FNMA and FMCC junior preferred and common shareholders are aware that when FHFA and the US Treasury entered into the 3rd Amendment to the Senior Preferred Stock Purchase Agreement (SPSPA) in 2012, FHFA, as conservator for FNMA and FMCC, agreed to replace the dividend rate on the Treasury senior preferred stock from 10%, if paid in cash, or 12%, if paid in kind, to a dividend that swept to the Treasury all of the net worth of FNMA and FMCC then existing at the time of the dividend (subject to a de minimus retention amount that declines to zero in 2018) (NWS).
The NWS had the effect of i) nationalizing FNMA and FMCC, by diverting all future profits to Treasury and away from existing private shareholders, and ii) denuding FNMA and FMCC of any capital cushion, notwithstanding that they are massive financial institutions with trillions of dollars of debt securities outstanding.
FHFA and Treasury performed this drastic transaction notwithstanding that FHFA's mandate, under its organizing statute [the Housing and Economic Recovery Act of 2008 (HERA)], is to rehabilitate FNMA and FMCC, and to preserve and conserve their assets (or liquidate them in receivership if they cannot be rehabilitated).
This transaction is in direct opposition to FHFA's duty as conservator to rehabilitate FNMA and FMCC. Moreover, it is absurd to believe that HERA, a statute providing for the alternative programs of either rehabilitation through conservatorship or liquidation through receivership, could be interpreted to authorize FHFA to nationalize private corporations such as FNMA and FMCC without any hint of Congressional intent to that effect. The NWS permitted Treasury to reap approximately $130 billion more in distributions than what would have been distributed to Treasury if the original 10% cash dividend had been paid. (see p. 23 of Perry appeal brief).
To be blunt, however, Treasury's defalcation of two private corporations' capital and profits will only continue unless and until a federal court invalidates the NWS and orders an appropriate remedy. In such an event, assuming the 10% dividend rate on Treasury's senior preferred stock is reinstated and deemed to have been in effect due to the invalidity of the NWS, the approximately $130 billion in excess distributions to Treasury should be recharacterized as return of senior preferred principal, inuring to the benefit of the FNMA and FMCC junior preferred and common stockholders.
The investment implication for FNMA and FMCC junior preferred and common shareholders from litigation seeking to invalidate the NWS is that their investment return resembles a barbell distribution, with either a turbo-charged return or total loss of entire investment riding on the fortune of litigation seeking to invalidate the NWS.
This NWS invalidation litigation comprises, in particular, two prominent federal cases that have been filed on behalf of FNMA and FMCC junior preferred and common shareholders: Perry in the DC Federal District Court, and Hindes/Jacobs in the Delaware Federal District Court (assigned to Judge Sleet). Perry was dismissed for lack of jurisdiction by the DC Federal District Court on September 30, 2014 in an opinion by Judge Lamberth (Lamberth Opinion); Perry is now on appeal at the DC Circuit Court of Appeals.
The Perry and Hindes/Jacobs cases bear many similarities to each other. FHFA in its motion to dismiss (FHFA's Motion to Dismiss) in Hindes/Jacobs relies heavily upon the Lamberth Opinion and its analytic framework in seeking to dismiss Hindes/Jacobs. Since it is reasonable to assume that Judge Sleet in the Hindes/Jacobs case will look to the Lamberth Opinion for guidance because of the similarities of the cases, it is reasonable to ask whether the Perry dismissal implies that Hindes/Jacobs will suffer a similar fate.
In other words, isn't Perry a relevant precedent that indicates that Hindes/Jacobs will be dismissed as well?
As I have discussed in two of my prior SA articles (at The Perry Appeal, Prospects For Reversal And The Possible Effects On Fannie Mae And Freddie Mac Share Prices and The Perry Appeal, Prospects For Reversal And The Possible Effects On Fannie Mae And Freddie Mac Share Prices: Part II), there are strong reasons to believe that the DC Circuit Court of Appeals will reverse the Perry dismissal because of legal errors made in the Lamberth Opinion.
But let's assume that the Lamberth Opinion remains "good law" at the time Judge Sleet rules on FHFA's Motion to Dismiss in Hindes/Jacobs, whether because the DC Circuit Court of Appeals affirms the Perry dismissal or has yet to render its decision.
