One feature of the current financial turmoil is that the government has taken or will take control of or ownership positions in a number of business organizations. The phenomenon of government ownership of a private enterprise potentially could present any number of conflicts and challenges. Among other problems that may arise is the question of exactly what the government’s role should be with respect to ongoing or future litigation.


This particular litigation dilemma is explored in an October 18, 2008 Wall Street Journal article entitled "Fannie Suit Vexes Regulator, May Pay Shareholders" (here). The article states that the securities lawsuit filed in connection with Fannie Mae’s September 2008 collapse puts the government regulatory agency now acting as Fannie Mae’s conservator "in an awkward position." Background regarding the lawsuit, filed on September 8, 2008, can be found here. My prior post about the lawsuit can be found here.


The Journal article notes that Freddie Mac settled a prior securities lawsuit for $410 million (about which refer here). Implicitly using the amount of this prior settlement as a point of reference for the possible magnitude of any future settlements of the Fannie Mae lawsuit, the Journal article observes that the "government’s control of Fannie puts taxpayers potentially on the hook for hundreds of millions of dollars of damages stemming from the lawsuit."


The Journal article also notes that one of the key elements of the new case will be the government regulator’s 340-page May 2006 report that was highly critical of Fannie Mae. The article notes that "a vigorous defense on Fannie’s part would require rebutting the agency’s own report. An acknowledgement of the report’s veracity could mean admitting wrongdoing and an even bigger payout."


The Journal article may well be correct that the government regulator’s role as Fannie Mae’s conservator potentially puts the regulator in an awkward litigation position. But in making this point, the article overlooks a number of important considerations about the lawsuit.


First and foremost, the recent lawsuit, unlike the prior Fannie Mae lawsuit, does not in fact name Fannie Mae itself as a defendant. The only defendants named are several present or former directors or officers of the company. Because the company itself is not a defendant, it will find it less awkward to stand by its report than the Journal article suggests.


Second, while the May 2006 report may be relevant, it is unlikely to be the centerpiece of the plaintiffs’ case, simply because the report was published nearly a year and a half before the start of the class period alleged in the plaintiffs’ complaint. The complaint purports to assert claims on behalf of persons who bought Fannie Mae shares between November 16, 2007 and September 5, 2008, and the alleged misrepresentations and omissions on which the complaint is based allegedly occurred during that period. The prior report is unlikely to play a role anywhere near as crucial as the Journal article suggests.


UPDATE: An observant reader has pointed out the possibiltiy that the Journal article is not referring to the newly filed Fannie Mae lawsuit, but rather is referring to a 2004 lawsuit involving Fannie Mae, in which Fannie Mae is in fact a defendant. Background regarding this prior lawsuit can be found here. On close reading, it appears possible that the Journal article was referring to this earlier lawsuit. To the extent the article was referring to the 2004 lawsuit not the most recenlty filed one, my two prior comments may be inapplicable. However, the following comment remains valid, regardless of which lawsuit the article was referring to. As an aside —  with a publication like the Journal, we really shouldn’t have to wonder  which lawsuit an article is referring to.


Third, it remains to be seen what role if any the company or its governmental conservator will play in any eventual settlement. Fannie Mae likely has tens, if not hundreds, of millions of dollars of D&O insurance that at least potentially could respond to this lawsuit. (In making these observations, I emphasize that I have no firsthand knowledge of Fannie’s D&O insurance program.) To the extent the insurance does respond to this claim and to the extent that policy terms and conditions do not otherwise bar coverage, the insurance program, rather than the government itself, would likely fund potential settlements. The Journal article fails to address or even acknowledge this possibility, which potentially could be a critical settlement factor.


Notwithstanding these observations, there are legitimate concerns about the possible role of the government regulator in the pending litigation. The essential point of the Journal article – that the government has its own interests– is unquestionable true. Moreover, this concern about diverging governmental interests is true not only with respect to the conduct of litigation alone, but applies broadly to the general conduct of business in the various enterprises in which the government has taken a controlling or an ownership interest.


Government Ownership in Private Enterprise: In connection with the various entities and organizations that the government has nationalized in whole or in part in recent weeks, Treasury Secretary Henry Paulson has stated that the government’s role will be passive and apolitical. But, as James Grant, the author of Grant’s Interest Rate Observer, noted in an October 18, 2008 Wall Street Journal essay (here), "the record of the Depression-era Reconstruction Finance Corp. suggests that the government is a shareholder that can throw its weight around. Besides, would Mr. Paulson’s apolitical intentions bind his successor?"


Anyone doubting the complicating nature of the government as an owner in private enterprise should consider what has occurred at AIG since the government’s bailout and 79.9% ownership stake was first announced. The incredible scrutiny that AIG has faced regarding severance compensation and marketing expenses clearly demonstrates that the arrival of government control is by no means a friendly embrace.


Moreover, AIG’s recent agreement with New York AG Andrew Cuomo, as a result of which, among other things, AIG has "canceled 160 conferences and events" underscores the austere, constrained existence AIG must now sustain under the supervision of its government appointed caretaker/liquidator.


I am not defending AIG’s severance compensation payments. However, the problem with the more generalized austerity requirements is that they may be contrary to taxpayers’ larger interests. AIG’s ability to service its interest obligations (which now reportedly amount to $1 billion per month), sell off business units in an orderly way, and repay its debt obligation to the U.S. government is unlikely to be advanced by the prohibition on conferences and events. Politicians’ insistence that the company forbear from ordinary marketing activities will impede the company’s ability to conduct business and potentially could hinder the company’s ability to fulfill its bailout obligation. Unfortunately, grandstanding politicians appear to be a compulsory accessory of governmental ownership.


Other companies faced with the prospect of government ownership in exchange for a government bailout might consider the offer at least a mixed blessing, if not an actual poisoned chalice.


D&O Insurance: There Will Be Blood: Though the Journal article discussed above may have overlooked the significant potential litigation role of directors’ and officers’ liability insurance, others have not been so remiss. For example, the October 18, 2008 New York Times article entitled "Financial Crisis Provides Fertile Ground for Boom in Lawsuits" (here), expressly cites the availability of insurance as one reason why plaintiffs’ lawyers may be interested in pursuing litigation related to the current credit crisis.


The article states that "even companies that have suffered huge losses may still be worth pursuing because of their liability insurance." The article also quotes Stanford Law Professor Joseph Grundfest as saying that "You can’t get blood from a stone. But you sure can get money from the insurance company that covered the stone."