Reorg Research - GSEs: Lamberth Opinion Dismissing Lawsuits Against FHFA, Treasury Deals Blow to Hedge Fund Case on HERA Jurisdiction

Reorg Research has actively covered the various GSE litigations ongoing in the District Court of the District of Columbia, the Court of Federal Claims, and Iowa. Using our technology, we were one of the first to break the dismissal filed by Judge Lamberth. More importantly though, we put out a comprehensive story and analysis that same night so our subscribing investors and traders across the distressed and event driven equity space were better informed than those trying to untangle the complicated opinion on their own.

Now that Perry has appealed the ruling (just hit the docket), we wanted to reproduce our review of the dismissal below. Enjoy!

Lamberth Opinion Dismissing Lawsuits Against FHFA, Treasury Deals Blow to Hedge Fund Case on HERA Jurisdiction

Relevant Documents:

Judge Royce Lamberth of the United States District Court for the District of Columbia granted the government motions to dismiss and denied the hedge fund plaintiffs' motions for summary judgment, brushing aside a class action lawsuit and three individual lawsuits with overlapping claims. 

The decision will most likely be appealed according to multiple sources. Both the D.C. District Court, where Judge Lamberth sits, and the D.C. Circuit Court, where the appeal will proceed, are highly respected around the country. While not binding on other jurisdictions, a final negative result for the funds could be highly precedential on other courts. 

Below are our initial impressions of the opinion, which will be augmented throughout the day tomorrow.


At heart of today’s opinion is a finding by Judge Lamberth that the bulk of the funds claims are barred by the Housing and Economic Recovery Act, or HERA. Specifically, the opinion concludes that HERA contains only an extremely narrow window for suits against FHFA as conservator. Rejecting the contention that even claims of “arbitrary and capricious” behavior by the FHFA are barred by HERA, Judge Lamberth concluded that the only types of declaratory relief that could survive HERA’s “express anti-injunction provision” are those premised on the FHA acting beyond the scope of its authority

Even construing the facts in the light most favorable to the funds, Judge Lamberth found that they could not allege that FHFA was acting beyond its authority. Importantly, he also found that FHFA’s subjective motivations are irrelevant in this inquiry. “The court must look atwhat has happened, not why it happened,” reads the opinion. (emphasis in original). Judge Lamberth also stresses that both sides are sophisticated 

Specifically on the critical question of FHFA’s authority, the opinion notes: “Of most relevance to the present litigation, HERA empowered FHFA, as conservator or receiver, to “immediately succeed to—(i) all rights, titles, powers, and privileges of the [GSE], and of any stockholder, officer, or director of such [GSE] with respect to the [GSE] and the assets of the [GSE].” Further, the HERA statute sets forth a limitation on court action that “may take any action to restrain or affect the exercise of powers or functions of [FHFA] as a conservator or a receiver.”

The opinion rejects claims by the funds that the conservatorship was a de facto liquidation and allegations that Treasury was improperly directing the FHFA. “The plaintiffs cannot transform subjective, conclusory  allegations into objective facts,” says Judge Lamberth.

Judge Lamberth finds that even claims that FHFA acted arbitrarily or capriciously are barred by HERA. He bases this on “a distinction between acting beyond the scope of the constitution or a statute, see § 702(2)(B) and (C), and acting within the scope of a statute, but doing so arbitrarily and capriciously, see § 702(2)(A).” Only the former allegations can proceed, and Judge Lamberth found (as noted above) that this simply could not be claimed on the facts put forward by the funds.

Factual Findings

Going even further than his legal conclusions, Judge Lamberth ties FHFA's actions as conservator to the GSEs recent profitability. Footnote 21 to the opinion reads: “Indeed, the GSE’s current profitability is the fundamental justification for the plaintiffs’ prayers for equitable and monetary relief. In other words, this litigation only exists because the GSEs have, under FHFA’s authority, progressed from insolvency to profitability.”

The Court also considered the technical aspects of the the government’s actions in regards to whether the Treasury purchased new securities through the Third Amendment. On this point, Judge Lamberth states that the Treasury’s authority as a market participant and the inherent sunsetting provisions (hold, exercise rights, sell) does not “preclude other non-security-purchasing activities otherwise permitted under an already agreed-upon, pre 2010 investment contract with the GSEs. To then say that the purchase authority sunset provision also categorically prohibits any provision within Treasury’s contracts with the GSEs that requires ‘mutual assent’ is to reach too far.”

