The recent decision in the U.S. Federal Court of Claims by Judge Thomas Wheeler is the latest, but by no means last, decision on the highly contentious claims that Starr International has brought against the Federal Reserve Bank of New York (FRBNY), charging the FRBNY with conducting an illegal bailout of AIG in September 2008. The decision has received extensive coverage and praise for the way in which it has slapped down FRBNY for its illegal actions and abuse of authority. Indeed, it is highly commendable that Wheeler thought it imperative to examine the merits of this claim noting that unless it heard the case, “the Government could nationalize a private corporation, as it did to AIG, without fear of any claims or reprisals.”
In doing his own exhaustive analysis, Wheeler at no point either cites or discusses an earlier decision arising out of the bailout, Starr International Co v. Federal Reserve Bank of New Yorkdecided by Judge Paul Engelmayer in 2012 in the Southern District of New York. In that case, Starr claimed that FRBNY had breached its fiduciary duties to AIG. There are of course many points of overlap between the takings and exaction claims that were brought before Judge Wheeler in the Federal Claims Court, and the breach of fiduciary duty claim brought before Judge Engelmayer. It is therefore instructive to note the gulf that separates the two on many key points.
Judge Wheeler’s decision is sure to be appealed by Starr because of its decision to brand the actions of the FRBNY illegal, without awarding any damages to Starr, on the theory that AIG would have gone under without the last-ditch efforts to rescue the company. The decision is of course of great relevance for its potential relationship to the ongoing shareholder disputes in the Fannie and Freddie lawsuits, (on which I have advised several institutional investors) which were tossed out on summary judgment last September by Judge Royce Lamberth in Perry Capital LLC v. Lew, in what I regard as a highly dubious opinion, that was far less respectful of legitimate shareholder claims than either the Engelmayer or Wheeler opinions.
Judge Wheeler found FRBNY liable under an illegal exaction theory, with two parts. The first rests on a generalized abuse of monopoly power. The second is that FRBNY exceeded its authority under section 13(3) of the Federal Reserve Act (FRA), which did allow the Fed to act in a time of “unusual and exigent circumstances.” Judge Engelmayer disagreed on both points. I think that Engelmayer is on balance correct in his rejection of the monopoly claims, although there is much to be said on both sides of this difficult issue. I also think that Wheeler has the stronger position on the scope of FRBNY’s statutory authority under section 13(3), which plays no direct role in the Fannie/Freddie litigation.
The Monopoly Theory Judge Wheeler accepted AIG’s claim that the FRBNY abused its monopoly power to extract an impermissible set of concessions from AIG. That claim has a deep paradox because it is widely accepted that the federal government had no duty whatsoever to come to the aid of AIG, at which point its only recourse would have been in a court of bankruptcy. Indeed, Wheeler’s decision offered no belated consolation to the shareholder’s of Lehman Brothers, which the government let die just a few days before it arranged for the elaborate bailout of AIG.
In dealing with this abuse argument, Wheeler, like Engelmayer, offers very detailed description of the how AIG was rapidly deteriorating by the hour before the bailout. Wheeler also explained how, as Section 13(3) required, that the government looked for private lenders to take up the slack. When none came forward on the terms that the government proposed, it took over the deal that put it on the hook for $85 billion.
At this point, it is hard to see how there is any abuse of a monopoly position, given the private benchmark of these private firms. Indeed, the case against the abuse of monopoly position gets still stronger when it is recalled that the initial loan called for interest at LIBOR + 8.5 percent in September, which was thereafter reduced to LIBOR + 3 percent less than two months later. Instead, it looks as though Engelmayer was correct in insisting that the AIG directors, with full control over the company, were within their purview to accept a hard take-it-or-leave-it-offer when no better alternative was available. Unless there was some fiduciary duty for the Fed to deal with AIG on terms equal to that of other companies - why, then, has the Fed misbehaved in making this offer?
To Judge Wheeler, the answer to that question starts with the observation that the FRBNY singled out AIG for special treatment, most notably by taking an equity position in the firm, which it had not done with any of the other institutions to which it extended assistance. He therefore concluded that the “Government’s unduly harsh treatment of AIG in comparison to other institutions seemingly was misguided and had no legitimate purpose, even considering concerns of moral hazard.” The point seems fair enough, but it still does not establish any claim because Wheeler rightly said that the ultimate question was “whether the Government’s actions created a legal right of recovery for AIG’s shareholders.” And it is here that the no-duty part of AIG’s case is hardest to overcome.
