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Holly LaFon
Holly LaFon
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Bruce Berkowitz's 2nd Quarter Fairholme Capital Management Public Conference Call Part II

June 2017 conference call with Fairholme founder and chief investment officer

July 11, 2017 | About:
Daniel Schmerin: The remaining Fannie Mae and Freddie Mac questions pertain to the ongoing litigation so I’d like us to turn to David Thompson from Cooper & Kirk, whose team has been representing the Fairholme Fund (Trades, Portfolio) on behalf of all our shareholders. David, I get to speak to you every day but our shareholders do not, so given the large number of questions that we’ve received on this topic I wonder if you could begin by providing some historical context.

How do these cases compare to Glendale Savings or the Winstar litigations? And have you ever seen such blatant overreach by the administrative state before?

David Thompson: Dan, I think there are a lot of parallels to the Winstar situation. Back in the late 1980s, the government upended settled expectations of investors in financial institutions and specifically the S&L industry. And we brought suit challenging that governmental action. Very few people thought we would succeed and indeed, when we went to the Court of Appeals for the first time, we lost two to one, just as we have in the Perry Capital case.

We ultimately prevailed seven to two before the Supreme Court in that case, and I think the lesson we learned is that the path to victory isn’t without some bumps along the road. I think this path to victory will be more expeditious because the issues are not as factually complicated and we’re proceeding in multiple forums, but I do think that’s a powerful historical analogy.

Daniel Schmerin: Can you discuss the current state of play in the Court of Federal Claims? Where do we stand on discovery? How do you feel about the results to date, and what are the anticipated next steps?

David Thompson: Just to refresh recollections, when we had our last call together, at that point we had been very upset that the government had given us a privilege log with over 12,000 items. It was really the mother of all privilege logs. So we selected 56 documents for the court to look at to see if the government had been turning square corners.

The court agreed with us that the government had improperly withheld all 56 of those documents. The government appealed since our last call to the Federal Circuit and prevailed on four presidential privilege documents, but on 48 of the 52 deliberative process documents, the government lost. So it was remanded back and we went to the court and said, Your Honor, if they’re wrong on 48 of the 52 documents that we’ve randomly selected, they should have to go back and reassess all the others.

And they were ordered to do so through the full privilege log and we’ve now received over 3,500 additional documents. We’re continuing to skirmish a little bit in the weeks ahead, but discovery should end shortly. We’re very gratified that we have insisted on our rights and on receiving documents that should not be improperly withheld, and we’ll be amending our complaint in the coming months, and then our case will move forward to adjudication on the merits.

Daniel Schmerin: The cases brought around the country under the Administrative Procedure Act have had only limited success to date. Can you discuss the D.C. Circuit’s recent opinion in our case and next steps for us and other similarly situated plaintiffs?

David Thompson: Sure. So the D.C. Circuit ruled at the end of February of this year and we were gratified that Judge Janice Rogers Brown saw the case exactly the way we see the case. I’d like to just read to you a few of the quotes from her excellent dissent. Thanks to our Court of Claims discovery, she said that “information recently obtained in this litigation creates, to put it mildly, a dispute of fact regarding the motivations behind FHFA and Treasury’s decision to execute the Third Amendment.”

She continued, FHFA (FHFA) “pole vaulted over” the boundaries of its statutory authority when it agreed to the Net Worth Sweep, “disregarding the plain text of its authorizing statute and engaging in ultra vires conduct.”

She added, “Having been appointed as conservator for the companies, FHFA was obligated to behave in a manner consistent with the conservator role as it is defined in HERA or risk intervention by courts.”

She went on to say that by imposing the Net Worth Sweep, Treasury received a contractual right from FHFA “to loot the companies to the guaranteed exclusion of all other investors,” and “FHFA’s decision to strip these cash reserves from Fannie Mae and Freddie Mac, consistently divesting the companies of their near entire net worth, is plainly antithetical to a conservator’s charge to ‘preserve and conserve’ the companies’ assets.

She added, “The capital depletion accomplished in the Third Amendment, regardless of motive, is patently incompatible with any definition of the conservator role … rendering Fannie Mae and Freddie Mac mere pass-through entities for huge amounts of money destined for Treasury does exactly that which FHFA has deemed impermissible.”

She went on to say, “The practical effect of the Court’s ruling is pernicious. By holding, contrary to the Act’s text, FHFA need not declare itself as either a conservator or receiver and then act in a manner consistent with the well-defined powers associated with its chosen role, the Court has disrupted settled expectations about financial markets in a manner likely to negatively affect the nation’s overall financial health.”

She concluded, “What might serve in a banana republic will not do in a constitutional one.”

