Delaware Corporate Law Once Again Invoked In Fannie Mae And Freddie Mac Litigation

Includes: FMCC, FNMA
by: Rule of Law Guy

SA readers following GSE litigation are aware that with the Hindes/Jacobs case, Delaware corporate law has been invoked to supplement the federal law-based Perry and Fairholme litigation.

Now a second Delaware law case, Pagliara, has been filed that seeks to invalidate net worth sweep (NWS) dividends under another provision of Delaware corporate law.

It may turn out that FHFA/Treasury's achilles heel is their federal hubris, in promulgating the NWS without appreciating its state law consequences.

In a Pi Day complaint filed with the Delaware Chancery Court, Timothy Pagliara has sued FHFA under Delaware General Corporation Law (DGCL) Section 220, seeking to inspect the books and records of Fannie Mae (OTCQB:FNMA), after his shareholder demand made to FNMA's board of directors to review such records had been ignored.

The purpose of this demand is spelled out in complaint, and it can be gleaned from the demand letter that preceded the complaint. The NWS dividends distributed to Treasury are subject to invalidation, and the FNMA directors are subject to personal liability, in the event the NWS dividends were distributed in violation of DGCL Section 170, which prohibits dividend distributions made when there is insufficient capital.

To put this Pagliara case in context, SA readers following the GSE litigation are aware that Perry has challenged the net worth sweep (NWS) dividends in DC Federal District Court on federal law grounds, claiming that FHFA as conservator exceeded its statutory duty under its organic statute, HERA, in connection with the NWS. Fairholme has challenged the NWS in the Federal Court of Claims in DC on federal law grounds, claiming that if the NWS is not a violation of federal statute, then it constitutes a violation of the Takings Clause of the 5th Amendment to the US Constitution.

The Hindes/Jacobs case switched legal gears by claiming the NWS was void under state law, DGCL Section 151, insofar as the NWS dividend provisions violated Delaware law relating to the permissible terms of preferred stock issued by Delaware corporations, such as FNMA.

The Pagliara case can be understood as progeny of Hindes/Jacobs, insofar as Pagliara alleges in his complaint that:

"197. The Board violated Section 170 of the DGCL in voluntarily declaring and paying the dividends under the Net Worth Sweep.

198. Based on the information available, Fannie Mae's capital in respect of its issued shares of preferred stock was impaired as of each of the dates for which dividends were paid under the Net Worth Sweep. The capital was impaired because Fannie Mae's net assets, which ranged between approximately $3.6 billion and approximately $62.4 billion, as of each of the relevant dates, fell short of the apparent capital in respect of the Senior and Junior Preferred Stock, which by default is the amount of cash consideration paid for the stock, an amount exceeding $129 billion, based on public records."

One reason for the suit for production of FNMA's books and records is to determine whether the board of directors recorded the proceeds from the issuance of its preferred stock as anything other than the default treatment of paid-in capital equal to the cash proceeds received from their issuance. If it is determined from FNMA's books and records that it did not elect an alternative treatment, then Pagliara will promptly follow up with a new complaint, or an amended complaint, alleging the DGCL Section 170 dividend impairment violation.

One other reason to inspect the books and records is to determine whether at the time of each NWS dividend distribution, the board reevaluated the net assets of the issuer to increase the value of the surplus available for dividends. If the board did not make this reevaluation analysis, then this will further support Pagliara's DGCL Section 170 dividend impairment claim.

So, as Hindes/Jacobs seeks to void the NWS stock itself as a violation of the type of preferred stock that can be issued by Delaware corporations such as FNMA, Pagliara seeks to void the NWS dividends made in respect of the stock as a violation of the capital impairment provisions that must be observed by Delaware corporations. When Hindes/Jacobs and Pagliara are taken together, you have a "tree root and fruit" attack on the NWS under the DGCL, seeking dual paths under Delaware law to invalidate both the NWS stock itself, as well as dividends issued in connection with the stock.

Both cases derive support from the recent Aurora Loans case, the 9th Circuit Court of Appeals decision, which made clear that corporations under FHFA conservatorship remain private corporations, and FHFA's conservator powers are those powers it inherits from the corporation's board of directors under state law (unless additional conservatorship powers are specifically set forth in the conservatorship statute).

So, when FHFA as conservator caused FNMA and Freddie Mac (OTCQB:FMCC) to issue preferred stock, and the board of directors caused dividends to be declared on that stock, they needed to take into account applicable Delaware corporate law. When FHFA and the board fail to do so, they can find no succor in the federal conservatorship statute which, as the court in Aurora Loans held, places FHFA in the shoes of FNMA and FMCC boards of directors with respect to corporate powers, and affords the boards of directors no greater powers than they had pre-conservatorship.

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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