The Set Up
For more than a year, Treasury and the Department of Justice (which represents Treasury in litigation) have maintained opposing policy and litigation positions with respect to the GSEs, resulting in an overall incoherent strategy. Treasury released an administrative plan to, among other things, recapitalize Fannie and Freddie with private capital in 2019, while the DOJ has consistently continued to argue in litigation that the Net Worth Sweep was a valid exercise by FHFA of its conservator power under HERA (a litigating position it inherited from the Obama administration).
These two US government positions are mutually incompatible. If the NWS is valid, then no rational institutional investor would be willing to invest new capital in Fannie and Freddie if they can be nationalized by FHFA at the drop of the hat so long as they remain in conservatorship…and Fannie and Freddie will not be able to exit conservatorship unless they can raise substantial amounts of private capital. A prototypical Catch-22. So, as long as DOJ argued that the NWS is valid, neither FHFA nor Treasury could execute the Trump administration plan to recap and release Fannie and Freddie.
This is a truly insane state of affairs that has persisted over the past year. Moreover, one can add to this state of government incoherence that the current FHFA director, Mark Calabria, emphatically accused the NWS of being illegal prior to becoming FHFA director, and has consistently maintained as FHFA director that the conservator is under a statutory duty to rehabilitate Fannie and Freddie while in conservatorship.
In the face of such incoherence, one must leave prose and turn to poetry. As Yeats would have it, “Things fall apart; the centre cannot hold” when you have two branches of the US government treating Fannie and Freddie in such a mutually inconsistent way over the past year. I believe that Fannie’s and Freddie’s shareholder litigation will be settled soon, as the Collins case before SCOTUS is too weak for the US government to have any realistic expectation of victory. What form will the settlement take? Continuing with Yeats, from The Second Coming, “And what rough beast, its hour come round at last, Slouches towards Bethlehem to be born?”
As I discuss below, I expect that the Collins case will be settled prior to SCOTUS oral argument on December 9, 2020, irrespective of the result of the POTUS election on November 3, 2020 (though there may be a greater impetus to settlement in the event of a Biden POTUS). Settlement negotiations often culminate in a “rough beast” of compromise. I will outline how I would proceed on the part of Collins plaintiffs in this settlement, and I will explain the importance that prejudgment interest should play in the Collins plaintiffs settlement negotiation strategy (an aspect of the Collins case that has not been discussed by the cognoscenti in the blogosphere/twitterverse).
Settlement Objectives (and the Importance of Prejudgment Interest)
Collins plaintiffs, in essence representing all Fannie and Freddie shareholders insofar as the damages recovery will be paid to the companies themselves, will seek an economic objective in settling Collins. Given the strength of the Collins case before SCOTUS, Collins plaintiffs should seek, as an opening proposition, almost as much in settlement as a court would award the plaintiffs in connection with a judicial victory. Most people have focused this damages computation as being based upon the difference between what Fannie and Freddie would have paid Treasury under the original terms of the senior preferred stock (10% dividend) and the amount actually paid to Treasury under the NWS (“Compensatory Damages”). This Compensatory Damages amount has been calculated to equal, roughly, the outstanding balance of Treasury’s senior preferred stock plus about $25 billion.
So, one may think that Treasury could, by way of a Fourth Amendment to its preferred stock agreement, unilaterally eliminate its senior preferred stock and provide Fannie and Freddie a $25 billion credit to be applied to future federal corporate income tax liability, and then walk into the SCOTUS clerk’s office and state that the Collins case has become moot, because Collins plaintiffs have just received by way of the Fourth Amendment the damage remedy plaintiffs are seeking in prosecuting the Collins case.
This is wrong. Plaintiffs have another card to play. In the event of a SCOTUS win, Collins plaintiffs can ask the court to award not only Compensatory Damages, but also prejudgment interest on the amount of Compensatory Damages.
Federal courts do not prescribe an interest rate for prejudgment interest, but the purpose of prejudgment interest is to provide plaintiffs restitution, by adding to the Compensatory Damages award an additional amount to account for the time delay between the receipt of damages and the occurrence of the injury. SCOTUS has left federal district courts significant leeway in determining the availability, and appropriate rate, of prejudgment interest, and consequently there is no uniformity in application. Some have argued that the prejudgment interest rate should equate to the plaintiff’s cost of capital. This is the coerced loan theory, which argues that the prevailing plaintiff has been forced by the defendant to accept a loan from defendant in the amount of the Compensatory Damages award, so the court should look to the plaintiff’s cost of capital to determine what rate this coerced loan should bear. The 5th Circuit, which would hear any appeal of an award of prejudgment interest in Collins at the District Court, has affirmed an award of prejudgment interest at the plaintiff borrower’s cost of borrowing.
