Two weeks ago, the Ninth Circuit filed a decision that may well bring shareholders in Fannie Mae and Freddie Mac one step closer to the accountability they have long been seeking. In United States v. Aurora Loan Services, the court ruled that the government-sponsored entities (GSEs) are not government instrumentalities but “private companies, albeit companies sponsored or chartered by the federal government” from the standpoint of the federal False Claims Act. The Court further ruled that the FHFA’s conservatorship of the GSEs did not transform the private companies into government instrumentalities.
The potential ramifications of the ruling are far-reaching because by characterizing Fannie and Freddie as private companies, the Ninth Circuit effectively held that they are governed by ordinary rules of corporate law. In particular, shareholders may now be able to sue the GSEs’ boards of directors – which have effectively been displaced by the FHFA – for breaching their legal obligations under the conservatorships established in 2008.
The origins of this story hardly bears repeating. In 2008, Congress cut a deal with the GSEs: Fannie and Freddie would give the federal government $1 billion of interest-bearing stock in exchange for a $100 billion advance to each company. (The GSEs have since paid back that loan and then some.) Under the Housing and Economic Recovery Act of 2008 (HERA), Congress authorized the FHFA to act as a conservator for the GSEs. In this capacity the FHFA may: (1) take such actions as may be necessary to put the GSEs into a sound and solvent condition, and; (2) carry on the GSEs’ business in such a way as to preserve and conserve their assets.
The text of HERA suggests that the conservatorship of Fannie and Freddie is governed by the very standards of fiduciary obligation that apply to conservators in the ordinary corporate context. This means that the conservator has an obligation to manage the company’s assets for the benefit of its shareholders.
Indeed, this seems to have the FHFA’s original understanding of its obligations at the time the conservatorship was instituted. In a September 2008 Fact Sheet, the FHFA reassured shareholders that:
The Company’s obligations will be paid in the normal course of business during the Conservatorship. The Treasury Department, through a secured lending credit facility and a Senior Preferred Stock Purchase Agreement, has significantly enhanced the ability of the Company to meet its obligations. The Conservator does not anticipate that there will be any disruption in the Company’s pattern of payments or ongoing business operations.
And in 2011, the FHFA stated that, “A conservator’s goal is to continue the operations of a regulated entity, rehabilitate it and return it to a safe, sound and solvent condition.”
But in 2012, the course of business under the conservatorship turned out to be anything but normal. It was at this point that the FHFA and Treasury signed the Third Amendment into effect. The Amendment entailed a “Full Income Sweep of All Future Fannie Mae and Freddie Mac Earnings to Benefit Taxpayers for Their Investment,” which continues in force to this day. With the stroke of a pen, the Department of Treasury and the GSEs’ own conservator helped themselves to 100 percent of the companies’ profits, leaving the companies’ shareholders holding the bag.
The GSEs now find themselves governed by coercive agreements with the Treasury Department, and with Boards of Directors that have effectively been displaced by the FHFA. Scholars Steven Davidoff Solomon and David Zaring explained this regime effectively when they wrote, “when the government is regulating, it is administrative law that evaluates the fundamentals of that regulation. But when the government regulates by deal, it has to comply, at least in some cases, with the requirements of corporate governance.” Among those requirements is the fiduciary duty to manage Fannie and Freddie for the benefit of all its shareholders, not just the government.
By the second quarter of 2013, Solomon and Zaring note, Treasury had dealt itself $60 billion more than the $4.7 billion it would have enjoyed under the original agreement with the GSEs. Under the Third Amendment, the GSEs’ shareholders have not seen a penny of their dividends. To be sure, the federal government is a shareholder in the GSEs; but it is no more the owner of 100 percent of their stock than it is entitled to 100 percent of their profits.
Now that the Ninth Circuit has held that the GSEs are private companies and thus subject to ordinary rules of corporate law, shareholders have a basis – independent of the HERA conservatorship – upon which to challenge the boards’ conduct. Namely, shareholders may sue the GSEs’ boards for breach of the fiduciary obligations imposed by state law. For example, under the law of the state of Delaware — the state in which Fannie Mae was originally incorporated and whose precedents many other jurisdictions follow with respect to corporate fiduciary law – corporate officers owe a company’s shareholders duties of loyalty and care that are enforceable in court. A fiduciary is held to an even higher standard of scrutiny when, like Treasury, it receives a benefit to the exclusion of and at the expense of its intended beneficiary.
By ruling that Fannie and Freddie are private companies, the Ninth Circuit has opened the door for shareholders to hold the companies’ boards accountable for their breach of these obligations. If the profit sweep does not amount to self-dealing by a fiduciary, it is difficult to imagine what would. Government accountability is on the line. With its latest holding on the nature of the GSEs as private companies, the Ninth Circuit has come one step closer to putting an end to the Treasury Department’s charade.
Tara Helfman is associate professor of law at Syracuse University College of Law.