It is a powerful opinion, yet unfortunately, it was a dissent. There were two judges on the panel who disagreed. Now, one might say how could you look at the Net Worth Sweep and conclude that it is consistent with the statute’s language that FHFA is supposed to preserve and conserve assets and operate institutions in a sound and solvent manner?

I would submit that it is impossible to square that language with the Net Worth Sweep. And the majority essentially conceded as much, because the maneuver the majority employed was to say that those are mere suggestions, that they’re not binding on the FHFA, and so FHFA wasn’t required to operate the companies in a sound and solvent manner. And the problem with that argument and holding is that for years in official filings and sworn written statements, the FHFA has consistently acknowledged that those are statutory mandates.

In sworn testimony to Congress just last month, Mel Watt said, “FHFA’s statutory mandate obligates it to conserve and preserve the assets of the enterprises while they are in conservatorship.” So we feel very confident that the line of analysis adopted by the Perry Capital majority – and that was really the linchpin of the decision – is not going to withstand judicial scrutiny.

It’s likely that you’ll see a cert petition filed in the coming months in Perry Capital and if the Supreme Court takes that case, we’ll get a decision about a year from now.

In addition, Cooper & Kirk has now been retained in four cases that we had been closely following but we are now counsel of record for those cases in the Fifth, Sixth, Seventh, and Eighth Circuits. The Sixth Circuit oral argument will be on July 27, and I think it is reasonable to expect that we might well get a decision by the end of the year out of the Sixth Circuit. There is a lot going on around the country.

Daniel Schmerin: Good. Are there any other legal avenues that plaintiffs are exploring?

David Thompson: Yes, there are. Just in the last couple of weeks, there are two very interesting new suits that have been launched in Michigan and Minnesota, and we’re following them closely because they are premised on the idea that even if the government is absolutely right about the factual background of the Net Worth Sweep and the reasons why they did it – and discovery has shown they’re not – but even if they were right, these suits say the Net Worth Sweep must be invalidated on the basis of three separate theories.

The first is the separation of powers theory. Namely, that the FHFA is unconstitutionally structured. It is an agency that we are told is immune from judicial oversight. It is immune from congressional oversight because it doesn’t rely on Congress for appropriations. It’s immune from presidential oversight because the president can only remove the director for cause. And it has a single director, not a multimember panel which is more frequent among independent agencies.

To my knowledge, there is only one other prominent agency that is so constituted and it’s the CFPB. And both are obviously of recent vintage, and the CFPB was recently ruled unconstitutional on exactly this theory by a majority of the D.C. Circuit.

The second theory is the Appointments Clause, which requires principal officers to be nominated by the president and confirmed by the Senate. In this instance, Ed DeMarco, when he was the acting director of FHFA and signed the Net Worth Sweep, had been acting for three years and these lawsuits maintain that it’s inconsistent with the Appointments Clause to put someone in as a principal officer in an acting capacity for three years. That would just be way too easy an end run around the Appointments Clause.

The final theory is nondelegation, which is a constitutional doctrine that says that agencies need to have an intelligible principle that binds their conduct. Well, of course, the Perry Capital majority said that the intelligible principle of preserving and conserving assets and operating the institutions in a sound and solvent manner was not binding at all. And so these new lawsuits are saying that if that’s correct, then we have a nondelegation problem because there is no intelligible principle binding the FHFA because it can do whatever it wants. So those are two suits to be watching. The first theory is present in the Fifth Circuit appeal that we’ll be handling in a case called Collins, but all very important litigation that is proceeding.

Daniel Schmerin: Another shareholder focused on the violations by big banks of federal securities laws and common law in the sale of residential private-label mortgage-backed securities to Fannie Mae and Freddie Mac, and he asked why plaintiffs have not brought direct or derivative suits against those big banks for the harm they caused to the GSEs?

David Thompson: The short answer is that the companies themselves have brought that litigation and have garnered settlements well in excess of $20 billion. So it wouldn’t make sense to try to bring a derivative case when the companies have already directly vindicated their rights. That is pretty much water under the bridge at this point.

Daniel Schmerin: What is your assessment of the timeline for this multifaceted legal fight, and what events should we mark down on our calendars as we look ahead to the remainder of 2017?

David Thompson: As I noted, on July 27 the Sixth Circuit will be having oral arguments in a case that is very similar to Perry Capital and we expect that an opinion may be rendered before the end of the year. So that’ll be a very important moment. Certainly if the cert petition for Perry Capital is filed as we expect later this year, it will be important to see whether the Supreme Court grants cert and that should probably happen toward the end of the calendar year.

We’ll be amending our complaint in the Court of Federal Claims and bringing together the fruits of all of the documents that we found that are helpful, including from those 3,500 additional documents that we recently received. I think six to 12 months from now, we’re going to know a lot more than we do right now. So there are number of important events over the next year.

Daniel Schmerin: If you have to summarize the most important points for someone who is new to the situation, what would you say to them?

