Saturday, August 29, 2015 9:36:13 AM
Somewhere Over The Rainbow: Discovery, Near-Term Catalysts And The Appeal
Aug. 28, 2015 6:24 PM ET | 7 comments | About: Freddie Mac (FMCC), FNMA
Disclosure: I am/we are long FMCKJ, FNMAS, AND OTHER GSE PREFERRED STOCKS. (More...)
Wayne Olson, CFA .... Deep value, special situations, long only, CFA
Summary
- Why did Fairholme ask for judicial notice and supplementation of the record in the case before the Court of Appeals, D.C. Circuit? Why was the schedule dropped (for now)?
- Herewith are some speculations on possible outcomes on the discovery issues before the Court of Appeals.
- A favorable ruling by the Court of Appeals would be an encouraging development for GSE common and preferred holders.
- While it is unclear what has been uncovered on discovery, it is possible to "read the tea leaves" based on public information.
Q1. Why is the status of the Court of Appeals case of interest to common and preferred investors?
A1. Overturning the 3rd Amendment to the Senior Preferred Stock Purchase Agreement is central to the "value proposition" supporting an investment in the Freddie Mac (OTCQB:FMCC) and Fannie Mae (OTCQB:FNMA)) (collectively known as the government-sponsored enterprises, or GSEs) common and preferred stocks. The Freddie Mac and Fannie Mae common stocks are traded in the over-the-counter market. The GSE preferred stocks include OTCQB:FMCKJ and OTCQB:FNMAS, among others.
Q2. Why wouldn't the plaintiffs object to the Court of Appeals decision to drop the schedule to allow time to address "discovery" issues?
A2. Fairholme and its legal counsel, Cooper & Kirk, must think delaying the schedule is worth the wait, i.e., they must think that the potential benefits of having the court review the factual support that underlies Judge Lamberth's decision outweighs the potential costs of doing so, including the cost of the delay in the schedule. Fairholme's motion is here. The replies of U.S. Treasury (Treasury) and Federal Housing Finance Agency (FHFA) are here and here.
Q3. How does a competent public utility regulator develop an "administrative record" in a regulatory proceeding?
A3. In public utility rate cases, the administrative law judge will very carefully try to ensure that the regulatory agency has collected adequate factual information to support its eventual decision in the case, whatever that decision might turn out to be. Due diligence in the administration of regulation typically requires that the regulator holds hearings, warn participants of impending rule changes, allow participation by the affected parties, and accept evidence (subject to cross-examination). As a practical matter, if a party wants something to be "on the record," the ALJ will typically allow it and say something to the effect that "we'll give it the weight it deserves." In other words, a competent regulator is relatively permissive in its willingness to allow the parties to place documentary evidence to be "on the record."
Q4. Did Treasury/FHFA develop an "administrative record" when they agreed to the 3rd Amendment?
A4. Yes, but compared to a typical public utility regulator, the Federal Housing Finance Agency (FHFA) and U.S. Treasury (Treasury) were startlingly lax in their collection of an administrative record. Oddly, the FHFA filed a "document compilation and declaration" in lieu of an administrative record. This is odd because FHFA, as a financial regulator, could reasonably be expected to be competent in collecting an administrative record and would ordinarily be expected to be able to file that record with the court. Treasury did file an administrative record with the court.
Moreover, no hearings were held, no one was warned of pending changes, participation by affected parties was not allowed, and cross-examination of expert witnesses was not allowed. Thus, the Competitive Enterprise Institute pointed out that the least transparent administration closes records on Fannie and Freddie. Luckily, the Court of Appeals reviews cases on a de novo (as new) basis and Fairholme's motion for judicial notice and supplementation of the record provides this court an early opportunity to begin the process of doing so.
Q5. How might the Court of Appeals respond?
A5. I would highlight three possibilities that would be favorable to GSE common and preferred investors and one less favorable possibility.
