Author Archives: David Reiss

The Taking of Fannie and Freddie 2

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Today, I look at one more complaint filed in response to the federal government’s amendment to its Preferred Stock Purchase Agreements with Fannie and Freddie (the PSPAs).  Cacciapelle et al. v. United States, filed July 10, 2013, is another takings clause case like the one filed by Fairholme the day before. The facts alleged in the complaint should be familiar to readers of REfinblog.com (here, here and here), although this is a class action complaint.

The plaintiffs state that the members of the class “paid valuable consideration to acquire these rights, and in doing so helped provide financial support for Fannie and Freddie, both before and after the conservatorship, by contributing to a viable market for Fannie’s and Freddie’s issued securities. Plaintiffs certainly had a reasonable, investment-backed expectation that the property they acquired could not be appropriated by the Government without payment of just compensation.” (4-5)

Now having read four complaints dealing with the same issue arising from the financial crisis, I am struck by the importance of narrative in litigation. Given that the federal government saved the Fannie and Freddie from certain financial ruin, we may label the Cacciapelle narrative the “Have Your Cake and Eat It Too” storyline.

One can well imagine the government’s version of events in its inevitable motion to dismiss.

Fannie and Freddie were at the brink of ruin.  We swept in, provided unlimited capital and rescued the companies, the housing market, the country and the world from the Second Great Depression.  To have the private preferred shareholders engage in Monday Morning Quarterbacking and focus on the details from the crisis response that harmed them, to have them ignore the competing concerns that were at stake for each of these critical decisions, adds insult to this injurious lawsuit.  Judge, do not succumb to this hindsight bias!

Let’s label this the Corialanus storyline.

These lawsuits have caught reporters’ eyes and will be well-covered in the press. I would look to see which narratives resonate and I wouldn’t be surprised if the dominant narrative finds its way into the judicial opinions that decide these cases.

Federal Government’s a Fairholme-weather Friend?

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Following up on my posts (here and here) about other suits against the federal government over its amendment of the terms of the distribution of dividends and other payments by Fannie Mae and Freddie Mac, I now look at Fairholme Funds, Inc. et al. v. FHFA et al., filed July 10, 2013.  The suit alleges very similar facts to those found in Fairholme Funds, Inc. v. United States, filed July 9, 2013, but the claims for relief are more similar to those found in Perry Capital, LLC v. Lew et al.

Here are some of the key claims made by the plaintiffs (owners of Fannie and Freddie preferred shares):

  • While the FHFA is the conservator of the two companies, it is acting acting like a receiver by “winding down” Fannie and Freddie’s “affairs and liquidating” their assets, while conservatorship should aim to return a company “to normal operation.” (15) The goal of the conservator, claim the plaintiffs, is to return the company “to a safe, sound and solvent condition.” (15, quoting Conservatorship and Receivership, 76 Fed. Reg. 35, 724, 35, 730(June 20, 2011)) As a result, plaintiffs argue that the Net Worth Sweep (which gives to the federal government substantially all of Fannie and Freddie’s profit) “is squarely contrary to FHFA’s statutory responsibilities as conservator of Fannie and Freddie” because it does not put them in “a sound and solvent condition” and it does not “conserve the assets and property” of the two companies. (25, quoting 12 U.S.C. section 4617(b)(2)(D))
  • “Neither Treasury nor FHFA made any public record of their decision-making processes in agreeing to the Net Worth Sweep.” (29) The plaintiffs argue that the FHFA’s “authority as conservator of” Fannie and Freddie “is strictly limited by statute.” (31, citing 12 U.S.C. section 4617(b)(2)(D)) As a result, the FHFA’s actions were “arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law.” (33, quoting the APA, 5 U.S.C. section 706(2)(A))
  • The plaintiffs’ relationship with Treasury as Fannie and Freddie’s controlling shareholders is governed by state corporate law and thus Treasury owes “fiduciary duties to minority shareholders.” (38)
  • “Implicit in every contract is a covenant of good faith and fair dealing. The implied covenant requires a party in a contractual relationship to refrain from arbitrary or unreasonable conduct which has the effect of preventing the other party to the contract from receiving the fruits of the bargain.” (41) Plaintiffs argue that their contractual rights pursuant to their preferred shares have been breached by FHFA’s consent to the Net Worth Sweep.

The validity of these claims should not be assessed superficially. The courts will need to read HERA in the context of the APA and the amendment to the terms of the government’s preferred shares in the context of the contractual obligations found in the private preferred shares. The court will also need to assess the extent to which state corporate law governs the actions of the federal government when it is acting in the multiple capacities of lender, investor, regulator and conservator.  Let the memoranda in support and in opposition to motions to dismiss come forth and enlighten us as to how it should all play out . . ..

