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From Banking and Finance Law Daily, May 7, 2018

Dismissal of Fannie and Freddie shareholders’ challenge to ‘Net Worth Sweep’ affirmed

By Joseph Arshawsky, J.D.

A court cannot enjoin the deal by which Fannie Mae and Freddie Mac pay over their quarterly net worth to the Treasury Department, the United States Court of Appeals for the Seventh Circuit ruled, affirming a dismissal by the Northern District of Illinois. The Housing and Economic Recovery Act of 2008 (HERA) contains a broad prohibition against courts from restraining the Federal Housing Finance Authority’s (FHFA) functions, as long as FHFA is acting within its statutory authority (Roberts v. Federal Housing Finance Agency, May 3, 2018, per curiam).

Net Worth Sweep. At the height of the 2008 financial crisis, Congress created the FHFA and authorized the FHFA to place the Federal National Mortgage Association ("Fannie Mae") and the Federal Home Loan Mortgage Corporation ("Freddie Mac") into conservatorship. In exchange for a cash infusion and fixed funding commitment for each enterprise, Treasury received senior preferred shares. These shares gave Treasury extraordinary governance and economic rights, including the right to receive dividends tied to the amount of Treasury’s payments.

Additional rounds of funding led to three additional amendments to the original stock purchase agreement. The third such amendment introduced a variable dividend under which Treasury’s dividend rights were set equal to the companies’ outstanding net worth, known as the "Net Worth Sweep." Private shareholders in Fannie Mae and Freddie Mac then brought this suit against Treasury and the FHFA, claiming that the FHFA violated its duties in two ways: (1) agreeing to the Net Worth Sweep; and (2) succumbing to the Treasury. The shareholders also alleged that Treasury exceeded its statutory authority and failed to follow proper procedures. The district court dismissed the complaint for failure to state a claim, and the Seventh Circuit affirmed.

HERA. Unless otherwise permitted by the statute or requested by the FHFA’s director, "no court may take any action to restrain or affect the exercise of powers or functions of the [FHFA] as a conservator or a receiver" under 12 U.S.C. § 4617(f). The shareholders argued that the Third Amendment was adopted just as Freddie and Fannie were returning to profitability to capture all anticipated upside for Treasury to the detriment of the corporations and their private shareholders.

The FHFA and Treasury countered that the net-worth dividend served to prevent the companies from running up against the soon-to-be fixed funding commitment. They note that Freddie and Fannie had consistently borrowed from Treasury to pay the fixed-rate dividends—a practice that resulted in a spiral of ever greater liquidation preferences and dividends. The district court granted both defendants’ motion to dismiss the complaint, finding that Section 4617(f) precluded the relief requested. The Seventh Circuit examined that ruling de novo, looking first at the FHFA and then at Treasury.

FHFA’s motion to dismiss. Regarding the FHFA, the Seventh Circuit’s review was squarely foreclosed by 12 U.S.C. § 4617(f), which bars judicial interference with the FHFA’s statutorily authorized role as conservator. Because the FHFA acted within its powers as conservator in agreeing to the Preferred Stock Purchase Agreements and the Third Amendment, declaratory and injunctive relief could not run against it. The FHFA did not have a rigid duty to conserve Fannie Mae’s and Freddie Mac’s assets. Instead, Section 4617(b)(2)(D) grants additional authority to the FHFA, allowing the FHFA to take additional actions "as may be … appropriate to carry on the business of the regulated entity and preserve and conserve" its assets.

"In short, the plaintiffs have failed—both as a matter of statutory interpretation and as a matter of facts alleged—to state a claim that the [FHFA] acted outside its authority as a conservator and thereby lost the protection of section 4617(f)," according to the appellate panel. So long as the FHFA remained free to reject the terms offered by Treasury and to exercise its independent judgment, nothing prevented the FHFA from taking Treasury’s advice or agreeing to its terms.

Treasury’s motion to dismiss. Just as Section 4617(f) barred the plaintiffs’ claims against the FHFA, it prevented the court from granting declaratory and injunctive relief against Treasury. "An injunction or declaratory judgment preventing Treasury—the [FHFA]’s counterparty—from honoring the terms of the Third Amendment would fundamentally "affect" the [FHFA]’s conservatorships of Fannie and Freddie and so would run afoul of section 4617(f)," the appellate panel reasoned. The court also found unconvincing the shareholders’ attempt to equate the Third Amendment to the issuance of new securities. "Any economic equivalence between the Third Amendment and the issuance of new securities does not manufacture new stock out of thin air," the court stated.

The case is No. 17-1880.

Attorneys: Christian D. Ambler (Stone & Johnson, Chartered) for Christopher Roberts. Howard N. Cayne (Arnold & Porter Kaye Scholer LLP) for Federal Housing Finance Agency.

Companies: Federal Housing Finance Agency

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