasers of stock in the open market succeed to all the rights and duties of their predecessors in title. On the government’s strange position, the secondary market would close down if any sale stripped both buyer and seller of the right to pursue any and all claims against FHFA and Treasury.
After these preliminaries, the government brief throws procedural obstacles in the path of the Fannie and Freddie shareholders. Its first move is to claim that every court in the land lacks jurisdiction over these claims because HERA provides that “no court may take any action to restrain or affect the exercise of powers or functions of the [FHFA] as conservator.” It then notes that FHFA as conservator succeeds to “all rights, title, powers, and privileges of the regulated entity, and of any stockholder” thereof. 12 U.S.C. § 4617(b)(2)(A). What is striking about this claim is that the government never once quotes the language in HERA that defines FHFA’s obligations as a conservator. FHFA must “conserve and preserve” assets for the benefit of its shareholders the assets that the sweep gives away to the government. FHFA must “rehabilitate” the two companies to “a sound and solvent” condition, with an eye toward their “orderly resumption of market funding or capital access,” as “private shareholder-owned company[ies]”… It is impossible to understand how a massive giveaway falls “squarely” in its the statutory authority.
The key provision on which the government relies is 12 U.S.C.§4617(f), which provides: “(f) Limitation on court action “no court may take any action to restrain or affect the exercise of powers or functions of the Agency as a conservator or a receiver.” As the government reads this provision, there is no effective judicial oversight over FHFA ever, which should be treated as a conservator even when its actions are utterly inconsistent with its explicit fiduciary duties. To be sure, this provision makes good sense making sure that shareholders could not “second guess” each and every business decision of FHFA in dealing with third-parties.
Unfortunately, that is not what is at stake here: namely stripped assets instead of managing them. As stated in Kellmer v. Raines, the correct rule reads as follows: “absent a manifest conflict of interest by the conservator not at issue here, the statutory language bars shareholder derivative actions” (emphasis added). But in this case, there is a manifest conflict of interest in the self-dealing between FHFA and Treasury. Nor are the shareholders in question bringing a derivative action on behalf of the corporation against any third party. They are suing as direct beneficiaries for breach of fiduciary duty that HERA imposes on FHFA as conservator of Fannie and Freddie.
The same approach was taken in Hindes v. FDIC under 12 U.S.C. § 1821 (j), the parallel provision in FDIC on which 12 U.S.C.§4617(f) is model. There the court wrote:
“Our interpretation of section 1821(j) only denies appellants the declaratory and injunctive relief they now seek, but does not deny them judicial review for their constitutional claims. Courts uniformly have held that the preclusion of section 1821(j) does not affect a damages claim.”
And further, “Courts, however, have recognized a limited exception to a statute’s specific withdrawal of jurisdiction where the plaintiff claims that the agency acted in a blatantly lawless manner or contrary to a clear statutory prohibition.”
The above exceptions 12 U.S.C.§4617(f) (found in the very cases cited by the government) make perfectly good sense. The Jacobs plaintiffs are not trying to upset FHFA’s decisions on whether to hold or sell specific assets for the benefit of the shareholders. They are seeking to reverse a blatant set of constitutional violations brought on by the sweep, which was an egregious case of self-dealing. It is indefensible to insist that corporate looting by government falls outside the scope of judicial review. To back up its aggressive claim, the government insists that under 12 U.S.C. §4617(b)(2)(J)(ii) FHFA may “take action that it determines is in the “best interests of the regulated entity or the Agency,” without bothering to mention that this phrase is tucked into an obscure section that only gives “incidental powers” to the Agency. No such ancillary provision can negate FHFA’s bedrock obligations as conservator. The government claim for total immunity is wrong as a matter of statutory interpretation, and wrong as a matter of constitutional law.
The government then seeks build up its procedural fortress by insisting that the case is not yet ripe for any judicial response. The first part of the claim is that the shareholders under state corporate law have no right to demand dividend payments, and the second is that shareholders cannot protest the loss of capital value until the corporations are liquidated. Those dual claims are wholly inconsistent with the ripeness doctrine, which is there to make sure that the dispute is resolved only at a time when all the information needed for its resolution are available.
Under the government’s argument, however, this case will never be ripe for adjudication, because FHFA will strategically avoid all challenges to the lawsuit by keeping Fannie and Freddie alive as zombie entities in perpetuity, while shoveling all their assets over to Treasury. In order to avoid that perverse ripeness claim, one only need to recognize that there is no new information that will be acquired about the legality of the sweep with the passage of time. Everything to be known about this lawsuit is apparent from the paper record right now. Nothing turns on future events. The government notes that under National Hospital Association v. Department of Interior the twin tests for ripeness involve “(1) the fitness of the issues for judicial decision, and (2) the hardship to the parties of withholding consideration.” Both points cut against the government. On the first, there is no missing information. On the second, to allow FHFA’s request delay is to permit all the assets to disappear from Fannie and Freddie into the coffers of Treasury, so that the shareholders will face the additional burden of having to recover the cash from Treasury long after it has been illegally paid over. The simple solution is to resolve the case on the merits now, and then to credit all the payments in excess of the 10 percent dividend to a redemption of the senior preferred shares.
Delaware and Virginia State Law Claims The novel feature ofJacobs is its state law claim under both Delaware and Virginia law, namely, that the sweep engineered by the Third Amendment falls outside the power of the corporation. The question involved here has been well explored and stated by the anonymous Rule of Law Guyhere. For these purposes, the government brief addresses two issues, both inadequately. The first is the question of whether HERA preempts state law so that their corporate law provisions are irrelevant. Given that this conclusion is incorrect, it is necessary to go onto the second question, namely, exact what kinds of transactions do these corporate law provisions prohibit.
