AIG Court Of Claims Decision Likely Is Not The Last Word Jul. 16, 2015 11:19 AM ET | 6 comments | About: American International Group Inc (AIG), Includes: FMCC, FNMA Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. (More...) Summary
The Court of Claims found for Starr International on its claim that the Federal Reserve lacked power to take control of AIG. The Court of Claims found, however, that Starr and its fellow shareholders had suffered no damage as a result. Either conclusion could be reversed on appeal. The judge’s dicta tell us (and the Court of Appeals) that he did not like the Fed’s high-handedness. The AIG (NYSE:AIG) case, Starr International v. U.S., was decided by the U.S. Court of Claims on June 15 after a trial that took place in the fall of 2014 and numerous post-trial motions and filings. The case is now five years old, the acts complained of took place almost seven years ago, and AIG, the company at the heart of the case, has mostly recovered from its near-bankruptcy in September 2008. Yet it seems likely that the case is far from over.
I had intended to publish this account of the case a few weeks ago, but other work got in the way. I hope it still is of interest to investors and public policy wonks.
The opinion by Judge Thomas Wheeler is full of interesting dicta-that is, things the court did not have to say to reach its conclusions-and I will discuss some of the dicta later on. But first let's outline the holdings in the case and some of the controversial points that we might expect to be raised on appeal.
Starr International is a holding company that was set up by AIG's founder, Cornelius Vander Starr, to control AIG. Starr International now is controlled by Vander Starr's successor, Maurice Greenberg, who ran AIG for many decades. Starr International brought suit against the U.S. government for damages to AIG stockholders that were caused by the Federal Reserve Bank of New York overstepping its legal bounds when it exacted a controlling equity stake as a condition of its providing liquidity to AIG in September 2008, right after Lehman Brothers had declared bankruptcy.
There seems to be no question but that if the FRBNY had not provided very substantial liquidity to AIG (even today $85 billion is substantial, I think), AIG would have had to declare bankruptcy during the week of September 16. There also seems to be no question but that there were no private parties that were willing to provide such liquidity. The major question in the case is the legal issue of whether under the emergency lending power of the Federal Reserve, Section 13(3) of the Federal Reserve Act, the Federal Reserve had the power to require that it receive an equity interest in the borrower-and, in this case, a controlling equity interest.
From the outset of the Fed's AIG rescue effort, the Fed's lawyers agonized over whether the Fed had such power. It is clear from the email traffic between the outside lawyers at Davis Polk and Tom Baxter, GC of the FRBNY, and Scott Alvarez, GC of the Federal Reserve Board, that none of them had confidence that the Fed had such power or that the Fed or the FRBY had power to own or hold common stock of a non-bank. Baxter and Alvarez are career public servants whose reputations among the banking bar are excellent.
The twists and turns that arrived at the final deal structure under which preferred stock representing a 79.9% interest in the equity of AIG was placed in trust for the benefit of the U.S. Treasury are a corporate lawyer's delight or nightmare, depending on how you look at it. The Federal Reserve Board had approved (on September 16) a transaction in which the FRBNY would take equity in the form of warrants. But the warrant transaction was seen to have a problem: the warrants could not be exercised without an increase in the authorized stock of AIG-and that increase could not be accomplished without a stockholder vote, which the government wanted to avoid because then the stockholders could render the warrants, in effect, worthless-and it would be in their interests to do so. That recognition set Davis Polk and Tom Baxter off looking for a way to take the equity without requiring a stockholder vote. The preferred stock held in trust was what resulted.
That the lawyers were the ones who changed the deal may come up as a significant point on appeal. But in saying that, I am getting ahead of the story. Please just mark that for now.
The court ultimately held that the Fed did not have authority under Section 13(3) to require (or, as I read it, accept) an equity interest as a condition of extending credit under Section 13(3). That is a ruling on the law that the U.S. can appeal. There also are some technical jurisdictional issues on which the U.S. can appeal.
But the court awarded no damages to Starr International or the class of stockholders that it represents. That was because the court found that if the government had not provided substantial credit to AIG, it would have had to file for bankruptcy, in which event, the common stockholders would have ended up with nothing-and 20% of something is better than 100% of nothing. That is a finding of fact that an appeals court usually will respect. However, there may be issues of law that lie behind the conclusion of fact, and on the issues of law, there could be an appeal.
