I have previously written SA articles assessing the merits of the Perry plaintiffs' appeal to the DC Circuit Court of Appeals of Judge Lamberth's opinion dismissing the plaintiffs' challenge to the net worth sweep (NWS) in Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC). In these articles, I discussed the likelihood of success in obtaining either reversal (which would invalidate the NWS), or the vacating of the opinion and remand back to the District Court for further fact-finding (including supplementation of Treasury's administrative record and ordering FHFA to produce an administrative record).
In these articles, I tried to analyze what a federal appeals court judge should do, based upon my reading of the voluminous briefing in the case and my knowledge of applicable law. However, now that we have access to an audio recording of the actual oral argument (which you can download at case #14-5243 here), we can all try to assess what these three judges (Brown, Millet and Ginsburg) will do when they actually rule on the merits.
If you have not already done so, you should listen to the oral argument before reading further in this article.
As a preliminary matter, divining a judge's inclination as to how he or she will rule, based upon oral argument statements and questions, is a highly fraught endeavor. It is appropriate, since often a judge's disposition towards a case is revealed at least to some extent in oral argument. Judges often signal or tip their hands as to which party's argument the judge finds more persuasive or troubling, at least in part to try to persuade the other merits panel judges. However, one shouldn't put too much reliance upon the oral argument. Judges will return to the written briefs and colloquy among themselves in order to decide the merits. So, there can be no guarantee as to how oral argument will guide the judges as they collectively proceed to decide the case and draft their opinions (and quite often it is a collaborative process among all the judges in reaching a decision).
With that said, I will try to distill 2 hours and 45 minutes of oral argument into a roadmap to anticipate the DC Circuit Court of Appeals decision. This roadmap sets forth three possible results of the appeal: i) affirmance for the government and dismissal of the plaintiffs' case, ii) reversal and invalidation of the NWS, and iii) vacating Judge Lamberth's opinion, and remanding the case back to the District Court for further fact-finding, including supplementation of the administrative records, in the case.
The Oral Argument Roadmap
In laying out this roadmap, I will try to analyze the following arguments:
1. The arguments by the government that judicial review is barred either by the i) anti-injunction provision of HERA (Section 4617(f)), which, the government argues, prevents judicial review of FHFA's decision, as conservator, to enter into the NWS (the Anti-Injunction Argument"), or by ii) a non-reviewable reclassification of capital made by FHFA, as regulator, under 12 USC 4623 (the "Capital Reclassification Bar"). If either of these provisions is found to preclude judicial review, the appeals court will affirm for the government.
2. The arguments by plaintiffs that require the appeals court to reverse, and order judgment in favor of the plaintiffs. As an initial matter, this would require the appeals court to reject the Anti-Injunction Argument and the Capital Reclassification Bar in paragraph 1 above. The appeals court would also find that i) Treasury no longer had statutory authority to purchase securities after 2009, and the NWS necessarily involved such a purchase of securities (the "Securities Purchase Argument"), or ii) that the NWS, to the extent that it requires FHFA to distribute all GSE net worth and profits in perpetuity to Treasury, is incompatible as a matter of law with the obligations of FHFA, as conservator, under HERA to preserve and conserve the assets of the GSEs, and return the GSEs to a sound and solvent condition (the "Conservator Arbitrary and Capricious Argument"). The Conservator Arbitrary and Capricious Argument holds that, as a matter of law under the Administrative Procedure Act (APA) and HERA, the NWS on its face is an arbitrary and capricious act by FHFA as conservator that is inconsistent with the conservator's HERA statutory duties. In other words, any FHFA act as conservator that requires the complete depletion of the entire net worth of the GSEs, so that they can never build or retain capital, cannot stand in face of the conservator's statutory duty to return the GSEs to a sound and solvent condition.
3. The arguments by plaintiffs that require the appeals court to vacate the Lamberth opinion and return the case for further fact-finding. As an initial matter, this would require the appeals court to reject the Anti-Injunction Argument and the Capital Reclassification Bar in paragraph 1 above (I will discuss below whether the appeals court could vacate and order more fact finding without holding that the Anti-Injunction Argument was invalid). The appeals court would also find that i) the motivation of FHFA in connection with the NWS is material to any determination whether FHFA improperly or failed to exercise its conservator powers and function (the "Conservator Power Exercise Argument"), or ii) the Motion to Dismiss granted by Judge Lamberth improperly resolved factual questions alleged by plaintiffs in a manner adverse to the plaintiffs and in the absence of a complete administrative record (the "Incomplete Administrative Record Argument"), or iii) the NWS breached contractual duties owed to GSE junior preferred stockholders and a fiduciary duty owed to GSE common stockholders, which give rise to common law remedies apart from and in addition to the APA remedy of vacating remedy the NWS (the "Shareholder Breach Argument").