In my view as I discuss below, even if one assumes that the analytic framework of the Lamberth Opinion is adopted whole cloth by Judge Sleet in Hindes/Jacobs, I believe that Hindes/Jacobs will survive FHFA's Motion to Dismiss, and Judge Sleet will invalidate the NWS under Section 151 of the Delaware General Corporation Law (DGCL).
The Lamberth Opinion, HERA's Anti-Injunction Provision, and Distinguishing Between Power and Duty Claims
This article examines the analytic framework of the Lamberth Opinion, especially with respect to Judge Lamberth's distinction between claims that are, and are not, barred from judicial inquiry by HERA's anti-injunction provision, which provides that:
"no court may take any action to restrain or affect the exercise of powers or functions of FHFA as a conservator".
Analysis of the Lamberth Opinion is crucial in considering the prospects of the Hindes/Jacobs case. FHFA argues in the FHFA Motion to Dismiss that the Lamberth Opinion requires that Hindes/Jacobs be dismissed. However, as discussed below, FHFA misapplies the Lamberth Opinion. In fact, the Lamberth Opinion, properly understood, provides support for the Hindes/Jacobs plaintiffs' core argument.
This article asserts that even if Judge Sleet applies the Lamberth Opinion as precedent in deciding Hindes/Jacobs, the Hindes/Jacobs plaintiffs will prevail because:
- Judge Lamberth distinguishes between FHFA actions that are beyond the scope of FHFA's statutory power (and hence, in Judge Lamberth's view, are not barred from judicial review by HERA's anti-injunction provision), and
- FHFA actions that are within FHFA's statutory power, but where FHFA's exercise of such power is claimed to violate FHFA's statutory duties or the purposes of FHFA's statutory power (and hence, in Judge Lamberth's view, are barred from judicial review by HERA's anti-injunction provision).
In other words, Judge Lamberth establishes a bright line between i) claims that a FHFA power does not exist, and ii) claims that the exercise of a power was improper, with the former not barred, and the latter barred, from judicial scrutiny. I will use the terms "Power Claim" and "Duty Claim" below to distinguish between these two respective claims.
As discussed below, Hindes/Jacobs alleges that the NWS is void under applicable law, the Delaware General Corporation Law (DGCL), because the NWS provides for a preferred dividend that is not permitted by the DGCL. This is a prototypical "Power Claim." The Hindes/Jacobs claim is that the purported FHFA power to cause the issuance of the NWS does not exist under applicable law.
In Perry, the Perry plaintiffs sought to invalidate the NWS by alleging that, among other things:
- the 3rd Amendment constituted a purchase of securities under federal law because there was a fundamental change in the terms of the Treasury senior preferred stock (fundamental change doctrine), and Treasury was barred by a sunset provision under HERA from making purchases of securities after 2009;
- In effect this "securities purchase after 2009" claim alleges that Treasury's claimed power to acquire the NWS did not exist (for purposes of understanding Judge Lamberth's analytic framework, I will call this a Power Claim); and
- FHFA acted arbitrarily and capriciously as conservator by entering into the 3rd Amendment, because the NWS transferred without consideration approximately $130 billion of FNMA and FMCC value to Treasury, even though FHFA's fiduciary duties as conservator and statutory duties under HERA required FHFA to rehabilitate them, and conserve and preserve their assets;
- In effect, this arbitrary and capricious claim, that FHFA failed to preserve and conserve assets and promote the rehabilitation of its FNMA and FMCC in connection with the NWS, alleges that FHFA exercised its statutory power in a manner inconsistent with the statutory purpose of its conservatorship powers, and contravened statutory duties imposed upon FHFA as conservator under HERA (for purposes of understanding Judge Lamberth's analytic framework, I will call this a Duty Claim).
With respect to the merits of the Lamberth Opinion, I believe Judge Lamberth engaged in a highly flawed analysis i) in distinguishing between a Power Claim and a Duty Claim, and ii) in connection with analyzing the merits of the "purchases of securities after 2009" Power Claim.
In essence, I believe that with respect to Judge Lamberth's distinguishing between a Power Claim and Duty Claim, the same statutory power may both exist if exercised in a manner consistent with its statutory purpose, and not exist if exercised in a manner inconsistent with its statutory purpose.
