Perverse Statutory Construction Allows A Government Conservator To Loot The Property That It Manages For Its Beneficiaries
For many years, I worked as an advisor to a number of hedge funds with positions in preferred and common stock of Fannie and Freddie. But no longer. The question that was raised then, and which has been answered decisively in Collins v. Yellen, as of June 23, 2021, is whether these preferred and common shareholders of Fannie and Freddie could undo the so-called “net worth sweep” (NWS) that the United States Treasury and the Federal Housing Financial Agency (FHFA) jointly adopted in August 2012 in the Third Amendment to the basic Senior Preferred Stock Purchase Agreement (SPSPA) of September 2008.
Throughout my previous work, indignant shareholders constantly denounced the NWS as outright theft. True enough, I answered, with this caveat: Even with an airtight case, any plaintiff’s odds of winning against the government are under 50 percent. Financial cases often fall into a judicial black hole, leading uneasy judges to trust government lawyers when the stakes are high and the issues complex.
WASHINGTON – SEPTEMBER 19: A statue of the first United States Secretary of the Treasury Alexander … [+]
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That prediction was first borne out in September 2014 in Perry Capital v. Lew, when District Court Judge Royce Lamberth granted the government’s motion to dismiss the shareholders’ case without discovery. At the time, I protested loudly against that outcome, which in retrospect was simply the end of the road. Fast forward to Collins: Indeed, Justice Samuel Alito spoke for a unanimous court on this particular issue—despite the justices squabbling over difficult separation of powers issues—and adopted the government’s position hook line and sinker, ignoring any and all arguments that I, among others, had raised to the contrary. By way of epitaph, let me unpack how a unanimous Supreme Court went so badly astray.
In July 2008, Congress passed the Housing and Economic Recovery Act (HERA) to implement strong government controls to counteract future financial meltdowns in the wake of its then-recent expensive rescue operation for Bear Stearns. HERA gave the newly created FHFA the power to displace existing trustees of any company with its own officials. It also authorized the United States Treasury Department to enter into financial deals with distressed entities subject to conditions under 12 U.S.C. § 1719(g)(1)(C) that worked “to protect the taxpayers” and allowed the government to create appropriate preferences, priorities, and maturities, with an eye towards creating a plan that would allow for “the orderly resumption of private market funding or capital market access.”
Quite simply, any deal should be a bargain, not a giveaway. Indeed, the scheme could work well so long as these bailout negotiations took place between genuinely adverse parties. But that was no longer the case once the interim head of FHFA, Ed DeMarco, himself a former high-level Treasury official, removed the private trustees, thereby allowing the government to negotiate with itself.
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The initial SPSPA involved the issuance of senior preferred stock to the Treasury that carried with it a 10 percent annual dividend for a bailout payment of $188 billion. That deal also allowed Fannie and Freddie to defer dividend payments if it carried the unpaid amounts on its books at 12 percent interest. That arrangement governed until the NWS of August 2012, which scrapped the original deal and allowed the Treasury access to all of the net receipts from Fannie and Freddie operations in exchange for releasing Fannie and Freddie from any obligation to make its payments in the event that it had insufficient funds. The purported rationale, fully embraced in Collins, was that this new arrangement ended a vicious cycle in which the Treasury would lend Fannie and Freddie the cash to pay the dividends required on the senior preferred.
The Supreme Court treated this deal as if it were a win/win transaction, when in fact it was a complete wipeout of the Fannie and Freddie shareholders. Justice Alito described the situation under the NWS as follows:
Shifting from a fixed-rate dividend formula to a variable one materially changed the nature of the agreements. If the net worth of Fannie Mae or Freddie Mac at the end of a quarter exceeded the capital reserve, the amendment required the company to pay all of the surplus to Treasury. But if a company’s net worth at the end of a quarter did not exceed the reserve or if it lost money during a quarter, the amendment did not require the company to pay anything. This ensured that Fannie Mae and Freddie Mac would never again draw money from Treasury just to make their quarterly dividend payments, but it also meant that the companies would not be able to accrue capital in good quarters. (Italics in original.)
Unfortunately, this passage reveals a total misunderstanding of the financial situation. No one needs to be released from obligations that they do not have the wherewithal to pay, thus making such a release worthless. In addition, the 2008 deal never called on the government to make additional advances. It did, however, let Fannie and Freddie defer all payments, which would then carry the higher rate of interest. A conscientious trustee would be reluctant to defer because the accrued debt would have priority over the regular Fannie and Freddie dividends. Indeed, the Court sounded somewhat surprised that the Treasury reaped close to $200 billion between 2013 and 2016—or at least $124 billion more than it was owed under the original arrangement. That outsized profit should have raised Supreme Court eyebrows, especially since FHFA owed duties to its shareholders, not the Treasury. Once the financial deal was put into place, the value of the private shares plunged—but not quite to zero because investors thought there was some chance that the courts would set aside the NWS on the basis of separation of powers, which indeed dominated the case.