Analyzing the Oral Argument Roadmap
In terms of Roadmap paragraph 1 above, what can be said about what the merits panel thought of the Anti-Injunction Argument?
Judge Lamberth found that as long as FHFA as conservator was exercising a statutory power or function, such as managing the GSEs businesses and entering into or amending contracts such as the NWS, there could be no judicial review, and hence no judicial invalidation, of the NWS. FHFA has since interposed this Anti-Injunction Argument in all other cases attacking the NWS including, most notably, the Hindes/Jacobs case that raises serious doubt as to whether the NWS complies with Delaware and Virginia corporate law relating to permissible terms of preferred stock. So any win by the Perry plaintiffs with respect to the Anti-Injunction Argument will also redound to the benefit of the Hindes/Jacobs and other plaintiffs. A favorable holding by the DC Circuit Court of Appeals will likely have persuasive effect for District Courts in other federal circuits (assuming all of the cases are not consolidated in the DC federal district, in which case the favorable holding would be binding, not just persuasive).
To be clear, no judge stated flatly that he/she either supported or rejected the Anti-Injunction Argument. But there were two telling examples of judicial questioning with respect to the Anti-Injunction Argument that I set forth below. In addition to these snippets, I set forth below in my analysis of paragraphs 2 and 3 additional reasons why I believe the appeals court will not affirm on the basis of the Anti-Injunction Argument.
The Anti-Injunction Argument makes irrelevant the conservator's motivation in connection with its exercise of a conservator power. Indeed, Judge Lamberth stated that it was the what (the exercise of a power), and not the why (whether the exercise of the power was in furtherance of a conservator duty), that required dismissal of the plaintiffs' case.
At 0hr.41-0hr.43 (all timing references to oral argument audio are approximate), Judge Ginsburg specifically states that Judge Lamberth found that FHFA's motivation as conservator was irrelevant, and Judge Ginsburg stated that, together with plaintiffs' counsel, they had found two examples where conservator motivation was relevant under the statute. Moreover, at minutes 1hr.52-1hr.53, where Treasury counsel was arguing that there was no limit to the exercise of conservator power, Judge Brown interrupted Treasury counsel and interjected that it was not a question as to whether a conservator power was exercised, but rather a question as to whether the conservator power that was exercised was ultra vires, or without statutory authority.
These snippets from the oral argument tend to lend support to the notion that at least Judges Brown and Ginsburg are uncomfortable with a denial of judicial authority to review conservator action. Judge Millett at one point parries with plaintiffs' counsel by saying that the anti-injunction provision eliminates requirement to produce an administrative record, at which point plaintiffs' counsel replies that the Sonoma County case in the 9 th circuit makes clear otherwise. Judge Millett does not press the matter further at that point.
It is my sense that the merits panel will not affirm for the government by virtue of the Anti-Injunction Argument. Of course, these snippets (and my discussion regarding paragraphs 2 and 3 below) are not dispositive, but they are clear examples of judicial pushback against the government's defense of Judge Lamberth's what but not why holding.
Before proceeding further, one interpretative difficulty regarding the oral argument, beyond trying to decipher what the judges are thinking by looking to what they are saying, is the paucity of questioning by Judge Brown. Apart from this example of focusing on whether the NWS was an ultra vires conservator act, Judge Brown said and asked little. I believe it is fair to say that from what we know of Judge Brown's general judicial disposition, Judge Brown is more likely to vote with Judge Ginsburg than Judge Millet (which is not to say necessarily that Judge Millet wont vote with Judge Ginsburg). This leads to the notion that if Judge Ginsburg decides in favor of the Perry plaintiffs (not answering for the moment whether by reversing, or vacating and remanding, Judge Lamberth's opinion), but Judge Millet votes to affirm, it is my view that it is more likely than not that Judge Brown will side with Judge Ginsburg. This is admittedly an unreliable line of thinking in terms of how Judge Brown may decide, but one is left with little indication given her lack of questioning, when compared to Judges Millett and Ginsburg.
In terms of Roadmap paragraph 1 above, what can be said about what the merits panel thought of the Capital Reclassification Bar?
