Richard Epstein’s Full Introductory Remarks from October 7 Legal Briefing

Investors Unite Briefing: ‘What’s Next?’ in Legal Challenges to Unlawful Conservatorship of Freddie Mac and Fannie Mae

October 7, 2014

Investor Unite’s Tim Pagliara Hosts GSE Legal Update Call with Ralph Nader and Richard Epstein

Listen to audio of teleconference here

Richard Epstein’s Full Introductory Remarks

This is going to be a very long and complicated saga. Right now there are many other lawsuits involved. There is the one case before the Court of Federal Claims before Judge Margaret Sweeney. There is a lawsuit in Iowa and there’re probably another 10 and 20. It’s not as though a single district court opinion is necessarily going to set the sights, although it certainly has had much more influence by virtue of being first than its merits would otherwise justify, but it’s important to go back and try to understand the statutory framework with which these particular decisions have been made as well as the particular run-up to the particular case and other litigation.

First, there’s a very complicated statutory system with respect to the bailout and the two separate sets of duties. One set of duty falls upon Ed DeMarco and now Director Mel Watt with respect to FHFA and there’s a second set of duties and rights that fall to the Treasury Department. The way in which these two things start to interact is a subject of real importance.

The basic statute provides power to the Treasury Department to benefit the taxpayers to enter into transactions with any corporation that is in need of some kind of a bailout. The second provision announces that it can’t force themselves down on these corporations; they have to get an agreement and they don’t talk about whether or not economic duress might be involved. I quite agree with Ralph Nader in the AIG case which I regard as very weak by AIG.

They were in a very bad situation, Treasury gave them a very tough deal, they had their own board and they accepted the deal and it turns out they probably would’ve gone under unlike Fannie Mae because they were on the hook for a variety of obligations with respect to these derivative contracts which would’ve come immediately payable. They have given collateral out to Goldman Sachs and to several other companies; it wasn’t a question as it is with respect to Fannie Mae as to whether or not you can liquidate in time the mortgages or other assets that you have in order to meet any current liabilities. I think they were probably a cooked goose under these circumstances because the financial underlying situation there was so different from the one that we have here.

This government has this power and then it starts to tell you the things that it has to take into account. Many of these things have to do with the time of the payback, with the nature of the securities given, but it also has to do with the obligations. The obligations are to make sure that when these bailouts are finished, the companies can be returned in an orderly fashion to the private market. So essentially what the bailout is designed to do is to make sure that these things get back on their feet. The bailout was not instated, from the government’s point of view, to liquidate the GSEs.

Normally, what would happen is they would negotiate with the private directors of the corporation, but the Government-Sponsored Entity, unlike AIG, is a chameleon. It’s a Government-Sponsored Enterprise and the more you hear about that term, the more you realize that the status is the source of endless confusion. So if you then look at the case, they made it very clear that they were going to take over this organization in 2008. The deal comes through and you look at that particular bailout, whether you like it or not, with respect to the current litigation on the third amendment, the basic assumption was that this particular arrangement was perfectly okay. This arrangement was that the government took 10% of the preferred shares which became then senior preferred. The old preferred became a new junior preferred that was still common and then the government took the right to acquire 79.9% of the common shares at about $0.00001 cent per share which is not a lot of money at all, to put it mildly.

This arrangement went on for four years. The original bailout takes place in early September [2008] and then on August 17 [2012], the agreement was re-jiggered by the third amendment. I want to stress there is no thing remotely comparable to a third amendment with respect to the situation with AIG and it’s also the case that AIG had its own board all the way through and when the option came up to join with Starr International in the suit against the Federal Reserve Board of New York, it declined to do so which I think was in fact the right decision. The third amendment starts to change everything, but instead of having an amendment which is negotiated by a board of trustees or a director whose sole duty of loyalty is, at it is under corporate law, to the Fannie and Freddie shareholders, both Ed DeMarco and afterwards Mel Watt both announce that they’re representing the shareholders.