 

 

 

Fairholme or Foul? Investor Complaint Over Fannie and Freddie Preferred

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I recently reviewed the complaint filed by former Solicitor General Olson in Perry Capital LLC v. Lew and today I review the complaint in a similar lawsuit, Fairholme Funds, Inc. v. United States, filed July 9, 2013.  Fairholme filed another lawsuit the next day, Fairholme Funds, Inc. et al. v. FHFA et al., which I will review tomorrow. Whereas the Perry case alleged violations of the Administrative Procedures Act and the Housing and Economic Recovery Act of 2008 (HERA), the July 9th Fairholme case alleges that the United States must pay just compensations pursuant to the Fifth Amendment of the US Constitution for taking the plaintiffs’ property, by gutting Fannie Mae and Freddie Mac preferred shares of all of their worth.

As with the Perry case, the Fairholme complaint turns on whether an amendment to the government’s preferred stock documents which gave to the government all of Fannie and Freddie’s profits created a new security in violation of HERA.  In particular, the complaint alleges that by “changing the dividend on its Government Stock in this manner, FHFA actually created, and Treasury purchased, an entirely new security.” (5) This, it appears to me, is a highly contested claim.

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Evoking a famous Supreme Court case, the complaint also states that just “as the Federal Government cannot seize the assets of corporations (for example, the nation’s steel mills) for a public purpose without paying just compensation, so too it cannot seize the shares of stock in corporations to accomplish the same end.” (23) This implicit comparison to the Youngstown Steel case does not work as far as I am concerned.  In Youngstown Steel, the Supreme Court struck down President Truman’s exercise of his inherent authority to seize steel mills in order to support the Korean War mobilization.  Here, we have the federal government already knee deep in the affected companies.  Fannie and Freddie are government-sponsored enterprises; were placed in conservatorship; and have the federal government as their majority shareholders.

While the issues here are complex, my first read of the complaint is that the plaintiffs have a tough row to hoe even though the federal government may have upended preferred shareholders’ settled expectations.

Shadowed by the Shadow Inventory

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My former colleague at Seton Hall, Linda Fisher, has posted Shadowed by the Shadow Inventory:  A Newark, New Jersey Case Study of Stalled Foreclosures & Their Consequences on SSRN. The paper presents the findings of a small, but interesting empirical study.  The study “tests the extent to which bank stalling has contributed to foreclosure delays and property vacancies in” one neighborhood in  Newark, New Jersey. (6) Fisher states that this “is the first study to trace the disposition of each property in the sample through both public and private sources, allowing highly accurate conclusions to be drawn.” (6)

Fisher reaches “a similar conclusion to the previous studies with respect to stalling: without legal excuse or ongoing workout efforts, banks frequently cease prosecuting foreclosures.” (7) Fisher also finds that the stalled foreclosures in her study “do not strongly correlate with property vacancies.”(7)  Fisher claims that her findings “are generalizable to similar urban areas in judicial foreclosure states,” but I would like to have seen more support for that claim in the paper. (45)

As a side note, I found her description of foreclosure in New Jersey interesting:

The New Jersey foreclosure system provides a representative example of a judicial foreclosure regime, albeit one with heightened procedural protections for borrowers enacted into the state’s Fair Foreclosure Act. For instance, lenders must file a notice of intention to foreclose containing information about, inter  alia, the lender, servicer and amount required to cure, before filing a foreclosure complaint in court. Once borrowers are served with process, they may file a contesting answer and litigate the matter, as with any civil case. Because ninety-­‐four percent of New Jersey foreclosures in a typical year are not contested, the process is largely administrative and handled through a statewide Office of Foreclosure. Court personnel scrutinize bank evidence in support of default judgments. Borrowers may file late answers, and are responsible only for curing arrears and paying foreclosure fees up until the time of judgment. (14-15, emphasis added, citations omitted)

Because this blog has as one of its main focuses downstream litigation judicial opinions, it is important to remember how few cases actually reach a court room, let alone result in a written opinion by a judge.

 

Dirty REMICs, Revisited

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Brad and I have posted, Dirty REMICs, Revisited (also on BePress).  The abstract reads:

We review the differences between two visions for the residential mortgage markets, one driven by the goal of efficiency and the other driven by the goals of efficiency and consumer protection. Both visions advocate for structural reform, but one advocates for industry-led change and the other advocates for input from a wider array of stakeholders. Broader input is not only important to ensure that a broad range of interests are represented but also to ensure the long-term legitimacy of the new system. This is a response to Joshua Stein, Dirt Lawyers Versus Wall Street: A Different View, Probate and Property (2013 Forthcoming), which in turn is a response to Bradley T. Borden & David J. Reiss, Dirt Lawyers and Dirty REMICs, Probate and Property 12 (May/June 2013).

Bad Faith Remedies for Loan Modification Negotiations

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New York Supreme Court Justice Torres (Bronx) issued a Decision and Order in Citibank, N.A. v. Barclay et al., No. 381649-09 (June 21, 2013), in which he evaluated what the appropriate remedies were for failing to negotiate in “good faith” as required by CPLR section 3408(f). Like other cases, it recites a litany of facts that make the owner of the note look comically (darkly comically) incompetent or even malevolent.

