Correction, 2/28/14, 11:11 a.m. EST: An earlier version of this story misidentified the type of fund that Fairholme Capital is and the relationship to its founder. It is a mutual fund manager, and Bruce Berkowitz manages the fund.
An investor group won a key discovery motion Wednesday in one of the lead cases challenging the government conservatorship of Fannie Mae and Freddie Mac. Lawyers for the plaintiffs say the ruling may bring them closer to brokering a deal for preferred shareholders who lost billions in expected profits when the terms of the government’s Fannie and Freddie takeover suddenly changed in mid-2012.
The case, Fairholme Funds v. U.S., is part of a crush of shareholder lawsuits and class actions claiming that the U.S. government duped Fannie and Freddie investors when the companies were placed in conservatorship under the Federal Housing Finance Agency in 2008. The plaintiffs allege that they were led to believe that they would retain their stakes in Fannie and Freddie’s fortunes, only to learn years later that only the U.S. government would collect future dividends on the now-profitable companies.
The plaintiffs include Fairholme Capital, a mutual fund manager founded and managed by Bruce Berkowitz, and insurance companies collectively holding millions of shares of preferred stock in Fannie and Freddie. Berkowitz’s funds scooped up the shares post-takeover for pennies on the dollar, betting that the entities would return to solvency. The companies now appear to be solvent and profitable, but in August 2012, the U.S. Department of the Treasury announced that all excess profits would now go to the government and not to shareholders.
Fairholme sued in July 2013 in the U.S. Court of Federal Claims, alleging that the decision violated Treasury’s temporary legal authority under the 2008 Housing and Economic Recovery Act, constituting an uncompensated taking under the Fifth Amendment. Fairholme also filed a parallel Administrative Procedures Act suit in U.S. district court in Washington, D.C.; government motions to dismiss are pending in both cases.
The Fairholme dispute focuses on an agreement between the government and FHFA in 2008 that allowed Treasury to acquire senior preferred stock as well as warrants to buy nearly 80 percent of the common stock in both Fannie and Freddie. In exchange, Treasury was entitled to repayment for its $188 billion recapitalization of the companies, and, once repayment was complete, to 80 percent of profits as dividends going forward. But shortly after the companies announced healthy earnings in July 2012, FHFA announced that the rules had changed: Treasury was now entitled to all the companies’ current and future profits. “In short, Treasury and FHFA effectively nationalized two of the nation’s largest financial institutions, while they were under the protection of FHFA as conservator,” Fairholme alleged.
The plaintiffs tapped Charles Cooper of the Washington, D.C., litigation boutique Cooper & Kirk, a specialist in challenging state and federal agencies, to lead the charge. Cooper, a darling of extreme conservative causes, has a superlative track record: In 1996, the year he founded his firm, he won a major breach of contract case, U.S. v. Winstar, persuading the U.S. Supreme Court that the government was liable for breaching contracts with banks that took over troubled thrifts during the 1980s-era savings and loan crisis. That case also involved a takings claim. (Cooper didn’t fare so well in his most recent Supreme Court appearance defending of California’s Proposition 8.)
The government argued in December that Sweeney should dismiss the case because FHFA, as conservator for Fannie and Freddie, isn’t an arm of the U.S. government, but is acting on behalf of the two quasi-private entities themselves. It also argued that the future profitability of Fannie and Freddie isn’t known, so the claim is premature. Shareholders responded that the government’s assertions went to the heart of the facts alleged, so they should be able to pursue additional discovery. They claim that Treasury never intended the conservators to protect shareholder interests, pointing to public and previously nonpublic Treasury communications as evidence. They also say it’s reasonable to assume that the entities are now solvent, since they posted $85 billion in profits in 2013.
Siding with Cooper, U.S. Court of Federal Claims Judge Margaret Sweeney granted investors the additional discovery on Wednesday, including internal email communications and depositions of government officials. Cooper said he’s confident that discovery will show that FHFA acted not as an independent conservator but as an agent of the Treasury. “The government is acting in its own self-interest,” said Cooper, reached on Thursday. FHFA “was never acting in its capacity as a fiduciary.”
Lawyers involved in the case say Sweeney’s discovery ruling is likely to add leverage to Berkowitz’s and other investors’ efforts to negotiate a broader deal with the government over Fannie and Freddie—whether that takes the form of a liquidation, a restructuring, a sale, or some combination. Fairholme, which owns roughly $4.5 billion face value in preferred shares, proposed to FHFA in November that it acquire the mortgage guarantee business of both entities for $52 billion. That proposal, which would require congressional approval, was rejected.
In addition to Cooper, Fairholme and a group of stockholders have tapped restructuring partner Andrew Dietderich at Sullivan & Cromwell to advise them in exploring a potential settlement.
The Fairholme litigation is just one of a dozen parallel takings cases stemming from the Fannie and Freddie takeover. Boies, Schiller & Flexner and Kessler Topaz Meltzer & Check have a takings class action pending on behalf of preferred stockholders. Another group of takings class actions, including one filed by Hagens Berman Sobol Shapiro and Spector Roseman Kodroff & Willis, alleges that the conservatorship itself constitutes a regulatory taking, because neither company was yet insolvent when the government stepped in. Those cases also claim that the conservators destroyed the value of Fannie and Freddie stock without compensating investors, when they were required to preserve and restore the companies. (The Hagens Berman investor class action echoes the takings class action filed by Hank Greenberg on behalf of stockholders in the American International Group Inc.)
There is also a group of parallel cases asserting that Treasury and FHFA exceeded their authority under HERA by acting in an arbitrary and capricious manner, violating the Administrative Procedures Act. Those cases include a $64 billion suit brought by Perry Capital under the in D.C. federal district court. A team from Gibson, Dunn & Crutcher including Theodore Olson and Matthew McGill is representing Perry.