The Capital Reclassification Bar was not referred to by Judge Lamberth in his opinion, nor briefed by either party to Judge Lamberth or in any party's appeal briefs to the DC Circuit Court of Appeals. Nonetheless, the appeals court asked counsel, apparently the morning of the argument, to address whether the act by FHFA, as regulator, to remove the GSEs from the obligation to hold any statutorily prescribed level of capital prevented judicial review of the case, which in turn would have the effect of affirming Judge Lamberth's opinion (but for reasons other than stated by Judge Lamberth). This was such a last minute judicial request of counsel that FHFA counsel stated that he was reading the capital regulatory statutory reference cited by the appeals court request on his iPhone while walking into court.
The appeals court has requested additional briefing as to the Capital Reclassification Bar, and anything that I can say before such briefing is provisional. But at minutes 1hr.26-1hr.31, Judge Ginsburg teased out a concession from FHFA counsel that FHFA, as regulator, did not reclassify the capital requirements of the GSEs (and it is a capital reclassification that is insulated from judicial review), but rather made a discretionary determination to except the GSEs from statutory capital classification (and such discretionary regulatory act is subject to judicial review, and judicial invalidation if arbitrary and capricious or otherwise not in compliance with applicable law…and certainly the plaintiffs will argue in supplemental briefing that an important applicable law is the conservator duty to return the GSEs to a safe and sound condition).
While not implying that Judges Brown and Millett were not up to speed on regulatory capital law, it was only Judge Ginsburg who engaged FHFA counsel on this legal matter (one might think that, out of an excess of judicial caution, it was Judge Ginsburg who asked counsel to address it), and I believe it was telling that Judge Ginsburg spent a fair amount of time walking FHFA counsel back from FHFA counsel's initial assertion that, at least as a practical matter, FHFA had made a judicially unreviewable capital reclassification (or had adopted a new capital "paradigm," to use FHFA counsel's term).
So, while none of this is definitive, based upon the general tenor of the questioning and the examples cited, it appears to me more likely than not that the appeals court will not affirm Judge Lamberth's opinion on the basis of either the Anti-Injunction Argument or the Capital Reclassification Bar.
In terms of Roadmap paragraph 2 above, what can be said about what the merits panel thought of the Securities Purchase Argument?
From the viewpoint of the plaintiffs, this is the most disappointing aspect of the oral argument. During plaintiffs counsel's opening remarks, plaintiffs' counsel referred to the Securities Purchase Argument briefly, and Judge Millett quickly moved plaintiffs' counsel back to a discussion of the scope of the conservator's powers. The Securities Purchase Argument was not raised again during the entire oral argument.
While I believe the Securities Purchase Argument has merit from the plaintiffs' viewpoint, it is hard to see how it might be likely that the merits panel thought likewise if it did not direct any questioning about this claim. The Securities Purchase Argument may be viewed as highly technical, and that it requires the judicial reading into HERA of an interpretation, regarding the definition of a securities purchase, borrowed from securities and taxation law that would be better for Congress to have made explicit in the statute.
On the other hand, if one were to interpret law only in a manner that did not involve technical interpretation, the entire tax code would be up for invalidation. Moreover, it is common for courts to interpret language in a way that borrows from the settled legal interpretation of the same language in question from other areas of law. If under securities and tax law, a substantial change in the terms of a security involves a new purchase transaction, why shouldn't a substantial change in the terms of a security that Treasury purchased under HERA also involve a new purchase transaction (which after 2009 was not within Treasury's power)?
Nonetheless, I would have to conclude that the absence of judicial attention to the Securities Purchase Argument indicates a lack of interest in deciding the case under this argument.
In terms of Roadmap paragraph 2 above, what can be said about what the merits panel thought of the Conservator Arbitrary and Capricious Argument?
This is the core of the case. Plaintiffs' counsel argued that not only does conservator motivation matter, so as to prevent the anti-injunction provision from being a bar to judicial review (which is the Conservator Power Exercise Argument from paragraph 3 discussed below), but that as a matter of law the NWS is incompatible with the conservator statutory duty to conserve and preserve assets, and return the GSEs to a safe and sound condition.
Judge Millett tested this proposition early during plaintiffs' counsel opening statement, asking a hypothetical as to whether if there was no other reasonable course of action for the conservator to "stop the hemorrhaging," would plaintiffs counsel agree that, under these facts, the NWS was a valid exercise of conservator power? Plaintiffs' counsel responded no, and there was some back and forth in which plaintiffs' counsel stated that the conservator should have used the pay-in-kind (PIK) provision of Treasury's stock if it wanted to stop the hemorrhaging, to which Judge Millet responded that wasn't it within the conservator's discretion to be able to choose between the NWS and the PIK? This leads me to conclude that if Judge Millett doesn't decide to affirm, she will only go so far as to vacate and remand (see the Conservator Power Exercise Argument from paragraph 3 discussed below).
