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For Fannie And Freddie Shareholders, The Road To Litigation Settlement Runs Through Seila

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About: Freddie Mac (FMCC), FNMA, Includes: FNMAS
by: Rule of Law Guy
Rule of Law Guy
Special situations
Summary

A litigation settlement is a practical necessity in order for FNMA and FMCC to execute their recapitalization and release from conservatorship.

The Collins 5th Circuit en banc decision, that declared FHFA unconstitutionally structured, but most importantly for Fannie and Freddie shareholders, denied retrospective relief to plaintiffs, is on hold at SCOTUS.

So one may think settlement among Treasury/FHFA and Fannie/Freddie shareholders will similarly be on hold until after SCOTUS grants certiorari in Collins and hears the case (decision in 2021).

This is wrong. SCOTUS's decision in Seila (oral argument 3/3/20, decision late summer 2020) will provide direct read-through to Collins, and represent a huge win for Fannie and Freddie shareholders.

In effect, Seila is Collins in disguise at SCOTUS, and Treasury/FHFA likely will be facing a Seila decision that provides Collins everything needed for GSE litigating shareholders to claim a $100 billion plus victory.

Thesis

  • I anticipate that SCOTUS will decide in Seila that the CFPB is unconstitutionally structured and, importantly for Fannie and Freddie shareholders, SCOTUS will void the Civil Investigation Demand (CID) issued by CFPB against Seila (retrospective relief). Seila will be argued before SCOTUS on March 3, 2020, and SCOTUS’s decision in Seila can be expected sometime in the summer of 2020.
  • FHFA’s structure is in all material respects identical to the CFPB structure (single agency director removable by POTUS only for cause). If as I expect SCOTUS finds CFPB unconstitutionally structured in Seila, Seila will be non-distinguishable SCOTUS authority for concluding that FHFA is unconstitutionally structured.
  • The big issue for Fannie and Freddie shareholders is whether retrospective relief will be granted in Seila, or will SCOTUS only provide prospective relief (void as unconstitutional the single director removable only for cause provision). In the 5th Circuit en banc Collins ruling, the 5th Circuit (properly in my view) held that FHFA was unconstitutionally structured, but declined (improperly in my view) by a 9-7 vote to grant Collins plaintiffs the retrospective relief they sought, which was to invalidate the Net Worth Sweep (NWS). Invalidating the NWS will result in a $100 billion plus litigation victory for Fannie and Freddie shareholders, and should result in substantial and immediate capital appreciation for GSE junior preferred shareholders.
  • This retrospective relief would have been proper in my view because there is substantial SCOTUS authority for the proposition that final agency action by an unconstitutionally structured agency must be voided. Under this SCOTUS authority, the NWS must be vacated because it was an official action taken by the FHFA Acting Director at a time in which the FHFA was unconstitutionally structured. The 5th Circuit provided only prospective relief, severing the removal only for cause provision from the other provisions of the statute, rendering the FHFA director removable by POTUS at will.
  • The concurring opinion by two 5th Circuit en banc Collins judges, the swing votes in the 9-7 decision to deny retrospective relief, made clear that they thought they were obligated by SCOTUS precedent (Free Enterprise case) to provide only prospective relief as a remedy for a separation of powers constitutional claim. As I will discuss in the Analysis section below, this is a misreading of the Free Enterprise case and indicates total ignorance of the Bowsher case, in which SCOTUS granted plaintiffs retrospective relief for a constitutional separation of powers claim.
  • As discussed in the Analysis below, I expect SCOTUS to grant retrospective relief in Seila. If so, then sometime during the late summer/fall of 2020 and immediately after the Seila decision, Collins plaintiffs should be able to go directly to the 5th Circuit and seek an order invalidating the NWS. Collins plaintiffs will be able to do so if, as I expect, SCOTUS issues a “GVR” with respect to the Collins plaintiffs’ petition for certiorari on their constitutional remedy claim (see Analysis for further discussion).
  • Treasury/FHFA will face an ultimate reckoning on the validity of the NWS once SCOTUS releases its Seila opinion and, as I expect, grants a GVR with respect to the Collins case. It is around this time, late summer/fall 2020, that I would expect Treasury/FHFA to feel compelled to engage in serious settlement discussions with litigating Fannie and Freddie shareholders. It is important to realize that because of the read-through from Seila, (I) this late summer/fall 2020 time frame is many months in advance of the time if GSE shareholders had to wait for SCOTUS to take up and decide Collins directly, and (II) Collins plaintiffs will have an extraordinarily powerful negotiating position, necessitating little discount in settlement from what would be obtainable through litigation to final outcome. I don’t believe the market realizes either of these points.
  • Based on this thesis, I believe GSE junior preferred stock is currently undervalued. I have no view of the valuation of GSE common stock.