It is a highly artificial distinction to find that a power exists even where it is exercised in a manner that is contrary to the purposes for which Congress created the statutory power. It seems to me that a claimed power does not exist, both in the case where there is simply no statutory authority for the claimed power, but also in the case where the claimed power is exercised in a manner or with a purpose that is invalid under the statute that gives rise to the claimed power.
As to Judge Lamberth's merits analysis with respect to the "purchases of securities after 2009" Power Claim, I believe Judge Lamberth misconstrued the legal effect of the HERA sunset provision on Treasury security purchases, and ignored without any discussion the fundamental change doctrine under federal law that would hold the NWS to constitute the issuance of a new security purchased by Treasury (after all, FHFA and Treasury agreed that the 3rd Amendment should be construed under federal law). I believe this holding will be reversed on appeal.
But the important point to bear in mind is that the Lamberth Opinion does not constitute an adverse precedent for Hindes/Jacobs since the plaintiffs in Hindes/Jacobs are making a Power Claim that FHFA did not have the power to cause the issuance of the NWS preferred stock. This Hindes/Jacobs DGCL Power Claim under the Lamberth Opinion is not foreclosed from judicial scrutiny under the Lamberth Opinion's understanding of the HERA anti-injunction provision.
The Hindes/Jacobs plaintiffs seek to invalidate the NWS by arguing that i) under the DGCL, FHFA had no power to cause FNMA and FMCC to issue preferred stock entitling such preferred stock to all of the dividends that may be declared by the issuer, ii) the DGCL applies to preferred stock issuances by FNMA and FMCC, and iii) therefore, the NWS is void and unenforceable. This Hindes/Jacobs DGCL claim constitutes a prototypical Power Claim claim.
As discussed below, it is noteworthy that the FHFA Motion to Dismiss is almost entirely an attempt at i) invoking the HERA anti-injunction provision to foreclose judicial inquiry into the Power Claim claim presented by the Hindes/Jacobs DGCL claim, and ii) using the Lamberth Opinion as precedent for this result. Because of this, the FHFA Motion to Dismiss will fail.
The Lamberth Opinion and FHFA's Motion to Dismiss in Hindes/Jacobs
FHFA's Motion to Dismiss relies heavily on the Lamberth Opinion for the proposition that HERA's anti-injunction provision forecloses judicial inquiry into whether FHFA had the power to cause the issuance of preferred stock under DGCL having such terms as are incorporated in the NWS.
FHFA's reliance is entirely misplaced. According to the Lamberth Opinion, HERA's anti-injunction provision does not apply to questions as to the existence as opposed to the exercise of a FHFA conservator power, and the Hindes/Jacobs DGCL claim challenges the existence as opposed to exercise of a conservator power.
Let's look more carefully at the FHFA Motion to Dismiss and the relevant text of the Lamberth Opinion.
In FHFA's Motion to Dismiss, FHFA invokes the HERA anti-injunction provision by stating "[t]he Court lacks jurisdiction over Plaintiffs'…claims because "no court may take any action to restrain or affect the exercise of powers or functions of the [FHFA] as a conservator," and the Conservator acted squarely within its statutory powers in executing the Third Amendment." [citations omitted] (FHFA Motion to Dismiss at p. 4)
FHFA does not, however, identify the issuance of preferred stock that entitles only the preferred stockholder to all dividends as a conservator power.