Specifically, Lamberth writes  “the Court finds that Treasury did not purchase new securities under the Third Amendment. Under the Third Amendment—unlike the first two amendments—Treasury neither granted the GSEs additional funding commitments nor received an increased liquidation preference. Instead, Treasury agreed to a net worth sweep in exchange for eliminating the cash dividend equivalent to 10% of the GSEs’ liquidation preference. This net worth sweep represented a new formula of dividend compensation for a $200 billion-plus investment Treasury had already made. As FHFA further claims, the agency executed the Third Amendment to ameliorate the existential challenge of paying the dividends it already owed pursuant to the GSE securities Treasury purchased through the PSPA; it did not do so in order to sell more GSE securities.”

In regards to FHFA acting within its statutory authority, Judge Lamberth concludes that HERA gave “immense discretion” to the FHFA as conservator. Given the breadth of powers to the FHFA the Court’s decision is narrowed to the what instead of the why FHFA executed the Third Amendment. Specifically, “FHFA’s underlying motives or opinions—i.e., whether the net worth sweep would arrest a downward spiral of dividend payments, increase payments to Treasury, or keep the GSEs in a holding pattern” do not matter. 

Continuing: “However, when the Court is asked to determine whether FHFA acted beyond, or contrary to, its responsibilities as conservator under a statute that grants the agency expansive discretion to act as it sees fit, it is the current state of affairs that must weigh heaviest on this analysis. If the Third Amendment were really part of a scheme to liquidate the GSEs, then the GSEs would, presumably, be in liquidation rather than still be “immensely profitable.” Further, Lamberth notes that no precedent was cited stating that a net worth sweep is functionally equivalent to liquidation.

This follows then that claims for liquidation preference are not ripe. Specifically, “therefore, by definition, the GSEs owe a liquidation preference payment to a preferred shareholder only during liquidation. It follows that there can be no loss of a liquidation preference prior to the time that such a preference can, contractually, be paid. Here, the GSEs remain in conservatorship, not receivership, and there is no evidence of de facto liquidation.”

In an interesting footnote in relation to the ongoing debate of whether the GSEs could have pursued a PIK option in lieu of the Third Amendment, Judge Lamberth states that “the provision makes clear that 10% cash dividends were “required by” the stock certificates, and that 12% dividends deferred to the liquidation preference were only triggered upon a “failure” to meet the 10% cash dividend requirement. Thus, classifying the 12% dividend feature as a “penalty,” as Treasury does, is surely more accurate than classifying it as a “right.” 

Market Background

The plaintiff funds Perry Capital, Fairholme, and Arrowood who own either preferred or common stock in the Federal National Mortgage Association or the Federal Home Loan Mortgage Corporation - Fannie Mae and Freddie Mac, respectively. The plaintiffs had arguedthat the Federal Housing Finance Agency and U.S. Treasury exceeded their statutory authority under the Administrative Procedures Act and the Housing and Economic Recovery Act of 2008 when they made an amendment that required every dollar of GSE net worth above a certain amount to be paid to Treasury as a dividend. 

The common shares of the GSEs had been trading down steadily over the past month. Before the after-market-close decision, Freddie Mac quoted on the pink sheets under FMCC closed at $2.64 and Fannie Mae, FNMA at $2.69, down 7.37% and 6.6%, respectively compared with the previous day’s close. 

Other Legal Findings

Much of the opinion is devoted to HERA’s bar on declaratory judgment actions (which formed the bulk of the funds claims). Separately, today’s opinion addresses and rejects a number of other categories of claims:

Unconstitutional Taking: Regarding claims that the Third Amendment was an unconstitutional taking, Judge Lamberth found that plaintiffs can not allege a “cognizable property interest” because the funds took equity subject to “existing rules, understandings and background principles.” As such, Judge Lamberth notes the “specter of conservatorship” has long been part of the GSEs regulatory oversight. Further, according to the opinion, the funds “lack the right to exclude the government from their property.” (emphasis added). The GSEs are subject to “governmental control at the discretion of the FHFA’s director,” reads the opinion. 

