Forbes
Opinion # Theverdict
MAR 3, 2017 @ 11:23 AM 2,476 VIEWS
D.C. Circuit Refuses To See Limits To Government Power And Inexcusably Upholds The Net Worth Sweep
Richard Epstein CONTRIBUTOR
Opinions expressed by Forbes Contributors are their own
(AP Photo/Susan Walsh)
On February 21, 2017, the Court of Appeals for the District of Columbia issued its long-awaited opinion in Perry Capital LLC v. Mnuchin in his official capacity as Secretary of Treasury. (The original name of the case was Perry Capital LLC v. Lew. Lew was Treasury Secretary when the case was brought.) By a two-to-one vote, the Court, through Judge Patricia Millett and Senior Judge Douglas Ginsburg, rejected the request of Perry Capital that the Court set aside the August 17, 2012 net worth sweep (NWS) under the Third Amendment to the Preferred Stock Purchase Agreements (PSPAs) that diverted all profits from the operations of Fannie Mae and Freddie Mac into the United States Treasury. That portion of the opinion was met with a pointed dissent by Judge Janice Rogers Brown. The majority’s opinion also contained, as a second act, an extensive and convoluted discussion of the nature of the individual claims against Treasury that might on remand survive, a set of issues which was never at issue in the appeal, never briefed by the parties and on which Judge Brown did not comment. The majority opinion contained 73 pages of dense, frequently impenetrable, prose that too often dwelled on a variety of esoteric procedural and pleading issues collateral to the big dollar dispute
It is impossible to analyze this decision in a single column, but in my capacity as advisor to several institutional investors, this initial analysis is devoted to examining the clash of views between the majority and Judge Brown on whether the various plaintiffs’ claims against the Federal Housing Finance Authority (FHFA) and Treasury should survive. It should be no surprise that, in my view, the dissent has the stronger of the argument. The majority opinion is rife with factual errors, fundamental business misconceptions, and deliberate statutory sleights of hand in which, as will become painfully apparent, an omitted ellipsis turns a well-crafted statute utterly upside down. In my view, this decision needs to be overturned, either by the panel on reconsideration, the D.C. Circuit en banc, or the Supreme Court.
The Factual Record
It is often said that the outcome of a case turns on its statement of facts, and in Perry the confused and skewed account of the basic transaction at issue from the start tilts the balance heavily in favor of the government. The majority opinion rightly notes that the original bailout deal of September 2008 created a new senior preferred stock to Treasury that carried with it a 10% annual cash dividend or 12% “in kind” dividend on the amounts drawn from Treasury. After that it is all downhill:
Fannie’s and Freddie’s frequent inability to make those dividend payments, however, meant that they often borrowed more cash from Treasury just to pay the dividends, which in turn increased the dividends that Fannie and Freddie were obligated to pay in future quarters. In 2012, FHFA and Treasury adopted the Third Amendment to their stock purchase agreement, which replaced the fixed 10% dividend with a formula by which Fannie and Freddie just paid to Treasury an amount (roughly) equal to their quarterly net worth, however much or little that may be.
At no time does the majority opinion note the vast difference in the chaotic financial environment at the time of the original 2008 bailout and the stable markets when the NWS undertaken nearly four years later, or the massive profits that documents revealed in litigation show that Treasury and FHFA fully knew would come right after the NWS went into effect—payments that would have eliminated any supposed inability of Fannie and Freddie to pay dividends going forward. Indeed, the majority opinion deliberately chose to ignore documents on this point showing that Treasury and FHFA affirmatively misled the very lower court the opinion of which was being appealed here. Instead, the majority opinion only makes one fleeting reference to the realization that the deferred tax assets (DTAs), which had been incorrectly written off in 2008 had not lost all their market value and were about to be written up. The majority opinion also noted that Fannie and Freddie in their SEC filings (reviewed and blessed by FHFA which as conservator put them into this harmful financial arrangement, of course) both companies admitted that they would be unable to make payments in the long run, which is of course true if the company is going to be bled dry by the NWS.
Worse, the majority made light of the option built into the agreement that allowed FHFA to exercise an “in-kind” option that allowed for Fannie and Freddie to defer, indefinitely dividend payments so long as they paid 12% dividend on the added balances, which completely obviated the need for any further draws. Rather than facing up to this point, the majority simply concluded that FHFA, as conservator or receiver, had no obligation to take advantage of this deferred option, because “[The Housing Economic] Recovery Act [HERA] doe not compel that choice over the variable dividend to Treasury put in place by the Third Amendment.” So, the majority opinion held that it did not matter that the FHFA could have avoided any purported danger to the GSEs by exercising its payment in-kind-option. In so doing, the majority allowed FHFA and Treasury in combination to impose the NWS that necessarily undermined the conservatorship by turning the enterprises’ money over to Treasury for its own purposes. FHFA’s statutory charge to return the GSEs to a safe and solvent condition was wholly ignored.