David Thompson: I would say we are in multiple forums and there are multiple theories that are moving forward. If a plaintiff wins in just one of these places, the Net Worth Sweep will be enjoined on a nationwide basis. As in Winstar, the path to victory may not be without setbacks along the way, but we remain very confident that the federal judiciary will not uphold the Net Worth Sweep.

Daniel Schmerin: Thank you, David.

David Thompson: My pleasure.

Bruce Berkowitz (Trades, Portfolio): David, on behalf of all our shareholders, thanks to you and all of your team members for their hard work. We are looking forward to a positive outcome in one of the venues.

David Thompson: Thank you.

Daniel Schmerin: Bruce, I’d like to return to The St. Joe Company (NYSE:JOE) (“St. Joe”) and wrap up. You recently said that if you could only invest in one of our positions, St. Joe would be it. A shareholder asks a slightly different question: If you had no investment positions at all, what is the first investment you would put money into today? Would it still be St. Joe?

Bruce Berkowitz (Trades, Portfolio): Yes, it would.

Daniel Schmerin: So what is happening at St. Joe these days that gives you cause for optimism and what is the timeline for meaningful profitability?

Bruce Berkowitz (Trades, Portfolio): I should give everyone a taste of the new activities starting at St. Joe in Northwest Florida. St. Joe is increasing jobs in the area by helping to create global high-tech manufacturing facilities. St. Joe signed its first global high-tech company, GKN plc (“GKN”), an automotive and aerospace components company. Hopefully they will open up before the end of this year. St. Joe is increasing primary home choices for the first time, building apartments to rent as well as townhomes and condominiums to increase density. Of course, there is also the further expansion of retail and village spaces that go along with more jobs and more homes.

St. Joe is trying to increase the quality of education, looking to build new schools and very much focused on the “STEM” areas: sciences, technology, engineering, and mathematics. They are in talks to expand the healthcare system in the area. They’re working hard on a very large biomedical engineering project. Of course, they’re also looking to continue to increase tourism. I believe that Northwest Florida Beaches International Airport has crossed a million legs. I know airlines are exploring additional routes. For the first time they’re starting the process of looking to build new hotels and a new convention center. They’re also finalizing plans for a very large national sports facility.

I’m sure people haven’t heard of Triumph Gulf Coast. Triumph Gulf Coast is a nonprofit corporation that was created by the Florida legislature to distribute about a billion and a half dollars of funds for economic damages in the State of Florida that resulted from the 2010 Deepwater Horizon oil spill.

Florida’s Governor Rick Scott executed the Triumph legislation earlier this month, and it is now in effect. Triumph Gulf Coast attempts to establish, hold, invest, and administer this trust of a billion and a half dollars for the economic recovery, diversification, and enhancement of eight Northwest Florida counties that were disproportionately affected by the spill.

St. Joe owns property in five of the eight counties, with significant ownership in three of the counties – Bay, Gulf, and Walton counties.

I mentioned GKN. We’re constructing a 137,000 square foot building at Venture Crossings, which is proceeding well and should be completed later this year. St. Joe is constructing the building and leasing it to GKN. GKN has started the hiring process, and we expect them to create 170 aerospace manufacturing jobs with a median annual salary of about $65,000. We also expect another 400 to 500 jobs to be created from the knock-on, secondary effects associated with this new facility.

I mentioned apartments. St. Joe is constructing 240 units in a joint venture with HomeCorp near Pier Park. It is expected to commence in the third or fourth quarter of this year. St. Joe will be the majority owner of the JV and owns most of the land surrounding this project.

We expect many more starts to come, so I tell everyone to stay tuned.

Daniel Schmerin: Here’s an interesting one we received. Given that the Intergovernmental Panel on Climate Change expects that the oceans will rise between 11 and 38 inches by 2100, can you please discuss how much, if any, of St. Joe’s highly desirable real estate properties would be at risk?

Bruce Berkowitz (Trades, Portfolio): The coastline in Northwest Florida typically has higher elevations than other parts of Florida. For example, the gulf front at our Watercolor Inn has an elevation of 13 feet. Pier Park North commercial center has an elevation of 30 feet. Watersound Origin, one of our growing communities, has an average elevation of 35 feet. And our high-tech manufacturing area at Venture Crossings is adjacent to the airport with elevations ranging between 50 and 60 feet above sea level.

St. Joe is going to be A-OK, at least for the next few hundred years. I think those of us living in Miami have a lot more to worry about.

Daniel Schmerin: For the last several years, shares of St. Joe have underperformed the market and its peer groups. What action do you anticipate the company will take to highlight the value for investors of its cash and property, and when? And what actions will the company take to potentially increase capital allocation for shareholders, whether in the form of dividends or accelerated buybacks, especially given the strength of St. Joe’s balance sheet?