1. First, take judicial notice and order entry of judgment for plaintiffs as a matter of law, i.e., summary judgment.
2. Second, take judicial notice, vacate Judge Lamberth's decision, and remand to lower court with instructions.
3. Third, take judicial notice, supplement the administrative records to reflect additional information that has come to light, and then proceed with the appeal.
4. Finally, the Court of Appeals could also decide to leave the administrative records of Treasury and FHFA alone, resume the schedule, and make its decision at a later date.
Q6. Please evaluate these possible outcomes?
A6. Disclaimer: I have no way of knowing what the Court of Appeals will do. I would, however, expect a decision fairly quickly. I would note that the decision on discovery may provide a "signal" about how the Court of Appeals case will ultimately go.
The best case outcome for GSE common and preferred investors would be a decision by the appeals court to order entry of judgment for plaintiffs as a matter of law, i.e., summary judgment. This outcome seems unlikely, but possible.
Another possibility would be that the appeals court takes judicial notice, vacates Judge Lamberth's decision, and remands to the lower court with instructions to consider the information that has been discovered.
Somewhat more likely would be a decision by the Court of Appeals to consider some or all of the discovery materials that have been filed with the court by Cooper & Kirk on behalf of Fairholme as it considers the appeal. Accurate information is essential for sound economic decisions. Thus, a well-informed court could be expected to be able to better evaluate the case before it, which could be expected to lead to a better decision by the court. Thus, a desirable outcome for GSE investors would be a decision by the Court of Appeals that clearly signals its interest in having up-to-date information on the reliability and completeness of the administrative record filed by Treasury and the document compilation and declaration filed by FHFA. It is my understanding that appeals courts typically have a "motions panel" that resolves procedural issues in the early stage of an appeal. It is my understanding that the "merits panel" won't be identified until around the time of oral arguments. I would expect that a motions panel would address the issues about supplementation of the record in a manner that is consistent with its interpretation of the applicable law.
A less-desirable possibility for GSE investors would be a remand to the lower court that does not vacate Judge Lamberth's order. My own view is that Judge Lamberth took a draft prepared by a law clerk and modified it quickly over the course of a weekend to reflect his views without fully considering all of the issues that were before him. Given this context, a remand to the lower court without clear instructions could be an unproductive waste of time.
It would not be at all surprising if the appeals court does not decide to supplement the record. A decision to "do nothing" on discovery would mean that the Court of Appeals would have a less-than-comprehensive view of the information that could have or should have been available to Judge Lamberth. Thus, compared to a decision on discovery that recognized that Judge Lamberth had relied on an "incomplete, misleading, and, in important respects, outright false" administrative record (as Cooper & Kirk had argued), a decision to "do nothing" would be less favorable for GSE investors. However, there are many different potential paths to winning an appeal and supplementation of record is not relevant to a number of theses alternative paths to a successful appeal.
I would add that none of the possible outcomes I've identified are truly bad for GSE common and preferred investors. Indeed, it seems probable that the prospects of GSE investors will improve to some extent after an appeals court decision on discovery issues. Thus, I would tend to agree with Fairholme's and Cooper & Kirk's apparent view - an early decision on discovery issues does seem to be worth the wait caused by dropping the schedule in the appeals case for now.
Q7. What information does Cooper & Kirk think they have uncovered?
A7. While the information that Cooper & Kirk have uncovered is non-public in nature, with its filings to the court having been heavily redacted, it is possible to attempt to "read between the lines" in order to speculate about the possible relevance of the information that has been uncovered via discovery. Thus:
1. Mr. Ugoletti's December 17, 2013, written Declaration, which states, in essence, that Treasury/FHFA didn't know that the sweep would accelerate the repayment of taxpayers, appears to have been undercut by the deposition of former Fannie Mae CFO Susan McFarland. The implication is that Treasury/FHFA could have known, should have known, and/or did in fact know that the GSEs would have large earnings once the valuation allowances related to the DTAs were removed (this in fact happened in 2013 once they became profitable and were expected to continue to be profitable), which would accelerate the inflow of cash into Treasury's coffers. Treasury, in particular, had recent experience with DTA issues with respect to AIG.
