In a previous column, Grand Theft Treasury, I highlighted the recent lawsuits (now numbering seventeen) brought against the United States in connection with its controversial conservatorship of two government-sponsored enterprises, The Federal National Mortgage Association (Fannie Mae) and The Federal Home Loan Mortgage Corporation (Freddie Mac).
The occasion for that story was the then-recent public announcement that about $59 billion had been paid to the United States Treasury as a “dividend” on the $188 billion in purchase money payments that Treasury had advanced to Fannie and Freddie pursuant to agreements that it had entered into with its conservator, the Federal Housing Finance Agency (FHFA). The two key agreements were the initial “Senior Preferred Stock Purchase Agreement” of September 26, 2008, and the Third Amendment to that agreement of August 17, 2012. (All the relevant documents can be found here).
This past week two events of note took place. First, the United States filed its much anticipated brief in Washington Federal v. United States, defending itself against charges that it had seized the wealth of the private shareholders of Fannie and Freddie. The second is that FHFA, on behalf of Fannie and Freddie, paid the Treasury another $39 billion in dividends on the original advances of about $188 billion. Combined with the earlier payments, the Treasury has now virtually recouped its huge original advance. The prospect of further and equally lucrative paydays promises to turn Treasury’s erstwhile “rescue operation” into an unparalleled bonanza for the government. The deal looks almost too good to be true. Indeed, a close examination of the government’s responsive brief reveals that it is.
The Original Deal
At root, the legal challenges to the government’s action rest on the one-sided terms of the original stock purchase agreement and especially the controversial Third Amendment. In September 2008, FHFA wrested control away from the Boards of Directors of Fannie and Freddie by installing itself as the conservator of both corporations, charged with managing all of their affairs. Armed with these extensive powers, FHFA promptly entered into a sweetheart deal with Treasury whereby Treasury purchased a new issue of senior preferred stock from Fannie and Freddie for about $188 billion, which carried with it a 10 percent dividend, and an option that allowed Treasury to acquire some 79.9 percent of the common stock for the nominal price of $0.00001 per share. That transaction drove down the prices of the common and (now junior) preferred. The 2012 Third Amendment replaced the previous 10 percent dividend with a “sweep” to Treasury of all the net profits of Fannie and Freddie, as of January 1, 2013.
The deal was made just as both companies were returning to profitability. As commonly expected, the revised agreement has proved wholly one-sided. Treasury has reaped over one hundred billion dollars and, through the profit sweep, has assured that Fannie and Freddie will never amass a single dime to enable the repurchase of the senior preferred stock. A conservatorship requires the conservator to act in the best interest of its beneficiaries—here the shareholders of Fannie and Freddie at the time the conservatorship was imposed. The original stock purchase agreement, and most emphatically the Third Amendment, which benefited only FHFA and Treasury, were signed in blatant violation of that basic duty. FHFA’s responsibility to the shareholders demands, at the very least, was that the Third Amendment be unraveled, and not exalted.
The Government’s Response
In speaking and writing about this issue (which I have done as a paid consultant for several hedge funds), I have often been asked how the government could defend itself in these dubious transactions that would be regarded as both intolerable and illegal if done by private parties. The government brief does not provide an acceptable answer to that question on either procedural or substantive grounds.
The Procedural Move.The government’s initial move is to refer to a key provision of the conservatorship law that it reads as making it impossible for the shareholders to have their day in court. Thus under 12 U.S.C. § 4617(b)(2)(A), FHFA shall “as conservator or receiver, and by operation of law, immediately succeed to—(i) all rights, titles, powers, and privileges of the regulated entity, and of any stockholder, officer, or director of such regulated entity with respect to the regulated entity and the assets of the regulated entity.” According to the government, this provision silences the shareholders because all their rights and powers have been transferred to FHFA.
That extravagant claim makes sense only so long as the interests of FHFA are aligned with those of its shareholders. The obvious distress of many financial institutions means that something has gone amiss. It is therefore a legitimate legislative judgment to grant the new government officials the power to pursue all claims that the corporations and their shareholders could bring against outsiders.
In support of its position, the government cites a 2012 Circuit Court decision, Kellmer v. Raines, which held that only FHFA was in a position to sue the former officers and directors of Fannie and Freddie for the breach of their duties to the corporation. That court insisted that, as a general proposition, its sole job was to “read the statute,” from which it concluded that “all rights, titles powers, and privileges” meant just that.
Therefore, on the basis of Washington Federal, the government now insists that individual shareholders cannot sue FHFA and Treasury either as owners of shares or “derivatively” (that is, not in their own right but on behalf of the corporation). Thus the government concludes that persons who claim that billions of their dollars have made it into the treasury lack “standing” to challenge the FHFA and Treasury in court on, it appears, any and all legal grounds.
