A D.C. Circuit Court of Appeal’s decision earlier this year, Perry Capital LLC v. Mnuchin, 848 F.3d 1072 (D.C. Cir. 2017), highlights the breadth of the government’s ability to take actions that harm creditors of federally regulated financial institutions while in conservatorship or receivership. Perry affirms the government’s broad statutory power to divert assets for the government’s benefit, to arrogate contractual rights and to circumvent statutory priorities and other creditor protections, all without judicial review.

While creditors may view Perry as an ad hoc decision related to the specific facts — the financial distress of two widely maligned entities, Fannie Mae and Freddie Mac — the court’s decision is of relevance to investors in federally regulated financial institutions generally. The provisions on which the court based its ruling are also found in statutes that govern bank holding companies, national banks and significant non-bank financial companies.

Background

The 2008 financial crisis resulted in the government taking drastic measures to stanch the decline of the national economy. One such measure related to Fannie Mae and Freddie Mac, referred to as “government sponsored entities” or “GSEs,” which provide liquidity to the housing mortgage market by securitizing mortgages that they purchase from lenders. During the financial crisis, the GSEs experienced significant financial stress, and in order to provide the government with the flexibility to keep these entities afloat, Congress passed the Housing Economic Recovery Act of 2008 (HERA). Under HERA, the GSEs were put into conservatorship by their regulator, the Federal Housing Finance Agency (FHFA). Between 2009 and 2012, the U.S. Department of Treasury injected over $187 billion of capital into the GSEs in the form of a preferred stock investment.

Under the terms of its initial capital infusion, Treasury was entitled, among other things, to a fixed quarterly dividend of 10% of the liquidation preference of its preferred stock investment and periodic commitment fees. However, in August 2012, Treasury and the FHFA amended the terms of the preferred stock investment such that all of the GSEs’ quarterly profits were transferred to Treasury. This amendment, referred to as the “net worth sweep,” was made for no additional consideration. Instead, Treasury and the FHFA simply declared that the net worth sweep was necessary so that the GSEs would not draw on Treasury’s funding commitment to pay dividends on the preferred stock.

The net worth sweep proved to be a boon for Treasury. Shortly after its effectiveness, the GSEs had significant profits and required no further capital infusions from Treasury. Through May 2017, Treasury had earned $271 billion on its investment of $187 billion.1

The GSEs’ preferred and common stockholders objected to the net worth sweep, for obvious reasons. Because of the net worth sweep, the GSEs could never redeem the preferred stock issued to Treasury, and consequently would never be able to make distributions on the equity held by private investors.

HERA

HERA is modeled on the Federal Deposit Insurance Corporation’s statutory conservatorship authority found in the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA). HERA grants the FHFA broad rights as conservator of the GSEs. Among other things, the FHFA is appointed as conservator “for the purpose of reorganizing, rehabilitating, or winding up the affairs of a regulated entity” and may “take over the assets of and operate the regulated entity … and conduct all business of the regulated entity.” However, unlike FIRREA, which requires FDIC to factor in the best interests of depositors, HERA allows the FHFA to consider only the best interests of FHFA and the GSEs, to the exclusion of all other constituencies.

HERA also limits the ability of aggrieved creditors and other parties to bring suit against FHFA. Under Section 4617(f) of HERA, “no court may take any action to restrain or affect the exercise of powers or functions of the [FHFA] as a conservator or a receiver.” As the Perry court noted, the statute “draws a sharp line in the sand against litigative interference — through judicial injunctions, declaratory judgments, or other equitable relief — with FHFA’s statutorily permitted actions as conservator or receiver.”

The Case

Arguments of the Parties

In their briefs, the GSE investors argued that anti-injunction provisions should not apply because the FHFA acted beyond the scope of its authority as conservator of the GSEs when it entered into the net worth sweep. According to the GSE investors, the FHFA has a statutory obligation to “preserve and conserve” the GSEs’ assets, and to rehabilitate them to a “sound and solvent condition.” But “[b]y prohibiting the [GSEs] from retaining any capital, the Net Worth Sweep renders soundness and solvency impossible, and FHFA therefore exceeded its statutory authority as conservator.” In effect, the FHFA operated the GSEs as a receiver rather than conservator. If adopted, they argued, the “FHFA’s view would permit a conservator to give away the assets of any federal regulated institution placed into conservatorship … without being subject to judicial review.”

The FHFA emphasized the plain language of Section 4617(f), which it said barred all claims for declaratory or equitable relief. This reading, the FHFA argued, was consistent with the court’s prior interpretation of a substantially identical provision governing the FDIC’s role as conservator, in which the court held that “even plausible and specific allegations that a conservator or receiver acted improperly — or in violation of a contract or state or federal law — ‘do[] not alter the calculus.’” The FHFA also disputed the investors’ position that, as conservator, the FHFA had an obligation to “preserve and conserve” and to “rehabilitate” the GSEs.

The Court’s Ruling

In a split decision, the court sided with the FHFA. The majority held that HERA granted the FHFA exceedingly broad powers, and that it did not compel the FHFA to preserve or conserve the GSEs’ assets or to return the GSEs to private operation. Given the breadth of the FHFA’s authority under HERA, the court held that entry into the net worth sweep was within the FHFA’s powers as a conservator.

In a highly critical dissent, the minority warned of the consequences of the Perry decision for future investment in regulated financial entities:

Now investors in regulated industries must invest cognizant of the risk that some conservators may abrogate their property rights entirely in a process that circumvents the clear procedures of bankruptcy law, FIRREA, and HERA. Consequently, equity in these corporations will decrease as investors discount their expected value to account for the increased uncertainty — indeed if allegations of regulatory overreach are entirely insulated from judicial review, private capital may even become sparse. Certainly, capital will become more expensive, and potentially prohibitively expensive during times of financial distress, for all regulated financial institutions.

Implications for Creditors

Creditors of financial institutions should take note of Perry. While HERA is a creature of the 2008 financial crisis, the court’s reasoning does not seem confined to investments in Fannie Mae and Freddie Mac. Similar anti-injunction provisions appear in the receivership or conservatorship statutes applicable to bank holding companies and other financial institutions subject to the Orderly Liquidation Authority of the Dodd-Frank Act (12 U.S.C. § 5390(e)) and the FIRREA (12 U.S.C. § 1821(j)).

Perry blurs the lines between conservatorship and receivership, even where residual value exists in restructured financial institutions that in a bankruptcy would be available to satisfy the claims of creditors. With the recent decision of the Court of Appeals for the Federal Circuit in Starr International Company, Inc. V. U.S., 856 F.3d 953 (Fed. Cir. 2017), in which the court held that ex-AIG chief executive Maurice Greenberg had no standing to bring suit over the AIG bailout under the “takings clause” of the Fifth Amendment, government action in these situations appears immunized both under statutory and constitutional theories.2 Perry, though, is particularly shocking, because it not only sanctions the ability of the government to “take it all,” it allows the government to change the rules in the middle of the game. How far Perry’s reach will extend in practice to other distressed regulated financial institutions remains to be seen, but for investors it is something well worth watching out for.