As I suggested, mark the process by which the form of equity interest came about. It was the lawyers who took over and, seeking a way to avoid a stockholder vote, created the final form of the deal. No member of the Federal Reserve Board seems ever to have insisted that if an equity interest was unlawful, the Board would not approve the deal. There is nothing in the court's opinion that suggests that the Board ever took such a position. I have not read the record (and I regret that I do not have time to do that), so I do not know whether that is in the testimony of Chairman Bernanke, FRBNY President Geithner or Treasury Secretary Paulson, all of whom testified at length. (It cannot be something that Starr International's brilliant counsel David Boies did not think of. But it is not in the opinion.)
The fact that such a question requires the court to make a judgment about a counterfactual cannot preclude it from being asked because the court explicitly made its ruling based on the counterfactual that AIG declares bankruptcy.
As I read the statements of Bernanke, Geithner and Paulson that are discussed in the opinion, I would infer that they would have extended the credit without the equity kicker if they had been told clearly that the kicker could not be done legally. They all testified that the entire financial system was at stake and that that was why they were taking the extraordinary step in the first place. They testified that the equity and control were to prevent moral hazard.
From the testimony of Bernanke, Geithner and Paulson, an appellate court might ask why the counterfactual of a deal without equity was not considered by Judge Wheeler as an alternative to the bankruptcy assumption. And under that counterfactual, the damages could be seen to be quite substantial-maybe $50 billion if I understood the expert testimony correctly-and even that seems like it might be low. Maybe an appellate court would send the case back for a finding on that issue.
But the U.S. might have good ground to appeal on the basic issue of whether the Fed had power to extract an equity kicker under Section 13(3). Here is the court's conclusion:
"Upon a full consideration of the record and the arguments of counsel, the Court finds that FRBNY's taking of 79.9 percent equity ownership and voting control of AIG constituted an illegal exaction under the Fifth Amendment. The Board of Governors and the Federal Reserve Banks possessed the authority in a time of crisis to make emergency loans to distressed entities such as AIG, but they did not have the legal right to become the owner of AIG. In the Federal Reserve's history of making hundreds of emergency loans to commercial entities, the loan to AIG represents the only instance in which the Federal Reserve has demanded equity ownership and voting control. There is no law permitting the Federal Reserve to take over a company and run its business in the commercial world as consideration for a loan."
Keen readers will have noted that I framed the issue as one of power to extract an equity kicker. The court framed the issue as one of extracting control. They might be different issues, but there is nothing in the language of the statute (which is silent either way) that would lead one to make a distinction.
As I read the cases cited by the court, they are not strong precedents for the court's conclusion. I will mention only one Supreme Court case here. It is Suwanee S.S. Co. v. U.S. The Supreme Court language Judge Wheeler quoted is as follows:
"We suggest that no statute should be read as subjecting citizens to the uncontrolled caprice of officials, unless the statute has to do with the powers of the President in dealing with foreign relations, the powers of a military commander in the field, or some comparable situation. . . ."
If the worst financial crisis in 80 years, threatening the global financial system with chaos, is not "some comparable situation" to war, and if the Secretary of the Treasury and the Chairman of the Federal Reserve Board are not, in such a situation, comparable to the President, I do not see what the Supreme Court could have had in mind in leaving its restriction open-ended.
In many ways, Judge Wheeler's opinion is a curious one. I have given you the gist of the holdings in the last few paragraphs. But a great deal of the opinion is taken up with what we might call obiter dicta-that is, things he did not have to discuss at all in order to reach his legal and factual conclusions. That he did discuss such things at length suggests that they were important to his state of mind.
The dicta I refer to fall into two categories: (1) the wrongness of the government taking over control of a private corporation, and (2) the relative innocence of AIG when compared with the heinous conduct of the banks that also received government largesse but without being forced to give up equity, much less a controlling equity stake. Judge Wheeler has good points to make here. He shows that Goldman Sachs, Morgan Stanley, Citigroup, Bank of America and JPMorgan Chase all received government assistance, some more, some less, and that none of them surrendered voting stock. He shows as well that all of those companies participated in the fraudulent credit boom that caused the boom in house prices that led to the bust and crisis. He details the settlements and billions of dollars that these companies have paid to the government as a result of their wrongdoing. AIG has not been implicated. Indeed (although Judge Wheeler does not say this) AIG could be seen as a victim. But the government did not know of the frauds in October 2008 when it advanced the TARP money, so I think Judge Wheeler's venting about bank wrongdoing can have little relevance.