Two responses are appropriate. First, it is an absurd literalism to read the statute as though it contains no implied and necessary exception for those cases in which shareholders claim that FHFA has acted in violation of the duty of loyalty to them. The general legal maxim is that no person shall be a judge in his own cause, which is just what the government does with its wooden reading of the statute. The judicial injunction to read the statute means to read it as a whole, so as to make sense of all its moving parts, not just some.
Second, read as the government would have it, the statute is flatly unconstitutional because it denies individuals and their property the protections afforded against the government by the Fifth Amendment to the Constitution, which says “No person shall . . . be deprived of life, liberty, or property, without due process of law.” This, at a minimum, gives them the right to a hearing before a neutral and impartial judge in cases that involve major disputes over the nature and validity of substantial property claims.
The canon of constitutional avoidance holds that all statutes should be construed to avoid any serious clash with the Constitution “unless such construction is plainly contrary to the intent of Congress.” The government’s interpretation of the statute flouts that rule; if adopted, it should lead to the statute’s invalidation to the extent that it bars shareholders from the courtroom door.
The Substantive Move. The government’s second response is that even if they are allowed into Court, the shareholders of Fannie and Freddie really have nothing to complain about because their property has not been taken. At one point, the government makes the weird claim that this action should be barred because the plaintiffs do not allege that “the Government has the citizen’s money in its pocket.” The technical reason for that claim is that Washington Federal did not allege that the government had taken the money, but only that it had suffered a reduction in its shares’ value as a result of the government’s action.
Yet that perceived defect in pleading is easily remedied. The explicit purchase agreement took stock from the corporations in exchange for the infusion of cash. The taking comes from the fact that the value given to Fannie and Freddie was less than the value taken from the corporations. Phrased in this way, there are 100 billion reasons why money that belonged to the two corporations ended up in the pockets of the United States after the last two major sweeps.
The argument that these transactions count as takings is no more complex than the simple claim that the government forcibly takes the house of A, worth $100,000, for a mere $25,000. The forced purchase on unequal terms is a taking of $75,000, which should be enjoined unless the government ponies up the remaining $75,000. The situation does not change if the government plunks down that $25,000 in cash in exchange for a mortgage upon the property for $75,000, which it then empowers itself to collect by renting out the premises, keeping all the rents net of expenses for itself.
The Third Amendment to the Stock Purchase Agreement represents just this kind of one-sided transaction. Yet the government seeks to avoid this obvious implication by three specious arguments. First, it claims that there really was a mutually beneficial bargain here. After all, the Third Amendment was needed “because of a concern that the Enterprises, although solvent with Treasury’s assistance, would fail to generate enough revenue to fund the 10 percent dividend obligation.” Fat chance. Indeed, the one way to magnify the miniscule risk of default is to strip Fannie and Freddie of liquidity by the unilateral “dividend” payment made to the government. As a conservator, FHFA is supposed to defend shareholders, not fork over their money to Treasury.
Next, the government offers two more threadbare arguments for its position. The first is that the time is not “ripe” for a complete accounting because the books have not closed on the transaction. But the goal in this case is to stop the bloodletting before the patient is dead, not to let the government go on with its rigged scheme until that future day when it will solemnly pronounce that it is just too late to unravel this complex transaction.
Finally, the government claims that the shareholders of Fannie and Freddie have assumed the risk that they will be looted. After all, an extensive body of law, much of which comes out of the Financial Institutions Reform, Recovery and Enforcement Act of 1989 (FIRREA), takes the highly contentious line that all banks know that they cannot challenge government regulations because they have willingly entered into a highly regulated area. Consequently, they do not have the requisite “investment-backed expectations” that they will be free of government regulation.
But this lawsuit is not a case where the government has acted pursuant to its general powers to regulate thrift institutions. Those cases are worlds apart from the present for two reasons. First, the source of the shareholders’ disaffection here is the purchase agreement of the senior preferred stock, and not any form of general government regulation of banks that have otherwise failed. Second, those cases do not contain the obvious element of self-dealing which pervades the Third Amendment.
Notwithstanding the government’s efforts to sugarcoat the obvious, this deal remains one of the most lopsided and unfair transactions in the annals of United States history—which says a lot about the sad state of public law and finance today.
Richard A. Epstein, Peter and Kirsten Bedford Senior Fellow at the Hoover Institution, Laurence A. Tisch Professor of Law at New York University, and senior lecturer at the University of Chicago, researches and writes on a broad range of constitutional, economic, historical, and philosophical subjects. He has taught administrative law, antitrust law, communications law, constitutional law, corporate law, criminal law, employment discrimination law, environmental law, food and drug law, health law, labor law, Roman law, real estate development and finance, and individual and corporate taxation. His publications cover an equally broad range of topics. His most recent book, published in 2013, is The Classical Liberal Constitution: The Uncertain Quest for Limited Government (2013). He is a past editor of the Journal of Legal Studies (1981–91) and the Journal of Law and Economics (1991–2001).