I’ve just moved down to New Orleans to join the faculty at Tulane Law School (my bio will be updated  … um, eventually), where I’ll be teaching Business Enterprises and Securities Regulation to start.  As you can imagine, Louisiana is quite a change from both North Carolina and, before that, NYC.  One thing I noticed right off the bat is that most of the banks in Louisiana are local/regional institutions – not many national banks have branches here.  Which means that, as a former plaintiffs’ attorney, for the first time in my adult memory I have a bank account with a financial institution I haven’t sued.

(Sidenote: That was actually kind of an issue when I worked for the law firm then-known as Milberg Weiss.  I was told we had trouble getting firmwide health insurance because we’d sued all the carriers and they didn’t want to do business with us.)

Anyway, as I procrastinate from unpacking….

*actual representation of my apartment

….the big news that has my attention is the AIG verdict.  There have already been conflicting views on what it portends for future bailouts, but what fascinates me is how much of the opinion is devoted to the judge’s moral condemnation of the Fed’s actions, and his moral absolution of AIG, even though the relative good or evil of either player was really not relevant to his ultimate holding.

[More under the jump]

In September 2008, AIG was teetering on the verge of bankruptcy, due to its heavy exposure to mortgage-backed securities.  AIG’s extensive connections with the broader financial system meant that its collapse would be devastating to the economy.  So, the Fed stepped in to bail out the company, even though AIG was not a financial institution under the Fed’s supervision.  Under the terms of the bailout, the Fed subjected AIG to fairly steep interest rates, secured by various assets as collateral, and also demanded a 79.9% equity stake, in the form of preferred shares with voting rights.  The Fed then used its voting power to oust AIG’s chief executive and basically take over the company.

Judge Wheeler found that the Fed had exceeded its statutorily-authorized powers by demanding an equity stake and assuming voting control, thus constituting an “illegal exaction.”  According to Wheeler, Section 13(3) of the Federal Reserve Act (as it existed prior to Dodd Frank) granted the Fed the power to make emergency loans secured by collateral, but did not authorize the Fed to take an equity stake as a form of payment/compensation for the loan.  Collateral, unlike compensation, is released when the loan is repaid; the equity stake obtained by the Fed in the AIG bailout was taken in addition to collateral, and was not released when the loan was repaid; therefore, it was unauthorized by Section 13(3). 

So that’s a very specific, almost arcane holding, that depends on the precise wording of the Federal Reserve Act and the specific terms of the Fed’s September 2008 AIG bailout.  And because AIG would have gone bankrupt absent the Fed’s intervention, Judge Wheeler concluded that the shareholders suffered no compensable damages.

Which is why the opinion is so intriguing.  Because the rest of it – all 75 pages – is devoted to what even the court admits is dicta, excoriating the Government for its actions, and opining that AIG should not shoulder the blame for the crisis, at least as compared to other, more culpable financial institutions.

For example, the court characterized the terms of the Fed’s loan – not just the equity stake, but also the high interest rate – as “unduly harsh” with “exorbitant” rates.  The court pointed out that the Fed did not charge similarly high interest rates to any other institution, and was only able to do so for AIG because of the Fed’s status as a “monopolistic lender of last resort.” The court even went so far as to conclude that the government’s treatment of AIG as compared to other borrowers had “no legitimate purpose,” and suggested the Government was at fault for imposing terms that required AIG to sell “valuable insurance assets worth billions of dollars” in order to repay the loan.  The court pointed out that other institutions received loans at much lower rates, without equity stakes, despite the fact that these institutions were – in the court’s view – more culpable in the crisis, as several had been defendants in government enforcement actions for various misrepresentations regarding mortgage-backed securities.  AIG, according to Judge Wheeler, was only at fault for a “failure of risk management,” and the court apparently believed its bets on the housing market to be reasonable in light of the environment. 

The court also faulted the Government for “usurp[ing] control of AIG without ever allowing a vote of AIG’s common stockholders” and for imposing nonnegotiable loan terms, even though, as the court would later conclude, the consent – or not – of AIG’s shareholders was irrelevant; the Fed had no power to demand equity or assume control of AIG, regardless of shareholder consent. 