Judge Wheeler also, without going into much detail but relying on expert testimony, says that tens of billions of the government's dollars that were lent to AIG ended up going into the pockets of some of these same banks, whose AIG obligations were paid in full. And Goldman Sachs and Morgan Stanley, to top it all off, were allowed to become bank holding companies in an unusually expeditious manner.
As I said above, the dicta tell us something potentially important about Judge Wheeler's state of mind, and that will not be lost on the D.C. Circuit Court of Appeals.
There also is a serious question of whether Starr had standing to bring an action based on lack of power under Section 13(3). Judge Wheeler had decided that question in an earlier ruling that could not be appealed at the time. But it can be appealed after a final judgment has been entered. The reason that standing question is serious is that Starr's claim is basically a Fifth Amendment claim that the government took Starr's (and other shareholders') property without just compensation. The illegality under Section 13(3) is used to make the lack of compensation unjust. But think about why Congress might not have given (if it did not give) the Federal Reserve Board power to take equity. Would it have been to protect shareholders? Why would Congress have been protecting shareholders in a case where, if the loan was not made by the Fed, the shareholders would lose everything? Would Congress not (if it considered the question) have intended the lack of authority to protect taxpayers from profligate lending by the Fed? After all, the Fed was empowered to make loans only on good collateral. That was the major restriction. Congress might well have thought that potentially worthless stock (even if it constituted control) was not good collateral. Thus, Starr and its class may not have been in the zone of protection, and pyramiding the Fifth Amendment on top of Section 13(3) may not have put them there.
I do not know what will happen on appeal. Both sides have good points to make. And I should offer a disclaimer: In my legal career, I litigated infrequently, so I look at the issues of this case as a person who was steeped in regulatory policy and represented the government in what way back in the 1970s looked like emergency situations. My sympathies lie with people like Tom Baxter and Scott Alvarez, who I know gave every ounce of energy they had to protect the American people at a time of great stress. (I also have law school colleagues on both sides of the case. It is nice to see old guys still getting respect.)
If one is a holder of securities that may increase or decrease in value based on the outcome of Starr International v. U.S. (such as securities of AIG or Fannie (OTCQB:FNMA) or Freddie (OTCQB:FMCC)), I would not bet on Judge Wheeler's rulings holding up. But what the outcome will be still seems to me unknowable.
Editor's Note: This article discusses one or more securities that do not trade on a major U.S. exchange. Please be aware of the risks associated with these stocks.
Share this article with a colleague 0 inShare
About this article Expand
Comments (6) Track new comments
leroythedog Comments (20)| + Follow | Send Message For banks and brokerages, the Fed tried to engineer some sort of merger or takeover (eg Bear Stearns, Merrill, Washington Mutual, Wachovia,..). Not sure whether they considered this with AIG, but it may have been that there were no suitable candidates, which left only the monetary authorities. The authorities were also under significant time pressure to act which probably limited their scope to find other avenues to preserve AIG.
Sure they could have just given AIG the money without taking the equity. But they probably calculated that they would have to deal with push back from Congress and an erosion of public trust and confidence. The authorities calculated that the trust of the public that the authorities would do what was needed to save the economy without bailing out risktakers would be critical going forward. To my mind, this was a legitimate, credible, and justifiable policy choice, and authorities making such choices in a crisis should be afforded considerable leeway.
I believe TARP came after AIG, and it was a more structured and well thought out means of extracting payment for the invaluable backstop that was being provided to the financial institutions in question. If TARP had been in existence, they could have taken their pound of flesh from AIG in the guise of TARP and no one would have said "boo".
But the lack of TARP structure doesn't reduce or invalidate the lifesaving backstop that was provided to AIG, nor should it enable what would be an unconscionable and unjust enrichment to pre backstop AIG shareholders that would accrue if the baseline for the counterfactual is that the support would have been provided even if the authorities could not extract any equity from AIG.
Martin, I Liked your post on Greece as well, by the way, and I generally enjoy reading your stuff.
News 
Market Data 
Discover 
