Fanniegate, The Sequel, Gets Two Thumbs Down

Shareholders of Fannie Mae and Freddie Mac have not seen much success lately in their lawsuits against the federal government that are related to the controversial net worth sweep. Two cases were dismissed recently, but still, plaintiffs are appealing and also proceeding with other lawsuits.

In August, the U.S. District Court for the eastern District of Virginia dismissed Timothy J. Pagliara v. Federal Home Loan Mortgage Corp. Pagliara is the founder of Investors Unite, a coalition that was formed to encourage shareholders of the government-sponsored enterprises (GSEs) Freddie Mac and Fannie Mae to advocate for their rights as investors and that seeks “to educate and mobilize in an effort to regain our investments in the GSEs that are currently being illegally confiscated by the Federal Treasury,” according to the coalition’s website. He is also chairman, founder and president of CapWealth Advisors, in Franklin, Tenn.

Pagliara brought the lawsuit as an individual, not as Investors Unite or CapWealth, against Freddie Mac, seeking to inspect its corporate records. He owns 360,000 shares of junior preferred stock, which he bought in 2009. Freddie Mac was created by a federal charter in 1970 and incorporated in Virginia. Freddie Mac’s bylaws, and the Virginia Stock Corporation Act, give stockholders the right to inspect certain records.

In 2008, as a result of the financial crisis, Freddie Mac and Fannie Mae were placed into conservatorship by the Federal Housing Finance Agency (FHFA). One of the results of this change was that the U.S. Treasury entered into a stock purchase agreement with the two GSEs. The Third Amendment of this agreement contained the “net worth sweep” provision, which was imposed in 2012 and entitled the Treasury to a quarterly dividend, which amounted to the entire net worth of Fannie Mae and Freddie Mac. Freddie Mac did not pay any dividends to preferred junior shareholders such as Pagliara, which, he contends, violates the (U.S. Constitution’s) Fifth Amendment “takings” clause.

In January, Pagliara sent a demand letter to Freddie Mac’s board of directors, seeking to enforce his right as a shareholder to inspect Freddie Mac’s books and records. Pagliara sought to examine the records specifically so he could investigate potential claims arising from the net worth sweep and other conduct by the FHFA, the U.S. Treasury and the GSE’s board.

According to the 32-page decision from the court, Pagliara “does not have the right he seeks to enforce.” The court even cited Perry Capital LLC v. Lew, which also considered a Fifth Amendment challenge and was dismissed. (In that case, which is being appealed, there were oral arguments in April, and they are awaiting a decision.) “Pagliara’s brief argument fails to address how the Fifth Amendment claim he envisions would avoid the same fate,” the court wrote, and it called his argument “unsubstantiated constitutional concerns.”

Pagliara says he was not surprised by the decision. “It clarifies at least at this level in that court that there are no corporate governance rights of shareholders,” he said. “It’s kind of odd that they have a board – but if they have absolute power, why do they even go through the motions?”

He adds that he will file a notice of appeal. He also had filed a case in Delaware, as Fannie Mae is a Delaware corporation.

Pagliara, who is also a lawyer in Tennessee, notes that the larger issue is the ability of the U.S. government to do some version of a net worth sweep to other banks or other institutions. “It’s a landmark case in determining property rights in times of financial stress,” he said. “There is now a tremendous body of evidence that Fannie and Freddie didn’t need to be in conservatorship in the first place.”

The important principles, he says, are what the Housing and Economic Recovery Act (HERA) provided for and what “conservatorship” means. “What’s going to happen next time we have a financial crisis and we have to rehabilitate a financial institution?” he asked.

A similar case in Kentucky was dismissed earlier this month. In that case, Arnetia Joyce Robinson v. the Federal Housing Finance Agency, the plaintiff was an individual investor who claimed that her investment in Freddie Mac and Fannie Mae was damaged when the GSEs entered the net worth sweep. The FHFA violated HERA in several ways, according to the complaint. First, the FHFA failed to act as a conservator, but “indeed, it has acted as an anti-conservator – because conservators are not allowed to use the companies under their care as ATM machines.” The other ways the net worth sweep damaged the GSEs included not putting Fannie and Freddie in a sound and solvent condition, as required; not conserving and preserving Fannie’s and Freddie’s assets but dissipating them on a quarterly basis; and not rehabilitating Fannie and Freddie and returning them to private control.

The U.S. District Court for the Eastern District of Kentucky dismissed that suit on Sept. 9. Chief District Judge Karen Caldwell granted the defendant’s motion to dismiss and wrote that the FHFA was granted the authority to wind down the GSEs as conservators and also that the FHFA may, as conservator, take action to put the regulated entities in a sound and solvent condition but that it was not required to do so.

The government’s lack of transparency is a major issue, says Saikrishna Bangalore Prakash, who is James Monroe Distinguished Professor of Law at the University of Virginia School of Law. He wrote a white paper, The Government’s Seizure of Private Property Behind a Veil of Secrecy, for Investors Unite, and he also speaks and writes about executive powers.

“One of the roadblocks to these suits is executive privilege, or, ‘We don’t have to turn over documents to you because they reflect confidential information and confidential advice to the White House,’” he said. “The second roadblock is secrecy.”

He adds that the dismissal of Pagliara’s case is not a predictor of the outcome of the other cases. “This was the opinion of one judge in Virginia,” he said, and different jurisdictions and different judges might have different opinions. “We are still waiting to hear what’s going to happen.”

Nora Caley is a Denver-based freelance writer.