On this issue, Engelmayer took the position that the FRBNY had every right to drive a hard bargain against AIG. Wheeler takes the opposite position when he suggests that the FRBNY should have followed the principles that were announced by the late nineteenth century English financial writer, Walter Bagehot, who argued that a central bank was not there to make a profit by extracting the greatest amount of financial gain from potential borrowers. Rather, the bank should act as a lender of last resort that charged only a reasonable rate to compensate it for its risk—a figure that Wheeler found was too high relative to the interest rates charged to the other financial institutions that were in distress at the time.
The question then arises, how should Wheeler have determined the correct interest rate? Even on the Bagehot position, the government is entitled to a competitive rate of return, which is hard to calculate in novel circumstances under severe time pressures. Wheeler thinks that looking at the far lower rates that the Federal Reserve generally extended to banks in distress can obviate much of the difficulty. But the argument from parity is not trouble free. More concretely, he offers no evidence that anything in the future rate agreement commits (FRA) the FRBNY to taking Bagehot’s view of the world in making its decision. And for good reason. The notion that loans must be made on reasonable rates works tolerably well, the FRBNY is under a statutory duty to make such loans, for in most situations it has the time and the benchmarks that allow for plausible comparisons. But even if these cases are subject to judicial review, as they should be, the usual standard in rate-making cases is deferential.
Moreover, in this case, it is hard to determine the proper baseline. These bailout transactions all differ one from the other. AIG is not a bank as are Bank of America, Citibank, JP Morgan and other such institutions that were in peril at the time. Banks operate under different regulatory structures, so it is hard to say that the interest rates should be parallel, when there is no duty to lend at all. And even if there were some duty for equal treatment, that would only be if like cases were treated alike. Yet these cases are necessarily different so that no version of the common carrier argument requiring “reasonable and nondiscriminatory rates” holds. After all, many of the banks were, as Judge Wheeler notes, subject to major fines, while AIG was not fined at all.
To be sure, there are common law cases dealing with the duty to rescue that hold once a person begins a rescue, he must use their best efforts to make sure that it is done correctly. But that rule only applies to chance encounters between ordinary individuals in cases of dire emergency. And as stated, the rule normally allows the rescuer to back off the transaction so long as he did not leave the victim worse off than she was before the rescue attempt began. Indeed, in this area, the great fear is that the imposition of any liability for a failed rescue will have the unfortunate effect of inducing individuals not to rescue at all, leaving the victim far worse off. Accordingly, the major legislative initiative in this area is to insulate rescues from liability unless there is gross negligence or willful neglect. In fact, there are virtually no cases whatsoever that address the potential liability of failed rescues. It is hard to extract from these cases a legal duty to use reasonable rates in the very different institutional setting when the parties have bargained to some conclusion. But it is easy to see that the prospect of heavy financial liability could deter the Fed from intervening at all, which could carry with it disastrous systematic consequences.
A closer analogy to the bailout situation involves cases in which a ship stranded at sea agrees to pay high fees to the only available rescuer. Here there is an obvious monopoly problem, which meant that oftentimes courts substituted a reasonable fee for the agreed upon price. But the entire area has been taken over by standard business arrangements, where the parties often agree on the spot to have their disputes over salvage fees to be resolved under a detailed set of rules put in place by Lloyd’s. Here again, the uniqueness of individual cases precludes this approach. At this point, it looks as though the diffidence to impose liability in these related no-duty contexts counts against the Wheeler position on the monopoly question.
In an effort to finesse this no duty objection, Wheeler also invokes the complex doctrine of unconstitutional conditions, which stands for the proposition that the government may not impose certain conditions on private parties that requires them improperly to waive their constitutional rights. But that doctrine has never blocked conditions that are germane to the underlying transaction, where the means chosen are reasonably adapted to the end in view. So long as FRBNY can walk away, it becomes odd to say as a matter of basic constitutional law that it cannot make whatever deal it wants. After all, given the approval of the AIG Board, the deal consummated left both parties believing that they were better off than before. The exact division of the gains is hard to tell in the abstract, and in this case, it could easily be that AIG did at least as well as the government, given the risks inherent in the transaction. In the end, Wheeler’s detailed argument probably is not strong enough to carry the day on the monopoly point. But clearly the matter will be up for further consideration.
