This is a follow up on my recent post, Fannie and Freddie: The NWS and the Implied Covenant of Good Faith and Fair Dealing.
Private vs Public
Notice that the joint venture agreement in Oxbow, that was the subject of the Delaware Supreme Court’s analysis of Crestview’s reasonable investment expectations, was a highly negotiated agreement specific to Crestview’s investment in Oxbow. Oxbow did not take a standard agreement with respect to a public security investment, as is the case with the GSE junior preferred stockholders with respect to their preferred stock certificates of designations. Oxbow negotiated a bespoke agreement for its own one-off private investment.
Moreover, Crestview obtained board of director representation on Oxbow to monitor its bespoke investment in Oxbow. Of course, the GSE junior preferred holders had no representation on the GSE boards of directors in order to monitor the issuer’s good faith discretionary actions.
If Oxbow serves as the principal Delaware rule of law with regard to the implied covenant of good faith and fair dealing in Judge Lamberth’s court, as I expect it will, some accounting should be made for the differences between a private and public investment and the investor’s reasonable expectations.
A private investor in common equity who negotiated its own investment agreement with negotiating leverage with respect to the issuer, and who had board of director representation to monitor into investment, should be held to a much higher standard with respect to the implied covenant than a public investor in a standard preferred stock issuance, such as the GSE junior preferred stockholder.
By “higher standard”, I mean that it should be easier for a Judge to invoke the implied covenant in the public case than the private case, since the private investor had every opportunity to negotiate the precise terms it wanted, such that the rationale or justification for “reading terms into the contract” by means of the implied covenant are not as present in the private case as the public case.
The Role of Math in a Motion for Summary Judgment (MSJ)
In a MSJ, the proponent of the motion must assume that the facts stipulated, or if not stipulated by agreement with the other party then as proposed by the other party, are true. Can the plaintiffs use math and the documentary evidence regarding the terms of the Net Worth Sweep (NWS), to win on summary judgment?
In Fannie and Freddie: The NWS and the Implied Covenant of Good Faith and Fair Dealing, I set forth the mathematical certainty supporting plaintiffs claim that
the GSEs could not benefit, but only suffer detriment, from the NWS;
Treasury could do no worse, incurred no risk and could only benefit, from the NWS; and
The government’s argument, that the NWS was necessary to avoid depletion of Treasury’s line of credit, is a shameful sham, as made clear by the terms of the Senior Preferred Stock Agreement that it negotiated.
While I did not spend time in my previous post in considering the merits of plaintiffs MSJ, expected at the end of this year, it occurs to me that the objective weight of a mathematical presentation, proving that the government’s arguments supporting the NWS are without merit, may have significant weight in front of Judge Lamberth.
To illustrate this point, assume that Judge Lamberth accepts as a legal rule that it would breach the implied covenant if the GSEs amended the Senior Preferred Stock Agreement without deriving any benefit and potentially suffering only detriment from Treasury….that to do so would be bad faith on the part of the GSEs. If Judge Lamberth finds that given the terms of the NWS there would be no mathematical possibility that the GSEs could obtain any benefit, and could only suffer detriment, then it would follow that Judge Lamberth should grant plaintiffs motion for summary judgment.
Walk with me here in general principles. The details can be refined.
Assume 10 billion earnings / year for Freddie. With warrants, there are around 3 billion shares, fully diluted. EPS = 3.33 With a ten multiple that’s 33 per share, give or take. Government owns 80% or 2.4 billion shares in warrants. That’s 79 billion with sale of warrants IF there were no capital raise.
Obviously there will be capital raise. If capital raise is 40 billion for Freddie, investment banks will want to put up the 40 billion at the lowest share price possible in order to own greater percentage of GSEs. If the share price were driven down to 1 dollar / share, there’d be 43 billion total shares after IPO. EPS would be 10 bln / 43 bln = 23 cents per share. That translates to an IPO multiple of only 4.3 x earnings to get to 1 dollar per share. The commons could run up to 10x earnings, or to 2.3 dollars per share. Government could net 2.4 bln shares x 2.3 = 5.52 billion dollars. Not a great sweetener.
A better deal for government is not to dilute existing shares + warrants any further if possible. But yet they need capital raise. So, let’s go back to the 79 billion value for warrants scenario (based upon $33 per share x 2.4 billion shares of warrants). If government sacrifices 50% of its warrants back to the gses for a 40 billion capital raise, it can walk away with nearly 40 billion from their remaining 1.2 billion shares, instead of 5.52 billion dollars by not playing hard ball with the banks and taking only 2.3 dollars per share for all 2.4 billion shares. By sacrificing percentage of warrants tsy can maintain pps integrity by avoiding unnecessary dilution.
In sum, doesn’t treasury have leverage if they care to engage banks on capital raise? Can’t Tsy go this alone? (Obviously jr pfds and maybe even SPS will come into play), but is the general concept sensible?
ROLG , when do you estimate that the Collins case will get a final court decision ? And do you think that it will affect the course of the case in Judge Lamberth court ?