Instead, FHFA argues that FHFA's conservator power to operate the business of FNMA and FMCC forecloses any judicial inquiry into whether FHFA had the power to issue such stock. Under FHFA's view, the issuance of such stock is an exercise of its power to operate FNMA's and FMCC's business:
- The court "must first determine whether the challenged action is within the [Conservator]' s power or function" under HERA. If so, the Conservator "is protected from all court action that would 'restrain or affect' the exercise of those powers or functions"[;] (FHFA Motion to Dismiss p. 12-13) and
- In HERA, Congress gave the Conservator "broad powers to operate Fannie and Freddie" as it sees fit, to "assume complete control" over the Enterprises, and to exercise "exclusive authority over [their] business operations." Of particular relevance here, Congress empowered the Conservator to "operate" the Enterprises, "carry on the business" of the Enterprises, enter into contracts on behalf of the Enterprises, and "transfer or sell any [Enterprise] asset or liability . . . without any approval, assignment, or consent." Moreover, Congress authorized the Conservator to exercise all of these powers in the manner the Conservator "determines is in the best interests of the [Enterprises] or the Agency." [citations omitted] (FHFA Motion to Dismiss at p.13)
- By executing the 3rd Amendment, the "Conservator acted within its broad statutory authority: it exercised its power to "operate the [Enterprises]" and to "conduct all business of the [Enterprises]" in the manner the Conservator "determines is in the [Enterprises' or FHFA's] best interests." [citations omitted] (FHFA Motion to Dismiss at p.13)
- "By executing the Third Amendment, the Conservator agreed to modify the manner in which the Enterprises satisfy their obligations under the PSPAs namely, by waiving the Enterprises' annual fixed dividend and periodic commitment fee obligations in exchange for the payment of a variable dividend based on net worth. That action, implementing the business and operational judgments of the Conservator, fits squarely within the Conservator's plenary powers under HERA." (FHFA Motion to Dismiss at p.13)
This FHFA argument, which is the core of FHFA's Motion to Dismiss, is an attempt to place the Hindes/Jacobs claim that the NWS is void under DGCL squarely within the context of an exercise of conservator power (to operate FNMA and FMCC under conservatorship), rather than a claim that the purported conservator power (to cause the issuance of preferred stock having the terms of the NWS) did not exist.
But let's closely examine the Lamberth Opinion to see if the Hindes/Jacobs DGCL claim is a Duty Claim (akin to the Perry claim of failure to preserve, conserve and rehabilitate), or a Power Claim (akin to the Perry "securities purchase after 2009" claim).
The Lamberth Opinion holds that the DC Circuit Court of Appeals "has established that, if the agency "has acted or proposes to act beyond, or contrary to, its statutorily prescribed constitutionally permitted, powers or functions, then 12 U.S.C. § 4617(f) [HERA anti-injunction provision] shall not apply" (Lamberth Opinion at p. 12-13).
The Lamberth Opinion continues with "this Circuit…implicitly draws a distinction between acting beyond the scope of the constitution or a statute…and acting within the scope of a statute, but doing so arbitrarily and capriciously…This distinction arises directly from the text of § 4617(f) [HERA anti-injunction provision], which prohibits the Court from restraining "the exercise of powers or functions of [FHFA]"-i.e., restraining how FHFA employs its powers or functions-but does not prohibit review based upon the statutory or constitutional origin of the powers or functions themselves." [citations omitted; emphasis in original] (Lamberth Opinion at p. 14-15).
Later in the Lamberth Opinion, Judge Lamberth contrasts between "arguments [that] concern…FHFA's conduct and the purported reasons for FHFA's conduct-the what and the why, so to speak."
Judge Lamberth finds that any judicial inquiry into whether FHFA complied with its duties to preserve and conserve assets and rehabilitate (what I have called a Duty Claim) necessarily involves a why analysis, inquiring into the motivation or purpose of the action, that is prohibited by the HERA anti-injunction provision.
A what analysis, in Judge Lamberth's view, is a direct examination of a Power Claim, i.e. whether a FHFA statutory power existed, without resorting to a purpose inquiry that is foreclosed by the HERA anti-injunction provision. The Lamberth Opinion contains an analysis of a Power Claim, the "securities purchase after 2009" claim, that is an exact analogue to the Hindes/Jacobs DGCL claim.
It is crucial to note that Judge Lamberth does not apply the HERA anti-injunction provision to the Perry "securities purchase after 2009" Power Claim:
"plaintiffs argue that Treasury acted beyond the scope of HERA [a Power Claim] because the Third Amendment constitutes the purchase of new GSE securities after HERA's December 31, 2009 sunset provision and because Treasury violated the APA by acting arbitrarily and capriciously when entering into the net worth sweep [a Duty Claim]. Here, given § 4617(f)'s [HERA anti-injunction provision] bar on non-monetary claims of arbitrary and capricious decisionmaking under the APA, the Court must only consider whether Treasury purchased new securities through the Third Amendment." (emphasis added)(Lamberth Opinion at p.16).
