It has been over nine months since Judge Royce Lamberth of the DC District Court stunned Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) shareholders with his decision to dismiss the consolidated plaintiffs (the Institutional and Class Action Plaintiffs) claims that, among other things, the Federal Housing Financing Agency (FHFA), as conservator, and the United States Treasury (Treasury) lacked statutory authority under the Housing and Economic Recovery Act of 2008 (HERA) to enter into the Third Amendment (Net Worth Sweep) to the Senior Preferred Stock Purchase Agreement.
Recently, the Institutional and Class Action Plaintiffs (Appellants) filed their appeal briefs in the DC Circuit Court of Appeals (the Institutional Plaintiffs brief and the Class Action Plaintiffs brief), and eight amici have filed amicus briefs (the several amicus briefs are embedded in this Value Walk article). The full briefing schedule calls for final briefs to be filed by the end of November 2015, with oral argument to be scheduled likely a couple months thereafter, and the appeals court decision forthcoming likely late spring/early summer 2016.
In my over 30 years as a corporate finance and securities attorney and private investor, I find the Lamberth FNMAA/FMCC decision to be the weakest-reasoned and most precedent-disrespecting opinion I have read since the 1987 Texas state court decision (applying New York law) that held that Texaco tortuously interfered with the Pennzoil/Getty merger "non-binding" memorandum of understanding.
Now, a word of caution before we proceed. That infamous Texaco/Pennzoil decision was upheld by the Texas intermediate appeals court. So, the road to reversal of Judge Lamberth's opinion is best considered by investors to be equally fraught with risk. My objective in this article, and ensuing articles that I will write, is simply to lay out the analytic contours of this road to reversal, in the hope that investors will be able to assess the process with greater clarity, and estimate what is at stake for FNMA/FMCC shareholders.
The Two Forms of Reversal and What's at Stake for FNMA/FMCC Shareholders
There are essentially three things the DC Circuit Court of Appeals can do with the appeal of the Lamberth District Court decision. It can either:
(I) Affirm the decision, which means that FNMA/FMCC shareholders will be left with no tangible economic interest in FNMA/FMCC.
(A) The trading value of FNMA/FMCC shares will then be premised solely upon the possibility that
(1) the United States Supreme Court will grant certiorari (which SCOTUS can elect not to grant) and hear an appeal the DC Circuit Court of Appeals, and
(2) there will be recovery in a companion takings case that certain of the Institutional Plaintiffs have brought in the US Court of Federal Claims; or
(II) reverse and vacate the decision, and remand the case back to the District Court with instructions to
(A) conduct such discovery as is necessary to determine whether summary judgment may be granted one of the parties, as a matter of law, or
(B) if there is one or more questions of fact that remains at issue, conduct a trial to and enter a judgment for one of the parties based upon the law (and the appeals court may correct Judge Lamberth with respect to errors of law in his opinion) and facts discovered at trial; or
(III) reverse and vacate the decision, and enter judgment on one or more questions of law in favor of the Institutional and Class Action Plaintiffs, and remand the case back to the District Court with instructions to implement the order in a manner not inconsistent with the opinion of the Circuit Court of Appeals.
Now, it should be readily apparent that there are substantially different investment consequences to FNMA/FMAA common shareholders arising from these two forms of reversal. The post-trading implications for FNMA/FMCC common stockholders of any reversal of Judge Lamberth's opinion will depend upon which form of reversal occurs.
In the case of a simple reversal without any entry of judgment in favor of Appellants, while the investment position of FNMA/FMCC common shareholders will continue to bear significant uncertainty, it is likely that the trading range of FNMA/FMCC common stock will return at least to the range that existed during the period before late September 2014, when Judge Lamberth issued his decision. Indeed, one might expect that the new trading range would modestly exceed this prior range, since there would be now certainty that didn't exist before the September 2014 decision that certain arguments supporting FHFA's/Treasury's defense are unavailing.