But they’re not representing the shareholders. They’re conservators. Their job is to maintain these particular assets and they’re supposed to bargain in a fashion which is adverse to that of the Treasury Department, but DeMarco is himself a former Treasury Department employee and instead, he, in effect, signs away the entire company. What happens is this third amendment comes out late afternoon on a Friday, there’s no evidence whatsoever of any financial work that has been done, any due diligence, any study by anybody telling this thing and it becomes inconceivable that whatever the position is of Fannie and Freddie, whether it’s profitable or not profitable, it cannot be in the interest of the shareholders to say “We’re giving you everything that we own in exchange for nothing in return.” John Carney spins this term which says “Look, it’s really terrible because the government was in this dangerous cycle. If they didn’t get the 10% in cash, then you could defer the dividend and make it up to 12% and it turns out therefore you could dig a deeper and deeper hole,” but he forgets to mention – because he’s going to get the economics right – every time you decide to defer a payment, this is actually going to be an implicit cost with respect to the junior preferred and to the common stock because they’re going to have to pay back more money on the principal loan before they could get anything, so it’s not really in their interest to want to do this indefinitely because if it happens indefinitely, they’re going to be out of money.

So what you should try to do is to figure out whether or not there’s any particular problem in this particular case which warrants you to move. At this point, I mean the salient facts that matter the most are that Fannie and Freddie took its last draw in late 2011. Freddie took it in 2011, Fannie took it in early 2012, so you have about a six-month period in which there are no further draws which makes it odd to say that there’s a debt spiral and then within the next year it becomes perfectly clear that $100 billion in excess money is paid over to the Treasury which suggests that the financial situation did not change on August 18; it was probably that way before this was done, and as Ralph said, if you don’t publish your financials on time, it means that you’re trying to conceal something rather than to reveal something. So the government I think has to be put to the proof as to whether or not anything that it says is remotely true on the facts and I think it’s not, but even if this thing were in serious trouble, that is a problem on the Treasury side; it’s not a trouble on Fannie and Freddie’s side. What those conservators have to do is to bargain hard to get whatever they can for the shareholders and then work out some modification that makes sense, but there’s no evidence that any modification turns out to be needed.

So what you do here is you have somebody who is in a very strong position, they have the cash to pay off the 10% interest which is about $18 billion a year and they wanted to, they had a deferral option which Judge Lamberth in an incomprehensible way says it’s a penalty when in fact if you look at the full [Unintelligible] which he doesn’t bother to quote, it ends with the observation that in the event that we defer payments, the dividend rate shall mean 12%. That doesn’t sound like a penalty; it sounds like a definition of provision which is exactly what it is. You want to put a penalty in there, you make them pay the money that they owe like you do on a standard mortgage, and then on top of that, you add a penalty of additional cash. A deferment option at no cost except the 2% interest isn’t a penalty; it’s an option.

So given all of this situation, what does he do? Well, what he does in effect is what the government urges him to do in its brief, and I have to say, I thought the government brief was particularly poor in terms of its candor and its sense. The basic proposition that it wants to make are two: the first one has to do with the way in which you conceptualize this case and the government basically says there’s no case for anybody to bring because if you look at the basic HERA statute, what it says is that the conservator succeeds to all the rights not only of the board of directors themselves, but also the shareholders, and “Since we have all the rights of the shareholders,” they say, “nobody could possibly sue us.” Well, I mean if in fact it really was meant to be the case that you had all the rights of the shareholders, then the statute would be clearly unconstitutional because what you’ve done is you’ve taken all the value of the shares and the only question would be what the valuation was. It cannot be that when you strip assets from a private corporation, that you are immune from all sorts of liabilities with respect to the takings clause. If you can do that, the government could announce any corporation in fact has to surrender its assets by passing a statute which makes it the conservator of General Motors or Apple or any other company on the face of the globe. So it can’t mean that and the correct way to read this particular statute as other courts have done is to say, “Look, when it comes to pursuing claims against third parties, we want the conservator to have a lot of pop.” You can then bring all this stuff back into the company and then we can decide what to do in accordance with the senior preferred stockholder agreement which was entered into in 2008.