Finally, the majority opinion showed little grasp of the basic economic transaction. As I have repeatedly argued, there is no need to take discovery on documents given that the transaction itself gave full evidence of both the intention and effect for two government agencies to wipe out the financial interests of the private shareholder. And to this extent, the plaintiffs were right to insist that they should win no matter what the financial state of affairs. All that is needed is to treat excess payments as a return of capital that reduced the outstanding levels of senior preferred shares on which the 10% dividend was owed. But if bad faith were required, then a remand to Judge Lamberth would quickly reveal that FHFA and Treasury colluded to hatch this scheme in August 2012 precisely because at that time they knew of the extent of the anticipated gain. There is no fatal inconsistency in the GSE’s position. The plaintiff’s case is so strong that they win whether or not they are asked to prove bad faith by FHFA and Treasury.
Conservator vs. Receiver
This bizarre reading of the business transaction set the stage for an equally improbable discussion of FHFA’s duty as “conservator or receiver” under HERA. The basic statutory scheme is set out under 12 U.S.C. § 4617(b). The difference between these two functions is that a conservator operates a business with an idea that it will eventually be rehabilitated so that it can then operate on its own and leave conservatorship. In contrast, a receiver is charged with winding down the business and distributing the residual asset value to stakeholders based on legal priority. As a matter of general theory, these two complementary powers are needed because no one course of action is ideal in all cases. With Fannie and Freddie, the immediate winding down of the businesses was fraught with risk, given the absolute dependency of the entire housing mortgage market on these enterprises and the wide range of heavily invested domestic and foreign financial stakeholders. But, with many businesses, it is best to end the agony by closing the business down. It is therefore necessary to have procedures that allow for the conversion of a conservatorship to receivership, with an eye to liquidation.
Under HERA, FHFA can at all times choose between these two paths, but it is equally critical to note the common thread between them. In all these cases, the value of a company’s assets may well be greater than the liabilities attached to it, at which point by standard procedure, the equity holders retain any residual value after the administrative costs are paid and all prior debt obligations are satisfied. It would be an open invitation to manipulative behavior to say that FHFA could decide to wipe out equity holders through the conservatorship but not the receivership, or the reverse. A paramount goal of this statutory operation is to make sure that FHFA makes an undistorted choice to maximize the value of the entire entity, which cannot be done if it retains the full value of the business for its sister government agency. And it is wholly odd to think that the way in which to preserve that parity is to allow the government to keep all the value either through operation or liquidation. Why create this conservator or receiver arrangement if the government is free to wipe out the beneficiaries under both paths? Just give the government all the property and stop with the charade. But HERA was a well-drafted statute, which addressed explicitly the question of what duties are imposed on FHFA in each separate role.
It is on just this question that the majority’s clear misreading of HERA unravels the statutory framework. In its initial gambit, the majority repeatedly stresses the word “may” as it appears in the statement of powers first of FHFA as conservator and then of FHFA as receiver. In the majority’s view, the use of the italicized term” may” in the definition of powers gives FHFA virtually carte blanche as either conservator or receiver. After that, the payoff is as follows: “Accordingly, time and again, the Act outlines what FHFA as conservator ‘may’ do and what actions it ‘may’ take. The statute is thus framed in terms of expansive grants of permissive, discretionary authority for FHFA to exercise as the “Agency determines is in the best interests of the regulated entity or the Agency. 12 U.S.C. § 4617(b)(2)(J).” Note that sentence contains no ellipsis between the words “the” and “”Agency. . .” to signal that the quoted material comes from section (b)(2)(j) while the basic powers of as conservator and receiver “may” exercise are contained in two different subsections (b)(2)(D) & (b)(2)(E), located five subsections away..
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To see the deliberate sleight of hand, it is necessary to quote all these sections in full, complete with captions:
(D) Powers as conservator
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.
(E) Additional powers as receiver
In any case in which the Agency is acting as receiver, the Agency shall place the regulated entity in liquidation and proceed to realize upon the assets of the regulated entity in such manner as the Agency deems appropriate, including through the sale of assets, the transfer of assets to a limited-life regulated entity established under subsection (i), or the exercise of any other rights or privileges granted to the Agency under this paragraph.
. . . .
(J) Incidental powers
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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.
At this point the charade should be up. The Court’s decision consciously joined together two entirely separate sessions as though they were a continuous whole, and thus eliminated all reference to the key phrase “Incidental powers” which is critical to the basic statutory structure. To be sure at one earlier point, the Court wrote as follows:
Consistent with Congress’s mandate that FHFA’s Director protect the “public interest,” 12 U.S.C. § 4513(a)(1)(B)(v), the Recovery Act invested FHFA as conservator with the authority to exercise its statutory authority and any “necessary” “incidental powers” in the manner that “the Agency [FHFA] determines is in the best interests of the regulated entity or the Agency.” Id. § 4617(b)(2)(J) (emphasis added)[in original].
