When it comes to Supreme Court cases, one can never be sure exactly what to expect. When finally issued, however, the Court's opinions often make good on expectations. True to form, the decision issued by the Supreme Court on June 23rd in Collins v. Yellen, a Fannie Mae/Freddie Mac shareholder lawsuit, largely delivered on the expectations of most structured finance industry participants. But the case may also bring unintended consequences not only to the parties, but also to Congress, and perhaps even to the Court itself. As a result, the Court's decision may have a broader significance that is especially relevant to organizations such as the Structured Finance Association and other participants in the securitization industry, given our frequent interactions with federal agencies and the development of policy positions for our industry.
First, a brief background on the case.
Sensing that trouble was around the corner, Congress in the summer of 2008 passed the Housing and Economic Recovery Act (Recovery Act), creating a new regulator, the Federal Housing Finance Agency (FHFA). The FHFA is the regulator of the two "government sponsored entities" (GSEs), Fannie Mae and Freddie Mac, as well as of the Federal Home Loan Banks. When Fannie and Freddie were placed in conservatorship in September of 2008, FHFA became their Conservator, and assumed all management responsibilities for the GSEs.
At the time of the Conservatorship, the FHFA on behalf of the GSEs entered into preferred stock purchase agreements (PSPAs) (one for each GSE) with the Department of the Treasury. The PSPAs are the mechanism through which Treasury provided capital to Fannie and Freddie to allow them to function during the Financial Crisis – often referred to as the "bailout". Originally, the PSPAs required the GSEs to pay a 10% preferred dividend on the amount of capital each received.
The PSPAs were subsequently amended, and, in 2012, the FHFA and Treasury entered into the "third amendment" to the PSPAs. This amendment replaced the fixed-rate dividend with a variable one that required each GSE to pay to Treasury, quarterly, all of their earnings – the so-called "Net Worth Sweep". In 2019, the GSEs were permitted to retain some earnings, and, under the "fourth amendment" entered into in January 2021, they must retain earnings until certain capital levels are achieved – a process expected to take years.
The money paid to Treasury under the Net Worth Sweep did not amortize, or "pay back", the capital previously injected.
Fannie and Freddie, at the time of the Conservatorship were, and remain, public companies, and numerous shareholders filed lawsuits challenging the Net Worth Sweep. As an economic proposition, the Net Worth Sweep prevented the GSEs from recapitalizing, and, for so long as it was in effect, transferred the entirety of Fannie and Freddie's net worth to Treasury, while not paying down the claim (liquidation preference) represented by the preferred stock.
The Collins shareholders had mixed success in the lower courts, with the Fifth Circuit Court of Appeals ruling in the shareholders' favor on both Constitutional and statutory grounds, but, to the shareholders' dismay, provided no monetary damage award.
Both the Government and the shareholders appealed, and the Supreme Court took the case.
Among the issues considered by the Court was a Constitutional issue relating to the doctrine of "separation of powers".
As has now been widely reported, the Supreme Court in Collins held that the governance structure of the FHFA violates the separation of powers architecture of the United States Constitution. The Recovery Act put in place a single director of the FHFA who can be removed by the President only "for cause" (and not "at will", as in the case, for example, for cabinet secretaries). That structure put the FHFA beyond the reach of Presidential control (and, because the FHFA does not rely on appropriations, beyond the control of Congress as well). The Court's holding was that the President can remove, at will, the FHFA Director, who at the time was Mark Calabria, a Trump appointee whose term as Director otherwise would have extended into 2024. But Calabria's term came to an abrupt end later on the same day that the Court's decision was released, when the Biden Administration removed him as Director. Before the day was over, the Administration had appointed Sandra Thompson, previously the FHFA's Deputy Director for Mission and Goals, as the Acting Director.
None of that was of any particular surprise. Last year the Court delivered an opinion with a similar holding in Seila Law v. Consumer Finance Protection Bureau. After the CFPB began an investigation of a law firm offering debt relief counseling, the law firm challenged the CFPB's authority to conduct the investigation using the identical argument later posed by the petitioners in Collins v. Yellen. The Court in Seila Law held that the CFPB's governance structure was fatally flawed because the CFPB's single director was removable by the President only for cause. For the Court to have held differently in Collins, the Court would have had to come up with some pretty fine distinctions between the governing structures of the FHFA and the CFPB. Instead, a majority of the Court opted to consider Seila Law as precedential.