2. Mr. Ugoletti's December 17, 2013, Declaration is also apparently undercut by his own deposition in 2015. While it is not possible to know exactly what Mr. Ugoletti had to say during his deposition, suffice it to say that one now suspects that Mr. Ugoletti may regret that he agreed to submit the 2013 Declaration. After all, this might leave him at risk of a charge of perjury with respect to any false statement he may (or may not) have made in the 2013 Declaration.
3. It appears that Treasury's rationale for the net worth sweep may have been based in part on stale data. FHFA forecasts that were publicly available in late 2011 make it clear that the GSEs were performing substantially better than FHFA's Scenario 1 ("Stronger Near-term Rebound') and thus the GSEs were well on the way to recovery. Nevertheless, it appears that Treasury may have relied on stale projections as the basis for assuming that Treasury would be no better off with the net worth sweep.
4. Reading between the lines, it is possible that there is credible evidence that Treasury/FHFA actually pursued the sweep as a means of "winding down" the GSEs, something FHFA arguably isn't authorized to do when acting as a conservator. Thus, one way to interpret the Cooper & Kirk brief is that it is saying that it has uncovered evidence that the true purpose of the sweep was to effect the effective nationalization of the GSEs and the expropriation of GSE common and preferred holders in order to effectuate the wind-down of the GSEs. With the benefit of hindsight, it seems clear that the former Acting Director of the FHFA was more interested in "winding down" the GSEs (something that would be statutorily permissible only if the GSEs were in receivership), than he was in performing his statutorily-defined duties. This theory is supported by Dr. DeMarco's recent commentary in the Wall Street Journal.
5. The argument that the sweep was initiated because the cash dividends would exhaust the government funding committed ignores the fact that they could pay the dividend in kind. Thus, the Cooper & Kirk brief asks that the court take judicial notice of the existence of documents supporting the notion that Treasury/FHFA knew that the existing Senior Preferred Stock Purchase Agreements had an option to pay senior preferred stock dividends in kind, rather than in cash.
Aug. 28, 2015 6:24 PM ET | 7 comments | About: Freddie Mac (FMCC), FNMA
Disclosure: I am/we are long FMCKJ, FNMAS, AND OTHER GSE PREFERRED STOCKS. (More...)
Wayne Olson, CFA .... Deep value, special situations, long only, CFA
Summary
- Why did Fairholme ask for judicial notice and supplementation of the record in the case before the Court of Appeals, D.C. Circuit? Why was the schedule dropped (for now)?
- Herewith are some speculations on possible outcomes on the discovery issues before the Court of Appeals.
- A favorable ruling by the Court of Appeals would be an encouraging development for GSE common and preferred holders.
- While it is unclear what has been uncovered on discovery, it is possible to "read the tea leaves" based on public information.
Q1. Why is the status of the Court of Appeals case of interest to common and preferred investors?
A1. Overturning the 3rd Amendment to the Senior Preferred Stock Purchase Agreement is central to the "value proposition" supporting an investment in the Freddie Mac (OTCQB:FMCC) and Fannie Mae (OTCQB:FNMA)) (collectively known as the government-sponsored enterprises, or GSEs) common and preferred stocks. The Freddie Mac and Fannie Mae common stocks are traded in the over-the-counter market. The GSE preferred stocks include OTCQB:FMCKJ and OTCQB:FNMAS, among others.
Q2. Why wouldn't the plaintiffs object to the Court of Appeals decision to drop the schedule to allow time to address "discovery" issues?
A2. Fairholme and its legal counsel, Cooper & Kirk, must think delaying the schedule is worth the wait, i.e., they must think that the potential benefits of having the court review the factual support that underlies Judge Lamberth's decision outweighs the potential costs of doing so, including the cost of the delay in the schedule. Fairholme's motion is here. The replies of U.S. Treasury (Treasury) and Federal Housing Finance Agency (FHFA) are here and here.