The critical omissions from this garbled passage are, however, accurately captured in Judge Brown’s dissent, which drives home the statutory point by noting: “the Agency “as conservator or receiver” may “exercise all powers and authorities specifically granted to conservators or receivers, respectively, under [Section 4617], and such incidental powers as shall be necessary to carry out such powers.” Id. § 4617(J)(i) (emphasis added)” [in original]. But those italicized words are eliminated without explanation in the only time that the majority opinion mentions it, but does not explicate the term “incidental powers.” By italicizing the phrase “or the Agency,” the majority gives the false impression that the conservator or receiver’s option is utterly unconstrained. But it never explains why the ability to allocate certain expenses between the regulated entity and the agency allows the agency to make huge transfer payments to the Treasury. But at least it is a small improvement over the government’s joint brief for FHFA, Fannie and Freddie which on five separate occasions performs the statutory tour-de-force of quoting from 12 U.S.C. § 4617(b)(2)(J), without once including either the phrase “incidental powers” or ‘specifically granted.” This omission matters a great deal, given that incidental powers are intended to deal with incidental expenses which have commonly been explicated as follows.
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What are 'Incidental Expenses'
Incidental expenses are expenses including fees and tips for porters, baggage handlers and other personal service employees. These expenses are part of the "meals and incidental expenses reimbursement" rates provided by the IRS. Unreimbursed incidental expenses are deductible according to a schedule prescribed by the IRS.
Under this standard definition, FHFA could decide whether to allocate the cost of a FedEx box sent during the ordinary course of business to either the Agency as conservator or receiver or to the regulated entity. But it makes no sense to allow Subsection J to do an end run around the specific, limited authorizations of Subsections D and E. Once the full text is put in here, it is palpably false for the majority to conclude: “In short, the most natural reading of the Recovery Act is that it permits FHFA, but does not compel it in any judicially enforceable sense, to preserve and conserve Fannie’s and Freddie’s assets and to return the Companies to private operation.” A conservator who is under no obligation not to preserve and conserve is not a conservator, but either an idler or a thief.
It should by now be painfully apparent that the failure to come to grips with the phrase incidental powers turns the entire statute on its head, by eliminating the tripartite separation of powers as a conservator, powers as a receiver, and incidental powers. All the delimited powers that are given to both the conservator and the receiver have the word “may” before them. It is, of course, conceptually conceivable that a conservator or receiver need do nothing at all, which is a rather odd assignment for a fiduciary charged with management duties. It is also clear that there is nothing else that they may do under either of these two sections, because there is no further language which suggests that they “may” do anything else, period. In particular, there is no statutory authorization under HERA to give away all the assets either under a conservatorship or a receivership to taxpayers or anyone else. It is thus wholly incorrect to see in any of the incidental powers of FHFA the “ability as conservator to give Treasury (and, by extension, the taxpayers) a preferential right to dividends, to the effective exclusion of the shareholders.” The list of things that FHFA may do as either conservator or receiver are fully exhausted by subsections (b)(2)(D) or (b)(2)(E). The use of the word “may” cannot therefore be read to state that they may not do anything on the ground that they have zero statutory duties. It means, rather, that FHFA may and should decide which particular actions they should undertake in the discharge of their primary duty based on the capacity assumed. The list in subsections D and E is exhaustive, and it is bizarre to assume that silently each of these sections contains a secret provision which states that FHFA “may give all the money to the taxpayers.”
Once this basic groundwork is established, it becomes clear why there must be an enforceable duty to make sure that theft does not replace conservation. In order to deflect that conclusion, the majority relies on Section 4617(b)(2), which in full reads:
(2) General powers
(A) Successor to regulated entity
The Agency 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;
Yet once again the majority misunderstands the import of this provision. Consistent with its theme of a fiduciary without obligations to its beneficiaries, it reads this section as allowing the Agency to do whatever it wants with the assets, including turning them over to the federal government on behalf of taxpayers. But in light of the more accurate account of the underlying powers, it is clear that the words. “as conservator or receiver,” must have some bite. Actions done in utter disregard of fiduciary duties are not done as conservator or receiver. Yet the cases cited by the majority to justify the broad reach of this provision involve government deals to sell properties or foreclose on mortgages with third parties. These actions are, of course, in general immune from liability under the business judgment rule, and the statute goes one step further by making sure that rapid-fire liquidation and management decisions are not interrupted by suits for accounting or injunctions. The shield from judicial review in these cases assumes that the government as conservator or receiver can be trusted to get fair value in return from what it gives up from the estate so that shareholders are better off, without the usual scrutiny of private fiduciaries, because beneficiaries can (or at least should be able to) rely on the greater character and trust of the government.
