Fed Court Says Nothing From Nothing Leaves Nothing In AIG Case

June 15, 2015

In the high-profile lawsuit of Starr International Company, Inc, Plaintiff, v. The United States, Defendant  (Opinion and Order, United States Court of Federal Claims, No. 11-779C, June 15, 2015), we are presented with a dispute as to whether the Federal Reserve Bank of New York legally acquired equity in AIG or whether the Fed's actions constituted an illegal taking under the Fifth Amendment. The Plaintiffs consist of:
  1. Plaintiff Starr International Company, Inc. ("Starr International") is a privately held Panama corporation with its principal place of business in Switzerland. Maurice R. "Hank" Greenberg is the Chairman of Starr International. Until 2005, Howard Smith was chief financial officer and chief administrative officer of AIG. He now serves as vice chairman of finance of C.V. Starr and as a director of Starr International. Smith, Tr. 7673-74. 
  2. The "Credit Agreement Class" is the class of persons and entities allegedly injured by the Fifth Amendment taking or illegal exaction of a 79.9 percent equity interest in AIG pursuant to the Credit Agreement. The "Credit Agreement Class" consists of "All persons or entities who held shares of AIG common stock on or before September 16, 2008 and who owned those shares as of September 22, 2008, excluding Defendant, any directors, officers, political appointees, and affiliates thereof, as well as members of the immediate families of Jill M. Considine, Chester B. Feldberg, Douglas L. Foshee, and Peter A. Langerman." Opinion and Order Regarding Class Certification, Starr Int'l Co. v. United States, 109 Fed. Cl. 628, 636-37 (2013). 
  3. The "Reverse Stock Split Class" is the class of persons and entities allegedly injured by the events and actions resulting in the reverse stock split. The Reverse Stock Split Class consists of "All persons or entities who held shares of AIG common stock on June 30, 2009 and were eligible to vote those shares at the annual shareholder meeting held on that date, excluding Defendant, any directors, officers, political appointees, and affiliates thereof, as well as members of the immediate families of Jill M. Considine, Chester B. Feldberg, Douglas L. Foshee, and Peter A. Langerman." Id. at 637. 
As further explained in the Opinion and Order:

Plaintiff Starr International Company, Inc. ("Starr") commenced this lawsuit against the United States on November 21, 2011. Starr challenges the Government's financial rescue and takeover of American International Group, Inc. ("AIG") that began 2 on September 16, 2008. Before the takeover, Starr was one of the largest shareholders of AIG common stock. Starr alleges in its own right and on behalf of other AIG shareholders that the Government's actions in acquiring control of AIG constituted a taking without just compensation and an illegal exaction, both in violation of the Fifth Amendment to the U.S. Constitution. The controlling shareholder of Starr is Maurice R. Greenberg, formerly AIG's Chief Executive Officer until 2005, and one of the key architects of AIG's international insurance business. Starr claims damages in excess of $40 billion.  

On the weekend of September 13-14, 2008, known in the financial world as "Lehman Weekend" because of the impending failure of Lehman Brothers, U.S. Government officials feared that the nation's and the world's economies were on the brink of a monumental collapse even larger than the Great Depression of the 1930s. While the Government frantically kept abreast of economic indicators on all fronts, the leaders at the Federal Reserve Board, the Federal Reserve Bank of New York, and the U.S. Treasury Department began focusing in particular on AIG's quickly deteriorating liquidity condition. AIG had grown to become a gigantic world insurance conglomerate, and its Financial Products Division was tied through transactions with most of the leading global financial institutions. The prognosis on Lehman Weekend was that AIG, without an immediate and massive cash infusion, would face bankruptcy by the following Tuesday, September 16, 2008. AIG's failure likely would have caused a rapid and catastrophic domino effect on a worldwide scale. 

On that following Tuesday, after AIG and the Government had explored other possible avenues of assistance, the Federal Reserve Board of Governors formally approved a "term sheet" that would provide an $85 billion loan facility to AIG. This sizable loan would keep AIG afloat and avoid bankruptcy, but the punitive terms of the loan were unprecedented and triggered this lawsuit. Operating as a monopolistic lender of last resort, the Board of Governors imposed a 12 percent interest rate on AIG, much higher than the 3.25 to 3.5 percent interest rates offered to other troubled financial institutions such as Citibank and Morgan Stanley. Moreover, the Board of Governors imposed a draconian requirement to take 79.9 percent equity ownership in AIG as a condition of the loan. Although it is common in corporate lending for a borrower to post its assets as collateral for a loan, here, the 79.9 percent equity taking of AIG ownership was much different. More than just collateral, the Government would retain its ownership interest in AIG even after AIG had repaid the loan

