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Tuesday, June 16, 2015

Revisiting Fannie Mae and Freddie Mac Takings Lawsuits in the Wake of Yesterday's AIG Decision

The decision issued yesterday by Judge Thomas Wheeler of the Court of Federal Claims concerning the lawsuit by Starr International, a large shareholder of AIG, will have significant implications for the similar claims brought by various shareholders of Fannie Mae and Freddie Mac (hereinafter, the "GSEs").   I've previously put up a post critical of the trial judge's Fifth Amendment reasoning in certain of those lawsuits.

There are definitely some similarities between the two and they should be worrisome to the government and heartening to the GSE shareholders.  For example, Judge Wheeler refers to the Federal Reserve taking a 79.9% stake in AIG equity (in the form of convertible preferred) as "draconian", writes that the government "usurped control of AIG without ever allowing a vote of AIG's shareholders" and notes that, even after the loan was repaid, the government retained its stake.  Of course those facts are all identical to the government takeover of the GSEs.

But I see some significant differences as well.  Judge Wheeler makes a very significant ruling under the Fifth Amendment, using a theory that, frankly, I was heretofore unaware of, that of "illegal exaction".  In short, he concludes that, while the Fed was authorized by law to provide credit to AIG, it did not have the authority to exact, as a price for such credit,  a 79.9% equity stake in AIG.  "An illegal exaction occurs when the Government requires a citizen to surrender property the Government is not authorized to demand as consideration for action the Government is authorized to take."  It is fascinating that there is language directly on point from an 1884 Supreme Court opinion, Swift & Courtney & Beecher Co. v. United States, 111 U.S. 22, 28-29 (1884) (“The parties were not on equal terms. . . . The only alternative was to submit to an illegal exaction or discontinue its business.”).  Judge Wheeler also rejects the argument that the emergency context augmented the government's legal power or diminished the citizens' Fifth Amendment rights:

"The Government’s inability to require forfeiture of rights and property in exchange for discretionary benefits is unchanged during times of crisis, when the rule of law is maintained by requiring that government acts be authorized by statute and the Constitution. Home Bldg. & Loan Ass’n v. Blaisdell, 290 U.S. 398, 425-26 (1934) (“Emergency does not create power. Emergency does not increase granted power or remove or diminish the restrictions imposed upon power granted or reserved. . . . ‘Although an emergency may not call into life a power which has never lived, nevertheless emergency may afford a reason for the exertion of a living power already enjoyed.’”) (quoting Wilson v. New, 243 U.S. 332, 348 (1917)); Youngstown Sheet & Tube Co. v. Sawyer, 343 U.S. 579, 653 (1952) (Jackson, J., concurring) (“In view of the ease, expedition and safety with which Congress can grant and has granted large emergency powers, certainly ample to embrace this crisis, I am quite unimpressed with the argument that we should affirm possession of them without statute. Such power either has no beginning or it has no end.”)"

Of course, that makes sense - the government can always take property to address an emergency or otherwise; it just has to pay just compensation when it does so.

Somewhat counter-intuitively, Judge Wheeler proceeds to quash Starr's takings claim, because, he says, a "taking" only occurs if the government's action is authorized; here, he says, since the exaction was "illegal", it was unauthorized.  This is purely a matter of semantics: either label says the government took property from private persons in violation of the Fifth Amendment.  But, as I show in my discussion below of the GSE takeover, the statutory foundation for the government to take a controlling equity stake in them is better than the Fed had in the AIG context.  Still, as I argued last year, a statutory foundation cannot, given the Supremacy Clause, relieve the government of its Fifth Amendment constraints.  It still has to pay just compensation for taking, even if the taking is authorized and a true emergency exists.

However, the specter of imminent bankruptcy causes the judge to determine that AIG shareholders sustained no economic loss from the illegal government action and therefore are due no further amount of  "just compensation".  He writes:
"Common sense suggests that the Government should return to AIG’s shareholders the $22.7 billion in revenue it received from selling the AIG common stock it illegally exacted from the shareholders for virtually nothing. However, case law construing “just compensation” under the Fifth Amendment holds that the Court must look to the property owner’s loss, not to the Government’s gain. Brown v. Legal Found. of Wash., 538 U.S. 216, 235-36 (2003) (The “‘just compensation’ required by the Fifth Amendment is measured by the property owner’s loss rather than the [G]overnment’s gain.”); Kimball Laundry Co. v. United States, 338 U.S. 1, 5 (1949) (“Because gain to the taker . . . may be wholly unrelated to the deprivation imposed upon the owner, it must also be rejected as a measure of public obligation to requite for that deprivation.”); United States v. Miller, 317 U.S. 369, 375 (1943) (“Since the owner is to receive no more than indemnity for his loss, his award cannot be enhanced by any gain to the taker.”); Boston Chamber of Commerce v. Boston, 217 U.S. 189, 195 (1910) (Holmes, J.) (“And the question is, What has the owner lost? not, What has the taker gained?”)"

And then he finds that the shareholders, had the government not intervened, would have lost everything.  So there is no further compensation required.  In doing so, he draws close parallels to the Takings cases brought by various auto dealers whose franchises were terminated as part of the restructurings of GM and Chrysler, in which the Federal Circuit opined: " Absent an allegation that GM and Chrysler would have avoided bankruptcy but for the Government’s intervention and that the franchises would have had value in that scenario, or that such bankruptcies would have preserved some value for the plaintiffs’ franchises, the terminations actually had no net negative economic impact on the plaintiffs because their franchises would have lost all value regardless of the government action."