As discussed below, this trading range is likely to be far less than the trading range resulting from a reversal and entry of judgment in favor of the Appellants (since with such reversal and entry of judgment in favor of Appellants, the case is over but for any appeal to SCOTUS that the government may request (and which SCOTUS may not grant)).
Based upon a review of the FNMA two-year chart set forth below, this implies that it would be reasonable to expect that the trading range of the FNMA common stock after a simple reversal, with no entry of judgment, would move from its recent range under $2.50 per share to a range of $4-6 per share.
In the case of a reversal with entry of judgment in favor of Appellants, the investment position of FNMA/FMCC common shareholders may be analyzed assuming the likely consequences to the companies' capital structures as a result of the invalidation of the Net Worth Sweep, as supported by the likely cash flows that the companies can be expected to generate.
In the event the DC Circuit Court of Appeals enters judgment that invalidates the Net Worth Sweep in connection with reversal, the Institutional Plaintiffs' brief speaks to the capital structure result at fn. 9:
Vacating the Net Worth Sweep necessarily would require some action by [FHFA/Treasury] to restore [FNMA/FMCC] to the position they would have occupied had the Net Worth Sweep not occurred. The precise mechanics of that process can be resolved by the district court on remand. One possible resolution would be for Treasury and FHFA to agree, pursuant to the Purchase Agreements, to allow the excess funds (over and above the pre-Net Worth Sweep 10% cash dividend) paid to Treasury under the Net Worth Sweep to be credited retroactively on a quarterly basis as a partial redemption of Treasury's liquidation preference. If that happened today, approximately $152.6 billion would be treated as redeemed, and Treasury would have $36.9 billion remaining on the liquidation preference on which it could continue to collect fixed-rate dividends and would still retain its warrants to purchase 79.9% of the Companies' common stock.
Assuming in the case of FNMA that the Treasury's outstanding senior preferred stock preference as of March 31, 2015, pro forma for Net Worth Sweep being invalidated, was $25 billion instead of $117 billion (actual), there is $92 billion of capital that will be transferred from the Treasury's senior preferred shareholding account to junior preferred and common stockholders. Let's assume that the $19 billion of outstanding junior preferred stock absorbs $15 billion of this value transfer to raise the trading value of the junior preferred stock to par. This leaves $73 billion of value that is available to be absorbed by FNMA common stock. With 6.5 billion shares of FNMA common stock outstanding of a fully diluted basis, after giving effect to Treasury's warrants, this implies that over $11 per common share of value is available to FNMA common stock upon the invalidation of the Net Worth Sweep.
Even assuming that one ascribes no value to the current FNMA common stock (on the theory that its current trading value at less than $2.50 is simply the market's valuation of the litigation bet on reversal of Judge Lamberth's opinion), this implies a post-invalidation of the Net Worth Sweep value for FNMA common stock of $11 per share.
This is a balance sheet analysis of the financial effect of Net Worth Sweep invalidation, so let's double check this result to see if a cash flow analysis supports it.
For the quarter ended March 31, 2015, FNMA recorded pretax income of $2.758 billion, and recognized $1.919 billion of losses arising from fair value accounting adjustments for its interest rate derivatives, of which all but $.229 billion were non-cash losses. By adding the non-cash losses for the quarter, $1.690 billion, to $2.758 billion, one arrives at $4.448 billion of cash pre-tax income for the first quarter. If one extrapolates this first quarter result for the entire year, FNMA can be expected to generate $17.792 billion of cash pre-tax income for the year. If one applies an effective tax rate of 33%, this results in FNMA annual cash net income of $11.8 billion.
Cash dividends payable on Treasury's senior preferred stock would now be $2.5 billion per year (though one can imagine that FNMA could easily refinance Treasury's preferred with cheaper senior preferred stock), and dividends payable on the junior preferred stock amount to about $1.5 billion per year (since the junior preferred dividends are not cumulative, all dividends omitted during conservatorship are not payable). This results in $7.8 billion of annual cash net income attributable to the FNMA common stockholders.