Bruce Berkowitz (Trades, Portfolio): I’m happy to report the company is executing on its plans. It’s focused on recurring revenues, executing joint ventures to maintain low fixed cost structures, working hard to diversify the regional economy. We’ve been very lucky and fortunate to have great support from the state and local officials, be it from Governor Rick Scott, Commissioner Adam Putnam, and many others who believe there’s a bright future for Northwest Florida. I’m quite excited.

And in terms of capital allocation, more capital will be directed toward new programs and projects. But St. Joe will still have significant excess liquidity, and shareholders could see substantial amounts of capital used to continue repurchasing shares if the price is right.

Daniel Schmerin: Another shareholder asked, “Are there accommodations for us small fry investors to go down to St. Joe and get a tour of the facilities and the region itself?” How would you recommend people go down and tour this area? And is Joe doing enough to promote itself?

Bruce Berkowitz (Trades, Portfolio): All of our shareholders are welcome at St. Joe. Feel free to call St. Joe and arrange a visit. Tell them I encouraged the visit. Shareholders who visit will be pleasantly surprised and it’s going to get easier and easier to get to the area, because every year, we expect more direct flights into Northwest Florida Beaches International Airport. And we’re hoping to see flights from the New York area in the not-too-distant future.

St. Joe is moving faster and faster on all fronts. However, they are still exercising prudence. Every project must be profitable from day one. Every project must add value to all other current or future projects. St. Joe has at least 30 years of organic growth ahead. People at St. Joe want to make sure that they achieve this tremendous growth with minimum risk to the company and communities. It’s my belief that the company is now ready for whatever may come.

Daniel Schmerin: I think we’ll leave it there. We’ve covered a lot of material today. Thank you all for taking the time to join us. If you have further comments on what you’ve heard, please send us a note.

Bruce Berkowitz (Trades, Portfolio): To all our shareholders, I continue to thank you for your trust and for your confidence, and we look forward to the next conference call.

Operator: Thank you for participating. This concludes the Fairholme Public Conference Call.

Please see the last page of this transcript for important disclaimers.

Past performance is not a guarantee of future results.

The opinions of Mr. Berkowitz expressed herein should not be considered a guarantee of future events or future results, or investment advice. Any references to past performance should not be construed as an indicator of future performance. Any projections, market outlooks or estimates that may be included in this material are forward looking statements and based upon certain assumptions. Other events that were not taken into account may occur, and may significantly affect the returns or performance of the Funds. Any assumptions should not be construed to be indicative of the actual events which will occur.

Mutual fund investing involves risk. Principal loss is possible.

The Fairholme Fund (Trades, Portfolio) is a non-diversified mutual fund, which means that The Fairholme Fund (Trades, Portfolio) invests in a smaller number of securities when compared to more diversified funds. Therefore, The Fairholme Fund (Trades, Portfolio) is exposed to greater individual stock volatility than a diversified fund. The Fairholme Fund (Trades, Portfolio) also invests in foreign securities which involve greater volatility and political, economic and currency risks and differences in accounting methods. The Fairholme Fund (Trades, Portfolio) may also invest in “special situations” to achieve its objectives. These strategies may involve greater risks than other fund strategies.

The Fairholme Focused Income Fund (the “Income Fund”) is a non-diversified mutual fund, which means that the Income Fund invests in a smaller number of securities when compared to more diversified funds. This strategy exposes the Income Fund and its shareholders to greater risk of loss from adverse developments affecting portfolio companies. The Income Fund’s investments are also subject to interest rate risk, which is the risk that the value of a security will decline because of a change in general interest rates. Investments subject to interest rate risk will usually decrease in value when interest rates rise and rise in value when interest rates decline. Also, securities with long maturities typically experience a more pronounced change in value when interest rates change. Debt securities are subject to credit risk (potential default by the issuer). The Income Fund may invest without limit in lower-rated securities. Compared to higher-rated fixed income securities, lower-rated debt may entail greater risk of default and market volatility.

Please see the last page of this transcript for important disclaimers.

The Fairholme Allocation Fund (the “Allocation Fund”) is a non-diversified mutual fund, which means that the Allocation Fund can invest in a smaller number of securities when compared to more diversified funds. The Allocation Fund may invest in lower-rated securities, which may have greater market risk. This strategy exposes The Allocation Fund and its shareholders to greater risk of loss from adverse developments affecting portfolio companies. The allocation of investments among the different asset classes, such as equity or fixed-income asset classes, may have a more significant effect on The Allocation Fund’s net asset value when one of these classes is performing more poorly than others.

Fairholme Distributors, LLC (07/17)

Read Part I here.

About the author:

Holly LaFon
I'm a financial journalist with a master of science in journalism from Medill at Northwestern University.

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