So what you do is you say, “Well, there’s no conflict of interest. You have all those rights, but if there is a serious conflict of interest, then the shareholders are in a position to protest what you’ve done and you have to account for them.” You can call this either a breach of fiduciary duty or a takings claim, but in either case what happens is given the manifest of dealing between two branches of the federal government with each other, all the monies that they call a dividend have to be re-characterized. You first get the 10% and there’re now lots of money to pay that off, and then in effect, the rest of them should be treated as a return of capital so that the underlying debt goes down. We don’t want to say and it would be wrong to say that since they paid over now about $150 billion on this thing, that the government has taken $150 billion. No, they’ve paid back the debt and whatever the shares turn out to be worth, that’s what they’re worth after you pay off the rest of the debt and put the company back to the private market in accordance with the original bailout plan.

So what the judge does is essentially he doesn’t even let them speak in court because of this exaggerated reading of the statute. He then has to face the takings claim and basically what he says there is incomprehensible unless you know something about the mysteries of the law, at which point it just becomes wrong. What he says in effect is that there is no cognizable interest in this particular case which is meriting protection. The question you want to ask is what do we mean by a cognizable interest? Cognizable means something which is known or observed, and the term has a perfectly sensible meaning at common law which bears no relationship to the situation here. So typically what happens is there are large numbers of cases in the world where somebody does something that somebody else doesn’t like and he is, in some broad sense of the word, harmed by it, and yet we realize that to take notice of that particular interest in the court, i.e., to call it cognizable, will shut down the entire universe.

So to give you an illustration, if I built a house on my land which blocks you a view, it’s not a cognizable interest because otherwise nobody would ever be able to develop real estate at any time. If I go into business and competition with you and take away your customers by offering them better prices and better products, your losses are not cognizable because otherwise, essentially any incumbent firm would have a monopoly position over its customers. So you say that something is not a cognizable interest when to protect it would lead to very socially destructive results where the norm that one tends to judge this against is whether or not you’re trying to advance or retard a competitive market, the theory being that competition is in fact the optimal way to allocate various kind of resources. Well, that’s what one means by it. Now, what happens in this particular case is the government does the following game. It says that “We’ve got control over this entity because we now are running Fannie and Freddie through FHFA. We’ve now run this sweep, so what we’ve done is we’ve taken away all the dividends and we’ve taken away all the liquidation preferences.” Well, there’s nothing else that a corporation has other than these three kinds of interest, but it says “You know what? We haven’t taken anything because we’ve left you with titles to the shares.”

Well, if that were all that it would take, then the government could do this with respect to anything, and there’s a very instructive case that you all ought to read from very early on called Pumpelly against The Green Bay Company in which what the United States government does is it floods somebody’s land permanently and then it says it doesn’t owe any compensation for the destruction because it didn’t bother to take the title. What the court says quite rightly is not taking title is a terrible way to allow for massive evasions of constitutional responsibility because when the government takes anything, it could always announce it leaves the title in the private owner and then takes all the beneficial interest for itself. Well, that’s what it’s done here. Right now the shares trade at a positive price, but the only value that the shares have depends upon the ability to knock out the third amendment. If in fact the third amendment is good law, then the shares trade at 0.0 price because there’s absolutely nothing whatsoever of value that’s left in the corporation.

So if you can’t do this title cognizable interest game with respect to real estate, you cannot do it with respect to corporations, and when the government puts forward this argument, it is just an open invitation for a complete kind of lawless behavior which his really hard to understand. I mean property law is difficult, I’m certainly going to concede that. I’ve spent the last 40-odd years of my career trying to understand how all these systems get put together, but the crude misunderstandings that pervaded the government’s brief and that pervaded Lamberth’s opinion are not entitled to the slightest bit of respect. So I think I’ve said enough now and I’m happy to turn this open and leave it for questions if that’s what you would like. Tim, back to you.


Listen to audio of teleconference here.