If one applies a rather conservative 10X P/E ratio to this $7.8 billion of annual cash net income, FNMA's common stock valuation would equal $78 billion. Dividing this amount by the 6.5 billion FNMA common shares outstanding on a fully-diluted basis, one arrives at a FNMA common stock valuation of $12 per share.
While there is a certain amount of political risk associated with an investment in FNMA, even apart from the litigation risk, it would seem that in the event the litigation risk is eliminated, one might think that the remaining political risk would not be so substantial as to keep the FNMA common share price from gravitating far closer to this $11-$12 per share valuation than remaining close to the current less than $2.50 per share valuation.
The Arguments in Favor of Reversal and Entry of Judgment in Favor of Appellants
The two Appellants briefs and the eight amicus briefs filed with the DC Circuit Court of Appeals lay out the case for reversal, but there are two principal arguments in particular that call for reversal and entry of judgment in favor of Appellants. I will focus on these two arguments in the rest of this article.
The additional arguments in favor of reversal involve claims of breach of conservator fiduciary duty, failure of the conservator to uphold its statutory duty to "preserve and conserve the conservatee's assets and restore the conservatee to a sound and solvent condition," and failure of the District Court to decide the case properly at the motion to dismiss stage and based upon a complete administrative record. These arguments call for remand back to the District Court for additional discovery and perhaps trial. I will focus on these arguments and additional developments that arise during briefing in subsequent articles.
The two principal reversal and entry of judgment arguments are that HFHA and Treasury:
(i) Lacked statutory authority under HERA to enter into the Net Worth Sweep, because the Net Worth Sweep constitutes a "purchase" of securities, and HFHA and Treasury did not possess authority under HERA to purchase securities after the sunset provision date of December 31, 2009; and
(ii) Lacked corporate authority, under applicable Delaware corporate law, to create a preferred stock that provided dividends equal to 100% of the net income of FNMA/FMCC to a preferred stockholder.
In either case, the Net Worth Sweep is invalid and void when entered into, and the effect of invalidation is to convert over $152 billion of excessive (and therefore improper) dividends paid since adoption of the Net Worth Sweep, as per fn. 9 of the Institutional Plaintiffs brief discussed above, into a Treasury payable to FNMA/FMCC.
Sunset Provision and Purchase of Securities
HERA provides at 12 U.S.C. 1794(g) that the authority of the Treasury to purchase obligations is temporary and expires December 31, 2009, provided that Treasury may thereafter sell or dispose of previously acquired securities, and exercise any right acquired in connection with the previous purchase of securities. This is referred to generally as a "sunset provision" and serves as a congressional limitation of statutory authority of Treasury.
There is a well-established doctrine in federal securities law that provides that any fundamental change in the terms of an outstanding issue of securities which substantially changes the rights and obligations of the securityholder or the economic character of the securities constitutes a sale and exchange of such securities, involving an exchange of the old securities and any additional value given, in exchange for the new securities with amended terms and any additional value received. See 2 Louis Loss & Joel Seligman, Securities Regulation 1086 (3d ed. 1989). Under various judicial decisions and SEC no-action letters, this standard has traditionally been met when amendments would significantly alter the "basic financial terms" or the "basic nature" of existing securities.
The Net Worth Sweep (effected in 2012, well after the sunset date) undoubtedly met this standard by effecting a fundamental change in the terms of Treasury's outstanding senior preferred stock. The Institutional Plaintiffs brief presents the following table to illustrate the point:
Pre-Net Worth Sweep
Post-Net Worth Sweep
10% cash dividend
Cash dividend equal to the Companies' net worth
Companies may elect to pay dividend in kind forever
No in-kind option; the Companies can only pay in cash
Annual cash dividend before the Net Worth Sweep = $18.9 billion
2013 cash dividend = $130 billion
Companies can retain capital to withstand periodic downturns
Companies cannot retain capital
Treasury's liquidation preference could be repaid, allowing payments to other shareholders
Payments under Net Worth Sweep not credited to payment of Treasury's liquidation preference, precluding payments to other shareholders
There is also substantial authority under federal tax law that a fundamental change such as had occurred in the Net Worth Sweep constitutes a sale and exchange for federal tax purposes, which gives rise to the authority of Treasury through the IRS to tax the transaction. See Treasury Regulation 26 C.F.R. § 1.1001-3.
