Here's a good story: A business runs into a serious crisis-a
fire, or flood, whatever, the detail is less important than the
magnitude of the problem, which is an existential threat to the
continuation of the business. Along come some guys with lots of
cash willing to become "silent partners" in the business.
They offer all the cash the business needs to get back on its feet
in the form of both a loan and stock purchase, but in return they
want a guaranteed 10% "interest" plus a pro rata share of
the profits of the business. The company already has both common
and preferred classes of stock and agrees with the
"money-guys" that their 10% guaranteed return will be
treated as "special preferred" stock. The balance of
their investment will be common stock equal to 80% of that entire
class of shares.
With this new capital, the business repairs the damage done by
the disaster, purchases new equipment, improves its operations, and
not only continues in business, but actually turns the corner and
starts to make a profit. It pays the 10% premium due on the
"special preferred" stock and tells the CFO to calculate
the dividend payments due to the holders of preferred and common
Sounds like an American success story, right? Risk capital
reaping its just reward! Well, not so fast.
One day the "money guys" show up at company
headquarters and tell the CEO: "Nice business you got here. It
would be too bad if something were to happen like that fire a few
years ago. So, tell you what we're going to do, instead of us
getting our 10% plus our 80%, we're going to get 100% of the
profits, not just this year but every year from now on. And, by the
way, don't even think about paying us back our investment,
because you won't have any money left to do that."
This sounds like a story line from The Sopranos that could be
played out over an entire season of thrilling home entertainment.
Instead, it is the reality of the federal government's most
recent assault on the rule of law.
Former U.S. Solicitor General, Theodore Olson, writing for the Wall Street Journal, provided
an excellent summary of what the government is up to: "The
federal government currently is seizing the substantial profits of
the government-chartered mortgage firms, Fannie Mae and Freddie
Mac, taking for itself the property and potential gains of private
investors the government induced to help prop up these
Investors are fighting back with lawsuits seeking money damages
and injunctions to stop the Treasury from continuing to sweep
Fannie's and Freddie's earnings into the federal coffers.
Institutional investors, including mutual funds, insurance
companies and other owners of preferred securities have sued in
federal court, claiming that the Treasury and the Federal Housing
Finance Agency have exceeded their statutory authority, breached
the contractual rights of the preferred shareholders, and breached
the fiduciary duty owed to investors arising out of the
conservatorship into which the mortgage GSEs were placed. Read a
copy of the complaint filed in one such lawsuit
Whether or not these lawsuits are meritorious, the consequences
of the Treasury's actions on financial institutions promise to
be profoundly bad and far reaching. Banks have long been encouraged
to hold preferred stock in Fannie and Freddie as part of their
regulatory capital. What will be the impact on those banks if these
investments are now worthless? How will the government's
actions impact Fannie and Freddie's ability to return to
profitability? And what does this conduct say about the
Administration's adherence to the rule of law?
Legislation has been introduced, under the guise of protecting
taxpayers, that would retroactively legalize the government's
actions. If the Treasury and FHFA were not acting beyond legal
bounds, why is such legislation even needed? And why are supposedly
conservative Republicans supporting it? These questions demand
In a recent decision, Continental Casualty Co. v. Symons, the Seventh Circuit Court of Appeals made clear that the structure of a transaction will not save it from being set aside as a fraudulent transfer if the facts warrant the transaction's avoidance.