Analysis

I have set forth above my current Fannie and Freddie investment thesis. I believe that the prospects for a favorable GSE litigation settlement are sooner and better than is implied by the current trading price of GSE junior preferred stock.

Readers who don’t want to get into some of the legal nitty gritty that supports this thesis can stop reading now. For a more complete assessment of the thesis, I set forth my analysis below. This includes my best guess as to the outcome of the Seila case before SCOTUS, which of course is uncertain.

Fannie and Freddie shareholders are aware that the 5th Circuit en banc held in Collins that (I) the conservator had a statutory obligation to conserve and preserve assets, and that the Collins plaintiffs had made a plausible allegation in their amended complaint that the NWS violated this conservator duty (APA Claim), and (II) FHFA was unconstitutionally structured insofar as the FHFA director could be removed by POTUS only with cause, but the Court denied Collins plaintiffs the retrospective remedy of vacating the NWS (Constitutional Remedy Claim). Instead the Court severed the for cause removal provision from the statute so that it would have no effect on a prospective basis.

As to the APA Claim in (I) above, while the Collins plaintiffs needed only to show, and the Collins 5th Circuit majority held that they did show, a “plausible allegation” that the NWS violated the conservator’s duty in order to deny the government’s motion to dismiss, one should understand that the Collins plaintiffs’ APA Claim is much stronger than a plausible allegation. Based upon the legal analysis set forth by Judge Willett in the majority opinion, and the fact discovery available to the Collins plaintiffs from other cases such as Fairholme in the Court of Federal Claims, it is highly likely that the Collins plaintiffs will prevail in the District Court for the Southern District of Texas (SDT) on the APA Claim. Furthermore, while the government’s certiorari petition of the APA Claim is on hold at SCOTUS (and one might think that if SCOTUS believed that the APA Claim was not correctly decided, it would not have placed the government's APA Claim certiorari petition on hold), the 5th Circuit issued its mandate to the SDT before the government’s cert petition had been filed with SCOTUS (a timely petition would have stayed the mandate). So, Collins plaintiffs are able to proceed with trial on the APA Claim at the SDT while the APA Claim cert petition is on hold at SCOTUS. As of the time of this writing, Collins plaintiffs have yet to file papers restarting litigation of the APA Claim in SDT.

But my investment thesis focuses on the Constitutional Remedy Claim rather than the APA Claim.

Before considering the Constitutional Remedy Claim in (II) above, it must be remembered that the 5th Circuit en banc found by a vote of 12-4 that the single director removable for cause statutory provision violated Article II of the US Constitution (that POTUS shall have the executive power to take care that the laws be faithfully executed). While this holding has not been appealed by FHFA to SCOTUS, it is implicated in the Collins plaintiffs’ petition for certiorari on the Constitutional Remedy Claim, which is also on hold at SCOTUS with the APA Claim. The underlying claim that the FHFA is unconstitutionally structured is almost identical to the Seila claim that the CFPB is unconstitutionally structured. If SCOTUS holds in Seila that the CFPB is unconstitutionally structured, SCOTUS will likely affirm the 5th Circuit en banc Collins holding that FHFA is unconstitutionally structured.

I believe it is highly likely that SCOTUS will find the CFPB to be unconstitutionally structured in Seila. For a preview of how that majority opinion may be written, one may read then-Judge Kavanaugh’s bravura PHH DC Circuit Court of Appeals opinion holding the CFPB to be unconstitutionally structured in 2017 (overturned by subsequent DC Circuit of Appeals en banc decision, which was not further appealed to SCOTUS).

As to the Constitutional Remedy Claim in (II) above, the 5th Circuit found by a vote of 9-7 that Collins plaintiffs were not entitled to retrospective relief for the constitutional violation posed by FHFA’s single director removable only for cause structure. The only relief afforded was to declare the director removal statutory provision void and severed from the rest of the statute, which would otherwise continue in full force and effect. The denial of retrospective relief is at odds with SCOTUS precedent, and the prospective remedy (requiring a severance analysis) is a highly questionable judicial action which I believe SCOTUS will disavow in Seila, at the invitation of Seila counsel.