The term sheet approved by the Board of Governors contained other harsh terms. AIG's Chief Executive Officer, Robert Willumstad, would be forced to resign, and he would be replaced with a new CEO of the Government's choosing. The term sheet included other fees in addition to the 12 percent interest rate, such as a 2 percent 3 commitment fee payable at closing, an 8 percent undrawn fee payable on the unused amount of the credit facility, and a 2.5 percent periodic commitment fee payable every three months after closing. Immediately after AIG began receiving financial aid from the Government on September 16, 2008, teams of personnel from the Federal Reserve Bank of New York and its advisers from Morgan Stanley, Ernst & Young, and Davis Polk & Wardwell, descended upon AIG to oversee AIG's business operations. The Government's hand-picked CEO, Mr. Edward Liddy, assumed his position on September 18, 2008. Although the AIG Board of Directors approved the Government's harsh terms because the only other choice would have been bankruptcy, the Government usurped control of AIG without ever allowing a vote of AIG's common stock shareholders. 

Out of this nationalization of AIG, Starr has identified two classes of common stock shareholders that were affected by the Government's actions: (1) a class comprised of AIG shareholders who held common stock during September 16-22, 2008 when the Government took 79.9 percent ownership of AIG in exchange for the $85 billion loan; and (2) a reverse stock split class comprised of AIG shareholders who held common stock on June 30, 2009 when the government-controlled board engineered a twenty-forone reverse stock split to reduce the number of AIG's issued shares, but left the number of authorized shares the same. The Court formally certified these two classes of shareholders as plaintiffs on March 11, 2013. See Starr Int'l Co. v. United States, 109 Fed. Cl. 628 (2013). Under the Court's Rule 23 "opt in" procedure to join in a class action, 274,991 AIG shareholders have become class plaintiffs in this case. 

The main issues in the case are: (1) whether the Federal Reserve Bank of New York possessed the legal authority to acquire a borrower's equity when making a loan under Section 13(3) of the Federal Reserve Act, 12 U.S.C. § 343 (2006); and (2) whether there could legally be a taking without just compensation of AIG's equity under the Fifth Amendment where AIG's Board of Directors voted on September 16, 2008 to accept the Government's proposed terms. If Starr prevails on either or both of these questions of liability, the Court must also determine what damages should be awarded to the plaintiff shareholders. Other subsidiary issues exist in varying degrees of importance, but the two issues stated above are the focus of the case. 

Pages 1 - 3 of the Opinion and Order

In explaining the rationale of its findings, the Court explained [Ed: Footnotes omitted]:

The weight of the evidence demonstrates that the Government treated AIG much more harshly than other institutions in need of financial assistance. In September 2008, AIG's international insurance subsidiaries were thriving and profitable, but its Financial Products Division experienced a severe liquidity shortage due to the collapse of the housing market. Other major institutions, such as Morgan Stanley, Goldman Sachs, and Bank of America, encountered similar liquidity shortages. Thus, while the Government publicly singled out AIG as the poster child for causing the September 2008 economic crisis (Paulson, Tr. 1254-55), the evidence supports a conclusion that AIG actually was less responsible for the crisis than other major institutions. The notorious credit default swap transactions were very low risk in a thriving housing market, but they quickly became very high risk when the bottom fell out of this market. Many entities engaged in these transactions, not just AIG. The Government's justification for taking control of AIG's ownership and running its business operations appears to have been entirely misplaced. The Government did not demand shareholder equity, high interest rates, or voting control of any entity except AIG. Indeed, with the exception of AIG, the Government has never demanded equity ownership from a borrower in the 75-year history of Section 13(3) of the Federal Reserve Act. Paulson, Tr. 1235-36; Bernanke, Tr. 1989-90. 

The Government did realize a significant benefit in nationalizing AIG. Since most of the other financial institutions experiencing a liquidity crisis were counterparties to AIG transactions, the Government was able to minimize the ripple effect of an AIG failure by using AIG's assets to make sure the counterparties were paid in full on these transactions.3 What is clear from the evidence is that the Government carefully orchestrated its takeover of AIG in a way that would avoid any shareholder vote, and maximize the benefits to the Government and to the taxpaying public, eventually resulting in a profit of $22.7 billion to the U.S. Treasury. PTX 658. AIG's benefit was to avoid bankruptcy, and to "live to fight another day." PTX 195 at 8; see also testimony of AIG Board member Morris Offit, Tr. 7392 ("we were giving AIG the opportunity to, in effect, live, that the shareholder would still have a 20 percent interest rather than being wiped out by a bankruptcy."). 

The Government's unduly harsh treatment of AIG in comparison to other institutions seemingly was misguided and had no legitimate purpose, even considering concerns about "moral hazard."4 The question is not whether this treatment was inequitable or unfair, but whether the Government's actions created a legal right of recovery for AIG's shareholders. 