On this issue, moreover, there is a striking contrast with the Fannie and Freddie deal. At no point in the Fannie/Freddie litigation has anyone argued that the government abused its monopoly power in dealing with an independent board. They didn’t have to. Their claim was that once the Federal Housing Finance Agency (FHFA) forced out the independent directors of Fannie and Freddie, the Director of FHFA owed explicit fiduciary duties to the shareholders under the Housing and Economic Recovery Act of 2008 (HERA), and therefore had to negotiate on their behalf with the government. The issue of “independence” casts a large cloud over the initial bailout arrangement given the serious conflict of interest that arose because FHFA was in cahoots throughout with Treasury on the deal. At that point the burden should be on FHFA and Treasury to prove the entire fairness of the deal, which no one attempted to do then or at any time thereafter.
These explicit fiduciary duties on FHFA were still in full force at the time the two sides agreed to the full dividend sweep under the Third Amendment of August 2012. At this point, there is no question of a fair value exchange, as both companies were left penniless once the agreement was put into place. For these purposes, nothing in the Fannie and Freddie litigation turns on choosing between Engelmayer and Wheeler on the monopoly issue. The case against FHFA and Treasury is far stronger.
Section 13(3) The second claim is that FRBNY acted illegally because it exceeded its statutory authority under Section 13(3). On this point there was a direct conflict between Engelmayer who held that the FRBNY had residual authority and Wheeler who held that it did not. The common premise in both opinions was that the FRA does not give the Board under Section 13(3) any explicit authority to take equity in its bailout provision. But at the same time, it is clear that the focus of the bailout is not only on the welfare of AIG, for Section 13(3) also provides that any actions under this section “shall be designed to ensure that any emergency lending program or facility is for the purpose of providing liquidity to the financial system, and not to aid a failing financial company, and that the security for emergency loans is sufficient to protect taxpayers from losses and that any such program is terminated in a timely and orderly fashion.” Judge Engelmayer concluded that AIG is not in a position to object to the program because it had as a collateral objective the financial health of AIG’s trading partners and the stabilization of the overall banking system; the statute supports that result.
In addition, the FRA contains 12 U.S.C. § 341 (Seventh) which in its “general enumeration of powers” holds that the Fed and its directors and agents, “have all powers specifically granted by the provisions of this chapter and such incidental powers as shall be necessary to carry on the business of banking within the limitations prescribed by this chapter.”
The two judges took diametrically opposed positions on the semantic meaning of the words, “incidental powers.” For Engelmayer, the test of incidental “is convenient or useful in connection with the performance of one of the bank’s established activities pursuant to its express powers.” For Wheeler it is narrower, insofar as it “would be inconsistent with other limitations in the statute. Long ago, the Supreme Court held that a federal entity’s incidental powers cannot be greater than the powers otherwise delegated to it by Congress.”
Clearly there are strong arguments both ways. The Fed has defended its position by saying "The terms of the credit were appropriately tough to protect taxpayers from the risks the rescue loan presented when it was made." One way for it to bolster that claim is to ask just how effectively the FRBNY can discharge its extensive oversight obligations of the entire financial system if Wheeler is correct in concluding that it cannot take any equity position in organizing a bailout.
Under that view, it would remain, as least as far as Section 13(3) is concerned, for the Fed to demand any rate of interest that it wanted. On Wheeler’s narrow account of incidental powers there is serious risk that interest-only deal will fail. What makes this ironic is that in private credit transactions, equity kickers are not uncommon; nor is it uncommon for creditors to remove the CEO as part of the restructuring in question. The case for extending the power looks more than “useful or convenient” in light of the dire circumstances and incredible time pressures. Indeed, it looks to be both necessary and proper, in the sense that from a systemic point of view the extended powers work to improved the overall operation of the Fed, without creating any abuse, especially if Engelmayer is right, and he is, that the comprehensive set of the Fed’s duties necessarily preempt any state law claim for breach of fiduciary duty that AIG might raise under Delaware law. There was, of course, no similar emergency with the adoption of the Third Amendment in August 2012. Yet there the deal was given a free pass.