Seila’s brief at pps 35-48 exhorts SCOTUS to simply provide the Seila plaintiff the limited relief requested, to vacate the CID entered against the plaintiff. Seila counsel argues that it is unnecessary for SCOTUS to go further and entertain whether the entire statute must be declared unconstitutional, or whether the director removal for cause provision may be severed and the rest of the statute may continue in full force and effect. Selia is not asking SCOTUS to enjoin any future action by the CFPB. This is in contrast to the plaintiff in Free Enterprise, which sought to affirmatively and prospectively enjoin the PCAOB from carrying out any of the powers delegated to it by the statute in the future. As the Collins plaintiffs amicus brief in Seila points out, there was no retrospective relief that SCOTUS could have provided the Free Enterprise plaintiffs (Collins Amicus brief pps 9-10) based on the facts of the case.

Indeed, since the Seila brief sets forth good reasons to believe that Congress would not have created a CFPB with a director removable by POTUS at will, any SCOTUS inquiry into the severability of the director removal provision would likely render the entire statute unconstitutional…a place SCOTUS doesn’t want to go, which is further reason not to even engage in the determination as to whether any prospective relief should be available.

Collins plaintiffs’ amicus brief in Seila makes clear that the 5th Circuit en banc concurring opinion which resulted in the 9-7 vote denying Collins the retrospective relief of voiding the NWS was based upon a confused and erroneous reading of the Free Enterprise and Bowsher cases. There is no basis for SCOTUS to engage in a prospective relief analysis in place of a retrospective relief analysis, as the former does not replace the latter. Indeed, since a prospective relief analysis requires SCOTUS to engage in counterfactual guesswork as to Congressional intent which is not consistent with the Article III judicial power to decide cases and controversies, it is highly preferable for SCOTUS to only provide retrospective relief.

Another amicus brief of note in Seila, on behalf of three Senators, supports this view that only retrospective relief should be provided by SCOTUS, arguing that SCOTUS should “craft a remedy that is narrow enough to resolve the controversy between the parties in this case, and leave the broader remedial questions to Congress.”

If SCOTUS had granted certiorari to the Collins plaintiffs to argue the Constitutional Remedy Claim, Collins counsel would make essentially the same arguments that Seila counsel has already made to SCOTUS in its brief. Seila is teed up for Collins in such a way that a Seila victory will be a vicarious victory for Collins, and Seila will become the basis for SCOTUS to grant Collins a GVR with respect to its Constitutional Remedy Claim currently on hold at SCOTUS.

A GVR is a “grant, vacate and remand” by SCOTUS, in which SCOTUS would not itself decide the Collins Constitutional Remedy Claim currently on hold, but rather instruct the lower court (presumable the 5th Circuit) to review the Collins Constitutional Remedy Claim anew in light of its decision in Seila. SCOTUS could render this GVR immediately after its decision in Seila. Collins counsel discusses the GVR at approximately 4:20 of a recent Investors Unite conference call.

One fear that many district and circuit court judges have with respect to a holding that the CFPB is unconstitutionally structured and retrospective relief is available is that there will be an avalanche of follow-on copycat suits, and that some of the $5 billion in fines collected by the CFPB over its decade of operation and the $500 million sitting in the CFPB Civil Penalty Fund will have to be disgorged. You will likely hear the Solicitor General raise this as a possible consequence of retrospective relief in oral argument on March 3, 2020. But there should be no realistic fear of such a result. SCOTUS has always conditioned a successful constitutional challenge to agency action upon the plaintiff making a “timely challenge” to the particular agency action. Seila made such a timely constitutional challenge when it sought to enjoin the CID issued by the CFPB against it (as did Collins plaintiffs with respect to the NWS). Payors of these historical civil fines already collected by the CFPB (usually pursuant to stipulations and consent orders binding the payors) would not be able to satisfy this “timely constitutional challenge” condition. I expect SCOTUS to cabin the retrospective relief granted to Seila precisely to only those plaintiffs making timely constitutional challenges to agency action (as opposed to trying to recoup fines already paid without constitutional challenge). The fear of follow-on copycat suits is misplaced.

I believe that the GSE junior preferred stock is undervalued at current trading values because I don't believe the market appreciates that (I) a SCOTUS Seila decision will precipitate a negotiated settlement of GSE litigation, which I anticipate will occur during late summer/fall 2020, and (II) such settlement will be favorable for GSE shareholders and result in substantial capital appreciation for GSE junior preferred shareholders. Nonetheless, the GSE junior preferred remains a highly speculative investment and should be subject to careful portfolio allocation.

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.

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