In the case of Fannie and Freddie, the coerced loan would be characterized as a coerced preferred stock investment, since the Treasury senior preferred stock has been coerced to remain outstanding. The dividend rate for this coerced preferred stock investment is easy to discern. One need only to look at the GSE/Treasury senior preferred stock agreement to find the 10% rate that was placed on Treasury’s senior preferred stock.
This is a big deal. It is immediately apparent that by including prejudgment interest in any calculation of Collins plaintiffs total damage recovery, the total damage award grows substantially. For example, Fannie paid Treasury dividends for Q2 2013 (the first quarter in which the NWS dividend benefited from reserve reversals) of over $59 billion, whereas the prior quarter dividend amount (calculated in accordance with the 10% dividend amount) was $4 billion. The $54 billion difference constitutes Collins plaintiffs Compensatory Damages (difference between NWS dividend and 10% dividend) with respect to this single improper dividend.
If one applies a 10% prejudgment simple interest rate (without compounding) to this $54 billion damage amount for the seven years since that dividend, Collins plaintiffs would be entitled to an additional $37.8 billion in damages, all with respect to this single improper NWS dividend payment.
Generally, in Federal courts where litigation is protracted over a long time period, such as in Collins with respect to the NWS, “the stakes are often high. When the injury occurred long before the judgment, prejudgment interest can greatly exceed the original judgment. For example, Kansas, in its 1986 complaint against Colorado, sought $9 million in damages going back as far as 1950, plus $53 million in prejudgment interest. In 1992, the Seventh Circuit awarded plaintiffs $65 million in damages and $148 million in prejudgment interest in a suit arising out of the grounding of the supertanker, Amoco Cadiz, off the coast of Brittany on March 16, 1978”. The Calculation of Prejudgment Interest, p.3
So even if Treasury/FHFA were to agree to eliminate Treasury’s senior preferred stock and grant the $25 billion future tax credit, and then go before SCOTUS and try to have the Collins case dismissed as moot, Collins plaintiffs could defeat any such attempt by claiming that plaintiffs haven’t gotten the benefit of prejudgment interest, so that a live case and controversy continues to exist.
This gives Collins plaintiffs leverage to bring the government to the settlement table. But leverage to do what?
Collins plaintiffs should insist in settlement negotiations that, in addition to an economic recovery discussed above, FHFA should, at the time of settlement, release Fannie and Freddie from conservatorship and into consent decrees by which their future operations will be governed.
One of the benefits of a SCOTUS win for Collins plaintiffs would be the final legal declaration that the NWS exceeded the conservator’s authority. Perversely, a Collins settlement before a SCOTUS decision constitutes a legal win for the government insofar as there would still be a split in the federal circuit courts as to whether the NWS was legal (and this uncertainty as to its legality). It would be shortsighted for the Collins plaintiffs to obtain its economic recovery and still be subject to the conservator’s arbitrary exercise of illegal authority, leaving FHFA with the continued ability to commit another illegal act similar to the NWS. One may think this is a small risk with Director Calabria, but it may not be a small risk in the event a Biden administration installs a new FHFA director…for example, someone such as James Parrott, a prominent advisor to the Democrat Party on housing, who was instrumental in implementing the NWS during the Obama administration in the first place.
The consent decrees are essentially contracts between Fannie and Freddie, respectively, and FHFA, under which the GSEs will agree to a prescribed set of operational activities and seek to execute a capital raising plan in accordance with FHFA’s final capital rule, due to be released shortly. As contracts, assuming they have been properly drafted, the consent decrees should be far more determinative as to the GSEs’ and FHFA’s rights and obligations than was the scope of FHFA’s power as conservator. In my view, there can be no proper settlement of the Collins plaintiffs’ case to void the NWS unless there is both an economic recovery for damages arising from the NWS, AND there is no longer a conservatorship over the GSEs that could make possible a repeat of this saga.
When negotiating the Collins settlement, I believe that the Collins plaintiffs should use the specter of prejudgment interest to achieve not only a satisfactory economic recovery but also the status change of ending the conservatorship. I expect Director Calabria will refer to the consent decrees as “Conservatorship-Lite”, and this is fine for political cover, for as a matter of legal substance, the conservatorships will be over.