In a concurring opinion, Justice Sotomayor attempted to draw a distinction between the FHFA case and the CFPB case in that the FHFA does not exercise "significant executive power" in the way the CFPB does. The FHFA's power, as argued by Sotomayor, is exercised only over other government actors – Fannie, Freddie and the Federal Home Loan Banks – and not over the public at large, exercised by the CFPB. Put another way, the FHFA is primarily a "financial regulator," and thus the FHFA is just not important enough in the overall scheme of government to be subject to the control of the elected branches. However, a majority of the Court rejected the suggestion that the FHFA is not important enough to merit being subjected to "electoral accountability" through the President and with that, one of the unintended consequences of Collins beings to emerge.
With a majority of the Court taking a clear stance in favor of electoral accountability for the FHFA, one of the unintended consequences begins to emerge.
When Congress enacted the Recovery Act in 2008, one of its goals was to improve upon the somewhat weak powers vested in the FHFA's predecessor, the Office of Federal Housing Enterprise Oversight (OFHEO). Although the causes of the Financial Crisis were many, the 2005-2007 mortgage market is often tagged as a prime culprit. In particular, observers point a finger at Fannie and Freddie – and, by extension, to OFHEO. Fannie and Freddie, pre-crisis, were allowed to engage in lobbying, and were on the receiving end of extensive lobbying efforts.
In an attempt to strengthen the powers granted to the new regulator, and to reduce other outside influences (i.e., lobbying), Congress decided to establish a strong, single-individual governance structure over an agency that, in addition, would not be beholden to Congress for appropriations. With the single director removable only for cause, Congress no doubt thought that the FHFA would be a truly independent financial regulator, free from political influences and the lobbying that comes along with it.
Congress had the same goal of independence in mind two years later when it passed the Dodd-Frank Act and created the CFPB with the same governance structure, including non-reliance on Congressional appropriations.
Eleven years—and two Supreme Court cases—later it is apparent that Congress has gotten almost the opposite of what it intended. The CFPB and the FHFA are now firmly under Presidential control, and will have only the level of "independence" that the White House sees fit to grant them. To the extent outside parties feel the need to lobby these agencies, they now have the exact address – 1600 Pennsylvania Avenue – to which to bring their requests. And that address has a new tenant at least once every eight years.
To the extent Congress wishes to bring these agencies back in line with the original intent of independence, it seems the best strategy would be to revise their governance structures along the lines of a bi-partisan board or commission, similar to the Federal Reserve Board or the Securities and Exchange Commission. The Supreme Court has generally approved these multi-member boards and commissions as being Constitutionally permissible. Such an approach would also tend to moderate policy swings, resulting from changes in Administration, such as has happened at the CFPB and as is likely to happen at the FHFA as well. This change in governance would require new legislation.
In addition to Congress, the shareholders that brought the lawsuit are likely also the victims of unintended consequences. Although the shareholders prevailed on the Constitutional point, they have likely lost on the issue of tantamount importance to them – monetary damages as the remedy.
The nature of any remedy to be accorded to the shareholders has been a thorny one through the history of the Collins case because it could mean the "unwinding" of over $100 billion in payments made over the years to the Government via the Net Worth Sweep. During oral argument last December, a number of the Justices were clearly struggling with the nature of the remedy if the Court were to rule in favor of the shareholders. As Justice Thomas asked at oral argument, "how would we unscramble the egg?" of reversing the impact of the Net Worth Sweep on the shareholders.
The Supreme Court largely ended up at the same place as did the Fifth Circuit, with one twist – a remand back to the lower courts to engage in more "fact finding." The appellate court expressly held that the only remedy it was prepared to offer was a ruling that the "for cause" restriction in the Recovery Act would be removed; the shareholders would not be permitted to "pick and choose parts of the PSPAs to invalidate." By contrast, the Supreme Court noted that nothing in the facts of the case suggested that any of the FHFA's Directors (or Acting Directors) incumbent during the Net Worth Sweep were unconstitutionally appointed, and thus, they lawfully had the power to enter into and implement the Net Worth Sweep. Consequently, the Court found ". . . there is no reason to regard any of the actions taken by the FHFA in relation to the [Net Worth Sweep] as void."