Setting aside this legal bar, on the facts, Judge Lamberth finds “the plaintiffs cannot show that the Third Amendment rendered their prospects of receiving dividends any less discretionary than they were prior to the amendment.” All that holders were left with was the market trading value of the instruments, the opinion notes.

Derivative Suits: Per the opinion, HERA bars derivative claims against FHFA and Treasury because the D.C. Circuit has held that HERA transfers the ability to bring derivative suits to the FHFA as conservator or receiver of the GSEs. 

Judge Lamberth notes a narrow exception in the case law for allegations that FHFA acted with manifest conflicts of interest. But, he says, “[i]t is a slippery slope for the Court to poke holes in, or limit, the plain language of a statute, especially when, as here, the plaintiffs have not asked the Court to weigh in on the statute’s constitutionality. Therefore, the Court finds that HERA’s plain language bars shareholder derivative suits, without exception,” according to the opinion. 

In explaining why the exemption should not apply, the opinion states that “Treasury represented the only feasible entity— public or private—capable of injecting sufficient liquidity into and serving as a backstop for the GSEs within the short timeframe necessary to preserve their existence in September 2008.” 

Further, “a relationship-based conflict of interest analysis [] does not require the Court to ignore the harsh economic realities facing the GSEs—and the national financial system if the GSEs collapsed—when FHFA and Treasury executed the PSPAs in 2008. Courts, generally, should be wary of labeling a transaction with an investor of last resort as a conflict of interest,” the opinion reads. 

Breach of Contract: Additionally, plaintiffs’ claims requesting monetary damages for breach of contract, or breach of implied covenant of good faith and fair dealing claims were dismissed under certain threshold analyses. 

First, the opinion states the preference claims are not ripe. The opinion calls the analysis of the plaintiffs’ argument about the liquidation preference “uncomplicated.” The GSEs owe a liquidation preference payment to a preferred shareholder only during liquidation, and therefore “there can be no loss of a liquidation preference prior to the time that such a preference can, contractually, be paid. Here, the GSEs remain in conservatorship, not receivership, and there is no evidence of de facto liquidation.” The opinion sums up the point that since there’s no right to a liquidation preference during a conservatorship, the plaintiffs are “no worse off today than they were before the Third Amendment.” 

Second, the dividend claims fail to state a claim for which relief can be granted. The opinion points out that the dividends plaintiffs are claiming a “‘right’” that is “wholly dependent upon the discretion of the GSEs’ board …” and that there is no “absolute right to dividends.” In a footnote to the explanation, the court “expressly rejects the individual plaintiffs’ additional contention that the Third Amendment ‘effectively converted [Treasury’s stock] into common stock,’ which would ‘represent a distribution to the common shareholder ahead of and in violation of the contractual rights of Plaintiffs and other preferred shareholders.’” Another footnote says that the plaintiffs have not demonstrated that the FHFA acted in bad faith. 


The opinion concludes:

“It is understandable for the Third Amendment, which sweeps nearly all GSE profits to Treasury, to raise eyebrows, or even engender a feeling of discomfort. But any sense of unease over the defendants' conduct is not enough to overcome the plain meaning of HERA's text. Here, the plaintiffs' true gripe is with the language of a statute that enabled FHFA and,  consequently, Treasury, to take unprecedented steps to salvage the largest players in the mortgage finance industry before their looming collapse triggered a systemic panic. Indeed, the plaintiffs' grievance is really with Congress itself. It was Congress, after all, that parted the legal·seas so that FHFA and Treasury could effectively do whatever they thought was needed to stabilize and, if necessary, liquidate, the GSEs. Recognizing its role in the constitutional system, this Court does not seek to evaluate the merits of whether the Third Amendment is sound financial--or even moral-policy. The Court does, however, find that HERA's unambiguous statutory provisions, coupled with the unequivocal language of the plaintiffs' original GSE stock certificates, compels the dismissal of all of the plaintiffs' claims.”


Anonymous,  10/05/2014  

So where is the analysis of this decision?


hunter [at] distressed-debt-investing [dot] com

About Me

I have spent the majority of my career as a value investor. For the past 8 years, I have worked on the buy side as a distressed debt and high yield investor.