On the preemption issue, the government never acknowledges the simple point that HERA contains no explicit preemption. At this point, the case necessarily turns on the rules governing of implied preemption, which start with a well-established presumption against preemption, which in general can be overridden by proving the case falls into one of three recognized exceptions. The first is that there is some necessary conflict between the state law and the federal command. The second is that the federal law occupies the entire field, displacing any possible state law. The third is that the state lawfrustrates the operation of the federal law. The operative provision of the SPSPA states:
Certificate of Designation 10 (e) This Certificate and the respective rights and obligations of Freddie Mac and the holders of the Non-Cumulative Preferred Stock with respect to such Non-Cumulative Preferred Stock shall be construed in accordance with and governed by the laws of the United States, provided that the law of the state of Delaware [or the Commonwealth of Virginia] shall serve as the federal rule of decision in all instances except where such law is inconsistent with Freddie Mac’s enabling legislation, its public purposes or any provision of this Certificate.
It should be apparent from the text that the basic approach relies on state law as the background rule of decision, which implies both that federal law does not occupy the field, further, that state does not frustrate the operation of federal law. So the issue boils down to whether establish that HERA is somehow “inconsistent” with state law. On this point, the Supreme Court has given a narrow reading to conflict preemption, virtually requiring the party claiming preemption to prove that it is impossible to comply with both state and federal law. The point is brought home by the 1996 decision inO’Melveny & Myers v. FDIC, not cited in the government brief, where the Supreme Court unanimously held that state law governed potential the tort liability to lawyers to a state chartered bank taken over by the Federal Deposit Insurance Corporation. O & M starts with the strong presumption that state law governs. It then stoutly rebuffed the contention that some form of federal common law should apply to the actions of the government as a receiver. Justice Scalia explained:
The rules of decision at issue here do not govern the primary conduct of the United States or any of its agents or contractors, but affect only the FDIC’s rights and liabilities, as receiver, with respect to primary conduct on the part of private actors that has already occurred. Uniformity of law might facilitate the FDIC’s nationwide litigation of these suits, eliminating state-by-state research and reducing uncertainty—but if the avoidance of those ordinary consequences qualified as an identifiable federal interest, we would be awash in “federal common-law” rules.
He then concluded that O&M “is not one of those extraordinary cases in which the judicial creation of a federal rule of decision is warranted.”
The position of FHFA in the instant case is parallel to that of FDIC inO&M. There is absolutely nothing in the text of FHFA which deals with the power of corporation to issue stock. On that issue, no extraordinary condition blocks the application of state law.
Delaware law sets out the legal position.
(c) The holders of preferred or special stock of any class or of any series thereof shall be entitled to receive dividends at such rates, on such conditions and at such times as shall be stated in the certificate of incorporation or in the resolution or resolutions providing for the issue of such stock adopted by the board of directors as hereinabove provided, payable in preference to, or in such relation to, the dividends payable on any other class or classes or of any other series of stock, and cumulative or noncumulative as shall be so stated and expressed. When dividends upon the preferred and special stocks, if any, to the extent of the preference to which such stocks are entitled, shall have been paid or declared and set apart for payment, a dividend on the remaining class or classes or series of stock may then be paid out of the remaining assets of the corporation available for dividends as elsewhere in this chapter provided. (Italics added).
As the Rule of Law guy notes the italicized words really matter. In order for a share of stock to be preferred it has to be preferred to something else, so that its dividends are payable prior to those of common stock or of junior preferred. But in this instance there cannot be a preference because under the sweep there is only oneclass of stock that counts, namely, the senior preferred, which now has rights to all dividends, which leaves no dividends left to the junior preferred or common. To be sure, the initial 2008 bailout agreement falls within the scope of the Delaware statute, because its 10 percent dividend did not preclude payment of dividends to either the junior preferred or the common. But the sweep necessarily precludes both those possibilities, given that dividends can be ever paid on the zombie junior preferred and common stock. It makes, therefore, good sense for Delaware to adopt this provision because it prevents as a matter of state corporate law the type of abuse embodied in the sweep, in which total confiscation is imposed by sleight of hand. The position of the government at root is so long as you hold “title” to your shares it does not matter that all the attributes of ownership are removed one by one. You have no voice in management, no rights to vote, no right to dividend, and no claims on liquidation. All you have are “title” to shares that are not worth the paper that they are printed on if the sweep is upheld.
Nor is there any reason for this to happen. There is nothing in the stock certificates or the positive law that prevents FHFA and Treasury from undoing the Third Amendment and reversing the net worth sweep. And there is indeed a great advantage in so doing. The government’s victory in Perry Capital will not persuade a single potential investor that FHFA and Treasury have acted honorably in a situation where most of their efforts is directed to explaining not why they are right, but why they cannot be sued. As HERA indicates only a private lending market can avoid all the risks associated with government misallocation of capital. But that will not happen so long as government can persuade courts to go along with some ingenious strategy that allows them to defeat the reasonable expectations of shareholders in firms that participate in residential housing mortgages. The government that takes money from the private market today will not raise it in the private market tomorrow. For these purposes, it should not matter whether the case turns on state or federal law. Each provides a sufficient reason to turn aside on of the most blatant government wealth grabs ever. Both in Perryand Jacobs the sweep should be undone to close this most unfortunate chapter in financial manipulation by FHFA and Treasury.
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.