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Fairholme Funds, Inc. v. Federal Housing Finance Agency

United States District Court, District of Columbia

September 28, 2018

FAIRHOLME FUNDS, INC., et al., Plaintiffs,
FEDERAL NATIONAL MORTGAGE ASSOCATION In re Fannie Mae/Freddie Mac Senior Preferred Stock Purchase Agreement Class Action Litigations This Memorandum Opinion relates to ALL S * Miscellaneous



         Before the Court is a motion to dismiss filed by the defendants Federal Housing Finance Agency ("FHFA"), as Conservator for the Federal National Mortgage Association ("Fannie Mae") and the Federal Home Loan Mortgage Corporation ("Freddie Mac," and together with Fannie Mae, the "GSEs, "); Melvin L. Watt, in his official capacity as Director of FHFA; and the GSEs (collectively, "Defendants"). The motion applies to all three of the above-captioned cases [ECF No. 68 for Civil No. 13-1053; ECF No. 77 for Civil No. 13-1439; ECF No. 66 for Miscellaneous No. 13-1288]. Upon consideration, Defendants' motion is GRANTED IN PART and DENIED IN PART. Additionally, because the Court considered the various plaintiffs' sur-replies in coming to this decision, the motions for leave to file sur-reply [ECF No. 79 for Civil No. 13-1053, ECF No.' 87 for Civil No. 13-1439, and ECF No. 78 for Miscellaneous No. 13-1288] will be GRANTED.

         I. BACKGROUND[1]

         This matter is brought before the Court by a class action law suit and two individual lawsuits. Following this Court's prior opinion, see generally Perry Capital LLC v. Lew, 70 F.Supp.3d 208 (D.D.C. 2014) ("'Perry F), and the D.C. Circuit's opinion, see generally Perry Capital LLC v. Mnuchin, 864 F.3d 591 (D.C. Cir. 2017) ("Perry IF), these lawsuits contain substantially identical claims.[2] The class action law suit was brought by a purported class of private individual and institutional investors (the "Class Plaintiffs") who own either preferred or common stock in the Fannie Mae or Freddie Mac. Second Am. Consolidated Class Action Compl. at ¶¶ 18-33, In re Fannie Mae/Freddie Mac Senior Preferred Stock Purchase Agreement Class Action Litigs., Misc. No. 13-1288 (D.D.C. Feb. 1, 2018), ECF No. 71 ("Class SAC"). The individual lawsuits were brought by separate institutional investors owning junior preferred stock in the GSEs. First Am. Compl. at ¶¶ 5-20, Fairholme Funds, Inc. v. FHFA, Civ. No. 13-1053 (D.D.C. Feb. 1, 2018), ECF No. 75 ("Fairholme FAC"); First Am. Compl. at ¶¶ 6-18, Arrowood Indem. Co. v. Fannie Mae, Civ. No. 13-1439 (D.D.C. Feb. 1, 2018), ECF No. 83 ("Arrowood FAC").

         A. The GSEs

         Fannie Mae and Freddie Mac are government-sponsored enterprises, born from statutory charters issued by Congress. See Federal National Mortgage Association Charter Act, 12 U.S.C. §§ 1716-1723; Federal Home Loan Mortgage Corporation Act, 12 U.S.C. §§ 1451-1459. Congress created the GSEs in order to, among other goals, "promote access to mortgage credit throughout the Nation ... by increasing the liquidity of mortgage investments and improving the distribution of investment capital available for residential mortgage financing." 12 U.S.C. § 1716(3). The GSEs accomplish this objective by purchasing mortgages from lenders, thereby relieving the lenders of default risk and clearing up funds to be used to make more loans. To finance these purchases, the GSEs pool the many mortgage loans they purchase into various mortgage-backed securities and sell these securities to investors.

         Fannie Mae and Freddie Mac are considered government-sponsored, rather than government-owned, because both congressionally chartered entities were eventually converted, by statute, into publicly traded corporations. In 1968, Congress made Fannie Mae a publicly traded, stockholder-owned corporation. Housing and Urban Development Act, Pub. L. No. 90-448, § 802, 82 Stat. 536-538 (1968). And in 1989, Freddie Mac followed suit. Financial Institutions Reform, Recovery and Enforcement Act, Pub. L. No. 101-73, § 731, 103 Stat. 432-433 (1989). To provide guidance to the GSEs on corporate governance issues not specifically addressed by federal law, the Office of Federal Housing Enterprise Oversight directed the GSEs to follow a chosen state's corporate laws as a gap-filling measure. See 67 Fed. Reg. 38361 (Jun. 4, 2002). The GSEs hence enacted bylaws in which they elected to follow a chosen state's law-Delaware law for Fannie Mae and Virginia law for Freddie Mac.

