With the Fairholme Funds Inc v FHFA well into discovery, many Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) minority shareholders are starting to feel confident that evidence of self-dealing and the government conservator acting in bad faith will come out, but this raises the tough question of what remedy the courts might be willing to order. In their recent paper, After the Deal: Fannie, Freddie and the Financial Crisis Aftermath, UC Berkeley Law professor Steven Davidoff Solomon & University of Pennsylvania Wharton School associate professor David Zaring argue that an ‘entire fairness’ approach would give the government a way to remedy the third amendment, though shareholders won’t be happy with the amount that Solomon and Zaring think that they are due.
“If the government, in making its deals, elected to preserve a stub of private shareholders in the course of a rescue, its subsequent management of the rescued firm was sure to implicate the rights of the stub,” they write. “It did not give itself license to treat minority shareholders in any way that it wished; nor would we want the government to have the power to seize businesses, run them for years, and decide to one day zero out the minority shareholders that retain parts of the firm.”
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Third amendment runs afoul of the law, say Solomon and Zaring
Solomon and Zaring are supportive of minority shareholders’ case in general. While they argue that the government has to be given some leeway to act in the heat of a financial crisis, the third amendment that created the full income sweep was put into effect well after the economy had stabilized. They see the third amendment as a clear case of self-dealing that “runs afoul of corporate, administrative and constitutional law.” But it’s administrative law that they turn to in suggesting a solution.
If majority shareholders freeze out minority owners, their decisions may be subjected to an ‘entire fairness’ analysis which asks if the decision was fair to everyone in terms of price and process. In this case, Solomon and Zaring say that an application of the entire fairness principle would be pretty straightforward: if Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) still had value when the third amendment was put into effect then minority shareholders are due some sort of compensation. Since they were turning a profit beyond even the large required dividend payments to Treasury, it’s pretty clear that they did.
Fannie Mae, Freddie Mac: Solomon and Zaring look to August 2012 prices for guidance
If you’re long on Fannie Mae / Federal National Mortgage Assctn Fnni Me (OTCBB:FNMA) and Freddie Mac / Federal Home Loan Mortgage Corp (OTCBB:FMCC) you’re probably nodding along at this point, but Solomon and Zaring aren’t looking to provide minority shareholders with a windfall.
“In the case of Fannie Mae and Freddie Mac’s common stock the market value is a good guide,” they write. “[In August 2012] the market was valuing the stub equity of Fannie and Freddie at between $.25 and $.23, per share, respectively.”
Preferred shares had a larger range, $1.40 to $0.42 for Fannie Mae Preferred Series E stock and $1.98 to $0.93 for Freddie Mac Preferred Series Z, but that’s the range that Solomon and Zaring think is a reasonable starting point when determining compensation, saying that they should be a reasonable estimation for a broader debate over valuation. That’s less than the stocks are currently trading at and far below what most people think they would be worth if the GSEs were allowed to exit conservatorship, so while Solomon and Zaring acknowledge the important of shareholder rights, it’s not the remedy any of those shareholders are looking for.