With the housing market collapsing in July 2008, President George W. Bush signed the Housing and Economic Recovery Act into law, 260 pages aimed at bolstering mortgage giants
Now, big and powerful investors, led by Perry Capital, a $9 billion hedge fund run by former Goldman Sachs trader Richard Perry, and Fairholme Funds, the big mutual fund firm run by Bruce Berkowitz, are suing the government, alleging it acted illegally by getting Fannie Mae and Freddie Mac to pay the government nearly all of its massive profits in the form of dividends. Perry Capital, Fairholme Funds, other big hedge funds and some retail investors, have bought junior preferred securities and common shares of Fannie Mae and Freddie Mac that still trade over the counter, betting those securities will jump in value if any of that money ever flows to them. Perry Capital has even hired one of the nation’s most respected lawyers, former U.S. Solicitor General Theodore Olson, to make its case.
But the big investment funds are going to have a tough time winning these cases. Perry Capital’s 34-page complaint filed in federal court in Washington D.C. makes four claims in seeking to stop Fannie Mae and Freddie Mac from paying much of their profits to the government. It alleges that both the Treasury Department and the FHFA violated the Administrative Procedure Act by exceeding their authority under the Bush-era Housing And Economic Recovery Act (HERA) and by acting in an arbitrary and capricious manner. Perry Capital claims these violations occurred in August 2012, when Treasury and the FHFA amended the preferred stock purchase agreements between the FHFA and the Treasury Department to implement a full income sweep under which most of the GSEs profits go to the Treasury’s senior preferred stock.
The problem for Perry Capital is that HERA gave the government extensive powers and authority to act in the face of the financial crisis. As Isaac Boltansky, an analyst at Compass Point Research & Trading points out in his note on the lawsuit, HERA “was crafted with incredibly broad discretion in terms of the mechanics of conservatorship as well as specifics surrounding investments in the GSEs.” Indeed, the starkest limitation on the government’s ability to maneuver under HERA appears to be that Treasury’s authorization to purchase securities of Fannie Mae and Freddie Mac expired at the end of 2009. Perry Capital claims that the so-called sweep amendment to the preferred stock purchase agreements “constituted a constructive purchase of a new security in violation” of the limitation on securities purchases.
Basically, Perry Capital wants to convince a federal judge, rarely keen to second-guess the federal government on financial markets matters of huge significance, that the sweep amendment was actually a securities purchase and have the judge rule that this purchase made by Treasury (in which it gave no consideration) exceeded its authority under HERA, a law that was designed to essentially let the government do whatever it wanted to do to battle the housing and financial crisis.
If that doesn’t work, Perry Capital’s next kick at the can is to prove that Treasury and FHFA acted in an arbitrary and capricious way because they did not enter into the amendment through “reasoned decision making.” There is no public record, Perry Capital claims, of Treasury and FHFA considering alternatives to the sweep amendment or other factors that are consistent with their obligations under HERA like the orderly resumption of private market funding. But the arbitrary and capricious standard is pretty easy for the government to meet as long as the government has some sort of record showing it did consider the relevant factors and arrived at its decision in a reasonable manner—even if sweeping the profits was not the best possible outcome. Reasonable people can disagree about how best to stabilize the financial system.
What’s interesting here is that there was no obligation for the government to make a public record of its decision-making. There are a lot of times when the government needs to have a public notice and comment period and Perry Capital’s complaint makes a big deal that “there is no public record that Treasury made the determinations or considered the factors required by HERA before executing the third amendment.” But then Perry Capital never brings a claim that the government violated some sort of public records requirement because clearly there was no requirement for the government in this situation to make a public record. So why is the hedge fund talking about there not being a public record?
Indeed, perhaps the most glaring thing about Perry Capital’s complaint is what is not in it. Another example: Perry Capital goes on and on about how it “relied” on the terms of the government preferred stock as it existed prior to the sweep amendment. Reliance is a loaded legal term and when it appears prominently in a complaint it often is building toward something like a fraudulent inducement claim. But in Perry Capital’s complaint the whole reliance argument fizzles out. It’s just talk and legally irrelevant. There is no fraudulent inducement or misrepresentation claim or any other claim that consists of a reliance component. Perry Capital seems to think that the government had the right to make amendments to the government preferred stock purchase agreements—the hedge fund has no beef with the other two amendments that came before the sweep amendment.
Maybe the strongest claim Perry Capital makes is against the FHFA for exceeding its authority under HERA because the sweep amendment is designed to wind down Fannie Mae and Freddie Mac and the FHFA has an obligation under HERA to conserve the companies, presumably forever, even though, again, HERA gives very wide latitude to the government. The hedge fund says FHFA needs to explain how its actions were consistent with its obligations to “conserve (the GSEs’) assets and property.” But even this argument is suspicious. It quotes a small snippet of the statute—four words—and requires the judge to see the dividend sweep as leading to the liquidation of the GSEs. In addition, this conserve-assets language is a general statement made in HERA about the role of FHFA. It’s aspirational and not a specific statement, which would be much more powerful. What does conserve mean anyway? How much must be conserved and for how long? Perry Capital doesn’t say and neither does the statute. Does that mean that FHFA can’t at some point sell the furniture at Fannie Mae’s colonial revival red brick headquarters? Does it mean that FHFA can’t get rid of one of its pens? The law doesn’t say specifically.
What is telling is that after going through a hefty piece of legislation, 260 pages, this is the best that Gibson Dunn’s excellent army of lawyers could come up with. You know what specific statement they did not find in the 260 pages of HERA? Language that said something like: Under no circumstances can Treasury or the FHFA disrupt the proper payment of profits in the form of dividends to private holders of Fannie Mae and Freddie Mac preferred securities. That would have really helped the case of the hedge funds. But the Perry Capital complaint really doesn’t cite any specific language other than the clear red light on the government buying stock in the GSEs after the end of 2009.
If anyone can convince a federal judge to go along with these theories, it’s probably Ted Olson. Or at least, maybe he can get the lawsuit through the government’s motion to dismiss and summary judgment efforts, which would probably cause both the preferred and common shares of Fannie and Freddie to jump. But Olson is playing with a weak hand.
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