         Since their founding, the GSEs have been major players in the United States' housing market. In the lead up to 2008, the GSEs' mortgage portfolios had a combined value of $5 trillion and accounted for nearly half of the United States' mortgage market.

         B. The 2008 Recession, the Creating of the FHFA, and the Beginning of Conservatorship

         In 2008, the United States' mortgage and housing markets went into crisis, leading in part < to a severe recession. Despite the GSEs' comparatively strong financial position amidst the crisis, Congress worried that a potential default by Fannie or Freddie would imperil the already fragile national economy. In response to these concerns, Congress enacted the Housing and Economic Recovery Act ("HERA" or "the Act"). HERA established the FHFA, granting it broad authority to ensure the GSEs remained stable. The Act denominated the GSEs as "regulated entit[ies]" subject to the direct "supervision" of FHFA, 12 U.S.C. § 4511(b)(1), and the "general regulatory authority" of FHFA's director (the "Director"). Id. § 4511(b)(1), (2). The Director was charged by HERA with "over see[ing] the prudential operations" of the GSEs and "ensur[ing] that" they "operate[] in a safe and sound manner," "consistent with the public interest." Id. § 4513(a)(1)(A), (B)(i), (B)(v).

         Additionally, HERA authorized the Director to appoint FHFA as either conservator or receiver for the GSEs "for the purpose of reorganizing, rehabilitating, or winding up the[ir] affairs." 12 U.S.C. § 4617(a)(2). If appointed as conservator, the Act granted the FHFA broad powers and authority over the GSEs. The Act provided that the FHFA "shall, as conservator or receiver, . . . immediately succeed to . . . all rights, titles, powers, and privileges of the regulated entity and of any stockholder, officer, or director of such regulated entity with respect to the regulated entity and the assets of the regulated entity." Id. § 4617(bX2)(B)(i), (iv). It also gave the FHFA general powers to take actions "necessary to put the [GSEs] in a sound and solvent condition" and "appropriate to carry on the business of the [GSEs] and preserve and conserve the assets and property of the [GSEs]." Id. § 4617(b)(2)(D)(i), (ii). And the Act further provides that the FHFA, as conservator, may take any action authorized under the act "which [it] determines is in the best interests of the [GSEs] or the [FHFA]." Id. § 4617(b)(2)(J)(ii).

         On September 6, 2008, FHFA placed the GSEs into conservatorship, assuming the powers granted to the conservator by the Act. According to statements by the Director, conservatorship was "designed to stabilize a troubled institution with the objective of returning the entities to normal business operations." Class SAC at ¶ 40 (relying on Press Release, Federal Housing Finance Agency, Statement of FHFA Director James B. Lockhart at News Conference Announcing Conservatorship of Fannie Mae and Freddie Mac (Sept. 7, 2008)). And that the "FHFA [would] act as the conservator to operate the GSEs until they [were] stabilized." Id. Once the FHFA determined that the GSEs were in a safe and solvent condition, the Director would issue an order terminating conservatorship.

         Despite the conservatorship, the common and preferred stock remained outstanding. In its Form 8-K filing just days after the beginning of conservatorship, Freddie Mac stated, "The holders of Freddie Mac's existing common and preferred stock... will retain all their rights in the financial worth of those instruments, as such worth is determined by the market." Class SAC at ¶ 42 (relying on Federal Home Loan Mortgage Corporation, Current Report (Form 8-K) (Sept. 11, 2008)).

         C. The GSEs Enter into a Senior Preferred Stock Purchase Agreement ("PSPA") with Treasury

         A day after its appointment as conservator, the FHFA struck a deal with the Treasury Department ("Treasury"), entering into the PSPAs. The state of the market limited access to private capital markets for Freddie and Fannie. To shore up the GSEs' financial positions, Treasury agreed to invest billions of dollars in the GSEs in exchange for one million senior preferred shares ("Government Preferred Stock") in each company. These shares had a principal value equal to the amount invested by Treasury in each company, plus $1 billion to reflect a commitment fee with respect to each GSE. The shares also entitled Treasury to:

• a senior preferred dividend each quarter in an amount equal to 10% of the outstanding principal value of the Government Preferred Stock if the dividend was paid in cash;
• a stock dividend, if the senior preferred dividend was not paid in cash, in the form of additional Government Preferred Stock with a face value equal to 12% of the outstanding principal value of the Government Preferred Stock;
• a priority right above all other stockholders, whether preferred or otherwise, to receive distributions from assets if the GSEs were dissolved;
• warrants allowing Treasury to purchase up to 79.9% of the GSEs' common stock; and .
• the possibility of periodic commitment fees over and above dividends.