My task here, however, is to explain why the NWS should have been undone. Three interlocking provisions in Section 4617 of HERA set the stage. First, the definition of a conservator; second, the definition of “incidental powers;” and third, the anti-injunction bar. I shall take them up in order.
Section 4617(b)(2)(D) sets forth the “powers as conservator” as follows:
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 carry on the business of the regulated entity and preserve and conserve the assets and property of the regulated entity.
FHFA, like any other trustee, must exercise its powers solely for its beneficiaries. Judicial oversight is needed because the private shareholders had no say in the choice of the conservator.
Nonetheless, the statutory protection proved of no help because of Section 4617(b)(2)(J) on “incidental powers”:
The Agency may, as conservator or receiver—
(i) exercise all powers and authorities specifically granted to conservators or receivers, respectively, under this section, and such incidental powers as shall be necessary to carry out such powers; and
(ii) take any action authorized by this section, which the Agency determines is in the best interests of the regulated entity or the Agency.
The Supreme Court never cared to notice that the word “incidental” commonly refers to things that are in service of some major objective—in this instance, returning Fannie and Freddie to a sound and solvent condition. Indeed, one standard dictionary defines “incidental” as “accompanying but not a major part of something” and then gives as an example, “for the fieldworker who deals with real problems, paperwork is incidental.” This understanding is precisely why subsection (J)(i) lets the conservator allocate certain joint costs, such as accounting or minor compliance expenses. But the Court gave the “or” in clause (J)(ii) a humongous reading that let the FHFA allocate all the receipts to itself and none to its shareholder beneficiaries. A sound and solvent condition be damned:
An FHFA conservatorship, however, differs from a typical conservatorship in a key respect. Instead of mandating that the FHFA always act in the best interests of the regulated entity, the Recovery Act authorizes the Agency to act in what it determines is “in the best interests of the regulated entity or the Agency.” § 4617(b)(2)(J)(ii) ([Court’s] emphasis added). Thus, when the FHFA acts as a conservator, it may aim to rehabilitate the regulated entity in a way that, while not in the best interests of the regulated entity, is beneficial to the Agency and, by extension, the public it serves. This distinctive feature of an FHFA conservatorship is fatal to the shareholders’ statutory claim.
Unfortunately, the Court never explained that this conservatorship is vastly different from every other known trust arrangement in that it authorizes the looting of the corporation that it is supposed to make sound and solvent. The easy way to reconcile the major duties of the conservator with the conservator’s narrow rights is to give the term incidental its ordinary meaning, which prevents a tiny exception from swallowing a commendable rule. But in ignoring the obvious, the Court did not even ask whether its interpretation of incidental powers could survive a constitutional challenge against confiscation—assuming it could be brought.
Which, alas, the Court held could not happen because of the “anti-injunction provision” of FHFA. It states as the Supreme Court held, that “unless review is specifically authorized by one of its provisions or is requested by the Director, ‘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.’ [§ 4617(f)]. Where, as here, the FHFA’s challenged actions did not exceed its ‘powers or functions’ ‘as a conservator,’ relief is prohibited.”
The initial mistake is to assume that the broad definition of incidental powers is consistent with the notion of a conservator when it is not. Nonetheless, Justice Alito resorted to an indefensible version of textual literalism to justify blocking this action, ignoring the functional explanation of this provision—which was to make sure that, when the conservator dealt with third parties on behalf of the trust, no combination of shareholders or creditors could slow down its effort to collect assets owing to the trust or disputing payments made by the trust. That provision speeds up the entire resolution process without hurting private shareholders. But the situation is wholly different when the shareholders want to challenge actions of the conservator that are wholly against their interest. To deny the action in this instance is tantamount to letting Congress pass a statute blocking any private party from suing the agents who confiscated its land or personal property.
It should come as no surprise that lower courts have been sensitive to just that point. Thus, in Kellmer v. Raines (2012), the opposite position was taken: “absent a manifest conflict of interest by the conservator not at issue here, the statutory language bars shareholder derivative actions.” (emphasis added) But, the NWS is the epitome of a manifest conflict of interest, given the self-dealing between FHFA and Treasury. Likewise, Hindes v. FDIC (1998) dealt with a similar issue under 12 U.S.C. § 1821(j), the parallel provision regulating the Federal Deposit Insurance Corporation on which Section 4617(f) was modeled: “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.”
And so you have it. Forget 50 percent. The government will always win when the Supreme Court imputes to Congress a definition of a conservator never adopted in the history of the world, by broadly reading a narrow exception for incidental powers to let a conservator gobble up all the money for itself—an action that could never be challenged in court as an abuse of power. A unanimous travesty.