Having considered the entire record, the Court finds in Starr's favor on the illegal exaction claim. With the approval of the Board of Governors, the Federal Reserve Bank of New York had the authority to serve as a lender of last resort under Section 13(3) of the Federal Reserve Act in a time of "unusual and exigent circumstances," 12 U.S.C. § 343 (2006), and to establish an interest rate "fixed with a view of accommodating commerce and business," 12 U.S.C. § 357. However, Section 13(3) did not authorize the Federal Reserve Bank to acquire a borrower's equity as consideration for the loan. Although the Bank may exercise "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," 12 U.S.C. § 341, this language does not authorize the taking of equity. The Court will not read into this incidental powers clause a right that 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. See Fed. Res. Bank of Richmond v. Malloy, 264 U.S. 160, 167 (1924) ("[A]uthority to do a specific thing carries with it by implication the power to do whatever is necessary to effectuate the thing authorized - not to do another and separate thing, since that would be, not to carry the authority granted into effect, but to add an authority beyond the terms of the grant."); see also First Nat'l Bank in St. Louis v. Missouri, 263 U.S. 640, 659 (1924) ("Certainly, an incidental power can avail neither to create powers which, expressly or by reasonable implication, are withheld nor to enlarge powers given; but only to carry into effect those which are granted."); Suwannee S.S. Co. v. United States, 150 Ct. Cl. 331, 336, 279 F.2d 874, 876 (1960) ("No statute should be read as subjecting citizens to the uncontrolled caprice of officials."). 

Pages 6 - 7 of the Opinion and Order

Achilles the Heel?

The appearance of victory, however, is short-lived. In a stunning and somewhat unexpected ruling, the Court notes:

In the end, the Achilles' heel of Starr's case is that, if not for the Government's intervention, AIG would have filed for bankruptcy. In a bankruptcy proceeding, AIG's shareholders would most likely have lost 100 percent of their stock value. DX 2615 (chart showing that equity claimants typically have recovered zero in large U.S. bankruptcies). Particularly in the case of a corporate conglomerate largely composed of insurance subsidiaries, the assets of such subsidiaries would have been seized by state or national governmental authorities to preserve value for insurance policyholders. Davis Polk's lawyer, Mr. Huebner, testified that it would have been a "very hard landing" for AIG, like cascading champagne glasses where secured creditors are at the top with their glasses filled first, then spilling over to the glasses of other creditors, and finally to the
glasses of equity shareholders where there would be nothing left. Huebner, Tr. 5926, 5930-31; see also Offit, Tr. 7370 (In a bankruptcy filing, the shareholders are "last in line" and in most cases their interests are "wiped out."). 

A popular phrase coined by financial adviser John Studzinski, in counseling AIG's Board on September 21, 2008 is that "twenty percent of something [is] better than 100 percent of nothing." Studzinski, Tr. 6936-37. Others, such as Mr. Liddy and Mr. Offit, also embraced this philosophy, believing the top priority was for AIG to live to fight another day. If the Government had done nothing, the shareholders would have been left with 100 percent of nothing. In closing arguments, responding to Starr's allegation that FRBNY imposed punitive terms on AIG (which it did), Defendant's counsel Mr. Dintzer observed, "[i]f the Fed had wanted to harm AIG in some way, all it had to do was nothing." Dintzer, Closing Arg., Tr. 151. 

Pages 9 - 10 of the Opinion and Order

Applying the reasoning of A&D Auto Sales, the Court must examine what would have happened to AIG if the Government had not intervened. The inescapable conclusion is that AIG would have filed for bankruptcy, most likely during the week of September 15-19, 2008. In that event, the value of the shareholders common stock would have been zero. By loaning AIG $85 billion under the September 22, 2008 Credit Agreement, the Government significantly enhanced the value of the AIG shareholders' stock. While the taking of 79.9 percent equity ownership and the running of AIG's business were not permitted under the Federal Reserve Act, the Government did not cause any economic loss to AIG's shareholders, because as Mr. Studzinski said, "[twenty] percent of something [is] better than [100] percent of nothing." Studzinski, Tr. 6937. Under the economic loss analysis, the Credit Agreement Class is entitled to zero damages. 

Pages 66 of the Opinion and Order

Concurring Opinion by Billy Preston, J.

The Court found that the Credit Agreement Shareholder Class prevailed on liability due to the Government's illegal exaction, but would recover zero damages, and that the Reverse Stock Split Shareholder Class had not prevailed on liability or damages.

Frankly, the parties could have saved us all a lot of time if they had simply remembered the sage legal counsel of Billy Preston, who admonished that "nothing from nothing leaves nothing."