The burden carried by the holders of stock in mortgage giants Fannie Mae and Freddie Mac, each operating for nearly six years under federal conservatorship, just got lighter. On July 16, U.S. Court of Federal Claims Judge Margaret Sweeney, in a procedural ruling, held that shareholder-plaintiffs in Fairholme Funds Inc. et al. v. United States are entitled to know material facts that the government wants to keep secret. The shareholders are seeking compensation for foregone income resulting from the Treasury Department’s “sweep” rule of August 2012, which forced the companies to forward all dividends to the department in perpetuity. Government lawyers had filed a motion for a protective order on May 30 to inhibit discovery. The outcome of this case will have major implications for the future of property rights in this country.
National Legal and Policy Center has been following the situation at the Washington, D.C.-based Federal National Mortgage Association (“Fannie Mae”) and the McLean, Va.-based Federal Home Loan Mortgage Corporation (“Freddie Mac”) following the federal takeover of the two publicly-traded companies in September 2008. The nation’s financial services industry at the time was in free fall. House prices were plummeting. Defaults and foreclosures were on the rise. And Fannie Mae and Freddie Mac, which now guarantee or hold a combined $5 trillion in U.S. residential mortgages – almost half of outstanding loan volume – had become dangerously undercapitalized. There was a real danger that the holders of their bonds, known as mortgage-backed securities, would not be repaid. An independent federal regulatory agency created by Congress that summer, the Federal Housing Finance Agency (FHFA), used its authority several weeks later to seize the companies and place them under conservatorship. Conservatorship was intended as a temporary measure. The purpose was to keep Fannie and Freddie, as “Government-Sponsored Enterprises,” solvent, thus ensuring timely payments to bond investors. The arrangement was not permanent.
Over the next few years, the Treasury Department provided the companies with a combined $187.5 billion in loans. The government in turn would have the option to own of 79.9 percent of shareholder common stock, plus dividends on senior preferred stock set at 10 percent. As share prices were depressed at the level of penny stocks, earnings depended on dividends. But during 2011-12, the housing market, unexpectedly and for various reasons, made a comeback. The Treasury Department, seeing an opportunity to speed up debt collection, developed the “third” or “sweep” rule. Announced on August 17, 2012, it would supersede the 10 percent rule. It effectively barred shareholders from realizing any profits on current or future earnings. In the department’s own words, the sweep refers to “every dollar of profit that each firm earns going forward.” Investors were righteously angry. And given that hedge funds and other financial intermediaries held much of their stock, a spate of lawsuits seemed inevitable. Over the course of 2013, they materialized. One of the most publicized of these suits was filed by the New York-based equity fund, Fairholme Capital Management. The action sought to rescind the sweep amendment and to compensate shareholders. This case eventually incorporated similar ones.
On merit alone, Fairholme and co-plaintiffs have a very strong case, especially at this point in time. During Second Quarter 2014, Fannie Mae and Freddie Mac already had sent more than $200 billion in profits to Treasury, a total that was set to rise to $213.1 billion by the quarter’s end – about $25 billion more than what the government had loaned them. To retain the rule would appear in direct contravention with the very purpose of the FHFA conservatorship. Forcibly diverting company profits to the government in perpetuity, argued the plaintiffs, was the antithesis of the intent of the Housing and Economic Recovery Act of 2008 (HERA), which authorized the conservatorship as a temporary measure. Indeed, this was little short of de facto nationalization. The Treasury Department has countered that the plaintiffs have failed to make a convincing case for a regulatory taking.
But there is a reason why the plaintiffs have had difficulties on this score: lack of access to information. The government over the years has kept secret its decisions regarding Fannie Mae and Freddie Mac. And when details of that decision-making are made publicly available, they validate suspicions that the Treasury Department has never had any intention of abiding by the terms of the conservatorship. In July 2013, a New York hedge fund, Perry Capital, filed a separate suit to rescind the sweep rule. Unlike Fairholme, the plaintiffs in that case are not seeking financial compensation. Representing Perry Capital, the Washington law firm of Gibson, Dunn & Crutcher somehow managed to acquire a Treasury Department internal memo, dated December 20, 2010 (see pdf), sent by Undersecretary Jeffrey Goldstein to Secretary Timothy Geithner. In discussing Fannie Mae and Freddie Mac, the memo referred to “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.” In no way did the Treasury Department notify shareholders of this policy change. Had it done so, it is highly unlikely anyone would have continued to hold stock in these companies.
The plaintiffs in Fairholme believe that where there is smoke, there is fire. They seek full access to Treasury Department documents, whether in the form of financial statements, memos or e-mails. In this way, they can better determine whether the department acted contrarily to the conservatorship law. The U.S. Court of Federal Claims issued an order this past February 26 that allowed each party to engage in jurisdictional discovery. The government didn’t like this. It meant that a good many of its private documents could be exposed to light. To that end, on May 30, the Treasury Department filed a motion for a protective order, arguing that Section 4617(f) of the HERA legislation bars the Court from taking “any action to restrain or affect the exercise of powers or functions of the Federal Housing Finance Agency.” Moreover, argued the department, disclosing the contents of the document would impede the conservatorship process and have “a destabilizing effect on the nation’s housing market and economy.” And it alleged that the documents, as privileged property, are protected from deliberative discovery.
