Fannie Mae, Freddie Mac: The WSJ Misinterprets Sweeney Decision by Todd Sullivan, Valueplays

I’m forced to respond to this simply because of the traction it got and the emails I have received over it.  Rather than answer them all individually , an entry here seems the best way. For a quick review here is a post I did on the subject a couple days ago

Late yesterday the WSJ ran the following piece and while much of it is just a rehash of how we got here, they draw what I think are erroneous conclusions from the Sweeney ruling. I’ve highlighted to part of disagree with the Journal on:

Court ruling: Fannie Mae shareholders cannot sue the U.S. government

The WSJ:

Investors in Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) have been hoping that the route to riches runs through U.S. federal courts. That road just got rockier.

A judge last Friday ruled a Fannie Mae investor couldn’t sue the U.S. government and a host of other parties, including the company itself, on behalf of Fannie Mae, in a so-called shareholder derivative lawsuit. While the case isn’t one of the most closely watched pieces of Fannie Mae and Freddie Mac litigation, it has important implications for investors anticipating favorable court rulings in separate suits brought by Fairholme Funds, Perry Capital, Bill Ackman’s Pershing Square Capital Management and other investors.

Those actions seek to unlock the government’s hold on Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC)’s profits. If they fail in the courts, the dramatic run-up in the companies’ shares since early 2013—Fannie’s common stock is up 1,119% and Freddie’s has risen 1,067%—could quickly reverse.

Some history first: The Federal Housing Finance Agency was appointed conservator of Fannie Mae and Freddie Mac during the financial crisis in 2008. Around the same time, both companies received promises of massive aid from the U.S. Treasury in exchange for senior preferred stock in the companies and warrants for up to 79.9% of their common stock.

The original agreements called for the companies to pay a 10% dividend plus an unspecified commitment fee based on the undrawn amount of the government’s pledge of support. This resulted in an absurd situation in which Fannie Mae and Freddie Mac were each drawing down bailout funds to pay the government dividend.

In mid-2012, FHFA and the Treasury struck a deal that relieved the companies from the burden of paying a set dividend. Instead, they were required to pay the government only when they profited and only in an amount equal to their earnings. This meant Fannie Mae and Freddie Mac wouldn’t suffer in bad quarters and the Treasury would capture the upside of good quarters.

A number of lawsuits have since been filed claiming this amounted to an unconstitutional expropriation of shareholder assets and illegal self-dealing between the Treasury and the FHFA. The government has argued the cases should be dismissed because the FHFA was acting as the companies’ conservator, not as an arm of the U.S. government.

Earlier this year, a federal claims court judge granted Fairholme’s request to seek evidence the FHFA acted as “an agent and arm of the Treasury,” rather than as a third-party conservator.

That is where Friday’s decision by Judge Amy Berman Jackson of the federal district court in Washington becomes relevant. She ruled the Treasury and FHFA weren’t so closely interconnected to allow the plaintiff, an investor, to overcome the general rule that only the conservator can sue on behalf of Fannie Mae.

The lawsuits filed by Fairholme, Perry and Pershing may turn on a similar issue: claims the FHFA lacked independence when it made the profit-sweep deal and that Treasury was essentially directing the actions of the FHFA. If judges in those cases also take Judge Jackson’s position, the government will have an easier time defending the terms of the 2012 deal.

Let’s take the last two paragraphs or actually, one sentence in them

She ruled the Treasury and FHFA weren’t so closely interconnected to allow the plaintiff, an investor, to overcome the general rule that only the conservator can sue on behalf of Fannie Mae.

When looking at any court decision, it is just, if not more important to understand “why” the judge made a ruling as for the actual ruling itself. This is especially so when then applying that decision to other cases.

In the Sweeney case (not the DC Court of Claims cases before Judge Sweeney) Judge Berman did in fact rule as the WSJ states above. But, now we need to get to the “why”.

Plaintiffs to sue Treasury on behalf of Fannie Mae

Plaintiffs in Sweeney alleged:

Plaintiff alleges that Treasury’s failure to consent to the sale (of Low Income Housing Tax Credits) constitutes a breach of its fiduciary duties as the purported “controlling shareholder” of Fannie Mae. Am. Compl. ¶ 76. Through this derivative action, plaintiff seeks to step into the shoes of the Conservator and sue Treasury on behalf of Fannie Mae.