         Additionally, the PSPAs included a variety of covenants. Most relevantly, the GSEs would have to receive Treasury's approval before declaring or paying any dividend or distribution. However, this covenant only applied during conservatorship.

         Initially, Treasury's commitment to invest capital was capped at $100 billion per company. But it was determined that this would not be enough to meet the GSEs' funding needs. The PSPAs were amended twice. First, in May 2009, Treasury agreed to expand the funding commitment to $200 billion for each company. Seven months, later the PSPAs were amended again, raising the cap to an adjustable figure determined by an agreed-upon formula. As of June 30, 2012, the GSEs together had drawn $187.5 billion from Treasury's funding commitment.

         D. The Return to Profitability

         When appointed as conservator, the FHFA did not expect the GSEs to be profitable. Expecting large losses in the coming years, FHFA directed the GSEs to book substantial loss reserves-recording anticipated mortgage loan losses before they were actually incurred-and required the GSEs to eliminate from their balance sheets the value of deferred tax assets that would only be of use if the GSEs became profitable. This accounting decision caused a strain on the GSEs' balance sheets, necessitating (in part) an increased draw from the Treasury's commitment. It even led to the payment of some circular dividend payments, where the GSEs drew on Treasury's funding commitment to pay Treasury its senior preferred dividend.

         By 2012, though, it became clear that FHFA had overestimated the Companies' likely losses and underestimated the possibility of a return to profitability. More than $234 billion had been set aside by the GSEs to absorb loan losses, whereas losses of just over $125 billion were actually realized.

         Additionally, the housing market had rebounded and the companies were well-positioned to begin generating profits for the foreseeable future. The GSEs, FHFA, and Treasury learned the GSEs were expected to be sufficiently profitable in the coming years to pay the 10% dividend on the Government Preferred Stock without the necessity of drawing from Treasury. It was believed that the period between 2012 and 2020 would be the "golden years of GSE earnings." See Class SAC ¶ 54; Arrowood ¶ 53; Fairholme FAC ¶ 56. In fact, the GSEs were forecasted to be so consistently profitable that they could repay Treasury its initial investment within the following eight years.

         E. The Enactment of the Third Amendment

         Despite this positive outlook, FHFA and Treasury agreed to amend the PSPAs for a third time (the "Third Amendment"). The Third Amendment changed the government's senior preferred dividend from 10% of the outstanding principal value of the Government Preferred Stock to a quarterly dividend equal to 100% of each company's net worth that exceeded a capital buffer of $3 billion, with that buffer decreasing annually down to zero by 2018 (the "Net Worth Sweep"). And, since the PSPAs provided that in the event of a liquidation of the GSEs, the government would receive a liquidation preference that included the amount of any prior unpaid dividend, the Third Amendment guaranteed that even if the GSEs were liquidated, Treasury would receive the full amount of the GSEs' net worth in that liquidation.

         The GSEs received no new investment in exchange for the change in dividend structure. The reason given publicly for the Third Amendment was to end the practice of circular dividends paid to Treasury from funds drawn from Treasury's commitment to the GSEs. As of February 2018, Treasury has received over $276 billion in dividends from the companies-$88 billion more than Treasury's total investment in both companies.


         In 2013, Plaintiffs filed suit challenging the Third Amendment. They alleged that, in adopting the Third Amendment, FHFA and the GSEs breached the terms governing dividends, liquidation preferences, and voting rights in the stock certificates for Freddie's Common Stock and for both Fannie's and Freddie's Preferred Stock. Additionally, they alleged that those defendants breached the implied covenant of good faith and fair dealing in those certificates. The Plaintiffs also alleged that FHFA and Treasury breached state-law fiduciary duties owed by a corporation's management and controlling shareholder, respectively. The Plaintiffs asked the Court to declare their lawsuit a "proper derivative action" and to award damages as well as injunctive and declaratory relief.

         The Court dismissed Plaintiffs' claims entirely for failure to state a claim, along with different claims by institutional investors under HERA and the Administrative Procedure Act ("APA)" seeking only equitable relief. See generally Perry I, 70 F.Supp.3d 208. On appeal, the D.C. Circuit affirmed in part and reversed in part, remanding some of Plaintiffs' claims. See generally Perry II, 864 F.3d 591.' Having amended their respective complaints, all plaintiffs bring claims for breach of contract, breach of the implied covenant of good faith and fair dealing, breach of fiduciary duty, and violations of Delaware and Virginia statutory law governing dividends.[3] See Class SAC; Fairholme FAC; Arrowood FAC. Additionally, the Class Plaintiffs bring derivative claims against FHFA for breach of fiduciary duties. And the individual plaintiffs bring APA claims. Again, Defendants move to dismiss Plaintiffs' claims. And once again, this Court must decide whether Plaintiffs have stated a claim upon which relief may be granted.