Judge Ginsburg evidences an internal battle in his mind as to whether to reverse, or just vacate for more fact-finding. At 2hrs.02, Judge Ginsburg laments how both government counsel, when positing possible justifications for the NWS (such as when Treasury counsel stated that the conservator was justified in agreeing to the NWS if only to benefit the secondary housing finance market, and even if not to restore the GSEs' capital), are just looking at the case from "30,000 feet", while the court has to "grapple with the terms of the statute". This bespeaks to me that Judge Ginsburg is feeling the weight of any decision to reverse (which in turn indicates to me that he is taking the question seriously).
At 2hrs.21, to make his point in a hyperbolic and, characteristically for Judge Ginsburg, amusing fashion, Judge Ginsburg issues the money quote of the oral argument: As early as 2011, " Treasury said we're going to wind this thing down, we're going to kill it, we're going to drive a stake through its heart, and we're going to salt the earth so it can never grow back." One cannot put too much reliance on this statement, other than to say that if he were to vote for reversal, it would be on the basis that while Treasury as a policy matter could have believed this, FHFA as a legal matter couldn't as conservator simply accede to Treasury's view. I believe that Judge Ginsburg is thinking whether this simply calls for a vacate and remand, so as to determine this factual question as to what FHFA was thinking, or whether the NWS speaks for itself as incompatible with the conservator's function.
It is apparent that another judge says "close enough" during the audience laughter that occurred just after Judge Ginsburg's money quote, and I believe it was Judge Brown. I'll refrain from going into a Zapruder-type inquiry into whether I am right, and if so what the implications might be.
One element of the Conservator Arbitrary and Capricious Argument that would call for reversal is the notion that there is not a continuum between actions within the proper scope of a conservator's power and actions within the scope of a receiver's power under HERA. The point is that the NWS is compatible with a receiver's powers, but is incompatible with a conservator's power. Judge Lamberth clearly indicated that such a continuum exists, so that the NWS is compatible with a conservator's "morphing" into a receiver, if indeed it ever decides to become a receiver.
At 2hrs.22, Treasury counsel argued before the appeals court that the HERA statute listing of FHFA powers itemizes "winding down" as both a conservator and receiver function, at which point Judge Ginsburg clearly opposes this notion, stating that the word "respectively" is implicit in the statute. This would make winding down only a receiver function, and it is clear to me that upon any fair reading of the statute, the structure of the statute and its other provisions, Judge Ginsburg's reading is required.
If Judges Brown and Ginsburg find that the NWS is, on its face, a "winding down" of the GSEs (as Treasury seemingly intended for it to be), and "winding down" is a receiver function as opposed to conservator function, then it would follow that Judge Brown and Ginsburg would vote for reversal. On this view, there would be no need for the appeals court to determine what the facts were surrounding the conservator's adoption of this "winding down" function, as it would be ultra vires as a matter of law.
Before proceeding, it is noteworthy that the class plaintiffs' counsel argued that it was outrageous for government counsel to argue that GSE shareholders have more rights in receivership than in conservatorship. This is the world turned upside down, and it indicates how strained the government counsels' arguments were in seeking to uphold the NWS as a winding down which is a permissible act of a conservator. This was a brief but arguably the most effective statement during the entire oral argument.
As a counter to this, during plaintiffs counsel's opening statement, Judge Ginsburg noted the enormous asset size of the GSEs and the difficulty to put them into receivership, and whether it might be appropriate for FHFA as conservator wind down the GSEs' asset size as a possible preparation for placing the GSEs into receivership. A question such as this might indicate that Judge Ginsburg might ultimately vote for vacating and remand, to gather facts as to what FHFA was thinking. However, I didn't note any particular enthusiasm to this question such as to indicate that Judge Ginsburg might be inclined to vote for affirmance.
In terms of Roadmap paragraph 3 above, what can be said about what the merits panel thought of the Conservator Power Exercise Argument and the Incomplete Administrative Record Argument?
I can be brief here, as the answer is that if the appeals court believes that there are factual questions that are necessary to resolve in order to determine whether the NWS was within the conservator's power, such that they are not willing to reverse as a matter of law, then the appeals court will vacate Judge Lamberth' opinion (which would not result in vacating the NWS in and of itself), in order for the district court to do more fact finding. This would likely result in a requirement that Treasury supplement its administrative record, FHFA as conservator produce an administrative record, and quite possibly the district court holding a full trial calling for the deposition of all the Treasury and FHFA individuals involved in the NWS adoption.