Q3. How does a competent public utility regulator develop an "administrative record" in a regulatory proceeding?
A3. In public utility rate cases, the administrative law judge will very carefully try to ensure that the regulatory agency has collected adequate factual information to support its eventual decision in the case, whatever that decision might turn out to be. Due diligence in the administration of regulation typically requires that the regulator holds hearings, warn participants of impending rule changes, allow participation by the affected parties, and accept evidence (subject to cross-examination). As a practical matter, if a party wants something to be "on the record," the ALJ will typically allow it and say something to the effect that "we'll give it the weight it deserves." In other words, a competent regulator is relatively permissive in its willingness to allow the parties to place documentary evidence to be "on the record."
Q4. Did Treasury/FHFA develop an "administrative record" when they agreed to the 3rd Amendment?
A4. Yes, but compared to a typical public utility regulator, the Federal Housing Finance Agency (FHFA) and U.S. Treasury (Treasury) were startlingly lax in their collection of an administrative record. Oddly, the FHFA filed a "document compilation and declaration" in lieu of an administrative record. This is odd because FHFA, as a financial regulator, could reasonably be expected to be competent in collecting an administrative record and would ordinarily be expected to be able to file that record with the court. Treasury did file an administrative record with the court.
Moreover, no hearings were held, no one was warned of pending changes, participation by affected parties was not allowed, and cross-examination of expert witnesses was not allowed. Thus, the Competitive Enterprise Institute pointed out that the least transparent administration closes records on Fannie and Freddie. Luckily, the Court of Appeals reviews cases on a de novo (as new) basis and Fairholme's motion for judicial notice and supplementation of the record provides this court an early opportunity to begin the process of doing so.
Q5. How might the Court of Appeals respond?
A5. I would highlight three possibilities that would be favorable to GSE common and preferred investors and one less favorable possibility.
1. First, take judicial notice and order entry of judgment for plaintiffs as a matter of law, i.e., summary judgment.
2. Second, take judicial notice, vacate Judge Lamberth's decision, and remand to lower court with instructions.
3. Third, take judicial notice, supplement the administrative records to reflect additional information that has come to light, and then proceed with the appeal.
4. Finally, the Court of Appeals could also decide to leave the administrative records of Treasury and FHFA alone, resume the schedule, and make its decision at a later date.
Q6. Please evaluate these possible outcomes?
A6. Disclaimer: I have no way of knowing what the Court of Appeals will do. I would, however, expect a decision fairly quickly. I would note that the decision on discovery may provide a "signal" about how the Court of Appeals case will ultimately go.
The best case outcome for GSE common and preferred investors would be a decision by the appeals court to order entry of judgment for plaintiffs as a matter of law, i.e., summary judgment. This outcome seems unlikely, but possible.
Another possibility would be that the appeals court takes judicial notice, vacates Judge Lamberth's decision, and remands to the lower court with instructions to consider the information that has been discovered.
Somewhat more likely would be a decision by the Court of Appeals to consider some or all of the discovery materials that have been filed with the court by Cooper & Kirk on behalf of Fairholme as it considers the appeal. Accurate information is essential for sound economic decisions. Thus, a well-informed court could be expected to be able to better evaluate the case before it, which could be expected to lead to a better decision by the court. Thus, a desirable outcome for GSE investors would be a decision by the Court of Appeals that clearly signals its interest in having up-to-date information on the reliability and completeness of the administrative record filed by Treasury and the document compilation and declaration filed by FHFA. It is my understanding that appeals courts typically have a "motions panel" that resolves procedural issues in the early stage of an appeal. It is my understanding that the "merits panel" won't be identified until around the time of oral arguments. I would expect that a motions panel would address the issues about supplementation of the record in a manner that is consistent with its interpretation of the applicable law.
A less-desirable possibility for GSE investors would be a remand to the lower court that does not vacate Judge Lamberth's order. My own view is that Judge Lamberth took a draft prepared by a law clerk and modified it quickly over the course of a weekend to reflect his views without fully considering all of the issues that were before him. Given this context, a remand to the lower court without clear instructions could be an unproductive waste of time.