To put it explicitly, the Lamberth Opinion did not apply the HERA anti-injunction provision to the Perry plaintiffs' "purchase securities after 2009" claim, since this claim called into question the basic premise of the provision, namely whether the 3rd Amendment was a securities purchase that FHFA and Treasury did not have the requisite statutory power to consummate.
I fully expect the Hindes/Jacob's plaintiffs' brief in reply to the FHFA Motion to Dismiss to begin along the lines of:
"Contrary to FHFA's assertion in the Motion to Dismiss that the issuance of preferred stock having the NWS's terms is an exercise of FHFA statutory power which is alleged to be insulated from judicial review by the HERA anti-injunction provision, in fact Plaintiffs allege that FHFA had no statutory power to cause the issuance of the NWS and, as such, this Court is not barred from deciding the merits of Plaintiffs' DGCL claim."
Let's now proceed to examine whether the Hindes/Jacobs DGCL claim is a Power Claim that also calls into question whether FHFA had the requisite statutory power to cause FNMA and FMCC to issue preferred stock having the NWS terms.
The Hindes/Jacobs DGCL Claim
DGCL Section 151(c) provides:
(c)The holders of preferred or special stock of any class or of any series thereof shall be entitled to receive dividends at such rates, on such conditions and at such times as shall be stated in the certificate of incorporation or in the resolution or resolutions providing for the issue of such stock adopted by the board of directors as hereinabove provided, payable in preference to, or in such relation to, the dividends payable on any other class or classes or of any other series of stock, and cumulative or noncumulative as shall be so stated and expressed. When dividends upon the preferred and special stocks, if any, to the extent of the preference to which such stocks are entitled, shall have been paid or declared and set apart for payment, a dividend on the remaining class or classes or series of stock may then be paid out of the remaining assets of the corporation available for dividends as elsewhere in this chapter provided. (emphasis added)
Hindes/Jacobs plaintiffs argue that Section 151(c) requires that preferred stock dividends must be payable in preference or in…relation to dividends payable on other stock of the issuer.
However, the terms of the NWS prohibits dividends payable on FNMA and FMCC junior preferred and common stock by virtue of the method for computing the dividends payable on the NWS. Since the NWS captures all "surplus" for payment of dividends on the NWS, there can be no dividends payable on the junior preferred and common stock to which the NWS dividends must be in preference or in relation to.
In effect, under DGCL Section 151(c), it is a "category mistake" to provide for a preferred stock that is entitled to all dividends payable by the issuer, which is precisely what the NWS requires. The Hindes/Jacobs complaint states:
"The Net Worth Sweep is not payable "in preference to" or "in relation to" the dividends payable to other classes or series of stock because it is payable to the absolute, permanent exclusion of dividends to other stockholders. Once the Net Worth Sweep is paid each quarter, there necessarily will be no assets remaining in the Company that would ever be available for the payment of dividends on any other classes or series of stock regardless of how valuable the Company becomes in the future. Accordingly, the Net Worth Sweep is invalid under Section 15l(c) of the DGCL and is void ab initio and unenforceable." (Paragraph 95).
Remarkably, the FHFA Motion to Dismiss does not counter this "in preference or relation to" argument, but simply proceeds on the basis that it is not a necessary requirement to be met in connection with the setting of the terms of any preferred stock. According to FHFA, "Section 151(c) of the DGCL simply states that, if a preferred stock provides for dividends, then the holders of that stock "shall be entitled to receive dividends at such rates . . . as shall be stated in" the corporate documents authorizing the issuance of the stock, such as the certificates of incorporation or applicable board resolutions."
It is as if the "in preference or relation to" language has no operative effect.
It should be apparent that this DGCL "in preference or relation to" requirement is not, for purposes of the Lamberth Opinion Power/Duty Claim dichotomy, a why analysis; it does not entail an inquiry into purpose or motive that affects the exercise of a conservator power. Rather, it entails a what analysis, or an inquiry into whether there exits as a FHFA conservator power the corporate power to issue preferred stock having terms as set forth in the NWS.
