The Confused Status of the Plaintiff Class Claims in Perry Capital v. Mnuchin: Epstein
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The Confused Status of the Plaintiff Class Claims in Perry Capital v. Mnuchin
The D.C. Circuit majority offers no path through the litigation nightmare on remand
My earlier column on Perry Capital LLC v. Mnuchin was devoted to an analysis of the claims that the institutional shareholders brought against at the Department of Treasury and the Federal Housing and Finance Agency (FHFA), challenging the propriety of the Net Worth Sweep (NWS). The correct disposition of that case would have required both FHFA, as conservator for Fannie Mae and Freddie Mac, and Treasury to return to the Government Sponsored Enterprises (GSEs) all the profits they illegally diverted from the enterprises to Treasury. These institutional claims were rejected for reasons that I, again in my capacity as an advisor to some institutional investors, argued were wholly unpersuasive. A conservator is supposed to protect the assets of a company in its charge for the benefit of its shareholders, with any eye to returning the GSEs to private control. It is not divert those assets to the government in a sham exchange that grants the private beneficiaries the right not to make payments if they become insolvent, a right which they already had. It is that simple.
Once the majority in Perry Capital rejected the obvious claims brought by these institutional investors, the case took on a surreal tone, by bringing to the fore a set of claims brought by a class of individual shareholders in the two companies. It is important to stress at the outset that this entire operation by the judiciary to rescue Treasury and FHFA is a second-best analysis that would have been wholly unnecessary if the compelling challenge of the institutional investors to the NWS had been accepted. Once the assets are restored to the GSEs, there is no need for any further relief at the shareholder level. The value of the shares would increase in responses to the increased value of the corporation, and that increase would thereafter be reflected in movements in the share price. All shareholders of the two GSEs, including the Treasury through its warrants for 79.9% of the common stock, would then see their values increase to the level that they should have if the NWS had never been adopted. Likewise, under this scenario, the class members would never have had to bring their contract claims, because they would have had full relief at the entity level.
The challenge to the NWS by the institutional shareholders has failed at the D.C. Circuit. Therefore, the possibility of double recovery is effectively eliminated, so the difficult question thus arises as to what should happen, if anything, to the claims the class plaintiffs brought for breach of contract and breach of the covenant of good faith and fair dealing. The majority opinion on these questions stands alone, because Judge Janice Rogers Brown did not attack a set of questions that could not have arisen if her views on the invalidity of the NWS had been accepted. The focus of this column is how the validation of the NWS at the entity level relates to potential liabilities of FHFA and Treasury in respect to the class plaintiffs.
The initial problem here deals with a set of procedural issues relating to finality of judgment and sovereign immunity, both of which go the jurisdiction of the D.C. Circuit, and neither of which was briefed by the parties. The salient points to the majority’s dense discussion are twofold. First, the majority in Perry held that the restoration of property taken from shareholders and awarded to Treasury does not count as an action for damages at common law that would be barred under Section 702 of the Administrative Procedure Act. That section allows an “action in a court of the United States seeking relief other than money damages . . . shall not be dismissed nor relief therein be denied on the ground that it is against the United States . . .” But restitution of funds taken from the GSEs under an unjust enrichment theory is not comparable to common law actions for personal injury or property destruction. Second, the majority held that sovereign immunity had effectively been waived.
At this point the initial substantive inquiry is whether it is possible to supply equitable relief against Treasury on the ground that it breached fiduciary duties to the private shareholders of Fannie and Freddie. The initial question is whether this point should be regarded as one of federal or state law. In the absence of any clear evidence of the difference in the applicable standard, it is not clear how the point would play out in court. But on the basis of the important 1994 Supreme Court decision of O’Melveny & Myers v. FDIC, it seems clear that the relevant issues here are to be decided as a matter of state law. While there might certainly be some differences between the law of Virginia and Delaware, on balance there are two ways in which to establish the requisite fiduciary duty.
To be sure, nothing in the position of a senior preferred shareholder normally extends any control rights over a firm, so long as the dividends that it is owed are fully paid. Indeed, the text of the Third Amendment does not refer to Treasury as a trustee, but simply treats it as the “purchaser” of the shares that were sold to it by Fannie and Freddie as “sellers” who acted “through the Federal Housing Finance Agency (FHFA) as its duly appointed conservators.” Likewise, the initial stock certificates for Fannie and Freddie also give no hint of any fiduciary duty between the parties. Indeed, both certificates contained an explicit provision that “the shares of the Senior Preferred Stock shall not have any voting powers, either general or special.” It thus appears from the paper record alone that the basic provisions of the Housing and Economic Recovery Act (HERA), Treasury owes its fiduciary duties to the public, not to the private shareholders of Fannie and Freddie.
Yet appearances can be deceiving. More concretely, there are two ways in which this claim becomes valid in the conduct that Treasury undertook in connection with the NWS subsequent to the original bailout arrangement in 2008. The initial source of that duty comes from the initial joint decision of Mr. Jim Lockhart, then the head of FHFA, and the Treasury Department to place Fannie and Freddie into conservatorship and force them to enter into the original PSPAs with Treasury. By September, 2009, Lockhart was replaced by Edward DeMarco, a former high-level Treasury employee who had previously served as director of the Office of Financial Institutions Policy before moving over FHFA. . It was DeMarco who in August 2012 signed the Third Amendment with then-Treasury Secretary Timothy Geithner that allowed Treasury to receive the additional dividend distributions. At this point, Treasury was acting in collusion with Mr. DeMarco, by taking over on a de facto basis the management of Fannie and Freddie in relation to the claims of their private shareholders. It is widely accepted under Section 303 of the Uniform Limited Partnership Act that whenever a limited partner takes over the operation of the firm, his status does not immunize him from the liabilities associated with a general partner. It is equally clear that similar duties to shareholders who similarly take over management functions. The same principle applies as Treasury’s action with regard to the GSEs, those actions went far beyond those of a senior preferred shareholder entitled to certain dividend rights. For example, the Senior Preferred Stock Agreement of 2008 included in Article V covenants that limited the power of FHFA and the Companies to make dividends or other distributions, to issue new capital stock or terminate the conservatorship without the consent of Treasury. In addition, to these formal powers, Treasury was in constant contact with FHFA during the entire period between 2008 and 2012. Given the combination of its formal and informal role, Treasury thus became subject to fiduciary obligations, by the well-established state law analogy to a limited partner who in practice takes an active management in partnership affairs.