Why are provisions of federal securities and tax law applicable to a determination whether the Net Worth Sweep constitutes a purchase under HERA? Importantly, the Senior Preferred Stock Purchase Agreement (SPA), which the Net Worth Sweep amended, provides that federal law shall apply to govern, and be applied to construe the provisions of, the SPA. The SPA provides:
This Agreement and the Warrant shall be governed by, and construed in accordance with, the federal law of the United States of America if and to the extent such federal law is applicable, and otherwise in accordance with the laws of the State of New York.
Therefore, where an amendment is made to the SPA, and a question arises under HERA, a federal statute, as to whether that amendment constitutes a prohibited purchase of securities, and the SPA provides that it shall be construed in accordance with federal law, it is clear that the parties, FHFA and Treasury, themselves have sought to have the provisions of federal securities and tax law apply to the Net Worth Sweep.
For some reason, the Institutional Plaintiffs brief did not point out that the governing law provision of the SPA requires federal law to be applied to construe the provisions of the SPA. This governing law provision makes clear that federal securities and tax law should be applied to characterize the Net Worth Sweep as a securities purchase. As characterized as a securities purchase under federal law made applicable by the SPA to construe its provisions, it is a simple step to find that, under HERA, Treasury was without statutory authority to consummate this purchase since it occurred after the sunset date of December 31, 2009.
I would hope that the Institutional Plaintiffs make this point with respect to the governing law of the SPA in subsequent briefing.
In addition, the Institutional Plaintiffs argue that Treasury was not exercising a right acquired in connection with a security (such as if it had exercised its warrants), as permitted after December 31, 2009, insofar as an amendment to an agreement that requires mutual consent does not involve the exercise of a right. A right is a power that may be invoked by the right holder alone, without the necessary consent of the counterparty. Here, Treasury could not amend the SPA as of right, but only with the consent of FHFA.
This argument regarding Treasury's lack of statutory authority to enter into the Net Worth Sweep was made before Judge Lamberth at the District Court, and his treatment of this argument was both inadequate and absurd.
Quite remarkably, in construing the applicability of the sunset provision to "purchases" of security under HERA under Section III(3) of his opinion, at pps 17-19, Judge Lamberth refers to no cases, precedents or statutory language or legislative history in his analysis. Borrowing a phrase from Justice Frankfurter, Judge Lamberth's analysis is "drawn like nitrogen from the air."
Judge Lamberth initially disputed the importance of the sunset provision, stating that:
[plaintiffs] contention overreads the provision governing the application of the statutory expiration date to purchased securities. While § 1719(g)(2)(D) notes that holding securities, exercising any rights under the securities contract, or selling securities are specifically exempt from the sunset provision, the existence of that provision does not therefore preclude other non-security- purchasing activities otherwise permitted under an already agreed-upon, pre-2010 investment contract with the GSEs. To then say that the purchase authority sunset provision also categorically prohibits any provision within Treasury's contracts with the GSEs that requires "mutual assent" is to reach too far.
Judge Lamberth doesn't explain why this argument "reach[es] too far." So, Judge Lamberth assumes without analysis the answer to the question under consideration, that is whether a fundamental change in the terms of Treasury's senior preferred stock accomplished through an amendment requiring mutual consent constitutes a "purchase" of securities for purposes of HERA.
Judge Lamberth goes on to point out that the Net Worth Sweep neither increased the Treasury preference amount or involved an investment of new money by Treasury. But if this is the sina qua non of a securities purchase for purposes of HERA, Judge Lamberth provides no reasoning as to why this should be the case. Judge Lamberth simply decides, without reference to precedent, that:
Notwithstanding plaintiffs' contentions regarding the "fundamental change doctrine," Treasury's own tax regulations, or otherwise, the present fact pattern strikes the Court as straightforward, at least in the context of the applicability of § 1719(g)'s sunset provision. Without providing an additional funding commitment or receiving new securities from the GSEs as consideration for its Third Amendment to the already existing PSPAs, Treasury cannot be said to have purchased new securities under § 1719(g)(1).