At no point did Plaintiffs argue that the SPSA (Senior preferred stock agreement signed under HERA) was illegal or invalid. At no point did they are that the 3rd amendment (the basis for the Fairholme, Perry and Pershing actions) was invalid or illegal. What they argued was a specific action (or inaction here) under the SPSA was a breach of fiduciary duty within those agreements and there was a “conflict of interest” between FHFA/Treasury that in their opinion should allow plaintiffs to then take action v Treasury. In short, they make an entirely different argument and those were the only issues before Judge Jackson .  A judge can only rule on the specific issues/arguments before them.

Now, since Plaintiffs did not challenge the validity/terms of the SPSA/HERA, the judge then has to take as “fact” that agreement for the purposes of the case before them.  So, where then is the “conflict of interest”? Plaintiffs argued (in its most basic form) there was one because of the financial support given to Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC)’s from Treasury via the FHFA and the obligations that support entailed. But here is the thing, that support was clearly laid out in the SPSA’s terms under HERA and those agreements were not challenged in this case. So we back to where we started, since the agreements were not challenged and the terms laid out the support to be given and its conditions, that support cannot then be considered a “conflict of interest”.

The Judge referenced the Delta ruling in which officials from FDIC and OTS were found to have a conflict of interest as they shared employees, board members etc. Those conditions are not present here, thus no conflict. As for the conflict in First Hartford, Jackson observed:

given that plaintiff here states that its “action is directed at Treasury . . . not the FHFA,” Pl.’s Opp. at 24, there can be no question that the alleged breach was not committed by the conservator agency. Therefore, the obvious conflict at issue in First Hartford is not present here, and that case’s reasoning does not support plaintiff’s claims.

Fannie Mae, Freddie Mac: Jackson’s ruling

Finally, Jackson ruled:

In sum, this case does not present the type of “manifest conflict of interest” at issue in either First Hartford or Delta Savings Bank. Rather, it appears that plaintiff’s true objection is to the terms of the Treasury Agreements, which plaintiff does not challenge in its complaint, and which were authorized by Congress in HERA. Therefore, the Court will grant the Conservator’s motion to substitute.

Again, because plaintiffs did not challenge the agreement itself, Jackson was in no position to then make a ruling on any action under it OR on the actual agreements (they are all assumed valid). For Jackson to do otherwise would be for her to advocate for a position the plaintiffs themselves were not making. The only decision then left before her to rule on was the “conflict of interest” and because of the above, her ruling was unavoidable.

Now the Fairholme actions, simply put, are challenging the 3rd amendment’s very legitimacy (for a variety of reasons) meaning the reasoning Jackson applied to the Sweeney case does not translate to the Fairholme, Perry, Pershing cases. Fairholme et al are in fact challenging the agreement made between Treasury and FHFA and that is what discovery is being granted for.  That simple distinction makes these cases two wholly different actions and thus why the Fairholme cases are continuing on their path to trial and why the Sweeney case is over.

We have to be careful assuming any case vs the government regarding Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC)’s correlates to every other case. There is a reason many of these are separate actions,  the cases and the arguments being made are not the same.  Because of that any rulings emanating from these cases don’t automatically apply the the Fairholme,Perry, Pershings (FPP) cases. In fact, if one really looks into the legal record of the FPP cases one does not find setbacks in any ruling to date.

Defendants fought hard first for summary judgement and to disallow discovery and then when that was lost, then severely limit it. The discovery that was granted was much broader than Treasury/FHFA wanted. They then fought to have all discovery permanently covered under a protective order and the judge said that while it may be initially to expedite the discovery process, plaintiffs are allowed to challenge that designation and have it removed (plaintiff win).

The next decision will be the admission of J Tim Howard to plaintiffs list of those allowed to view protected documents. The gov’t fought this with honestly absurd reasoning  and I expect they will be defeated in this also.  FPP vs Treasury/FHFA has seen a series of plaintiff wins and nothing that has happened in other cases has undermined that momentum to date.

Ask yourself, why haven’t defendants in Judge Sweeney’s court brought in the Western Continental ruling from 9/5 and asked for it to be used and the case before her thrown out? The answer is because the ruling there does not apply.  It remains to be seen what they try and do with this one. I’ll not be surprised if they try something with it (hey, sometimes hail mary’s work) but I’m pretty sure it goes nowhere also.