GSE Shareholder Claims To Go To Trial This Month (FMCKJ)

Fannie Mae (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC) are two companies that the government took over in 2008 by placing them into conservatorship and then took all of their future money for no additional consideration in 2012. In 2019, the companies were allowed to keep their money, but the government still continues to lay claim to that money they keep. Legally speaking, the Supreme Court ruled that the law allows the government to do all of this and this basically zeroes out shareholder interests in two of the most profitable companies in America and there are a handful of pending lawsuits still fighting for shareholder rights. The purpose of this article is to highlight some shareholder friendly perspectives in Lamberth’s most recent opinion.

Investment Thesis

According to the recently released legal opinion, a trial is set for October of this year. Moving forward to trial is the:

dispute of material fact as to whether the Third Amendment and its elimination of possible future dividends harmed plaintiffs by depriving them of much of the value of their shares.

The idea being that at the time of the net worth sweep, shareholder plaintiffs could not have reasonably expected the government to extinguish any possibility of them receiving any dividends ever in the future for no additional consideration, which is what the net worth sweep did. These claims are moving forward to trial. The basic idea is that shareholders are going to have to prove that their shares were going to have value absent the net worth sweep and that the government took that value because it saw that it was coming. I recommend owning preferred shares. I think these legal claims are worth $20-60B. Preferred shares have $34B of liquidation preference and if the common are worth a penny preferred are worth par. Preferred currently trade at 7-15 cents on the dollar and have significant upside on these legal claims alone.

The Lamberth Opinion

Judge Lamberth ruled that the Third Amendment eliminated any future possibility of dividends for shareholders:

The Third Amendment thus eliminated the circular-draw problem, but it also eliminated any future possibility for any non-Treasury stockholder, including plaintiffs, to receive dividends from the GSEs, because the GSEs owed their net worth to Treasury and would not take on further debt to pay dividends to other shareholders.

Judge Lamberth rules that these damage claims are going to go forward to trial in ruling against the government’s motion for summary judgment:

There is no reason to preclude plaintiffs from relying on the lost-value theory in the alternative to defeat total summary judgment. The Court therefore concludes that defendants are not entitled to summary judgment in full on the question of damages, there being a lingering dispute of material fact as to whether the Third Amendment and its elimination of possible future dividends harmed plaintiffs by depriving them of much of the value of their shares. Since defendants do not specifically dispute that plaintiffs can prove the amount of damages resulting from that alleged harm, the Court has no occasion to consider that separate question at this time.

These claims are moving forward to trial. Plaintiffs’ interests were effectively zeroed out by the net worth sweep whereas before the net worth sweep was implemented the junior preferred reasonably could have expected dividends to resume upon the companies eventually being able to exit conservatorship.

In Interpreting The Supreme Court Ruling

Previously Judge Lamberth ruled:

The Court finds nothing in the Plaintiffs’ stock certificates suggesting they could have reasonably expected the Net Worth Sweep.

Judge Lamberth did not change his mind here based on the Supreme Court ruling and points out that the government’s arguments misunderstand the context of reasonableness:

In other words, Collins does not resolve the issue here, because although reasonableness factors into both analyses, it is reasonableness with respect to different matters. At issue in Collins was whether FHFA could reasonably have determined that adopting the Third Amendment was “in the best interests of the regulated entity or the Agency,” and thus acted within its statutory authority as conservator of the GSEs in so doing. Here, in contrast, the issue is whether FHFA “violated the reasonable expectations of the parties” by adopting the Third Amendment.

Lamberth is arguing that FHFA in the spirit of doing whatever it wants can enact the net worth sweep, but not without consequence. In this lawsuit that is going to trial this month, Lamberth is arguing that the net worth sweep violated the reasonable expectations of the parties. These claims are what are moving forward for a jury to decide on the facts.

Summary and Conclusion

Shareholders have won in so far as having a path towards proving harm that is heading to trial. Evidence produced by discovery supports the narrative that the reasoning behind the net worth sweep was really about seizing the profits and preventing the companies from exiting conservatorship instead of saving the then profitable companies from a death spiral.

Left to do, GSE shareholder plaintiffs will have to convince a jury that the government knew Fannie and Freddie were going to be able to retain enough earnings such that their shares would have had value under the pre-NWS capital structure. I think that the history speaks for itself. Should shareholders win, they could win par plus damages, which is why my estimates for the value of this trial is $20-60B whereas par value is $34B. This may leave some residual value for common shareholders, but I expect the bulk of the win here would accrue to junior preferred shareholders.