It's an interesting question whether a judge should opine on a liability issue when damages under the plaintiff's theory are going to be zero.   Recently, in her Marblegate opinion, Judge Failla, SDNY, did the same thing, opining that an insolvent company's proposed out-of-court restructuring  violated the Trust Indenture Act of 1939, even when she found, as a fact, that the complaining bondholders would receive no value if the restructuring failed and the company entered bankruptcy.  So Judge Wheeler is not alone. I still am not sure it is the best practice under Article III, but I gather that appellate courts want the trial court to cover everything to avoid piecemeal litigation, so it may be just a fact of life in our legal system.

Comparison to the GSE Takings Lawsuits

There are a few distinctions between the AIG opinion and the litigation challenging the government's takeover of publicly-traded Fannie Mae and Freddie Mac.  First, the government's financial support of the GSEs came from the Treasury Department, not the Federal Reserve system; so a different statute was involved.  The statute (the Housing and Economic Recovery Act of 2008) established the Federal Housing Financing Agency (FHFA) as an "Independent agency" and authorized it to become conservator or receiver of the GSEs and in such role, to “immediately succeed to—(i) all rights, titles, powers, and privileges of the [GSE], and of any stockholder, officer, or director of such [GSE] with respect to the [GSE] and the assets of the [GSE].”  

Second, the equity stake Treasury took in the GSEs was a combination of preferred stock and warrants to buy 79.9% of the common stock; the stock itself was not convertible. as in AIG.  This may or may not be a matter of form; one legal consequence was that the Treasury Department  did not vote a formal 79.9% equity stake in the GSEs.  Of course, with its sister bureaucrats at FHFA, rather than a private board of directors  of private citizens, running the company, it didn't need to.

As to whether or not the Treasury's equity stake was properly authorized, "HERA amended the GSEs’ charters to temporarily authorize Treasury to “purchase any obligations and other securities issued by the [GSEs].” 12 U.S.C. § 1455(l)(1)(A) (Freddie Mac); 12 U.S.C. § 1719(g)(1)(A) (Fannie Mae).  This provision also provided that the “Secretary of the Treasury may, at any time, exercise any rights received in connection with such purchases.” 12 U.S.C. § 1719(g)(2)(A). Treasury’s authority to invest in the GSEs expired on December 31, 2009."  So arguably, the "illegal exaction" theory is not available in the GSE context if you read the statutory language broadly and literally.  That is not disabling because, as Judge Wheeler describes it, the "illegal exaction" analysis is just the label that is applied to a taking that is unauthorized; proving authorization does not necessarily equate to the absence of a taking.  Further, an "illegal exaction" argument still might be made, if one concludes that the statutory authorization to succeed to the rights of "any shareholder, officer or director"  does not authorize a right to engage in self-dealing and thus breach the fiduciary duty of loyalty, because none of them would be understood to have the "right" to do that.  In that view, any value extracted via self-dealing would be unauthorized and thus an illegal exaction.  Apparently, from another blog I looked at, although no one has yet succeeded in getting a federal court to review FHFA's actions as conservator, in Sweeney Estate Marital Trust v United States (D.D.C. 2014), District Judge Amy Jackson noted that under FIRREA, which she characterizes as HERA's predecessor statute, judicial review was provided consistently where the federal agency was alleged to have taken actions as conservator tainted by conflict of interest.  So, that line of attack appears to be the crucial determinant of the GSE plaintiffs' ability to challenge the Third Amendment. 

Third, a lesser-known, but extremely salient fact about the shareholder lawsuits in the GSE context is that they do not challenge the September 2008 terms.  Rather they challenge a much later self-dealing transaction, described by Judge Lamberth as follows:

"On August 17, 2012, Treasury and the GSEs, through FHFA, agreed to the Third Amendment to the PSPA, which is the focus of this litigation. The Third Amendment replaced the previous dividend formula with a requirement that the GSEs pay, as a dividend, the amount by which their net worth for the quarter exceeds a capital buffer of $3 billion. The capital buffer gradually declines over time by $600 million per year, and is entirely eliminated in 2018. In simpler terms, the amendment  requires Fannie Mae and Freddie Mac to pay a quarterly dividend to Treasury equal to the entire net worth of each Enterprise, minus a small reserve that shrinks to zero over time. These dividend payments do not reduce Treasury’s outstanding liquidation preferences." (Citations and internal quotations omitted).

The key point to see here is that, by August 17, 2012, the GSEs were not "on the verge of bankruptcy"; indeed, they were already profitable as Judge Lamberth himself acknowledges elsewhere in the opinion.  So, the damages analysis Judge Wheeler uses -- correctly, in my view -- that AIG's shares would have had no value in the absence of government action, is not going to help the government in the GSE context.  Rather, everything will come down to whether or not the self-dealing cash sweep agreed to between FHFA and Treasury was a cognizable taking or not.   If it is, the just compensation claim will be very large.  

I suppose I should disclose that my firm was one of the firms advising AIG at this time and further that I spent Sunday the 14th of September in their headquarters with an M&A partner and three top-bracket private equity firms that were studying whether or not a structure could be found to invest rescue funds.   Discussions never got off the ground because AIG's team of financial advisors determined its hole was too large for them to fund and AIG really spent no time at all with them. In fact, I spent the evening chatting on the phone with friends at Lehman and also with advisors to the Obama campaign, in both cases about the implications of the impending Lehman bankruptcy.  A memorable day and night in my career.