Court of Chancery Dismisses Complaint Seeking to Enforce a Stockholder’s Section 220 Demand to Inspect the Books and Records of Fannie Mae on Issue Preclusion Grounds

By: David L. Forney and David Valenti

In Pagliara v. Federal National Mortgage Association, C.A. No. 12105-VCMR (Del. Ch. May 31, 2017) the Court of Chancery dismissed a complaint brought by a preferred stockholder of Federal National Mortgage Association (“Fanny Mae”) seeking to enforce his rights under Section 220 of the Delaware General Corporation Law to obtain documents (“Section 220 Demand”) to investigate certain actions of Fannie Mae on issue preclusion grounds.  The Court of Chancery ruled that a prior judgment of the Eastern District of Virginia was preclusive on the dispositive issue of whether Fannie Mae stockholders retained the right to obtain the corporate books and records of Fannie Mae under the Housing and Economic Recovery Act of 2008 (the “HERA”).

By the early 2000s, Fannie Mae, which was originally designed by the federal government to improve the mortgage market, was largely privately owned and publicly traded but remained subject to federal regulation. In 2008, at the height of the U.S. housing crisis, Congress passed the HERA to stabilize the housing market.  The HERA replaced Fannie Mae’s regulator with the newly created Federal Housing Finance Agency (the “FHFA”) and authorized the FHFA to put Fannie Mae into conservatorship.  After being placed into conservatorship, Fannie Mae entered into a preferred stock purchase agreement (the “SPA”) with the U.S. Department of Treasury (the “Treasury”).

Under the SPA, Fannie Mae, among other things, issued one million shares of its Senior Preferred Stock, which had a senior liquidation preference of $1,000 per share and was entitled to a 10% cumulative cash dividend, to the Treasury. In 2012, Fannie Mae and the Treasury amended the SPA to replace the Treasury’s 10% cash dividend with a “net worth sweep,” such that Fannie Mae would distribute the bulk of its quarterly net worth to the Treasury for an indefinite period of time (the “Amendment”).  As a result of the Amendment, the Treasury’s dividends allegedly increased by $78.2 billion.

In January 2016, plaintiff Timothy J. Pagliara (“Plaintiff”), a preferred stockholder of Fannie Mae, made a Section 220 Demand on Fannie Mae, seeking documents and records to investigate whether the decisions to approve the Amendment constituted misconduct. Fannie Mae rejected Plaintiff’s requests. In March 2016, Plaintiff filed suit and Fannie Mae removed the action to the United States District Court for the District of Delaware.  In March 2017, the United States District Court for the District of Delaware remanded the case and Fannie Mae filed a motion to dismiss under (i) Court of Chancery Rule 12(b)(2) for lack of personal jurisdiction, and (ii) Rule 12(b)(6) for failure to state a claim.  The Court of Chancery found that Plaintiff’s complaint sufficiently alleged a prima facie case for personal jurisdiction based on the filing of the certificate of incorporation. The Court of Chancery then addressed Fannie Mae’s Rule 12(b)(6) motion to dismiss.

Fannie Mae argued that Plaintiff’s compliant should be dismissed on issue preclusion grounds because the dispositive issue in this case — whether Plaintiff has the right to inspect Fannie Mae’s books and records — was previously decided against Plaintiff in Pagliara v. Federal Home Loan Mortgage Corporation, 203 F.Supp. 3d 378 (E.D. Va. 2016) (the “Virginia Case”).  In the Virginia Case, the United States District Court for the Eastern District of Virginia held that a provision of the HERA transferred the rights of the stockholders to seek the books and records of the Federal Home Loan Mortgage Corporation (“Freddie Mac”), a regulated entity under the HERA like Fannie Mae, to the FHFA.  Plaintiff had similarly sought books and records from Freddie Mac under Virginia corporate law.  The court in the Virginia Case was faced with the question of whether Freddie Mac stockholders retained their right to examine books and records, and whether the relevant provision of the HERA divested stockholders of that right.

The Court of Chancery, applying federal law, noted that a party to a prior proceeding is precluded from litigating an issue when (i) the “issue of fact or law has been actually litigated” in the prior proceeding, (ii) the issue has been “determined by a valid and final judgment,” and (iii) “the determination is essential to the judgment.” An exception, however, may apply if the issue is one of law, and (i) the two actions involve claims that are substantially unrelated, or (ii) a new determination is warranted in order to take into account an intervening change in the legal context or to avoid an inequitable administration of the law.  The Court of Chancery found that the Virginia Case is preclusive because (i) Plaintiff had a full opportunity to oppose the motion to dismiss in the Virginia Case, and his counsel appeared and argued the motion to dismiss; (ii) the decision was reduced to a final judgment, which Plaintiff appealed and then voluntarily dismissed; and (iii) the interpretation of the relevant provision of the HERA was essential to the Virginia court’s decision.

Notably, the Court of Chancery rejected both of Plaintiff’s arguments asserting that an exception to issue preclusion applies in this case. First, Plaintiff asserted the dispositive issue in this case is a pure legal question, and a subsequent case, Perry Capital LLC v. Mnuchin, 848 F.3d 1072 (D.C. Cir. 2017) (the “D.C. Case”), rejected the Virginia Case and altered the legal context.  The Court of Chancery, however, disagreed, noting that the D.C. Case considered a different issue — the legal sufficiency of stockholder direct and derivative claims against Fannie Mae and Freddie Mac arising out of the Amendment.  Next, Plaintiff asserted that the prior order by the United States District Court for the District of Delaware in the present case changed the legal context.  The Court of Chancery also rejected this argument, noting that the United States District Court for the District of Delaware considered only certain jurisdictional issues relevant to the case, not the merits.  Lastly, the Court of Chancery stated that the claims in the Virginia Case and the current action were  not substantially unrelated.  Rather, in both actions Plaintiff sought books and records for the purposes of examining misconduct related to Treasury investments in Fannie Mae and Freddie Mac.  The two claims are not substantially unrelated because (i) Fannie Mae and Freddie Mac are both regulated entities under HERA, and (ii) the primary holding of the United States District Court for the Eastern District of Virginia in the Virginia Case was that the relevant provision of the HERA bars a stockholder from examining books and records.

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