The procedural stance at the time Judge Lamberth dismissed the case is important to keep in mind in this regard. Judge Lamberth granted the government's motion to dismiss before any fact-finding occurred. At this stage of the proceedings, Judge Lamberth was obligated to deem all of plaintiffs' factual allegations contained in their complaints as true for purposes of deciding the motion to dismiss.
It seems to me that one of the most uncontroversial conclusions one can reach about the oral argument is that the appeals court recognized, at a minimum, that certain of the plaintiffs allegations, as well as certain of the government's defenses, could be better decided with a developed factual record. In this respect, Judge Ginsburg explicitly refers to the SCOTUS the Overton Park case for support that would call for vacating, remand, supplementation of an administrative record and trial (including the deposition of government officials).
In terms of Roadmap paragraph 3 above, what can be said about what the merits panel thought of the Shareholder Breach Argument?
The Shareholder Breach Argument is in addition to the APA claims discussed above. The appeals court could decide to affirm with respect to the entire foregoing discussion, and still vacate and remand if it finds that the NWS violated the GSE junior preferred shareholders contractual rights, and the fiduciary duty the GSE boards of directors (and FHFA as conservator in the board's stead while in conservancy) owed to the GSE common shareholders.
This requires the appeals court to determine whether HERA requires that i) all shareholder economic and governance rights are transferred to FHFA, as conservator, which would be a bar to all shareholder direct or derivative claims, or ii) the transfer of shareholder rights is only with respect to the GSEs themselves (as in fact HERA states), which would not be a bar to shareholder direct claims and, except as discussed below, would be a bar to shareholder derivative claims.
Even though a fair reading of HERA leads one to believe that it clearly bars shareholder derivative claims, plaintiffs' counsel refers the appeals court to the Kellmer case, in which the DC Circuit Court of Appeals itself read into HERA an exception to the bar against shareholder derivative suits where FHFA as conservator would be called upon to sue itself (as would be the case with Perry).
Judge Millett showed some confusion as to the differences between a direct and derivative shareholder claim and the respective legal sources for such claims, at which point Judge Ginsburg (somewhat blithely) said the claims arose from the certificates. This is true for the junior preferred stock certificates, which contain actual contractual provisions obligating the issuer to certain terms in favor of the junior preferred stock holders, and it is implied into the common stock insofar as the governing corporate law obligates the issuer to act in a manner consistent with the fiduciary duty owed to common stock holders.
It seems to me that the bulk of the discussion with respect to the Shareholder Breach Argument will result in the appeals court overturning that portion of Judge Lamberth's opinion that held that GSE shareholders were not entitled to bring either direct or derivative claims.
It strikes me that this is how I see the appeals court ruling:
1. as a "bear case," the appeals court will vacate Judge Lamberth's opinion, and remand the case back to the district court with an order that i) Treasury supplement its administrative record, ii) FHFA as conservator produce an administrative record, and iii) depending upon the results of this record, a full trial be conducted that involves, among other things, the deposition of all the Treasury and FHFA individuals involved in the NWS adoption. The appeals court will articulate a rationality-based, deferential standard for the district court to apply to FHFA's actions as conservator in order to determine the validity of the NWS after fact-finding.
2. as a "base case," the court will rule as per paragraph 1 above, but in addition, the appeals court will enunciate a standard of stricter scrutiny by which the district court will determine whether or not, upon the facts elicited, the NWS complies with the scope of the conservator's powers and functions. The appeals court will specifically i) overturn Judge Lamberth's what but not why theory, ii) rule that motivation is an important factor in making this judicial determination, and iii) may go on to specify in greater detail what factors the district court should take into account.
3. as a "bull case," the court will reverse Judge Lamberth and enter judgment in favor of the plaintiffs, by vacating the NWS as a violation of the conservator's powers and functions under HERA.
I don't see any reasonable possibility that a majority of the merits panel will decide to affirm Judge Lamberth's opinion.
One more thing needs to be said. I do not see how any of these three expected results does not involve a repudiation of Judge Lamberth's holding that HERA Section 4617(f) constitutes a bar to judicial review of the NWS. The government has interposed this aspect of Judge Lamberth's holding as sufficient reason for all other cases contesting the NWS's validity to be dismissed. When, as I believe it will, the appeals court discredits Section 4617(f) as an anti-injunction bar to judicial review, this DC Circuit Court of Appeals holding will have a great persuasive effect upon these other cases.
And, if the government's own motion to consolidate all of these other cases into the DC District Court is granted by the Multi-District Litigation Panel, this appeals court holding will have binding, and not just persuasive, effect upon all such cases.
As Mom says, watch out what you wish for.
Disclosure: I am/we are long FNMA.
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.
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