Strikingly, the court even criticized Treasury for imposing an unusually high interest rate on AIG when it used TARP funds – even though Treasury’s use of TARP funds was explicitly authorized by Congress and not the subject of AIG’s lawsuit.

So what was the purpose of all of this?  Given that Judge Wheeler admitted – in several places – that these considerations were not relevant to his ultimate determination that Section 13(3) did not authorize the Fed to take equity for a loan, a real question is raised as to why he bothered with the ad hominem condemnation of the Fed’s other actions.

I believe the answer lies in the court’s discussion of the limits of the Fed’s powers.  In the context of explaining why the Fed could not demand equity in return for a loan – even if that equity had been voluntarily offered – the court invoked “unconstitutional conditions” cases, and, in particular, the Supreme Court’s recent decision in Koontz v. St. Johns River Water Mgmt. Dist., 133 S. Ct. 2586 (2013).  In Koontz, the Supreme Court married its unconstitutional conditions caselaw with its regulatory takings caselaw, and explained that the government may not condition the grant of a discretionary benefit on the surrender of a constitutional right, such as a property right.  To do so would amount to a taking in violation of the Fifth Amendment.   However, the Court also recognized that the Government may reasonably require some limited conditions in exchange for a benefit, where granting the benefit imposes costs on the general public. Thus, the distinction between a proper condition, and an improper one, is whether the condition bears a “rough proportionality” to, and “nexus” with, the public costs imposed by the benefit.   

The rough proportionality/nexus test should not have had any relevance to the AIG matter, because Judge Wheeler had an alternative test at his disposal – the limits of the Federal Reserve Act itself, which he interpreted to impose a statutory bar on the Fed’s claiming of equity.   I.e., he could simply have said that the equity stake was an unconstitutional condition because it was not authorized by the Federal Reserve Act, full stop.  Nonetheless, I believe that because Judge Wheeler viewed the case through an unconstitutional conditions lens, he also sought to evoke the rough proportionality analysis articulated in regulatory takings caselaw.  Thus, the purpose of Wheeler’s otherwise superfluous analysis becomes clear:  he sought to establish that the demands of the Government were not roughly proportional to the costs of the loan to the public.   And I’m guessing it was easier, from Wheeler’s perspective, to conduct the proportionality analysis by comparing the loan terms for AIG to the loan terms for other institutions, rather than by substantively attempting to second-guess all of the financial metrics involved in the AIG bailout.  In other words, Wheeler’s back-of-the-envelope comparison of interest rates offered to different institutions made for an easy shortcut in the proportionality analysis.

Substantively, however, Judge Wheeler’s conclusions were deeply flawed.  For starters, the only reason the Fed had a “monopolistic” position as a lender was because private entities refused to lend to AIG on any terms at all, despite the Fed’s best efforts.  In fact, according to SIGTARP, the “unduly harsh” terms of the Fed’s bailout – including the equity stake – were originally proposed by a private consortium of lenders, but they ultimately backed out because even those terms were not sufficient to justify the costs.  In other words, the “harsh” terms proposed by the Government were, if anything, less than the benefit conferred, at least according to market participants.

Moreover, Wheeler fails to note that even the Fed’s strong-arming of AIG was not unusual.  For example, Bear Stearns ultimately was “saved” through an acquisition by JP Morgan, which, with Government backing, also overrode shareholder objections and was seriously questionable from a corporate governance perspective.  See Marcel Kahan & Edward B. Rock, How to Prevent Hard Cases from Making Bad Law: Bear Stearns, Delaware and the Strategic Use of Comity.  The entire TARP program depended on forced Government purchases of equity stakes, and often (including in the case of AIG) the eventual sale of equity on the open market contributed to repayment.  The Government’s ultimate strategy, in other words, was to use equity investment as a bridge until the financial institutions could be recapitalized via market mechanisms.  Treasury did not assume voting control of the other institutions listed in Wheeler’s opinion, but then, it didn’t have to: they were already subject to Fed supervision, or agreed to more onerous regulation (Goldman, Morgan Stanley) as a condition of a bailout.  Indeed, Treasury and the Fed pretty much forced Bank of America to acquire Merrill Lynch, without the niceties of assuming voting control, simply by virtue of their regulatory role, see William D. Cohan, The Final Days of Merrill Lynch, and used the grant or denial of TARP funds to force other bank mergers.  Consistently, when private sector investment could be found for companies in particularly dire straits, the Government preferred it – hence Mitsubishi and Morgan Stanley, Buffett and Goldman Sachs, and JP Morgan and Bear Stearns.  But there was no private sector option for AIG on the table, so the Government stepped in.