After Seila, Collins is a Case the acting Solicitor General Does Not Want to Argue Before SCOTUS
I have discussed at length the reasons why I believe the Collins plaintiffs will prevail in front of SCOTUS at Boom! With Scotus Granting Cert On Both Collins Claims And Seila Scotus Decision, It Is No Longer If But When For Fannie And Freddie Shareholders.
Briefly, at the 5th Circuit en banc, i) the Collins plaintiffs won on the APA claim, that the FHFA as conservator did not have the authority to implement the NWS, with respect to which the DOJ filed a certiorari petition seeking to reverse, ii) the DOJ and Collins plaintiffs both won on the constitutional structuring claim, that FHFA was improperly structured with a single director removable only for cause, and iii) the DOJ won and the Collins plaintiffs lost on the relief for the constitutional structuring violation, with the 5th Circuit en banc holding by a 9-7 majority that only prospective relief (severing the removal clause form the HERA statute) was available, not backward relief of invalidating the NWS.
Collins plaintiffs smartly petitioned SCOTUS for cert on the remedy for the unconstitutional structuring claim, which was somewhat controversial insofar as Collins plaintiffs were the “prevailing party” on the underlying substantive claim, and prevailing parties are not entitled to cert grants.
But SCOTUS granted cert on both the APA and constitutional remedy claims, and then decided Seila. SCOTUS granted backward relief in Seila, a case involving the CFPB, which is in all material respects (see below re amicus’s brief) identical to FHFA. It invalidated the civil investigative demand issued by the CFPB to Seila, subject to the government’s claim that the CID had been subsequently ratified by a properly removable CFPB director.
So we have: i) the APA claim which Collins plaintiffs won below, and which I expect the plaintiffs will win at SCOTUS, especially since the DOJ brief before SCOTUS omits reliance on the argument that use of the word “may” in HERA leaves FHFA as conservator with no duty to conserve and preserve the GSEs’ assets (which was relied on by the circuit courts in which the government prevailed on this claim), and relies principally on the argument that plaintiffs claim is not a direct claim (which the government lost in all circuits); ii) Seila providing precedential authority for both the unconstitutionality of FHFA’s structure and the availability of backward relief, iii) the government not seeking to distinguish FHFA from CFPB, which is the only basis upon which the government really can prevail on the constitutional structuring claim, leaving this argument to a court appointed amicus to brief, and iv) Justice Ginsburg’s vacancy being filled by Justice Barrett (leaving SCOTUS even more receptive to Collins plaintiffs’ claims of separation of powers and administrative agency overreach).
In essence, the only viable chance that the government has for winning Collins rests on an argument that it is not making, relying on the amicus’ argument that Collins can be distinguished from Seila principally because an acting FHFA director executed the NWS and, as the amicus argues, the acting FHFA director is removable at will, and that FHFA is distinguishable from CFPB insofar as the CFPB directly regulates people directly, and their individual commercial transactions, while the FHFA directly regulates financial institutions. In my view, these are losing arguments.
Given all this, I believe that the acting Solicitor General does not expect that the government will prevail in Collins over SCOTUS, but there is a timing element to appreciate as well. As a repeat party arguing before SCOTUS, the Solicitor General relies on the goodwill of SCOTUS when it appears many times to argue the government’s position. It would tread upon this goodwill for the acting Solicitor General to argue Collins in front of SCOTUS on December 9, 2020 and then subsequently inform SCOTUS that the case is settled. This is not how SCOTUS expects to be treated, and certainly not by the Solicitor General. While a federal district court sometimes will hold a trial that results in a settlement before judgment, after the parties have seen their arguments play out in court (indeed, most cases settle before trial), SCOTUS does not expect that the parties will take an extremely hard to obtain cert grant, available to very few parties that seek it, go to oral argument, and then say thank you to SCOTUS for the cert grant and its time for oral argument, but no thanks.
So, if as I expect the government is inclined to settle Collins, I expect it will want to do so before December 9, 2020. Given the Collins plaintiffs negotiating power represented by the availability upon SCOTUS victory of both Compensatory Damages and prejudgment interest thereon, I expect that Collins plaintiffs should be able to negotiate for both a satisfactory economic recovery and a conservatorship status change…and I expect even FHFA and Treasury may also be inclined to a status change in the event of a Biden election (or even just uncertainty) on November 3, 2020.
If I am right, then there is prospect for significant GSE share price appreciation over the next few months.
Disclosure: I am/we are long FNMAS. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.