After the Deal: Fannie, Freddie and the Financial Crisis Aftermath

The following post comes to us from Steven Davidoff Solomon, Professor of Law at the University of California, Berkeley School of Law, and David T. Zaring, Associate Professor of Legal Studies and Business Ethics at the Wharton School, University of Pennsylvania.

In After the Deal: Fannie, Freddie and the Financial Crisis Aftermath, we offer a solution to the problem of what to do with the profits being made by Fannie Mae and Freddie Mac, the subject of a dispute between the government, which has declared that it will keep those profits, and the shareholders of common and preferred stock left behind after the firms were quasi-nationalized, who have sought, in court, a share of them.

We think that administrative procedure must provide the source and limits of much of the constraint on government action. But when the government regulates by deal, as it did when it took over Fannie and Freddie, it must also eventually comply with the requirements of corporate governance, mergers and acquisitions law, and the limitations imposed by the law on controlling shareholders as well. We combine the two doctrines to arrive at a solution about what to do with the profits. We think that this blend of corporate and administrative law is novel, and theoretically interesting—in the past, the subjects have not had much to do with one another, but as many of the principles of corporate governance have come to be formed not just by Delaware and deals, but by Washington and regulations, we suspect that corporate and administrative law will become increasingly intertwined.

More specifically, in the case of Fannie Mae and Freddie Mac, administrative law can provide a route to a remedy that rewards the minority shareholders with stakes in the mortgage giants, without providing them with a windfall. It can do so by looking to corporate law for that remedy. This would require a so-called “entire fairness” analysis, which provides that a deal—in this case, the government’s renegotiation of the terms of its dividend arrangement with Fannie Mae and Freddie Mac—is scrutinized to determine if the action is fair to the minority shareholders at the time it was made, both in terms of price and process.

The entire fairness analysis would likely result in some sort of payment to the minority shareholders, albeit one limited by the deeply impaired value of their holdings. Our legal analysis also suggests that:

  • The equitable nature of the entire fairness remedy is consistent with administrative procedure’s commitment to equitable, as opposed to damages, remedies.
  • The conflict of interest faced by the government in deciding whether to keep or share the firms’ profits provides an exception to many of the administrative law hurdles faced by shareholders seeking to subject the action of a government conservator to administrative law.
  • The fact that two government agencies were involved in the decision about what to do with the profits from the firms does not authorize the dividend decision, as the agencies did not act at arm’s length.
  • The firms were not in a zone of insolvency that might relax the fiduciary obligations of a controlling shareholder at the time the dividend decision was made, as some have suggested, and, even if they were, the government gave nothing of value to senior creditors in exchange for its decision to take all of the profits of the firm, to the detriment of shareholders.
  • The Takings Clause offers another doctrinal remedy to the plaintiffs, and it is also plausible, in part because the government’s conflict of interest overcomes many of the doctrinal hurdles posed by the government’s usual defenses against takings claims.

Our article has implications beyond the difficult problem of what to do with Fannie Mae and Freddie Mac. When financial crises come—and these crises are bound to reoccur—the government is likely to take drastic steps to bolster the economy. Sometimes these steps will involve a real trampling on property and contract rights that in normal times would ordinarily be sacrosanct; scholars such as Eric Posner and Adrian Vermeule have essentially argued that it is impossible to imagine a way to constrain this sort of action.

We are not so sure. The post-crisis, in particular, is not a time to let the government regulate only by deal and emergency decree. Our approach addresses the controversy surrounding the mortgage giants, and illustrates some principles that can be used to guide these issues in the future. It is also a lesson for the government’s approach in structuring the next “deal” in the inevitable future crisis.

The full paper is available for download here.

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