It would not be at all surprising if the appeals court does not decide to supplement the record. A decision to "do nothing" on discovery would mean that the Court of Appeals would have a less-than-comprehensive view of the information that could have or should have been available to Judge Lamberth. Thus, compared to a decision on discovery that recognized that Judge Lamberth had relied on an "incomplete, misleading, and, in important respects, outright false" administrative record (as Cooper & Kirk had argued), a decision to "do nothing" would be less favorable for GSE investors. However, there are many different potential paths to winning an appeal and supplementation of record is not relevant to a number of theses alternative paths to a successful appeal.
I would add that none of the possible outcomes I've identified are truly bad for GSE common and preferred investors. Indeed, it seems probable that the prospects of GSE investors will improve to some extent after an appeals court decision on discovery issues. Thus, I would tend to agree with Fairholme's and Cooper & Kirk's apparent view - an early decision on discovery issues does seem to be worth the wait caused by dropping the schedule in the appeals case for now.
Q7. What information does Cooper & Kirk think they have uncovered?
A7. While the information that Cooper & Kirk have uncovered is non-public in nature, with its filings to the court having been heavily redacted, it is possible to attempt to "read between the lines" in order to speculate about the possible relevance of the information that has been uncovered via discovery. Thus:
1. Mr. Ugoletti's December 17, 2013, written Declaration, which states, in essence, that Treasury/FHFA didn't know that the sweep would accelerate the repayment of taxpayers, appears to have been undercut by the deposition of former Fannie Mae CFO Susan McFarland. The implication is that Treasury/FHFA could have known, should have known, and/or did in fact know that the GSEs would have large earnings once the valuation allowances related to the DTAs were removed (this in fact happened in 2013 once they became profitable and were expected to continue to be profitable), which would accelerate the inflow of cash into Treasury's coffers. Treasury, in particular, had recent experience with DTA issues with respect to AIG.
2. Mr. Ugoletti's December 17, 2013, Declaration is also apparently undercut by his own deposition in 2015. While it is not possible to know exactly what Mr. Ugoletti had to say during his deposition, suffice it to say that one now suspects that Mr. Ugoletti may regret that he agreed to submit the 2013 Declaration. After all, this might leave him at risk of a charge of perjury with respect to any false statement he may (or may not) have made in the 2013 Declaration.
3. It appears that Treasury's rationale for the net worth sweep may have been based in part on stale data. FHFA forecasts that were publicly available in late 2011 make it clear that the GSEs were performing substantially better than FHFA's Scenario 1 ("Stronger Near-term Rebound') and thus the GSEs were well on the way to recovery. Nevertheless, it appears that Treasury may have relied on stale projections as the basis for assuming that Treasury would be no better off with the net worth sweep.
4. Reading between the lines, it is possible that there is credible evidence that Treasury/FHFA actually pursued the sweep as a means of "winding down" the GSEs, something FHFA arguably isn't authorized to do when acting as a conservator. Thus, one way to interpret the Cooper & Kirk brief is that it is saying that it has uncovered evidence that the true purpose of the sweep was to effect the effective nationalization of the GSEs and the expropriation of GSE common and preferred holders in order to effectuate the wind-down of the GSEs. With the benefit of hindsight, it seems clear that the former Acting Director of the FHFA was more interested in "winding down" the GSEs (something that would be statutorily permissible only if the GSEs were in receivership), than he was in performing his statutorily-defined duties. This theory is supported by Dr. DeMarco's recent commentary in the Wall Street Journal.
5. The argument that the sweep was initiated because the cash dividends would exhaust the government funding committed ignores the fact that they could pay the dividend in kind. Thus, the Cooper & Kirk brief asks that the court take judicial notice of the existence of documents supporting the notion that Treasury/FHFA knew that the existing Senior Preferred Stock Purchase Agreements had an option to pay senior preferred stock dividends in kind, rather than in cash.
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