This is the same corporate power analysis (analyzed under HERA as opposed to the DGCL) that Judge Lamberth undertook with respect to the Perry "securities purchase after 2009" claim, and which Judge Lamberth made clear was not barred from judicial inquiry under HERA's anti-injunction provision.
Without making a cogent reply to the "in preference or relation to" argument, FHFA relies in the FHFA Motion to Dismiss upon an argument that the DGCL does not apply as a rule of decision with respect to the validity of the NWS or, if it does, it is preempted by federal law and the provisions of the NWS certificate. As discussed below, FHFA's argument is not persuasive.
Applicability of the DGCL
FHFA argues that federal law and the NWS dividend provisions that FHFA and Treasury inserted into the NWS stock certificate govern the validity of the NWS instead of the DGCL. This argument is both wrong and audacious.
It is audacious because FHFA argues that it has the power to override any conflicting provision of the DGCL simply by inserting the overriding provision in the NWS stock certificate, and provide that this certificate provision overrides DGCL, as applicable law. FHFA sets forth the relevant language of the NWS stock certificate:
"This Certificate and the respective rights and obligations of the Company and the holders of the Senior Preferred Stock with respect to such Senior Preferred Stock shall be construed in accordance with and governed by the laws of the United States, provided that the law of the [State of Delaware (Fannie) [Commonwealth of Virginia (Freddie)] shall serve as the federal rule of decision in all instances except where such law is inconsistent with the Company's enabling legislation, its public purposes or any provision of this Certificate." (FHFA Motion to Dismiss, p.26)(emphasis in original).
Let's focus on this language: "except where such law is inconsistent with the Company's enabling legislation, its public purposes or any provision of this Certificate." FHFA clearly believes that it can simply insert any terms relating to preferred dividends into the stock certificate and, because such terms have become a provision of this Certificate, such terms must be given legal effect.
What is the legal basis for this audacious claim that by merely inserting a provision in the stock certificate, that provision overrides DGCL? FHFA has no legal basis for enforcing this audacious claim.
This is a claim of kings and queens, not of men and women governed by laws.
FNMA's and FMCC's bylaws provide that the DGCL and Virginia corporate law (which looks to Delaware law), respectively, govern their corporate affairs. After passage of HERA, the bylaws were amended, but not by any provision that empowered FHFA to insert any provision in a stock certificate, and have that provision enforced contrary to the DGCL (in the case of FNMA and as followed by Virginia Law in the case of FMCC), as FHFA argues in its motion to dismiss.
FNMA's bylaws provide at Section 1.05: "Corporate Governance Practices and Procedures. Pursuant to Section 1710.10(b) of the Office of Federal Housing Enterprise Oversight ("OFHEO") corporate governance regulation, 12 CFR 1710.1 et seq., to the extent not inconsistent with the Charter Act and other Federal law, rules, and regulations, the corporation has elected to follow the applicable corporate governance practices and procedures of the Delaware General Corporation Law, as the same may be amended from time to time."
FHFA did not cause FNMA to amend its by laws to provide that DGCL Section 151(c) shall no longer apply. Furthermore, there is no federal law, rules or regulation that is inconsistent with DGCL Section 151(c) simply because there is no federal corporate law that relates to preferred stock issuances that can be inconsistent with the DGCL. There is nothing in HERA that purports to create a power for FHFA to issue preferred stock having terms that conflict with the DGCL. All FHFA did was insert a provision into the NWS stock certificate that conflicts with DGCL Section 151(c) and assert, magisterially, that by the mere fact of the provision's inclusion in the NWS stock certificate, that provision overrides DGCL Section 151(c).
Now, if HERA had authorized FHFA to issue preferred stock that had provisions inconsistent with the DGCL, then the FHFA Motion to Dismiss might be valid. Also, if FHFA had amended the FNMA and FMCC bylaws to eliminate DGCL Section 151 as an operative provision relating to their corporate governance before the issuance of the NWS, then the FHFA Motion to Dismiss might be valid.
But neither of these occurred.
So, DGCL Section 151 applies as a rule of decision to the validity of the NWS, judicial inquiry into this application is not foreclosed by HERA's anti-injunction provision, even under the Lamberth Opinion's analytic framework, and the terms of the NWS are void under DGCL Section 151.
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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