Nonetheless, Wheeler is surely correct to note that Section 13(3) does have an explicit requirement, however unwise, that the transaction take the form of a loan. He is also correct to insist that it was part of the original plan to give the government preferred stock in the transaction, which was facilitated in part by the decision in late September 2008 to place the preferred shares in a separate trust operated by three high level officials with “close ties” to the Fed, whose sole duties under the trust would be to the United States. This trust was established only in January 2009, with the idea that preferred shares would be converted to common that could then be sold off, as appropriate to the general market. It would be one thing if some long-term loan agreement had an equity kicker attached. But it is quite another that the entire integrated transaction was intended to give the FRBNY extensive ownership over 80 percent of the equity, an outcome that was not authorized under the statute, which of course was meant to apply only in cases of emergencies. Judge Wheeler is right to call this action the nationalization of AIG.
The bottom line is that this transaction looks as though it fell outside Procrustean bed created under Section 13(3). It is also instructive to note that this portion of the opinion is of no relevance to the Fannie-Freddie dispute because the operative terms for the bailout do not preclude the issuance of preferred stock or even taking back warrants for the purchase of common stocks. At this point, the greater flexibility avoids the statutory tangle so evident in the AIG case. But at the same time it renders even less excusable the Third Amendment in August 2012, when there was no hint of the desperate circumstances of September 2008, which led the FRBNY to experiment with alternative structures. Quite simply, there is no defensible reading of the term incidental power that lets FHFA receive the power to advance Treasury’s interests in derogation of its explicit statutory duties toward the private shareholders under HERA.
The government in Perry Capital claimed: “HERA explicitly sanctions the Conservator to act as ‘the Agency determines is in the best interests of the [Enterprises] or the Agency.’” But in making that claim, the FHFA and Treasury omitted to note that those words were contained in a section of HERA, 12 U.S.C. § 4617(b)(2)(J)(ii) that referred to “The Incidental Powers” of FHFA. Judge Lamberth did not mention that provision at all, so weak is the argument that an incidental power can completely upset the explicit set of fiduciary duties which had as one of its prerequisites “the orderly resumption of private market funding or capital market access,” which the Third Amendment frustrated at every turn. There is no source of power that justifies the actions of FHFA and Treasury in the Fannie and Freddie disputes.
Remedies Last there is the question of remedies. Under the Engelmayer view, the FRBNY has breached no duty, so that the question of remedy does not arise. But Wheeler has to address that question, and his dismissal of AIG’s damage claim depended on his assessment of the basic claim. In the end, he thinks that there is no decisive answer to the government claim that that “twenty percent of something [is] better than 100 percent of nothing.” The point has this irony. The illegal actions worked to the benefit of AIG, a conclusion that no one could reach with Fannie and Freddie.
Nonetheless, Wheeler’s conclusion may be too hasty. Analytically, the only inference that can be drawn from the decision of the AIG Board to take the bailout option is that it adjudged the bankruptcy alternative as inferior. But it hardly follows that this bankruptcy option was worthless. The object of a bankruptcy proceeding is to pay creditors, while preserving all residual values to the bankrupt entity. Figuring out the residual value to the bankrupt firm is no easy task, and much depends on the extent to which a stay in bankruptcy could stabilize the situation in ways that would allow AIG to recover over time. That determination depends at least in part on the complex instruments in its portfolio, including its collateral debt obligations and the various positions that it has on its portfolio of credit default swaps. These are intensely difficult and fact-specific questions. At the very least, AIG is entitled to a hearing on the question. There is no reason whatsoever to assume as a matter of law that the common stock of AIG would have zero value.
Second, it is far from clear that the only measure of damage available in this case is what AIG could recover if sent into bankruptcy. One alternative under the monopoly exaction theory is to figure out the appropriate level of interest that should have been charged, and then to require the FRBNY to refund, with interest, that differential to AIG. In essence, the approach here is to remove from the government its asserted illicit gain from the transaction. There is, as Judge Wheeler notes, a common theme in “just compensation” cases that the proper measure of damages is the loss to the private party and not the gain to the government. But the interest overcharge looks both like a gain to the government and a loss to AIG, at which point, there seems little reason why that damage award could not be given.