However, the Court then went on to conclude that "it is still possible for an unconstitutional provision to inflict compensable harm," and on that basis remanded the case back to the lower courts to determine whether "the unconstitutional removal restriction caused any such harm" (emphasis added).
Exactly how the lower court will make a finding of fact on that question is not in the least bit obvious. Would President Obama or President Trump have fired former Directors Watt or Calabria over the Net Worth Sweep if they thought they could? Suppose those Presidents would have fired those directors for some other reason, like not moving fast enough to end the Conservatorship? Whose testimony will be taken by the lower court to get to the bottom of that? And, if the answer is that the removal restriction did cause harm, then how will the damages be measured?
At least the shareholders, if they want to pursue it, will have another day in court, and presumably it is worth something. But the unintended – but foreseeable – consequences of the Court's ruling are almost certainly a net detriment to the shareholders, or to any private petitioner seeking to monetize a constitutional Separation of Powers case.
Whatever else one might say regarding Director Calabria, he clearly was committed to ending the Conservatorships of Fannie and Freddie. Resolving the shareholder litigation is a necessary component of getting to that stage, and especially so if the exit from Conservatorship were to involve a public capital raise by Fannie and Freddie. The "risk factor" existence of this lawsuit, and the doubt cast on the capital structure of Fannie and Freddie would make any capital raise difficult. So, prior to the Court's decision, the shareholders had some leverage over Director Calabria's endgame.
By contrast, there is no indication that the Biden Administration is so keen to pursue a capital raise or even a Conservatorship exit. Having this case drag on for years to come is likely now less of a concern. The priorities of Acting Director Thompson and of the Administration lie elsewhere.
Unlike the Trump Administration, in which both Treasury Secretary Steven Mnuchin and his advisor Craig Phillips had ties to, and an interest in, the housing finance industry and Fannie and Freddie, there is no immediately identifiable member of the Biden Administration at either Treasury or in the White House charged with assuming responsibility for the question of "what to do with the GSEs."
At some point, the retained earnings that are now accumulating (as required by the "fourth amendment") will make a Conservatorship exit economically feasible – but that date is likely years off.
A final observation regarding the remedy aspects of this case relates to the Supreme Court's overall approach to these types of lawsuits. It may be somewhat head-scratching as to why cases involving the Constitutional doctrine of Separation of Powers can even be brought by private parties, as opposed to being brought by one of the other branches of the Government. One might think that the branch of Government that found itself threatened by the encroaching powers of another branch would be in the best position to bring such a challenge. This mostly comes up with Congress alleging the President has encroached on legislative powers. But the Supreme Court has generally held that Congress does not have "standing" to bring Separation of Powers cases.
So, somewhat oddly, private parties who base a claim for relief on a violation of Separation of Powers have become the petitioners in these actions – as in Seila Law as well as in Collins. The petitioner's challenge in bringing such cases is how to link a structural principle like Separation of Powers to monetary damages.
Interestingly, the Constitutional issue in Collins seems like one in which the Supreme Court likely would have found standing and accepted for review, had the issue been raised by the President. In the most likely scenario Trump would have dismissed Director Watt "without cause", and Watt could have objected, based on the text of the Recovery Act. But that never happened.
If the shareholder petitioners in Collins, following the "fact finding" of the remand, ultimately get nothing at all, that result might discourage future private parties from bringing these cases. It is unlikely that most private parties like the Collins petitioners would be satisfied with a "win" only on a principle of Constitutional law, rather than cash.
So, another unintended consequence of the Collins case may fall back on the Supreme Court itself.
Arguably, the Separation of Powers doctrine is the structural foundation of the Constitution. If the affected branches of Government cannot bring these cases, and if private parties who could bring them do not bother—because even if they win they get nothing—then how will future cases alleging Separation of Power abuses be brought before the Supreme Court?
Unintended Consequences all Around.
Originally Published by Structured Finance Association on 20thof June, 2021.
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