This is not to argue for or against government tactics, or even to dispute Wheeler’s conclusion about the legal limits of the Federal Reserve Act, but simply to point out that when viewed holistically, it is not obvious that the Fed’s treatment of AIG was categorically different from the Government’s treatment of other institutions.

Wheeler’s analysis also falters to the extent he tries to paint other institutions as somehow more “at fault” than AIG.  In doing so, he chooses to rely exclusively on later-filed government enforcement actions against these institutions.  But it is hardly surprising that no similar action was filed against AIG; AIG was at one point 92% owned by the federal government, so there was virtually nothing else for the Government to claim.  However, the private lawsuit against AIG settled for $960 million.  The NYT reported that an internal auditor who raised concerns about AIG’s accounting for its mortgage-related exposure was intentionally sidelined, and the concerns of PricewaterhouseCoopers were ignored.  All of this occurred, incidentally, in the wake of AIG’s multiple earlier settlements for fraud with public and private authorities involving misconduct throughout the decade.   So Wheeler’s forgiving characterization of AIG’s management rests on somewhat shaky ground.

Wheeler’s analysis is stronger, however, if one employs the framework described in Einer Elhauge’s recent article, Contrived Threats vs. Uncontrived Warnings: A General Solution to the Puzzles of Contractual Duress, Unconstitutional Conditions, and Blackmail.   In Elhauge’s view, the imposition of a condition becomes impermissibly coercive – whether for purposes of contract law, criminal law, or unconstitutional conditions – when the threatened action would only be taken because of the possibility of the threat.  That is, in Elhauge’s words, “When a threat is contrived, the government benefit would have been provided in the but-for world without that condition, and thus the threat to withhold the benefit penalizes the exercise of a constitutional right.”

In the context of AIG, the question becomes whether the Fed would still  have let AIG fail even if it did not have the opportunity to threaten the onerous loan terms.  That is, if the Fed had not had the possibility of an equity stake as an option at the outset – if the Fed believed, from the start, that it simply had no power to make the demand – would it really have refused the loan, or would it have nonetheless offered it?  Elhauge’s analysis posits that the threat to deny the loan would be unduly coercive only if the Fed – knowing it was legally barred from demanding these terms in the first place – would have granted the loan. 

This may very well have been how Judge Wheeler viewed the case.  He emphasized that the Fed could not have let AIG fail, due to the ripple effects on the broader financial system.  He explained that the Fed’s function, generally, is to make loans under precisely these circumstances.  He noted that the Fed quickly modified the loan terms so as to reduce the interest rate, once it became clear how onerous the burden was.  In other words, in Wheeler’s view, the AIG may have had no choice – but neither did the Fed, not if it wanted there to still be an economy to manage in the morning.  Thus, Wheeler may have believed the Fed’s threat to deny the bailout was only a product of its belief that it could get away with demanding the onerous terms in the first place.  Under Elhauge’s analysis, these sorts of conditions would render the loan terms unduly coercive within the unconstitutional conditions framework.

But if that was Wheeler’s view, was he correct?  It’s impossible to say, of course, but another view would simply be that AIG was far too deep in the hole for the Fed to trust its existing management with $85 billion and counting without control.  I.e., it may have viewed AIG as a lost cause but for the possibility that it could assume control of the company, and have been unwilling to lend absent that condition. 

If this is the right interpretation of Wheeler’s approach, it is rather ironic – because it means that the more dire the situation, the more limited the government’s power to address it.  And all of this may be an angels-on-pinheads inquiry – I tend to agree with those who argue that in times of crisis, the government is likely to act first and ask questions later, regardless of legal precedent – but it won’t always be the case that damages are absent.  It presents an interesting conundrum, although I suppose we can hope that crises will be so few and far between that we will never get real clarity on the issue.