Lawyers for shareholders of mortgage companies Fannie Mae and Freddie Mac argued in federal appeals court on Friday that the U.S. government has illegally seized much of those institutions' profits during the past three years, effectively bilking them out of hundreds of billions of dollars.

Shareholders are trying to reverse a federal judge's dismissal of civil lawsuits they brought against the government in 2013.

The legal battle, which is being waged by hedge fund Perry Capital LLC and other shareholders, centers on the government's 2012 decision to start collecting nearly all of Fannie's and Freddie's profits each quarter. To date, Fannie and Freddie have paid the government $246 billion in dividends.

The arrangement "systematically drained these entities of all value, leaving in its wake two unsound and insolvent zombies—a golden goose for the Treasury and utterly worthless for the individuals and institutions who in good faith invested in them," said Gibson, Dunn & Crutcher attorney Theodore B. Olson, who represented Perry Capital.

It could take several months for the three-judge panel in Washington, D.C., to issue a decision on the appeal. Although some shareholders have expressed willingness to discuss a settlement with the government, thus far the government hasn't been open to that.

Fannie and Freddie were put into a so-called conservatorship in 2008, under the control of the Federal Housing Finance Agency. The U.S. Treasury over time injected $187.5 billion into the firms to keep them afloat and in return received warrants to acquire nearly 80% of the companies' common stock along with a new class of senior preferred shares that initially paid a 10% dividend.

In August 2012, the Treasury Department and the FHFA changed the terms. Instead of paying a set rate of 10%, the companies would pay nearly all of their profit to the Treasury when they made one and skip the dividend when they reported losses.

At the time of the change, government officials said they needed to avoid a situation in which the companies would need bailout funds to pay the Treasury's dividends, a so-called "circular draw" the government said would quickly drain the remaining bailout money.

But shortly after the sweep took effect, the companies began to report substantial profits, as the strengthening housing market allowed them to release unneeded loss reserves and realize value on deferred tax assets.

Under the amended agreement, the Treasury also would step in to provide up to $258 billion in additional bailout funds if needed.

Investment firms that own shares of the company, including Perry Capital and Fairholme Funds Inc., sued the government, alleging officials knew the large profits were coming and took them illegally.

In his 2014 decision to dismiss the suit, U.S. District Court Judge Royce Lamberth wrote: "It is understandable [for the profit sweep] to raise eyebrows, or even engender a feeling of discomfort," but he also said the law was on the government's side. He said the government would win the case even assuming the shareholders' narrative of events was true.

A U.S. Treasury Department spokesman on Friday said, "The Administration agrees with Judge Lamberth's well-reasoned opinion to dismiss this case. The U.S. Court of Appeals Circuit should affirm the district court's decision to dismiss all of plaintiffs' claims."

So far, the shareholders' legal bid has been unsuccessful. However, in U.S. Court of Federal Claims in Washington, D.C., a judge did allow shareholders to conduct discovery and depositions. There, the shareholders and government are fighting over whether the government has improperly asserted executive privilege to withhold documents relevant to the case. Government lawyers have sought to keep the vast majority of the evidence under seal.

Earlier this week, the judge in that case unsealed certain documents and partial depositions so that lawyers could refer to them in Friday's oral arguments.

Most notably, ex-Fannie Mae chief financial officer Susan McFarland in a deposition said she had told U.S. Treasury officials that Fannie might start to report large profits only days before the Treasury Department initiated the profit sweep.

"When the [profit sweep] went into place, part of my reaction was they did that in response to my communication of our forecasts…that it was probably a desire not to allow capital to build up within the enterprises," Ms. McFarland said.

This week, common shares of Fannie and Freddie have risen more than 20%, though they were sharply down on Friday.

"At a minimum, more facts are needed to get to the bottom of what happened and to assess the extent to which [shareholders'] rights were breached and the value of the damages," said Hamish Hume, an attorney with Boies, Schiller & Flexner, in an interview after the hearing. Mr. Hume argued the appeal on behalf of other shareholders.

Write to Joe Light at joe.light@wsj.com

 

(END) Dow Jones Newswires

April 15, 2016 18:15 ET (22:15 GMT)

Copyright (c) 2016 Dow Jones & Company, Inc.
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