It is, however, the case, that it would be difficult within the context of a takings case to order the government to make restitution of the $22.7 billion profit that it gained from the AIG deal because that measure of damages is inconsistent with the takings case. Nonetheless, eventually that measure could come back into play if AIG eventually prevails on its claim that the government has acted illegally. That conclusion, which may well require an authoritative Supreme Court decision, would then allow Starr to prevail on its breach of fiduciary duty claim before Judge Engelmayer, at which point the net gains to the government becomes an appropriate measure of damages.
The Future Speaking more generally, there are several lessons to be learned from Judge Wheeler’s exhaustive opinion. The first is the seriousness with which he engaged - the claim stands in striking contrast to Perry Capital, where Judge Lamberth eagerly embraced every procedural argument meant to insulate FHFA and Treasury from judicial scrutiny. The correct standard for dealing with those actions is fair value. But the result in this case was a complete ouster of all judicial review, a result that should never be favored in cases where the probity of government conduct is at stake. In this regard, it was correct from Judge Wheeler to note that there are key limits of the law, such as those found in Section 13(3) remain in place during emergencies. I doubt very much that Wheeler, or for that matter, Judge Engelmayer, would have issued an opinion in Perry Capital that bears any resemblance to the decision of Judge Lamberth.
The harder question is what kinds of structural reform should be put into place to prevent a repetition of the uncertain situations that arose both with AIG and Fannie and Freddie. In this regard, I think that Seth Lipsky takes a wrong turn in the Wall Street Journal when he asks whether Congress will “rein in the Fed” now that it returned $22.7 billion to the Treasury. But it also returned a similarly large amount for the original AIG shareholders. The real question then is sensible institutional reform that would prevent a repetition of the unfortunate AIG dispute over the Fed’s authority.
In this case, ironically, the right answer is to give the Federal Reserve more powers under section 13(3) rather than less. The deal as structured with AIG did make sense from an economic point of view in that it left both sides better off. In the event future bailouts are needed, the ability of the government to include equity in the deal makes perfectly good sense, even if it leads to a bypass of shareholders who are, when deals are properly structured, net beneficiaries of transactions that have to move at warp speed.
Judge Wheeler is right to be concerned with the harsh terms in these cases, but it is not easy to develop any effective statutory language that can beat the outcome that comes from the tough negotiations that led to the AIG settlement. General good faith and reasonable rate of return language is very hard to administer in these cases. And more specific guidelines could be difficult to administer under short time constraints.
In light of these recent developments, it does make good sense to think through the type of equity interest that the government should be able to take in these cases. One real concern is, of course, that the equity stakes will allow the government to nationalize a firm in ways that create all sorts of other problems: do these firms get special status from government regulation? Can other firms compete fairly with them?
One way to respond to this problem is to design a bailout program so that the government does not control the common stock of the firm. That pattern seems desirable in the ordinary case where the private board of directors remains in place, answerable to its common shareholders, at least until some default results in the conversion of the preferred to common. But, that kind of default could result in the government taking equity even if the original bailout was structured in the form of a loan.
By this standard, the warranties for voting common exercisable at a nominal price at any time are uneasy given the control rights that they carry to the firm. In these cases, perhaps the better solution is to allow the warrants to call down a new class of new voting common stock so as to avoid the transfer of control when the business still capable of self-control. Needless to say, none of these important issues need to be addressed if FHFA or some similar organization can just take over operation of the firm without any proof of insolvency at all
As a general proposition, it seems to make sense that a uniform set of rules should govern bailouts no matter which government agency gets to administer them. Accordingly, even if the Fed’s authority is expanded so that it matches that which Treasury has under FHFA, it is still imperative to take steps to prevent government abuse of the sort found in the Fannie and Freddie dispute. Displacing of independent trustees is generally a dangerous mistake, fraught with political risk. But once it happens, safeguards must be installed to prevent organizations like FHFA and Treasury to steamroll shareholder rights. So the correct result is to broaden the Fed’s powers under Section 13(3) so long as it deals with an independent board. But by the same token, the power of the Treasury and the Fed should be sharply constrained by the fair value rule whenever they engage in actions of self-dealing, as happened with Fannie and Freddie.
So here is the bottom line: on the question of liability, shareholders of Fannie and Freddie have a far stronger case than the shareholders of AIG. The great inequity in the current state of affairs is that the weaker case has gotten the more favorable treatment. It is time to set this topsy-turvy world right side up.