In an earlier decision, the Court “found that the plaintiff had failed to act in good faith.” (3) In particular, the Court found that Citibank “made it impossible for Barclay to comply with its conflicting ever changing, never written requests for documentation.  Moreover, the plaintiff refused to review applications that were complete and it never took a clear position on the defendant’s loan modification application.” (3) The details in the decision add Dickensian color to this summary.

CPLR section 3408(f) requires that both “the plaintiff and defendant shall negotiate in good faith to reach a mutually agreeable conclusion, including a loan modification, if possible.” As NY courts have noted, the CPLR does not offer up any remedies for a party’s failure to negotiate in good faith, thereby leaving the appropriate sanction up to “judicial discretion.” (6)

Other cases have granted remedies such as barring “banks and loan servicers from collecting interest, legal fees, and expenses.  Other penalties have included exemplary damages and staying the foreclosure proceeding.” (6, citations omitted) The Court notes that remedies such as dismissal of the foreclosure, cancelling the note and mortgage, or ordering “a specific judicially imposed loan modification agreement.” (6) The court’s remedy in this case “is a bar on the collection of any arrears, including interest, costs and fees” from the date Barclay “received the unsupported HAMP denial.” (6)

On the one hand, this seems like a measured remedy because it punishes Citibank for the time period that it was not acting in good faith. But given how common this behavior seems to be, one wonders if it will deter future bad faith negotiations.

DoJ All FIRREA-ed Up With S&P Suit

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Law360 quoted me in a story, Prosecutors Unleashed As $5B S&P Action Rolls On (behind a paywall), about DoJ’s success in fending off S&P’s motion to dismiss its FIRREA case. It reads in part

While the latest ruling against S&P was lighter on substance, Brooklyn Law School professor David Reiss called it “a very big deal.”

“It adds to a body of law that gives the government another powerful tool to go after alleged misdeeds by financial institutions,” he said.

The suit, launched in February to much fanfare, targets S&P’s top-notch ratings for complex mortgage-backed securities that later failed. As part of a controversial, widespread practice known as the “issuer pays” model, banks created the securities, paid S&P to rate them and then sold them to investors. The DOJ claims S&P mismarked the securities on purpose to keep clients happy and boost profits.

In its motion to dismiss, the firm argued its public statements touting the ratings as objective, based on solid data and unaffected by potential conflicts of interest amounted to “puffery” and therefore could not form the basis of a fraud suit against S&P and parent company McGraw-Hill Cos. Inc.

But Judge Carter ruled Tuesday that the DOJ had sufficiently alleged S&P’s statements were not general, subjective claims, but were based on specific policies and procedures governing how the firm “shall” or “must not” rate securities. The judge called the firm’s puffery argument “deeply and unavoidably troubling when you take a moment to consider its implications.”

“Despite defendants’ protestations to the contrary, the court cannot find that all of these ‘shalls’ and ‘must nots’ are the mere aspirational musings of a corporation setting out vague goals for its future,” the judge wrote in an 18-page order. “Rather, they are specific assertions of current and ongoing policies that stand in stark contrast to the behavior alleged by the government’s complaint.”

Judge Carter also found the DOJ had sufficiently claimed S&P defrauded investors who had relied upon the ratings in determining the credit risk of certain investments. And the judge ruled the government did not have to plead “with a high degree of particularity” that S&P intentionally issued false ratings because the suit was filed under FIRREA. Tougher pleading requirements set out in the Private Securities Litigation Reform Act, which governs many securities suits, therefore do not apply, the judge ruled.

S&P spokesman Ed Sweeney noted Wednesday that the ruling did not address the merits of the case, as the judge was required to accept the government’s factual allegations as true during the early stages of litigation.

“We now welcome the opportunity to demonstrate the lack of merit to the Department of Justice’s complaint,” Sweeney said. “We firmly believe S&P’s ratings were and are independent, and expect to show just that in court.”

The decision followed a tentative July 8 ruling by Judge Carter. And indeed, given the sheer amount of resources the government has devoted to the case, the finding should have come as no surprise, according to Jacob Frenkel, an attorney at Shulman Rogers Gandal Pordy & Ecker PA who chairs the firm’s securities enforcement practice.

“When you have a deep-pocketed client that is willing to fight, a good lawyer will exhaust all options and remedies,” Frenkel said of S&P’s motion. “It would have been unreasonable to believe it stood any chance of success, but that does not mean you don’t try.”

Still, Judge Carter’s takedown should give the firm pause as it weighs whether to fight the claims or strike a settlement, according to Reiss, the Brooklyn professor.

“We now have a sense that the judge’s take on the guts of the case is pretty favorable to the government,” Reiss said. “And we’re now seeing the rating agencies start to crumble a little bit after their decades-long run of avoiding either settling or losing at trial.”