The proposition that it is "straightforward" for FHFA (as a conservator with a fiduciary duty to FNMA and FMCC) and Treasury to agree to change the provisions of a preferred stock to provide Treasury over $150 billion of additional "dividends" boggles even the uncritical mind.
Why it "reach[es] too far" to conclude that Treasury's preferred stock are different securities, pre and post the Net Worth Sweep amendment, such that the former must necessarily have been exchanged for the latter, without careful judicial explanation disrespects the rule of law and makes a mockery of judicial review.
I expect the DC Circuit Court of Appeals to reverse Judge Lamberth's holding that the Net Worth Sweep did not constitute a purchase of securities after the sunset date under HERA, and since there are no facts in dispute that would require discovery or determination at trial, I also expect that the appeals court will enter judgment in favor of the Appellants and vacate the Net Worth Sweep.
Relational Nature of Preferred Stock Violated under Delaware Corporate Law
Delaware corporate law is the "rule of decision" with respect to the validity of Treasury's senior preferred stock, as amended by the Net Worth Sweep.
This is the surprising beginning to the brief written by Myron Steele, Esq. the former Chief Justice of the Delaware Supreme Court and now private practitioner representing amicus curiae Center for Individual Freedom. Surprising insofar as this argument was not advanced at the District Court, and further surprising as this argument has great potential to decide the case in Appellants' favor.
The phrase, rule of decision, is familiar to lawyers who work in the federal courts where federal and state law often interplay, and it serves to point out that, generally speaking, while federal procedural law governs in federal court, state substantive law often must be applied in diversity jurisdiction cases. This is Ex-Chief Justice Steele's way of saying, in effect, let's take a timeout from considering the difficult interpretative questions arising under HERA (federal law), and pause to consider the importance of the heretofore overlooked state law (Delaware).
In the context of this appeal, Ex-Chief Justice Steele's brief asserts that there is a second independent base for the Net Worth Sweep to be invalidated, as a matter of law. Federal law and the lack of authority of FHFA and Treasury under HERA to implement the Net Worth Sweep is the basis that has attracted all of the attention and focus of litigants and the District Court below. However, Ex-Chief Justice Steele reminds everyone in the opening sentence of his brief that Delaware corporate law applies as well, since HERA has done nothing to preempt state law with respect to corporate law governance.
Spoiler alert--Expect the government briefs to contest this and argue that there is implicit preemption of state law under HERA. In addition, expect the government to argue that the DC Circuit Court of Appeals has no jurisdiction to rule on matters of DGCL, since the jurisdiction in the case before it is premised upon a federal question under HERA. As to this, the Appellants have clear precedent that federal courts apply "pendant jurisdiction" to decide state law claims in connection with the determination of federal law claims when both claims are presented and closely related.
So, notwithstanding all of the necessary analysis under federal law as to whether FHFA and Treasury acted with requisite authority under HERA, and whether FHFA fulfilled its duties as conservator under HERA, a separate, additional and fundamental analysis of the Net Worth Sweep must be made under principles of Delaware corporate law to determine whether the provisions of the Net Worth Sweep are enforceable as a state corporate law matter.
In a game-changing brief that is both authoritative and persuasive, former Chief Justice Steele points out that under Section 151 of the Delaware General Corporation Law (DGCL), preferred stock must bear a relational preference to common stock with respect to dividends. Preferred stock dividends must be payable at a rate such that they do not exhaust all of the issuer's net worth, so that there must be dividends at least theoretically payable on the common stock, such that preferred stock dividends may bear a preferential relationship to the dividends payable on the common stock. There is no preferential relationship when the preferred stock takes all funds legally available for dividend and leaves none for the common stock.