On July 16, Judge Margaret M. Sweeney issued an Opinion and Order (No. 13-465 C). It was all but a total victory for the shareholders. Her decision covered two areas: 1) the authority of the court to affect the exercise of Federal Housing and Finance Agency powers; and 2) the authority of the Treasury Department to invoke executive privilege to withhold the availability of confidential documents to outside parties. In each case, she ruled for the plaintiffs and, more broadly, for public transparency.
On the issue of whether the Treasury Department could insulate itself from discovery relating to the operations of the Federal Housing Finance Agency, Judge Sweeney referred to recent rulings by the U.S. Court of Appeals for the Ninth Circuit, which held that FHFA “cannot evade judicial review…simply by invoking its authority as conservator” (County of Sonoma v. FHFA) and “cannot evade judicial scrutiny by merely labeling its actions with a conservator stamp” (Leon County v. FHFA). The approach to be taken in this case, argued Sweeney, ought to be “for a court to examine the factual underpinnings and leg contentions presented by the complaint, in order to determine whether the exercise of its jurisdiction is proper.” Then she lowered the boom:
For purposes of the instant motion, there is no request by plaintiffs that would potentially restrain or affect the exercise of powers or functions of the FHFA as conservator. Consequently, blanket assertions concerning the court’s ability to conduct these proceedings, especially as they pertain to a discovery matter related to the question of jurisdiction, has no merit.
The court made its position clear: The Treasury Department and the FHFA have to release documents at the request of shareholder lawyers insofar as they have the potential to reveal the rationale for decisions affecting the value of Fannie Mae and Freddie Mac stock.
On the issue of whether the federal government reserves the right to assert executive privilege in turning over documents, the ruling also weighed in on the side of the plaintiffs. Justice Department lawyers referred to NLRB v. Sears, Roebuck & Co., which protects “documents reflecting advisory opinions, recommendations and deliberations comprising part of a process by which governmental decisions and policies are formulated.” Yet the court argued that while this principle is valid, it has practical limits. The ruling read: “Generally, to be exempt from disclosure under the deliberative process privilege, the government must show that the information is pre-decisional and deliberative.” Referring to In re United States, 321 F. Appendix at 958 (citation omitted), Judge Sweeney added that pre-decisional documents “may include recommendations, draft documents, proposals, suggestions, and other subjective documents which reflect the personal opinions of the writer rather than the policy of the agency.” Such documents qualify as deliberative “to the extent that they reveal the mental processes of decision makers.”
The court added that a claim of deliberative process privilege, even when properly established, “is not absolute” and “subject to judicial oversight” (Marriott International Resorts L.P. v. United States). Quoting other cases, Judge Sweeney stated that after the government makes a sufficient showing of entitlement to the privilege, “the court should balance the competing interests of the parties” (Scott Paper Co. v. United States) and that plaintiffs may overcome the privilege by making “a showing of evidentiary need…that outweighs the harm that disclosure of such information may cause to the defendant” (Pacific Gas & Electric Co. v. United States). The government’s claim of protection from discovery in the current Fairholme case, Judge Sweeney concluded, did not pass muster:
Here, defendant has not provided a privilege log explaining why documents identified as responsive to plaintiffs’ discovery requests would be protected. Indeed, defendant admits that even it has not reviewed some of them, and yet claims that the documents are privileged….Overall, the defendant advances general claims concerning the sensitive nature of the documents, and the adverse consequences that would result from divulging them. Without more detail regarding the content of the documents, or the opportunity to review them, the court cannot make a finding that they fall under the privilege…In essence, defendant asserts that the court should merely take its word that the documents – some of which defendant, itself, has not reviewed – are privileged. This suggestion is contrary to law. However, even as it is difficult to evaluate the likelihood of the fallout from disclosure that defendant describes, out of abundance of caution, the court will exercise care in attempting to avoid the dire consequences that defendant claims will occur.
Judge Sweeney concluded that she “has fashioned a solution to balance the parties’ competing needs, and to comply with the dictates of the deliberative process privilege.” Jurisdictional discovery, she wrote, must proceed in phases: April 1, 2008 through December 31, 2008; June 1, 2011 through August 17, 2012; and August 18, 2012 through September 30, 2012. The plaintiffs will inform the court as to their belief in the necessity of subsequent discovery.
The ruling is procedural, but it is a key victory for Fannie Mae and Freddie Mac shareholders all the same. In extracting all profits, the sweep rule at once has confiscated income and suppressed share prices. Surely they, and the lawyers who represent them, should have an opportunity to review documents pertinent to the issuance and enforcement of the rule. And shareholders are substantial in number. At the time of the December 20, 2010 memo from Under Secretary Goldstein to Secretary Geithner, about 18,000 investors held 1.1 billion shares of Fannie Mae common stock and about 2,100 investors held 650 million shares of Freddie Mac common stock. For the last couple of years these companies have been profitable. There is no reason why the shareholders shouldn’t be allowed to realize a portion of the profits.
The Fairholme case underscores a larger property rights issue. It’s true that Fannie Mae and Freddie Mac received a government lifeline in order to pay off the holders of their mortgage bonds. But that should not serve as a justification for putting them or their shareholders in a state of perpetual servitude. These two mortgage firms have more than paid off their $187.5 billion combined debt. They should be allowed to function as normal companies, minus their official Government-Sponsored Enterprise status. The problem with government bailouts is that even the “successful” ones may take a toll on the recipients. The conservatorships of Fannie Mae and Freddie Mac are not intended as a permanent arrangement. The forced diversion of company profits into federal coffers in perpetuity constitutes legalized theft. Shareholders are right to take action against the thievery.
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