The NWS sweep, by contrast, does not involve management of assets. Instead, it involves giving them away to Treasury, an action inconsistent with the duties of any conservator or receiver. To get there, the majority tortures the statute by giving an indefensibly expansive reading to a subsidiary clause that guts the entire system put into place by Congress. The majority quotes the timeless advice of Justice Felix Frankfurter, “(1) Read the statute; (2) read the statute; (3) read the statute,” which advice is hardly an authorization for its egregiously jumbled misreading of key provisions of the statute in front of them. In addition, as Judge Brown points out in her dissent, the majority erred in reading Felix Frankfurter. As she noted, Frankfurter, from that same article, also said that “if a word is obviously transplanted from another legal source, whether the common law or other legislation, it brings the old soil with it.” It just so happens that the language on the general power of FHFA were lifted from similar language in FIRREA, which dealt with just these issues, in making the clear distinction found in subsections D and E between conservators and receivers, while attaching fiduciary on conservators “responsibility for taking “such action as may be . . . necessary to put the insured depository institution in a sound and solvent condition; and . . . appropriate to carry on the business of the institution and preserve and conserve [its] assets,” 12 U.S.C. § 1821(d)(2)(D). None of that was done in the majority’s opinion.
The majority’s view has huge structural issues that are underscored by the way in which it pieced together the various statutory provisions. The missing piece thus far is the section in HERA which speaks about the duties that Treasury owes taxpayers, which comes from a different section, 12 U.S.C. § 1719(b), which specifically speaks to the obligations of Treasury as financier to the conservatorship and not of FHFA as the actual conservator. The heading reads “Temporary Authority of Treasury To Purchase Obligations or Securities.” That provision then provides that in the exercise of that authority, “the Secretary must determine that such actions are necessary to —
(i) provide stability to the financial markets;
(ii) prevent disruptions in the availability of mortgage finance; and
(iii) protect the taxpayer.
The D.C. Circuit Refuses to See Limits to Government Power and Inexcusably Upholds the Net Worth Sweep
Accordingly, the obligations on Treasury are called into action when a bailout arrangement is made with the company’s own directors, as happened in the AIG transaction. In those cases, Congress imposed these protections to stabilize markets without making free gifts to the corporations with whom Treasury transacts. The clear understanding is that the Treasury has to bargain within these parameters with a corporate representative whose interests are adverse to its own. That same distribution of responsibility should follow when FHFA takes the place of the board of the original corporation. Treasury cannot get money for free when FHFA stands in the same fiduciary relationship to the private shareholders as the board of directors whom it ousted. It is therefore wholly improper to conclude as the majority does that “Congress, consistent with its concern to protect the public interest, thus made a deliberate choice in the Recovery Act to permit FHFA to act in its own best governmental interests, which may include the taxpaying public’s interest.” Treasury, not FHFA, had that obligation. FHFA had the exclusive obligation to protect shareholders. That obligation would surely remain if the deal negotiated called for borrowing money from Treasury, both at the inception of the deal and in the event of any modification thereof. The difference between senior preferred stock and junior debt, which is normally thin, does not introduce some momentous change in the fiduciary duties of either FHFA or a private board of directors. Even after the senior preferred stock is issued, FHFA has fiduciary duties to all shareholders. Such duties do not run exclusively to holders of the senior preferred stock whose interest is still adverse to the junior, and it does not go to the “corporation,” if that term allows FHFA to improperly favor the government senior preferred over other shareholders.
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In closing, there is a simple test by which to measure the probity of the combined actions of FHFA and Treasury. If FHFA were replaced by a private trustee, and Treasury were replaced by a private supplier of fresh debt or equity capital, both parties would end up in jail if they concocted a scheme that resembled the NWS. Everyone would cut through the various smokescreens to see that the excess dividends were a naked raid on the interests of the other shareholders as happened here. The great tragedy of the majority opinion is it follows the all-too-common practice of giving the government a free pass when its own motives are as corrupt, or more so, than comparable private parties in similar roles and with similar legal duties. From the time that I started to work on this issue, I always said that litigating against the government is like playing craps with loaded dice. So far the sorry performance in Perry Capital has validated that gloomy prediction. The time is running short, but there needs to be some serious judicial action either in the Circuit Court or Supreme Court to correct against the egregious statutory contortions and manifest injustice of sustaining the Net Worth Sweep.
Richard A. Epstein is the Laurence A. Tisch professor of Law at NYU, senior fellow at the Hoover Institution, and senior lecturer at the University of Chicago Law School.