Because the Net Worth Sweep requires that all dividends payable by FNMA/FMCC must be paid on the preferred stock, the Net Worth Sweep dividends are not payable at a rate that bears a relational priority to dividends payable on the common stock. Ex-Chief Justice Steele therefore concludes:
The "Net Worth Sweep" is unenforceable and void ab initio under Section 151 of the DGCL. Preferred stock of a Delaware corporation cannot be given a cumulative dividend right equal to all the net worth of the corporation in perpetuity. The Net Worth Sweep is a flatly illegal term for any preferred stock instrument, whether or not held by the federal government.
Since FMCC is governed by Virginia corporate law and Virginia can be expected to look to Delaware for guidance, Ex-Chief Justice Steele's argument regarding the invalidity of FNMA's Net Worth Sweep applies with equal force to FMCC.
As to why the Net Worth Sweep preferred stock dividends are not payable at a rate, as required by Section 151 of the DGCL, Ex-Chief Justice Steele states:
First, the Net Worth Sweep is not paid at a "rate" because Treasury's participation in the Companies' earnings growth is unlimited, absolute, and perpetual. The essential difference between dividends on common stock and dividends on preferred stock is the debt-like rate of return on the preferred stock investment. While preferred stockholders have priority over common stockholders in the receipt of dividends, such dividends are necessarily limited as a preference and do not appreciate in an absolute and unlimited manner with the growth of the corporation.
Essentially, the argument is that there is a trade off embedded in Section 151 of the DGCL, which is that in exchange for priority of payment of preferred stock dividends in relation to common stock dividends, the preferred dividend rate must be such that it doesn't exhaust the possibility of common stock dividends, for if it does, then there can be no common stock dividends to which the preferred stock dividends may bear a relational priority.
Preferred stock dividends cannot be both total and bear a relational priority to nothing else that is payable on the common stock: This is a category mistake not countenanced by the DGCL.
Ex-Chief Justice Steele concludes by stating:
Section 151(c) permits corporations to establish a dividend "preference" that operates as a priority, and/or to afford a dividend participation right to preferred stock "in relation to" the dividend paid on common stock, but it does not permit corporations to establish dividend provisions that operate as a singularity-without regard for or relation to the interests of other classes or series of stock and forever precluding all other stockholders from the potential to receive dividend.
Ex-Chief Justice Steele's analysis is short on precedent citation because this is a case of first impression under the DGCL. There are no judicial precedents involving a Delaware corporation that issued preferred stock that provided for all dividends that might be payable by the issuer to be paid on the preferred stock, leaving nothing for the common stock. One might be thankful that there have been no private parties in the past that have had the audacity of FHFA and Treasury to cause an issuer to issue such a preferred stock that operates as a singularity.
I expect FHFA and Treasury to have their counterarguments, but the lack of judicial precedent (both validating and invalidating similar preferred stock) leads me to believe a court will have to perform a contextual and structural analysis of the DGCL provisions relating to classes of stock and dividends to determine whether such a preferred stock that operates as a singularity is enforceable.
I also expect that the federal DC Circuit Court of Appeals may take pause before deciding a case of first impression regarding a fundamental but highly nuanced provision of Delaware corporate law (especially with over $150 billion at stake), and it may ask the Delaware Supreme Court to render an advisory opinion to it. If that occurs and the Delaware Supreme Court asks for oral argument, then the Appellants will have standing before the Delaware Supreme Court presenting their case the man who a few years ago was sitting in the middle of the bench where the Delaware Supreme Court justices now sit.
If the Appellants win on the unenforceability of the Net Worth Sweep, Judge Lamberth's decision will be reversed and judgment invalidating the Net Worth Sweep will be entered in favor of Appellants, and remanded back to Judge Lamberth to implement such remedies as would also be required by invalidation under the unauthorized securities purchase argument above. As Ex-Chief Justice Steele's brief makes clear, there are no equitable remedies available to cure a void corporate issuance.
Disclosure: I am/we are long FNMA.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
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