         A motion to dismiss is appropriate when the complaint fails "to state a claim upon which relief can be granted." Fed.R.Civ.P. 12(b)(6). The Court does not "require heightened fact pleading of specifics, but only enough facts to state a claim to relief that is plausible on its face." Bell Atl. Corp. v. Twombly, 550 U.S. 544, 570 (2007). "[T]he complaint is construed liberally in the plaintiffs' favor, and [the Court] grant[s] plaintiffs the benefit of all inferences that can be derived from the facts alleged. However, the [C]ourt need not accept inferences drawn by plaintiffs if such inferences are unsupported by the facts set out in the complaint." Kowal v. MCI Commc'ns Corp., 16 F.3d 1271, 1276 (D.C. Cir. 1994) (internal quotation marks and citation omitted).

         IV. ANALYSIS

         A. Plaintiffs' Breach of Contract Claims Fail on the Merits

         In each case, the respective plaintiffs assert the Third Amendment breached Plaintiffs' contractual rights to receive a liquidation preference. See Class SAC Counts I-III; Fairholme FAC Count II; Arrowwood FAC Count III. While this Court previously dismissed these claims as unripe, see Perry I, 70 F.Supp.3d at 234-26, the D.C. Circuit reversed that decision, holding that the "claims for breach of contract with respect to liquidation preferences are better understood as claims for anticipatory breach[.]" Perry II, 864 F.3d at 633. Under this doctrine, "a voluntary affirmative act which renders the obligor unable ... to perform" is a repudiation, Restatement (Second) of Contracts § 250(b), that "ripens into a breach prior to the time for performance'. . . if the promisee elects to treat it as such" by, for instance, suing for damages. Franconia Assocs. v. United States, 536 U.S. 129, 143, 122 S.Ct. 1993, 153 L.Ed.2d 132 (2002) (internal quotation marks omitted); Restatement (Second) of Contracts §§ 253(1), 256 cmt. c; accord Lenders Fin. Corp. v. Talton, 249 Va. 182, 189, 455 S.E.2d 232, 236 (Va. 1995); W. Willow-Bay Court, LLC v. Robino-Bay Court Plaza, LLC, C.A. No. 2742-VCN, 2009 WL 458779, at *5 & n.37 (Del. Ch. Feb. 23, 2009). As the Circuit explained, "anticipatory breach is 'a doctrine of accelerated ripeness' because it 'gives the plaintiff the option to have the law treat the promise to breach [or the act rendering performance impossible] as a breach itself" Perry II, 864 F.3d at 633-34 (quoting Homeland Training Ctr, LLC v. Summit Point Auto. Research Ctr., 594 F.3d 285, 294 (4th Cir. 2010)). The Circuit, therefore, reversed this Court's decision, holding the Plaintiffs' breach of contract claims ripe for decision. Id. at 634.

         In making this determination, the D.C. Circuit made clear that it was not addressing the merits of the breach of contract claim. Id. ("Our holding that the claims are ripe sheds no light on the merits of those claims"). Instead, that court held that "[w]hether the class plaintiffs stated claims for breach of contract... is best addressed by the district court in the first instance." Id. After evaluating the merits of the claim, and for the reasons set forth below, the Court finds that Plaintiffs fail to state a claim for anticipatory breach of their contractual rights to receive a liquidation preference. As such, Defendants' motion will be granted as to these counts in the respective cases.

&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;&nbsp;As Defendants point out in their briefs, the doctrine of anticipatory breach is not limitless. See Defs.&#39; Mot. To Dismiss at 15-17. As this Court recently explained, see Glenn v. Fay,281 F.Supp.3d 130, 139 (D.D.C. 2017), the doctrine traditionally does not apply to unilateral contracts, especially when the only remaining performance is the payment of money. Smyth v. United States,302 U.S. 329, 356, 58 S.Ct. 248, 82 L.Ed. 294 (1937) ("[T]he rule of law is settled that the doctrine of anticipatory breach has in general no application to unilateral contracts, and particularly to such contracts for the payment of money only."). And, importantly for the purposes of this opinion, the limitation also applies to "bilateral contracts that have become unilateral by full performance on one side." 23 Williston on Contracts &sect; 63:60 (quoting Phelps v. Herro,215 Md. 223, 137 A.2d 159 (1957)); see also 23 Williston on Contracts &sect; 63:61 ("[W]hen a bilateral contract has become a unilateral obligation by full performance on one side, anticipatory repudiation of that obligation does not permit the immediate filing of an action.")-m other words, "if the payee has completely performed his side of the contract and is just ...

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